It is no secret that the shale oil and gas industry is in the midst of a phase of rapid consolidation, a move that was kicked off by Occidental Oil Co. with its acquisition of big independent producer Anadarko Petroleum in April 2019. Over the past two years, companies with familiar names like Parsley Energy, Concho Resources, Cimarex, Noble Energy and Equinor have disappeared from view, having been gobbled up by buyers like ConocoPhillips, Pioneer Natural Resources, Chevron and Oxy.
If anything, the pace of this ongoing industry consolidation has heated up during 2021. In its 2nd quarter M&A review, big energy data and analytical firm Enverus noted that deals with a total value of more than $35 billion took place from April through June, with over $85 billion in deal value happening in the past 12 months.
“Three of the last four quarters have been extremely active going back to 3Q 2020,” Andrew Dittmar, senior M&A analyst at Enverus, told me in an interview. “1Q 2021 was kind of quiet, but overall, we’ve had a little over $85 billion in U.S. upstream M&A over the last 12 months. So we’ve been on a busy run of consolidation since the market began to re-emerge from COVID.”
One of the most interesting aspects of the industry’s consolidation during 2021 is that the deals have become more geographically diverse. After a couple of years of Permian Basin-centric activity during 2019 and 2020, the Enverus report details seven $1 billion-plus deals during the second quarter, just one of which — Pioneer Natural Resources’ acquisition of Doublepoint Energy — was focused exclusively on the Permian.
Dittmar also said that the business drivers behind many of the deals have shifted. Beginning with Oxy’s blockbuster acquisition of Anadarko in 2019, the sector had seen a raft of big M&A deals focused on operational synergies involving companies with large swaths of contiguous acreage holdings with one another. “These (latest) deals were really about increasing scale and capturing those G&A synergies that are going to let you drive down costs and operate more efficiently and hit those cash flow returns that shareholders are looking for,” he told me.
Dittmar has also seen a shift in the kinds of companies being acquired by larger, public companies. Rather than targeting fellow public companies, these corporations have now “turned to acquiring private and private equity-sponsored E&Ps headlined by Pioneer Natural Resources’ $6.4 billion purchase of Midland pure-play DoublePoint Energy and including Southwestern Energy’s entrance into the Haynesville via its $3 billion acquisition of Indigo Natural Resources and EQT’s buy of Marcellus-producer Alta Resources for $2.9 billion.
“The uptick in acquisition activity targeting private equity-backed E&Ps is likely a welcome relief for sponsors that were challenged to find exit opportunities over the last few years,” Dittmar said. “The deals targeting private E&Ps are less about cost-cutting synergies and more about adding inventory. That can be in a buyer’s home basin, like Pioneer/DoublePoint, or entering a new area as Southwestern did by acquiring Indigo in the Haynesville Shale.”
Regardless of the specific drivers behind each individual deal, one preferred aspect of shale oil and gas development has become crystal clear: Bigger is better. The bigger a company becomes, the greater the economies of scale it will be able to deploy in its daily business activities. This dynamic enables companies to achieve major reductions in cost, streamline processes and reduce overall headcounts and other general and administrative expenses. Achieving all these things has become vital to the ability of acquiring companies to increase free cash flow and maximize returns to an increasingly demanding investor community.
Many of those investors are of the “ESG” variety, an acronym that stands for Environment, Safety and Governance. As governments and individuals have become more focused on climate change-related concerns and narratives over the past 15 years, the ESG investor community has formed itself into a very powerful influence segment, pressing oil and gas and other industries to become more focused on these issue areas in their daily business practices.
Given the focus on this area in recent years, I asked Dittmar if he sees companies pointing to it as a driving factor behind any of these recent deals.
“Yes, absolutely,” he said. “You see them talking almost as much about ESG as they do cash flow. It’s important to investors, and they want the deals to be ‘ESG-accretive,’ essentially. I think that definitely steers buyers towards companies that are already doing a good job meeting their ESG goals and who have asset-types that are going to be manageable under their own goals.” He went on to note that these concerns could also steer acquiring companies toward potential targets who own wells that have been completed recently with modern technology and away from owners of older, legacy assets.
