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Does Conoco Show the Way for Upstream M&A?

Copyright © 2021 Energy Intelligence Group
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Large, expensive upstream acquisitions are a tough sell for oil companies these days given investor focus on decarbonization and the energy transition. Those taking the plunge had better be able to explain the rationale and benefits to shareholders. ConocoPhillips appeared to pull it off this week with its $9.5 billion purchase of Royal Dutch Shell’s acreage in the oil-rich Permian Basin, perhaps offering a template for how US oil companies can continue to make growth-oriented deals in the coming years while keeping investors satisfied. The deal follows months of speculation around Shell’s plans to sell out of the Permian, its last remaining US shale asset. Shell’s Permian position includes around 225,000 net acres located within Texas in the Delaware subbasin of the Permian, as well as over 600 miles of operated crude, gas and water pipelines and infrastructure. Conoco estimates production from the assets in 2022 will hit about 200,000 barrels of oil equivalent per day, roughly half of which is operated. The assets currently produce around 175,000 boe/d. The deal will turn Conoco into a dominant force in one of the world’s most important oil fields, expanding its position with largely contiguous acreage at a low cost of supply.

Conoco has addressed many investor concerns about upstream expansion during the transition. By using existing cash reserves to fund the deal, it will keep new debt off the balance sheet while improving scale and cost-efficiency. It will also satisfy shareholder demands for more cash with an immediate 7% increase in the company’s quarterly dividend, while promising further cash returns over the next decade, even if oil prices drop. Conoco also plans to increase its asset sale target by 2023 from $2 billion-$3 billion to $4 billion-$5 billion. Additional sales will come from the Permian as Conoco high-grades its portfolio there. It will maintain its previous debt-reduction target, eliminating questions about leverage. Even if West Texas Intermediate oil prices fall to $50 per barrel — they are now around $70 — Conoco expects to generate $80 billion in free cash flow over the next decade and pay $75 billion back to shareholders in dividends and buybacks. Conoco also paid a relatively attractive price for the assets. It puts the value at $15,000 an acre — above the $10,000 an acre it paid for fellow producer Concho Resources earlier this year, but below the $60,000 paid by Occidental Petroleum for similar acreage from Anadarko Petroleum in 2019, according to Enverus.

Conoco has framed the deal as an opportunity to improve its emissions profile in hopes of heading off environmental, social and governance (ESG) concerns. In conjunction with the transaction, Conoco now says it will improve its Scope 1 and 2 (operational) greenhouse gas emissions (GHG) intensity reduction targets from a 35%-45% reduction by 2030 to a 40%-50% reduction, based on 2016 levels. Shell has done much of that work itself in the Permian, chopping GHG and methane intensity by 80% through investment in infrastructure and technology. But Conoco will now apply the intensity target to all equity production, not just operated production -- a significant new commitment.

With most forecasters calling for continued growth in oil and gas demand through this decade, Conoco has made a case for cash-accretive acquisitions of short-cycle assets for US oil companies. But risks remain, particularly if pressures to address Scope 3 emissions from end-product use intensify in the US as they have in Europe in recent years. Such demands are making it increasingly difficult for companies to justify future growth in oil production. Even as US oil companies have focused on both reporting and reducing their Scope 1 and 2 emissions, Wells Fargo analysts note that Scope 3 has “become the center of the debate for some investors, leading to an exclusionary view of the oil and gas industry.” At Conoco's May 11 annual meeting, 58% of shareholders voted for a resolution calling for Scope 3 emissions reduction targets. Scope 3 pressures have forced more radical energy transition strategies at top European oil companies. BP expects a 40% drop in its upstream production by 2030, while Shell has shifted its fossil fuel growth focus to gas and LNG. Regardless, analysts say further deals in US shale may be limited after a big consolidation wave in the past year.

Conoco's 10-Year Plan
 2019Jun'21Sep'21
Cash Flow From Operations$120 billion$145 billion$165 billion
Free Cash Flow$50 billion$70 billion>$80 billion
Shareholder Distributions$50 billion$66 billion>$75 billion
Return on Capital Employed (2031 target)--17%~20%
Average Capex<$7 billion$7 billion$8 billion
Production Growth>3%3%3%
WTI Price Assumptions$50, with 1.5%-2% annual inflation$50, with 2% annual inflation$50, with 2% annual inflation

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