"Exxon-Mobil and XTO Energy. Exxon is buying XTO for $41 billion. A natural gas play and all stock deal, Exxon-Mobil the biggest percentage loser in the Dow, down 4%." — Fox Business Network 12/14/2009

On Monday morning, Exxon Mobil (XOM) announced their largest acquisition since Mobil in 1999.  Exxon will pay around $51.69 (.71 shares of XOM) per share of XTO Energy (XTO) as well as assume about $10 billion in debt, in sum the deal will cost about $41 billion.  Although the offered price represents a 25% premium over XTO’s Friday closing price, Exxon is acquiring America’s largest unconventional natural gas producer. (following ratings chart of XTO)

This increased emphasis on natural gas will put further distance between Exxon and other major oil firms in terms of natural gas reserves.  Exxon hopes that natural gas will find favor in Washington and gain wider use as a domestic energy source over coal.  Proven reserves of natural gas in the United States have ballooned in recent years thanks to "shale gas" which is attainable through modern drilling techniques and makes natural gas an extremely abundant domestic resource.  Clearly, Exxon, already a heavy hitter on K-Street, will commit substantial resources towards these goals.

Exxon has a reputation for being one of the most conservative of the oil giants.  Led by CEO Rex Tillerson, Exxon has made a statement with today’s deal that they believe there is a long term trend that will benefit natural gas producers.  They obviously see a shift in the way natural gas is utilized, as prices have been suppressed for more than a year and a record 3.7 trillion cubic feet in storage proves supply is swamping demand.  However, Tillerson has said that he believes demand for natural gas will outpace both oil and coal in the coming years, based on his belief that natural gas will find more frequent use as a source of electricity generation in the future.  Gas burns cleaner than coal, and if cap and trade legislation passes through Washington a shift may be inevitable. (following ratings chart of XOM)

Exxon is looking towards natural gas for growth, and with the natural gas prices still low they hope to have bought valuable resources for a good price.  According to Bloomberg, this deal will cost Exxon $13.42 per barrel of oil equivalent reserves, which is expensive when compared to recent deals priced at around $10 per barrel of oil equivalent reserves.  But XTO’s assets in the Barnett Shale and other prodigious fields may justify the premium.  As for our methodology, we had an Undervalued stance on XTO as of Friday’s closing price $41.52, and given the current fundamentals the offered price does not seem unreasonable.  Given current revenue and earnings strength, we think any price south of $60 would have been in line with fundamentals.

This is no doubt a bold strategic move for Exxon and it will be very interesting to see if other domestic natural gas producers like Devon (DVN) or Chesapeake (CHK) are next to be targeted in a wave of consolidation.  If Exxon is right and natural gas sees wider adoption for electricity production, this will undoubtedly be a boon to shareholders.  From our view, the price paid is well worth the potential that this deal holds for the long term energy market.

When Peter Lynch coined the now famous term “invest in what you know”, he was thinking in terms of stock selection.  However, this term can be broadly applied to what Devon Energy (DVN) announced today.  Devon has decided to realign their capital investment focus to what they are best at; producing oil and natural gas fields onshore in North America.  The large energy company announced today that they will sell their international and Gulf of Mexico assets in hopes of raising between $4.5 and $7.5 billion after tax in the process.  The capital will then be put to work growing their domestic and Canadian onshore businesses and also to reduce debt.  Devon believes that streamlining their focus should provide a boost to earnings, cash flow, production and reserves as early as 2011.  Incidentally, that is the same timeframe in which Devon hopes to have the sales finalized.

The move is being met with optimism from the market and DVN is trading higher by about 5% on Monday afternoon.  While the assets on the auction block account for 7% of the proven reserves (equivalent of 2.8 million barrels of oil) and 11% of production, the projects are comparatively quite expensive and require 29% of Devon’s capital expenditures budget.  Clearly, redirecting this capital could yield tremendous benefits.  There is no doubt that Devon is getting much more bang for their buck right now producing oil and natural gas onshore in North America.

Of course, speculation has begun as to who would be interested in purchasing the assets.  The New York Times’ Dealbook speculates that this deal might attract some interest from the always energy hungry Chinese.

“One company that might be interested in taking the risk would be China National Offshore Oil Corporation, known as Cnooc. It recently agreed to buy a stake in some of Statoil’s Gulf assets, the first time that a Chinese company would take an ownership interest in energy assets in the United States.

