Diversify, consolidate or die: Energy transition poses stark choices to mid-sized oil companies

Noble Energy realised the independent E&P business model was failing long before Covid-19. Merging with Chevron buys investors some time, but is no silver bullet.

US oil supermajor Chevron’s headline-grabbing USD 13 billion deal to acquire independent outfit Noble Energy was hailed in some quarters as proof that Big Oil is far from dead and buried, no matter what the fossil fuel divest movement might say.

Battered and bruised, the supermajors still have a lot of life left in them. Armed with enviable credit ratings, they are weathering the commodity downturn by borrowing more, slashing capital expenditure, culling jobs, offloading assets and even dumping spare office space.

Some boards have cut shareholder dividends, while other more hawkish bosses have gone the extra mile to avoid doing this—such as stopping paying into their employees’ pension pots.

For companies like Chevron, with a deep global asset base and market capitalisation of USD 167 billion, there are many levers to pull in times of adversity.

But what about smaller independent exploration and production (E&P) players like Noble Energy, which was valued at USD 5 billion in the Chevron deal?

Independent oil companies with only a handful of major assets, often concentrated in one or two geographic locations, are not sitting so pretty. Their revenues are less diversified, so they are more sensitive to commodity price movements or regulatory changes in the markets where they operate. As a result, their share prices can be volatile.

Oil stocks have performed dreadfully across the board this year, some worse than others. Chevron stock (NYSE: CVX) is down 26% year to date, and in mid-March—as worldwide pandemic lockdowns were in full swing, killing fuel demand—the CVX ticker on Wall Street dipped to 55% below the price at which it began the year.

Pretty dire. But compare this to Noble Energy’s shares (NASDAQ: NBL), which fell 88% over the first two-and-a-half months of the year and have since recovered barely half of that. Noble—with operations in West Africa, the eastern Mediterranean and the US—was put on review for credit rating downgrade by Moody’s and Fitch when the oil price tanked in March.

Little wonder management bit Chevron’s hand off when they offered an outright acquisition. Being an all-shares deal, Noble’s shareholders are being paid entirely in Chevron stock, so will tie their fortunes to that of the much larger supermajor.

The deal is subject to approval from Noble’s shareholders, which should not pose an obstacle; the share exchange ratio (0.1191 of a CVX share for each NBL share) represents a 12% premium on the Noble share price at the time the deal was agreed.

Motivated seller

This is not a story of an opportunistic takeover of a smaller distressed rival by a predatory giant during a convenient ‘Black Swan’ event. A proxy filing by Chevron last week revealed that Noble had been pursuing every conceivable route out of ‘business as usual’ for at least a year and a half prior to even negotiating with Chevron.

Starting in late 2018, Noble’s board held a series of “strategic reviews and strategy sessions” in search of ways to avoid being swept aside by the energy transition. In particular, they were concerned by:

…Noble Energy’s position in an industry that is undergoing dramatic changes as a result of increasingly negative investor sentiment following years of sector financial underperformance, concerns about the viability of fossil fuels and the impact of expanding environmental, social and governance matters and legal requirements.

In a nod to the ‘divest’ movement mentioned earlier, they also flagged up:

…significant potential financial and operating risks associated with environmental and other regulatory considerations, and growing pressure to diversify away from fossil fuels.

Unnerved by the risk of assets becoming stranded, they also analysed the breakeven price of Noble’s undrilled shale acreage in Colorado against even the most optimistic oil price forecasts, and realised:

Within 5-10 years, the remaining inventory would require higher oil prices to generate adequate returns.

Not only that. They saw that cleaner energy sources will prosper, while carbon-intensive fuels won’t offer the best route back to profitability:

The Noble Energy Board determined that given investor sentiment toward the sector, environmental and climate concerns and increasing regulatory requirements, companies with a diversified portfolio of assets beyond traditional oil and gas, including renewables, would have a competitive advantage in the future, including with respect to free cash flow, value and sustainability.

So the board instructed management to go looking for buyers. They considered individual asset sales, joint venture partnerships, buying out a smaller player with better growth prospects, or a sale of their company ‘lock, stock and barrel’ to a larger player.

Noble hired US investment bank JP Morgan to advise on “strategic alternatives” while it shopped itself around the market. By 8 July 2020, the pair had discussed:

(i) a sale of Noble Energy with six potential acquirers, (ii) a strategic business combination with four potential counterparties and (iii) an acquisition of a smaller peer company. In addition, a number of other potential acquirers or counterparties were evaluated.

Chevron threw its hat in the ring fairly late on, in a call between senior company executives on 28 May 2020. During that call, the Noble team expressed its desire for an all-stock transaction rather than cashing out. This reflected the board’s view of Noble’s “intrinsic and overall value, especially given its portfolio of long-term, high quality and large scale assets”.

Short-term gains

This is an incongruous strategic move by a board well aware of the mounting risks posed to its core business by the decarbonisation megatrend. They might well fare better for the next few years by integrating with Chevron—but is this perhaps akin to upgrading your fax machine on the dawn of the internet age?

