Plains Exploration & Petroleum Company (NYSE:PXP) doesn’t merely think that it’s safe to go back in the water. This week the company announced that it was purchasing interests in deepwater Gulf oilfields from BP plc (NYSE:BP) and Royal Dutch Shell plc (NYSE:RDS.A) at a cost of about $6 billion. The $4.7 billion market cap company (its shares have taken a 10% hit on the announcement) will fund the transaction with debt, and then plans to reduce the debt load by selling its own interests in onshore natural gas fields including a position in the Haynesville Shale. As such, the transaction represents a major strategic shift for the company.
Putting aside the irony of “Plains” making such a large commitment to offshore oil, it’s easy to see why investors are cool on the deal. Shale plays are hot in the market these days as advances in horizontal drilling technology have unlocked oil and gas in several fields across the U.S. Meanwhile, the Gulf is experiencing a slowdown as current oil prices make drilling expensive offshore wells- especially deepwater wells- less profitable than in some previous years and sentiment continues to run against offshore drilling as a result of the Deepwater Horizon disaster (BP decided to sell these deepwater assets in part to help fund Deepwater Horizon-related expenses). Of course, onshore wells are also less profitable at low oil prices, but the cheaper costs of onshore drilling better allow exploration and production companies to maintain drilling activity as long as good locations can be found. In addition, some investors may have bought Plains stock thinking they were getting a company with a strong position in onshore shale plays; if that’s not what the company is any more, why not sell?
It will be interesting to see how large hedge fund holders of Plains react to this move. Billionaire Dan Loeb’s Third Point initiated a position of 2.2 million shares in the second quarter of the year (see more stock picks from Dan Loeb). Two other hedge funds managed by billionaires, SAC Capital Advisors (Steve Cohen) and D.E. Shaw (D.E. Shaw), increased their stakes in Plains by 33% and 31% respectively between April and June. SAC now owns 3.5 million shares and D.E. Shaw now owns about half as many. Find more of SAC Capital Advisors’ and D.E. Shaw’s favorite stocks.
By putting its chips on deepwater oil, we think that in addition to the companies we’ve mentioned we can compare Plains to Brazilian oil major Petroleo Brasileiro Petrobras SA (NYSE:PBR). Petrobras, which is an integrated oil company getting much of its production from deepwater, trades at only 15 times trailing earnings. Plains trades at 33 times trailing earnings, but some of this multiple is due to the high growth expected from its shale plays. As a result, we would expect its earnings to immediately pop as it benefits from the current output at its new oil wells. BP and Shell trade at 8 times trailing earnings.
Plains believes that in the long term this deepwater position will pay off. This implies that the company expects a rise in the price of oil and therefore positive economics for potential well locations in its new fields (according to the company, these locations were not developed by BP precisely because they were less profitable than the existing wells the supermajor did drill). Again, this strategy depends on rising oil prices, which in turn would depend on strong global growth, an exhaustion of prospective shale oil fields, or a combination of the two. We wouldn’t want to invest in deepwater based on an expectation that shale reserves will disappoint, so any bullish reaction to this move should be based on an expectation that the developing world is going to keep growing- that either China will resume strong growth soon, or the world will find another China.
Plains also expects that the existing wells will immediately produce enough cash flow to help pay off its debt. In this case, the company has locked in current prices for the vast majority of its existing production through hedging strategies and expects an additional $1 billion annually in free cash flow, compared to the $1.2 billion in cash flow from operations it has received in the last four quarters combined. As a result, we’re not particularly worried about the company’s ability to pay back the debt. Our primary concern is whether swapping shale for deepwater is a brilliant long term arbitrage move- selling something the market currently likes and buying something it doesn’t- or a gamble on oil prices moving up.
Another concern for the deal is that the market for shale gas fields may already be stacked against sellers with Chesapeake Energy Corporation (NYSE:CHK) needing to sell some of its own assets in order to cover cash flow for the year. As a result, it is possible that Plains might not be able to get the prices that it expects in its asset sales. We would at least wait to see the result of these sales before considering it a long-term buy, and even then might want to study its valuation against other deepwater oil companies to see if a pair trade may be appropriate.