Dittmar and Enverus also point to the fact that most of this latest round of M&A activity has involved the use of the acquiring company’s stock as the main means of compensating sellers. This was rarely the case during the early months of the current consolidation cycle, a time of low commodity prices when oil and gas stock values were depressed. This reality leads in large part to Enverus’s belief that the cycle of consolidation will continue in a strong way so long as the commodity prices for oil and natural gas remain strong, as they have throughout 2021.
That, of course, leads us to the OPEC+ cartel, which has come to play a major role in influencing the price of crude oil since its formation in late 2016. So long as that cartel manages to hold together and maintains its artificial reduction in the volume of crude that makes its way onto the global market, prices are likely to remain strong. But, as we saw in early July, when a dispute arose between Saudi Arabia and the United Arab Emirates about production quotas and a Saudi proposal to extend the deal among participating countries through the end of 2022, its ability to hold together is at times very tenuous.
Indeed, the entire thing blew up completely in early March 2020 amid a dispute between Saudi Arabia and Russia, an event that resulted in those two countries flooding the market and crashing the price to single digits and even into negative territory for one day in April of that year. Thus, as strong as things have been for the U.S. industry during the boom of 2021, so long as prices hinge on OPEC+ holding together, the boom can turn into the next bust on a moment’s notice.
Like it or not, though, that is the world in which this ongoing consolidation of the U.S. shale industry is taking place.
Enter Kimmeridge and Ben Dell
It is into this somewhat volatile milieu that a private equity firm called Kimmeridge has engaged in a series of major M&A deals during 2021 to create what will become the largest upstream company in Colorado’s prolific Denver-Julesburg (DJ) Basin. Having acquired a controlling interest in a company called Extraction Oil & Gas as it emerged from Chapter 11 bankruptcy in December 2020, Kimmeridge has executed the following transactions in recent months:
- On May 10, Extraction announced it would merge with fellow operator Bonanza Creek in an all-stock, $2.6 billion deal. The merged companies announced that the name of their new company would be changed to Civitas (Bonanza Creek had closed its acquisition of Highpoint Resources just one month earlier);
- Not even a month after that, on June 7, Civitas announced it was acquiring Crestone Peak Resources in another all-stock deal that would create a combined company valued at $4.5 billion.
It has been a breathtaking ride for the new company and its Board Chairman, Ben Dell, who also happens to be the Managing Partner at Kimmeridge. Dell and his team at Kimmeridge have a vision for the future of the shale oil and gas industry, one that envisions even more rapid consolidation than we have seen over the past few years.
That Dell/Kimmeridge vision also includes a far heavier focus by E&P firms on establishing and adhering to ESG-related goals. The private equity giant believes it is crucial for these companies to maintain their license to operate in a political environment that is rapidly evolving and becoming increasingly hostile to the future usage of fossil fuels.
To that end, Kimmeridge has published a series of white papers. Most recently, it published one in which the firm advocates for the creation of an industry-wide carbon offset exchange that Kimmeridge believes is key to facilitating company efforts to meet so-called “net-zero” goals. Here is an excerpt from the opening paragraphs of that white paper:
Amid the negative news of 2020, one bright spot was the rise in ESG statements and strategies among industrial companies, and in particular, the oil industry. While it was once a rarity to see an E&P company commit to reduce its carbon impact, now it is far more widespread. This trend has only just begun.
More companies are measuring their carbon emissions, managing their operations more sustainably and reporting on these metrics. Despite these positive developments, there are two main impediments to the oil and gas industry’s momentum:
- First, there is no uniformity in E&P companies’ goals and plans. Different companies are measuring different emissions using different technologies — while each company may be making progress, it is very hard to make comparisons across the industry.
- Second, currently, there is no explicit economic incentive for E&P companies to reduce their greenhouse gas (GHG) emissions. There are clearly benefits to being a good actor — gas that is not flared can be sold, for example, and investors may reward responsible companies with premium valuations — but without more explicit incentives, progress will stall.
As we will explain in more detail, and somewhat bizarrely, as one of the main industries at the epicenter of the environmental debate, E&Ps (and for that matter, most industrial emitters) have no way to generate offsets from reducing emissions, or even from keeping hydrocarbons permanently in the ground.