Only four years ago, Cnooc’s $18.5 billion bid for American oil company Unocal collapsed under pressure from Congress amid concerns about American oil assets falling under the control of the Chinese government. Since then, the Chinese have been wary of bidding on American energy assets and have concentrated their investments on undeveloped fields at home and in Africa, the Middle East and South America.

The Statoil deal seems to have changed all that. But Devon’s assets could be too much, too soon for Cnooc. It may simply continue to buy small stakes in fields across the region before it is ready to make a major purchase.” — NYT’s Dealbook 11/16/2009

Although this deal may attract the Chinese firm like CNOOC (CEO), it will not be because of the dollar’s weakness in relation to the Chinese Yuan.  The dollar has lost a lot of ground versus the Euro, but at least in the last year China’s currency has devalued as well and the relationship between the two is about the same as it was at the beginning of 2009.

Back to Devon, we think that this deal will likely improve our view of DVN stock, which we actually downgraded to Overvalued as of this week’s report.  The company has been hit very hard by still weak natural gas prices and earnings and revenue have fallen off considerably.  At the same time, the stock has appreciated by nearly 80% since March.  By our methodology, we need to see fundamentals improve in order to justify a price increase of this magnitude, and as of yet it just has not been there.  However, we have no complaints with this deal as it really should help Devon allocate resources more efficiently.

On a day where markets were down from the start and showed nary a glimmer of hope even with the signing of the economic stimulus package, the hits continued with Chesapeake Energy (CHK) swinging to a loss as they reported after the close.  The company reported net loss of $886 million, mostly because of $1.8 billion in one time charges related to writing down assets that are less valuable now that the price of natural gas has fallen so much recently.  In terms of real operations (excluding one-time charges) the results fell just short of consensus estimates as the company generated net income of 73 cents per share versus estimates of 74 cents.  Furthermore, the company increased revenue in the quarter by an impressive 43% on a year over year basis.

Chesapeake was off nearly 8% on the day, and has fallen further since the earnings were released at the close.  However, when you compare the $1.8 billion write down to the $7.1 billion write down reported recently by Chesapeake’s competitor Devon Energy (DVN), Chesapeake’s assets look comparably far more attractive.  Chesapeake is considering selling stakes in some of its highest producing fields including the Barnett Shale, currently the largest and most prolific unconventional natural gas resource field in the U.S., according to the release.  This property’s available average daily production increased 55% from a year ago and is home to 25 rigs at present.  Over the past several months, Chesapeake has sold stakes in all three other major shale operations, with Barnett being the only remaining holdout.  CEO Aubrey McClendon commented,

“Looking ahead, we believe that investors will increasingly recognize Chesapeake’s competitive advantages, including our industry-leading asset position in the Big 4 shale plays, our strong hedge position and our $4 billion in drilling carries, which will enable Chesapeake to deliver operational and financial results that we believe will be among the best in the industry for years to come.”

The fact that Chesapeake is willing to part with a portion of its leases in the valuable Barnett Shale speaks to just how tough things have gotten for natural gas producers as the price per unit has dropped from about $14 to just over $4.  One of Chesapeake’s biggest problems right now is debt, as the company has a not insignificant amount of long term debt of more than $11 billion.  We have little doubt Chesapeake will generate enough cash over the long term that the long term debt is not so much of a problem.  However, more pressing are the company’s current liabilities of $2.7 billion which will come due in less than a year.  With so much of Chesapeake’s assets tied up in leased property, as much as they may not like it, selling some of these assets may be the best way to cover the $1.3 billion gap between current assets and current liabilities.

So, although the price of CHK does look appealing compared to historical norms as sales growth has been quite strong and earnings are decent (excluding write downs), we are maintaining our Fairly Valued rating.  At this point, the company has too much debt to ignore even if its shale leases are increasing production at an attractive rate.  Of course, were the price of natural gas to recover in short order than Chesapeake would likely  be able to keep its interests in all of its leased properties.  All in all the company is managing fairly well to stay profitable considering the drop in gas prices, but at this time there is still a lot of risk until the company can get its debt liabilities under control.

OPEC oil ministers decided for the third meeting in a row to lower the daily oil production quota coming from the 12 member cartel. The 2.2 million barrel per day cut is the largest pledged decline in OPEC history in the face of crude oil prices that have fallen more than 70% from record highs this summer. This brings the cartel’s combined production cuts to about 4.2 million bpd. The obvious goal of member countries is to shrink global supply and thus stem the plunge in oil prices. OPEC, which produces about one-third of the world’s oil supplies, normally moves the market with such announcements, but oil is down about five percent today.

