The fossil fuels industry has had it rough the past couple of years, especially with 2020 adding a sudden drop in travel on top of the existing issues of unsustainable debt and supply growing at a faster rate than demand. The price of oil has hovered around the $40 mark since June, which is below what many companies need to profit off new shale wells.
As a result, many companies in the industry have turned to divestitures or consolidation in order to survive. One of the latest energy deals, and perhaps the biggest since the Covid-19 pandemic began, is ConocoPhillips' (COP, Financial) agreement to buy Concho Resources Inc. (CXO, Financial) in an all-stock deal valued at $9.7 billion.
Following the news, shares of both companies were mostly flat, with ConocoPhillips gaining 0.06% to trade around $32.72 and Conoco gaining 0.2% to trade around $47.36.
The terms of the deal
The acquisition value of $9.7 billion represents a 15% premium to Concho's closing price on Oct. 13. Shareholders of Concho will receive 1.46 shares of ConocoPhillips for each Concho common share that they own. The deal is expected to close in early 2021.
Even at a 15% premium to the recent price, the deal still represents a significant discount compared to what Concho's stock was worth at the beginning of 2020. Year to date, Concho shares are down 49%, while ConocoPhillips shares are down 46%.
Concho is selling itself for only $1.7 billion more than the $8 billion it paid to acquire RSP Permian Inc. two years ago, which reflects the $12.6 billion in impairment charges that the company has taken due to its recent struggles.
"Sector consolidation is both necessary and inevitable," ConocoPhillips CEO Ryan Lance said Monday after the announcement. "We both believe our industry needs solutions that address the lack of scale, poor returns and, increasingly, the challenges and opportunities of environmental, social and governance matters."
ConocoPhillips is already the largest oil producer in Alaska, and the Concho acquisition will give it the second-largest footprint in the Permian Basin, behind only Occidental Petroleum Corp. (OXY, Financial).
A change in strategy
This large-scale acquisition represents a departure from the strategy of shedding assets that ConocoPhillips has taken in recent years.
Unlike many competitors, which continued spending vast amounts of money to rapidly expand their operations over the same time period, the oil giant began its turn to frugality in 2018, focusing on conserving cash so that it could put more toward share buybacks and dividends.
This strategy is finally paying off. While competitors were buying in a bullish environment and have turned to selling now, ConocoPhillips sold when its assets were still in high demand and is buying now that prices are low.
Additionally, its balance sheet is solid, which is a rare thing in the energy sector these days. The cash-debt ratio of 0.52, current ratio of 2.69, interest coverage ratio of 3.6 and Altman Z-Score of 2.23 all point to very little risk of bankruptcy; add this to the company's status as an industry leader and investors can rest assured that their holdings will not be a victim of Chapter 11 bankruptcy anytime soon.
Valuation
On Oct. 20, shares of ConocoPhillips traded with a price-earnings ratio of 16.15, a price-book ratio of 1.11 and a price-sales ratio of 1.47. These ratios are higher than about two-thirds of other companies in the oil and gas industry; while earnings across the sector have dropped in recent quarters, share prices have dropped even more.
Even though the company is trading higher than many competitors, it is likely doing so because it is in a much better position to turn things around and make a profit again once demand for fossil fuels recovers to previous levels and growth. It is also well-positioned to take advantage of industry consolidation thanks to its strong balance sheet and scale.
The GuruFocus Value chart gives the stock a "modestly undervalued" rating. While the share price is currently above what the earnings are worth, it is slightly below the value that analysts are expecting the stock to reach by the end of 2022, and that's without the Concho acquisition factored in.
Conclusion
All things considered, the announcement of the Concho acquisition seems like it could be an encouraging sign of strength in ConocoPhillips among broader industry troubles. Companies that can take advantage of a downturn to increase their market share can often become top performers a few years down the line.
On the other hand, oil demand growth is expected to remain slower in the future compared to the heights it achieved in the past few decades. Though we are far from everyone in the world using fossil fuels, and the larger the existing market size, the less effect any future gains will gave in terms of percentage growth. There is also the increasing size of the renewable energy sector to consider, which has a considerably longer runway for growth in the long term, making it more attractive to investors as clean energy solutions become cheaper and more readily available.
Despite these factors, fossil fuels still represent the majority of the world's energy consumption. As long as we see decent demand growth in the future, that combined with industry consolidation could very well lead ConocoPhillips and other well-positioned oil and gas companies to success.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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