Exxon (XOM) and XTO: A Bold Vote for… the Status Quo
Exxon Mobil’s (XOM) blockbuster $40+ billion acquisition deal to buy natural gas producer XTO Energy (XTO) immediately raised questions about whether it was a signal nat gas is the future primary energy source for America. Exxon’s management team made it clear that the XTO deal was done with a long-term time horizon and is not meant to be judged on the basis of 2010 earnings accretion or dilution. This perspective is helpful because nat gas producers have many near-term earnings headwinds as their production hedges roll off in 2010; a nearly $2/mcf difference exists between spot prices and where XTO has, on average, hedged half of their scheduled 2010 production. When faced with the reality that future realized prices could be much lower (say, $5.50/mcf vs. $7.50/mcf from lucky hedges), producers needing to show earnings growth will have to produce much greater amounts of nat gas, leading to excess supply and lower prices – a situation that’s tough to break out of.
The sheer size of the transaction lends some weight to the idea that Exxon sees domestic nat gas sources as a valuable transition fuel, perhaps a decade out, but that does not lead to the conclusion that nat gas prices are going to soar. Whatever major sources of energy America uses as a country have always been cheap and readily accessible – something I call “Say’s Law of Natural Gas.” Say’s Law, the idea that supply creates its own demand, means that the over-supply of natural gas at present is keeping prices low, but it will eventually lead to incremental new demand for the fuel, and the friction costs of switching fuel sources will lead to future price inelastic demand for nat gas.
The better comparison than oil vs. nat gas could be the implications for the integrated major business model. Exxon Mobil is proverbially doubling down on that concept with this acquisition, while a company like ConocoPhillips (COP) has stated that the former advantages of the integrated major model are no longer attractive, and it will slowly be shrinking in size. By investing in new reserves rather than buying back its own, Exxon is casting its lot that the status quo – fossil fuels being essential to American energy consumption – will persist for some time.
Other potential nat gas-producing acquisition targets have been fairly well hashed out – Chesapeke (CHK), Devon (DVN), Anadarko (APC), EnCana (ECA), Range Resources (RRC), Petrohawk (HK), Ultra (UPL), and Southwestern (SWN). Funds I co-manage own UPL, as well as XOM.