Little has happened in the past year to quell the world’s thirst for oil. With global lockdowns and limited vapor trails overhead, in 2020, oil demand declined just 9% versus 2019. Not for the first time, reports of the industry’s death have been greatly exaggerated, and it is likely that the oil and gas industry will be around for many years to come.
Given this, it is imperative that the industry greatly reduces its emissions, and Kimmeridge believes that delivering net-zero scope 1 and 2 oil and gas production should be achievable. The current rules governing offset projects are too cumbersome, bureaucratic and academic, as they fail to grasp the potential for meaningful emission reductions from the industry. With an increasing number of oil and gas companies declaring net-zero emissions policies, it makes sense to do this through internal emissions reductions rather than purchasing offsets from outside the industry.
So, as we can see here, Kimmeridge believes the industry will be around for decades to come. But in order to ensure that future, the firm advocates that the industry become far more aggressive than it has been in establishing and meeting ESG-related goals, including getting to a “net-zero” emissions footing by a certain date in time. Not surprisingly, Kimmeridge and Dell also advocate for more rapid consolidation in the industry to facilitate the meeting of those goals.
Two years ago, this vision for the industry would have been considered fairly radical. But today, with companies like Shell, BP, Devon Energy, Diamondback and even ExxonMobil establishing “net-zero” targets and investing in renewable energy, things appear to be evolving towards the vision Kimmeridge lays out.
But, as Ben Dell told me when we sat down for a recent interview, that evolution is not proceeding fast enough in his view, and the consolidation piece of it has a long way to go. Here is how Dell responded when I asked him to give me his vision of what a perfect Shale upstream sector would ultimately look like:
“To me, if I look at what the optimal E&P sector looks like, in the U.S. I would think you’d have 10 or 15 of them, and all of them would be net-zero,” he said. “All of them would have best-in-class boards. All of them would have the compensation aligned with shareholders based on equity performance. I would expect dividend yields of 5-10%, no real growth, returning excess cash to shareholders, and return on capital employed that consistently outperforms their cost of capital. That’s how we’re trying to remake the industry. The easiest way to do this is to go acquire a company and demonstrate that you can do it.”
Even two years into this current consolidation phase, Enverus lists 19 sizable corporate operators in the Permian Basin alone, and that doesn’t include the dozens of smaller corporate entities, partnerships and privately held companies who drill and produce oil and gas in that single basin. Thus, winnowing it all down to 10 to 15 E&P companies nationally is going to take a lot of work and capital, but Dell — whose career in the industry began as a geologist at BP in 1998, the advent of a previous major wave of consolidation — believes it is work the industry needs to complete if it is to remain viable into the future.
As we have seen this year with his company’s own rapid consolidation efforts in the DJ Basin, Dell is a guy who is more than willing to put his money where his mouth and white papers are. But this will all obviously take some time to complete, even if everyone were to start moving as aggressively as Kimmeridge and Civitas. I asked Dell how long he thinks the process could take.
“I think this (consolidation) run is very similar to what we saw from 1998 to 2008, and I would say we’re kind of at 2003,” Dell said. “That consolidation started with BP/Amoco on August 10, 1998. That was my first day of work at BP. So, I remember it very well.
“That one started at the top of the house and then filtered down. This one has kind of started smaller and is filtering up. But it took a decade of consolidation. I think we’ll look back and say 2020 to 2030 was a decade of consolidation.”
Chasing Growth Without Profits
One of Dell’s recurring themes is his contention that the incentives the shale industry has chased over the last decade have been all wrong. He contends — and is able to document — that the business has seen an enormous destruction of shareholder value in pursuit of production growth that didn’t necessarily need to take place. He talks about the mistakes the shale industry has made in the past decade and notes that renewables are about to move down the same path.
“In the last five years, we have been big proponents of how the industry needs to change,” he said. “Over the last ten years, we have had the pursuit of growth for no return, which interestingly is what the renewable space is about to embark upon. So, we’re seeing that mistake being made again.
“We had a lost decade in chasing growth in an industry that didn’t really need growth, destroyed a lot of shareholder value. There’s been over $350 billion in book value written off in the last decade in the E&P space alone. And really, the investor base is at the end of their tether.”
