Vantage Point Advisors’ Energy Blog October 2020

De Minimis Control Premium and Formulaic Dividend Payouts

On Monday, September 28, 2020,  Devon Energy Corp. announced it will buy Permian basin peer WPX Energy Inc. for $2.56 billion.[1]  The deal comes as U.S. shale companies post losses due to weak crude prices and struggle to raise new capital to restructure debt. 

The deal terms reflect the current reality for shale companies – having control has little value and investors are focused on yields as compared to growth.

De Minimus Control Premium

Monday’s deal valued WPX at just a 2.7% control premium versus the stock’s closing price the prior day.  Normally such a low control premium might not be acceptable to the selling Board of Directors, but distressed industry economics are impacting the ability for acquirers to earn additional returns to offset a control premium paid.

In better economic environments, control premia are paid and justified by the acquirer intent to create operating or financial synergies.  Operating synergies are those synergies that allow firms to increase their operating income and/or their growth.  For E&P companies, the following are examples of operating synergies:[2]

  1. Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. Devon expects the enhanced operating scale to accelerate its transformation to a cash-return business model.
  2. Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income. Devon said the acquisition will improve operating cash flow by 5% to10%, double free cash flow generation, lower maintenance capital breakeven to a level consistent with $33/bbl WTI oil prices and be accretive to credit metrics.[3]

With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital. Given the distressed condition of shale company balance sheets, the key financial synergy to be realized is additional time and flexibility to repay or restructure existing debt.

With the market’s current low demand and corresponding low commodity prices, it is more difficult for investors to earn additional returns required to offset control premiums paid.

Formulaic Dividend Payouts

Future dividends will be paid using a “fixed plus variable” strategy, issuing a set $0.11 per share per quarter plus up to 50% of the remaining free cash flow.  The transaction was promoted in a press release issued by Devon as creating a “Leading Energy Company Focused on Generating Free Cash Flow and Return of Capital to Shareholders.”  Such a payout plan is seen as a new model for an industry that has fallen out of favor with investors after years of poor returns.

Under a higher-price commodity environment, investors would be expected to reward shale companies that grow by reinvesting free cash flow into more drilling .  Paying out 50% of the free cash flow to investors highlights the market demands for higher yields on equity investments.

WTI Strip Prices Decline

Over the past month, futures prices for the WTI contract fell about $3.00 per barrel.

 

The price distribution below shows the crude oil spot price on September 30, 2020, as well as the predicted crude oil prices based on option and futures markets.  The blue lines are within one standard deviation (σ) of the mean, and the red lines are within two standard deviations.

Oil Price Outlook

Based on these current prices, the markets indicate that there is a 68% chance that oil prices will range from $32.00 and $49.50 per barrel in mid-January 2021.  Likewise, there is about a 95% chance that prices will be between $19.00 and $63.50.  By mid-March 2021, the one standard deviation (1σ) price range is $31.50 to $53.50 per barrel, and the two standard deviation (2σ) range is $18.00 to $70.50 per barrel.

Key Takeaway

Remember, that option prices and models reflect expected probabilities, not certain outcomes, but that doesn’t make it any less useful.  If someone asks you longingly if oil will be at $75 per barrel again soon, you now can respond with “the markets indicate there is a 97.5% probability that oil prices aren’t expected to get above $71 by next March, so I wouldn’t count on it.”

For more information, contact:

Gregory E. Scheig, CPA/ABV, CFA, CMA
Vantage Point Advisors
Managing Director / Practice Leader
Certified Mineral Appraiser
180 State St., Suite 225, Southlake, TX 76092

Phone: 214.254.4801

Email: gscheig@vpadvisors.com

[1] https://www.reuters.com/article/wpx-energy-ma-devon-energy/update-1-shale-producer-devon-energy-to-buy-peer-wpx-energy-for-2-56-bln-idUSL4N2GP2HB

[2] Investment Valuation: Second Edition, Aswath Damadoran, Online Version, Page 8

[3] Enverus Drillinginfo Deal Insight, September 29, 2020