In moving to buy Anadarko Petroleum (APC) for $33 billion, Chevron (CVX) made a smart decision—and yet got punished by Wall Street.
Its shares closed down nearly 5% on Friday. And unfortunately for Chevron, there's a good chance that investors will continue to shun the stock, at least in the near term.
The deal, however, is sparking new enthusiasm for other companies whose stocks have been dormant for months, even as the price of crude oil has risen.
Drillers sitting on oil-rich land and offshore holdings are now poised to outperform. That includes large U.S. names like Diamondback Energy (FANG), Concho Resources (CXO), and Noble Energy (NBL). Of those, we are most bullish about Diamondback, whose valuable land in the fast-growing Permian Basin and smart capital management should appeal to investors—and possibly to an acquirer.
Chevron is buying Anadarko, a global oil and gas producer, for $65 a share, a 39% premium to its Thursday closing price. The deal values Anadarko's equity at $33 billion, or $50 billion on an enterprise-value basis. Chevron will pay 75% of the cost in stock and 25% in cash.
The logic of the deal makes sense. That 39% premium might look relatively steep, but Anadarko was trading above $70 as recently as October. In buying Anadarko, Chevron will increase its daily production to 3.6 million barrels, just under Exxon Mobil 's (XOM) 3.8 million barrels. Anadarko's oil assets are in regions where Chevron already has a foothold, and will allow the company to gain scale in crucial areas.
The deal makes Chevron the second-largest player after Concho in the Permian Basin, the country's most productive oil field, according to IHS Markit. Chevron will now control a land mass 75 miles wide in the heart of the basin.
"You think about driving 70 miles an hour for an hour, and you're in our acreage the entire time," Chevron CEO Michael Wirth tells Barron's. "That acreage is sitting on top of layer after layer after layer of this shale. And we're currently only recovering 10% of the hydrocarbons in that."
Anadarko also holds valuable assets in the Gulf of Mexico. A promising natural-gas development that Anadarko controls in Mozambique will help Chevron expand more into liquefied natural gas and at a much lower cost of capital.
But energy investors have little patience for acquisitions right now. Big oil stocks are considered steady income investments, not growth engines, and are valued for their cash flow.
Chevron has a 4% dividend yield, and it has won plaudits for reining in spending, and not splashing it out on megadeals. That discipline has helped its stock rise 16% through Thursday. The last thing that Wall Street wants is for the company to spend money that could be going back to shareholders. Yet Chevron will fund the acquisition in part by issuing 200 million shares, and will assume $15 billion in net debt.
So why do that when investors clearly want the opposite?
CEO Wirth argues that the deal will add to the company's annual cash flow, allowing it to buy back even more stock in the future—$5 billion a year instead of $4 billion.
"We're issuing stock that we bought back over the last decade at about $100 a share, and we're issuing it as currency at a much higher price. We're taking advantage of that," he says.
"We will have the capacity for further shareholder distributions as a result of this transaction, and we'll have the capacity to sustain those through the ups and downs of the commodity price cycle."
Even with the promised return of capital, investors may not reward Chevron in the near term. If anything, people who like the Chevron deal might be better served buying Anadarko, which rose 32% on the deal announcement but, at $61.78, was still trading below the deal price.
Anadarko holders will own about a 9% stake in Chevron if the deal closes. And there's still a chance that another buyer could swoop in to offer a higher bid.
The potential for further deal-making presents an opportunity for investors.
Other oil majors could feel pressure to make acquisitions to keep up with Chevron. And even if other deals don't come through, market chatter about acquisitions tends to keep stocks in the sector aloft for months, says David Heikkinen, CEO of Heikkinen Energy Advisors.
Other stocks considered possible acquisition targets rose on Friday, including Concho, Diamondback, and Noble. But even after gains of more than 6% each, they still look cheap.
That's because investors have shunned the sector over the past three months despite rising oil prices. The SPDR S&P Oil & Gas Exploration & Production exchange-traded fund (XOP) has risen 6.8% even as the West Texas benchmark has gained 24%, to $63.89 a barrel.
Oil analysts say that investors don't trust drillers to be smart about how they use their cash, and want to see them produce more cash flow. Heikkinen agrees that investors are right to be wary of this cyclical industry.
Still, the three U.S. companies that we have identified are in good positions right now. Concho is the largest producer in the Permian and has "dramatically underperformed" the market after buying a company called RSP Permian last year. Noble is attractive because its Leviathan offshore gas-field project will help the company become free-cash-flow positive by 2020.
And Diamondback has been among the most prudent companies at balancing its spending while still amassing important oil and gas stakes. It has the fifth-largest production in the Permian, an asset that other companies clearly will pay up for.
"Diamondback has lower risk [of overspending] in the first half, checks the box as a takeout candidate, owns minerals and midstream assets, and is a meaningful size, as well—a $20 billion company in terms of enterprise value is meaningful to a major," Heikkinen says.
Diamondback is also cheaper. It has an enterprise value of 6.9 times estimated 2019 earnings before interest, taxes, depreciation, and amortization, compared with 7.2 times for Noble and 8.2 times for Concho. Chevron is valued at 6.2 times.
The Anadarko deal may take a while to help Chevron stock, given investors' feelings about spending. But it has given a jolt to oil drillers, and that could last.
"I think they'll close some of the valuation gap [of the drillers]," Heikkinen says. "There's going to be a thesis for at least a few months that [other big oil companies] will have a fear of missing out."
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