OPEC member countries are losing money hand-over-fist as prices continue their free-fall. Furthermore, there is a substantial supply glut in the system, so much so that crude oil is being stored in tankers at sea because there is no place to deliver the product. Saudi Arabia, the largest oil producer in OPEC, is leading the way by lowering its oil production from 9.7 mbpd to 8.2 mbpd. However, Saudi Arabia does not have the massive financial and political pressures that Iran, Venezuela and non-OPEC member Russia have to contend with. All three of these nations need the barrel price of oil to be well north of $50 in order to sustain state budgets planned when oil prices were climbing.  After oil’s dramatic collapse, these countries are operating in the red and will be greatly tempted to ignore OPEC-established quotas in order to generate desperately-needed cash. It is possible that a sustained drop in oil prices could threaten the stability of the Venezuelan, Iranian, and Russian governments.

According to CNBC, the previous two OPEC production cuts have only met with an estimated 50% compliance. Expect that ratio to continue to fall if oil prices continue to slide and budget shortfalls intensify. So, in essence, although OPEC member countries are all incentivized to pledge production cuts in the hopes of generating a turn-around in prices, each member country has its own circumstances and many of the poorer nations are simply not going to sit on their hands waiting for oil to rebound. OPEC’s chronic failure to enforce its production quotas makes them of dubious value.

One part of the supply chain that we can track fairly accurately are domestic oil companies, many of which are reigning in capital expenditures greatly. The rapid decline in oil prices has made many U.S. oil and natural gas producers scale back on projects, especially the largest and most expensive ventures. Combine collapsing oil prices with difficult credit markets, and there is very little incentive for producers to bring new reserves to market at the present time. Nearly every company has found that certain projects that looked profitable six months ago simply do not make financial sense with oil now between $40-$50 per barrel. The latest round of cut-backs comes from SandRidge Energy (SD) and Equitable Resources (EQT), which are cutting CapEx spending by 50% and 40% respectively. Hess Corp. (HES) has indicated that CapEx will fall by nearly 40% in the coming year. In addition, Devon Energy (DVN) is holding off on setting a budget for 2009 until it officially closes the books on 2008, not a bad move considering recent volatility. 

While it is unclear just how much the supply will contract, it is clear that OPEC would like it to contract as quickly as possible. Global demand has been extremely weak in recent months as a world-wide recession has taken hold. Modern economies run on oil and when economic activity begins to grow again, watch out for a spike in oil prices, as supply will be likely be tight. This will only exacerbate the roller coaster ride in oil prices that we have seen over the past few years.

One word of note, readers of our blog will recall a post from October 16^th (Oil Stocks Are Cheap, But Will It Last?) describing the status of energy stocks as crude prices continued to drop. At the time oil had dropped exactly 50% from the high of $147 just a few months before, and I attempted to speculate as to where the floor in oil prices would be. I made the case that supply would be constrained by a further drop in prices from $74 as expensive production projects would be placed on hold, and that a drop substantially below $60 per barrel is not sustainable.

Well, let me say, that while a price this low may not be sustainable, I did not anticipate the steepness of the drop we have seen. However, my over-arching theory (as an equity analyst, not an energy analyst) was that oil stocks were due to rebound. And rebound they have, of the four stocks highlighted in that piece, only Transocean (RIG) is lower, dropping losing 18% since the post. RIG supplies deep-water drilling equipment and is especially susceptible to the declining price of crude. The big winner has been oil and natural gas producer Petrohawk (HK) which in two months time has gained 72%. Likewise the two major producers Exxon (XOM) and Chevron (CVX) have both gained more than 30% in that time.

So, the fundamental question is when will economic growth recover? According to the NBER, the current recession began a year ago, and it is already the 4^th longest recession in more than 80 years. We have included a helpful chart from the Wall Street Journal for reference.  We firmly believe that this recession is not going to be another Great Depression, as some pundits and politicians would have you believe. The Fed and other central banks around the world have pledge to take all available actions to preclude this type of economic catastrophe.  Yesterday, the Federal Reserve cuts its Fed Funds Target Rate to an historic low, .25%.   While it is anyone’s guess as to how deep this recession will ultimately be, it is likely that the worst is behind us and economic activity could very well begin to grow within the next few quarters.