As readers of SHALE Magazine will have noted over the past two years, this rising dissatisfaction among the investor community with the shale industry’s financial results has led to increasing pressure for companies to trim back their capital budgets for drilling new wells and redirect their cash flow to higher investor returns. This is a big reason why, during this current year of strong and consistently rising commodity prices, the shale E&P sector has seen only modest increases in rig counts and overall output.
Dell sees all of this as a positive sign and believes it is setting the sector up for future success.
“This has all coincided with this ESG narrative, and you can debate which one came first, but it’s been accelerated in my view by COVID,” he told me. “But you’re finally at a turning point in the industry where you are beginning to see what I call the three pillars of reform to actually make the sector investible again. This is important because this sector has got a long way to run. It’s not going to be done in ten years, probably won’t be done in 50 years if we’re brutally honest about it, and there’s a lot of profitability still to be generated.”
Dell’s three pillars of reform include:
- Establishing a profitable business model that creates a return above the cost of capital and returns free cash flow to investors;
- Establishing a corporate governance model that is aligned with the goals of investors and which bases executive compensation on metrics aligned with those goals; and
- Getting to net-zero on emissions.
“If we look at a scale of 0 to 100 of what a profitable industry should look like, right now we’re at about 15,” he continued. “We’ve sown the seeds, we are seeing people change, and the real question right now is whether the industry can keep the discipline. We’ve seen these multiples come down from six times EBITDA to three times EBITDA, and really that reflects the fact that people viewed this industry as not a going concern, that it’s not sustainable, and that reinvested capital generates no return.”
While he sees some in the industry changing their behaviors, Dell advocates for the adoption of an entirely new business model in order to ensure the sector’s longevity and success.
“We talk about three things in terms of the business model. We talk about the operating model, which at its core must be profitable and earning a return above your cost of capital. That’s been the big problem for the sector over the last decade. You can’t take money at 8% and invest it at 1% and create value. So, our core is to focus on return on capital employed and exceeding your cost of capital.
“The second thing is then taking that cash, your free cash generation, and returning it to shareholders. Because shareholders don’t have a belief that if you reinvest it in the ground that you can be profitable again. There’s just too much uncertainty about the out years.
“So, don’t focus on growth; focus on returns, earn a return above your cost of capital, generate free cash and then return that free cash to your shareholders. One thing I tell my shareholders is that the business is simple: You want to be near the front end of the North American cost curve. That means the lowest F&D (finding and development) costs and the highest cash margins. If you think about how you optimize cash margins, its scale, optimization of operations, low G&A (general and administrative costs), all those elements. Those are things you can control.”
Then, of course, he brings the discussion back to the ways in which rapid consolidation can help to move this new business model into the mainstream. “The trend towards M&A is really all about cutting costs. It’s really about expanding your cash margins. It’s about lowering your F&D by getting more efficiencies in the drilling and completion side.”
Of course, being an old oil and gas guy myself, when I see someone talking about not reinvesting your cash flow into new drilling efforts, that is a real departure from how the industry has always done things. After all, the large independent producers in the U.S. have often bragged openly about their past practice of borrowing money in order to reinvest more than 100% of their cash flow in new drilling and exploration efforts as a means of facilitating growth.
One of the industry’s favorite old sayings has been that ‘if you’re not growing, you’re going out of business.’ I asked Dell how he responds when confronted with that bit of old conventional wisdom.
“I think you have to separate out two things: Your rate of reinvestment in growth is proportional to the industry that you’re in. If the oil and gas business is a 1% per annum growth industry, then if I’m growing more than 1%, I’ve got to be taking market share. Now, it might be okay to take market share if I’m delivering net returns. But this is an industry that tried to take market share from OPEC at the expense of returns, and that’s not a viable business model,” an obvious truth that the domestic industry has learned the hard way repeatedly over the last decade.
“If you told me this industry became a 20% per year growth industry, then I’m not sure growth would be out of the question. You’d be incentivized to deliver growth, and the question would be, where does that growth come from? But the fact of the matter is that this is a low-to-no growth industry, and therefore, delivering low-to-no growth is probably the right rate of growth. So, it’s always going to be a question of where you are within the industry you are in.
“From an operating standpoint, we (at Kimmeridge) started out pushing companies down to a 60-70% reinvestment rate. At Civitas, we’ve guided to 50%, but honestly, that’s because the DJ Basin rock is probably some of the best in the country.”
Given the context of how the shale business has evolved in recent years, even us old oil guys would have to admit that that view makes perfect sense.
Like It or Not, ESG Matters
There remains an ongoing debate within the domestic industry over how much attention companies should really be paying to the demands of ESG investors. Those who don’t necessarily believe the narratives being spun by climate change alarmists are skeptical that they should be spending their precious capital on efforts that do nothing to make their companies more profitable.
It’s a valid debate, but the reality is that the industry surrendered on this matter many years ago, when the first round of letters began coming in from ESG investor groups in the 2007-08 time frame. The majors and large independent producers made the decision then to respond to those demands, even though some within the industry advised them that these groups could never be satisfied and that their demands would only grow over time. Once that initial decision was made, there was no going back, and the progression of intensity in demands was very predictable, and in fact, inevitable.
Dell’s view on this matter is elegantly simple: The industry is where it is, and companies must now establish and meet ESG goals to maintain their license to operate. There is no other choice. And he says the industry has put itself into this position largely thanks to bad governance practices in recent years.
“Governance in this industry has been atrocious,” he told me. “It’s been atrocious for years, people being compensated for the wrong metrics, management being compensated when they’ve destroyed value, and there needs to be a real alignment with shareholders. Shareholders don’t mind if management gets paid when they’re making money, but over the last decade, we’ve watched E&P managers get paid 10, 12, 15 million dollars a year while destroying shareholder value. It’s absurd, and the boards have let it happen.
“So now, we’re starting to see a governance revolution, and it was hard at first because the question was always ‘show me someone else who’s doing it,’ and there wasn’t anyone. But now we are starting to see the realignment, better corporate governance, more diversity, more diversity of thought, not just race and gender. I always talk about that on boards: “It’s diversity of background.”
Rather than viewing it as a nuisance that wastes dollars that would be better put to other uses, Dell views ESG’s environmental demands as an opportunity for the industry to embrace.
“One of the things I ask people is if all the E&Ps were net-zero and have no carbon footprint, or if you could sequester carbon for a dollar, would you change any of the energy infrastructure you have today? And most people say ‘no.’ Because, why would you change it? It works well; it’s very functional. Why would you invest trillions of dollars in something else if what you already have works?
“For the E&Ps, the question right now is do they have a license to operate. My view is, if you are net-zero, you are earning your license to operate. If the entire E&P space is net-zero, why wouldn’t you have it? What is the argument at that point? Then it’s just politics, and some people will say, well, I just don’t like it. Some people just hate the industry. And you can’t really address that. But that’s not really a strong, sticking argument over time.
“My goal is to be net-zero. I want to deliver a clean product. At that point, the refiner should be net-zero, the consumer should be net-zero, everyone needs to get to net-zero. If I’m net-zero, what issue do you have with my industry? So, I look at that as the license to operate.”
“At Civitas, we’ve committed to being net-zero. And that doesn’t mean I’m just going to buy offsets. What we’ve done internally is we’ve put a price on our own carbon. Because we now have to buy the offsets. So now, as an organization, you’re incentivized to actually reduce your own footprint because those offsets are a credit, and they can sit on your balance sheet, and they can accrue value.
With three mergers in the span of a few months, Dell has created his own case study at Civitas. But his view is that to survive for the long run, the entire industry will have to adapt as well.
“We want to be at the forefront of that movement. We want to set the standard,” he said.
Trying to change the behaviors of an entire industry — most of which have been long ingrained into its culture — is a lofty goal. But if Dell’s vision plays out in the years to come, those who hate the shale oil and gas industry for the sake of hating it will find themselves searching for new lines of attack.
About the author: David Blackmon is the Editor of SHALE Oil & Gas Business Magazine. He previously spent 37 years in the oil and natural gas industry in a variety of roles — the last 22 years engaging in public policy issues at the state and national levels. Contact David Blackmon at [email protected]