Chevron has resisted pressure to follow European rivals BP, Shell and Eni by committing to ‘net zero’ emissions by 2050, while taking incremental steps to increase its exposure to renewables and reduce the carbon intensity of its operations. Chevron last year pledged to align its emissions reductions with the goals of the 2015 Paris climate accord but, like the rest of its peers, its strategy still falls short.

Noble Energy’s view is that, post-merger:

Chevron would, on a pro forma basis in 2021 and 2022, have increased scale and capacity to address growing environmental and climate considerations and potential regulatory changes.

Yes, the extra revenue from Noble’s producing assets will give Chevron more money to spend on other things in the immediate term. But what about the longer view?

Well, insofar as the proxy filing indicates, Noble’s commercial analysis of ‘long term’ goes only as far as 2029—the end date for the future crude price assumptions it divulged. There is no mention of any date beyond this. The board’s qualitative description of a difficult future for oil companies is not quantified.

Noble’s bosses are banking on Chevron’s better odds of success, particularly when it comes to monetising Noble’s undeveloped upstream natural gas assets in Colorado, Israel, Cyprus and Equatorial Guinea this decade, long before global gas demand peaks some time in the 2030s.

If Chevron succeeds, the payout for Noble as minority Chevron shareholders will be less than if they were to somehow succeed alone—but infinitely greater than the more likely outcome of owning 100% of a slowly failing business under a ‘business as usual’ strategy.

This short-term thinking is consistent with Noble’s fiduciary duty to prioritise returning value to shareholders come what may. Selling out for cash and allowing each investor to put their money elsewhere—in zero carbon ventures, perhaps—would be less profitable in the near-term, the thinking goes.

Noble shareholders will be free to sell their Chevron stock post-merger, of course. If they do, they might make a 12% gain off the bat.

Photo: The Leviathan platform (c) Noble Energy

Regional complexities

The proxy filing also reveals that Chevron’s main motivation was to get its hands on Noble’s vast natural gas reserves offshore Israel and Cyprus—more than 35 trillion cubic feet (Tcf), roughly equivalent to the entire gas consumption of the UK and Europe for almost two years.

The eastern Mediterranean is, by Noble’s own reckoning, a region characterised by considerable “geopolitical instability”. It is also already awash with gas, to the extent that bringing on-stream more reserves is hindered by the high cost of development and the low prices in markets where the gas would be sold—both regionally and further afield.

Against this backdrop, and with energy demand still flagging under the weight of the pandemic, any local outlet for natural gas near to the gas reservoir is strategically valuable to upstream operators. And the sooner resources are developed, the sooner government earns production royalties.

In Israel, Noble has two producing offshore fields: Tamar and Leviathan, the largest energy project in the country’s history, and future plans to expand both. It also has undeveloped gas discoveries called Dalit and Tamar SW.

So it came as quite a surprise when Israel’s Ministry of Energy last week cancelled plans for four new large gas-fired power stations in favour of developing solar farms and other renewables, under pressure from colleagues at the Ministry for Environmental Protection.

Israel recently hiked its 2030 renewable energy target from 17% to 30% of the power mix. Natural gas will now meet 70% of Israeli electricity demand by end-decade, which might sound like a lot but offers only marginal growth from the ~66% market share it already has.

That a gas-rich Middle Eastern country would take these actions in the midst of a pandemic and global recession speaks to the resilience of the decarbonisation agenda. Israel today still burns some coal for power generation, but the government is already looking beyond that to curbing cleaner-burning gas, too.

No route to market

In January, Israel began exporting gas to Egypt from Noble’s Leviathan field via pipeline. Egypt has since capped the amount it buys from Leviathan to the contractual minimum, as its own domestic gas sector has taken off in the last couple of years and the country is in surplus.

Other regional export options are limited by geopolitics. Buying gas from Israel would not be countenanced in Saudi Arabia, Jordan, Syria or Lebanon. Also, Saudi has plenty of its own, and Lebanon hopes to develop its domestic resources (although that project is facing lengthy delays after the tragic Beirut explosion).

Exporting Noble’s Israeli and Cypriot gas reserves to Europe would involve building the world’s longest and deepest pipeline beneath the Mediterranean, the East Med gas pipeline. The project enjoys political support but makes little economic sense.

The same could be said for building a capital-intensive liquefaction plant to ship Israeli and Cypriot gas as liquefied natural gas (LNG) to global markets. This would have been an attractive idea a few years ago. But the LNG market was already stuttering under a global supply glut before Covid-19 eviscerated demand and crashed prices.

Chevron will likely pursue Noble’s plans to build a shorter pipeline to Egypt to liquefy only the Cypriot offshore gas in one of Egypt’s two existing LNG plants, which saves investing in more liquefaction capacity that the market frankly doesn’t need. However, this would further diminish the chances of the East Med pipeline to Europe ever being built, because it would divert upstream volumes needed to justify capital investment in the much larger piece of infrastructure.

Investors that were struggling to see a route to market for Noble Energy’s east Med exploration successes will probably be pleased to migrate their investment into Chevron stock. And the US supermajor will undoubtedly feel immediate benefits to its bottom line by bringing Noble’s producing assets into its portfolio.

Chevron highlighted that the deal will boost its proved but undeveloped oil and gas reserves by 18% at an acquisition cost of just USD 5 per barrel of oil-equivalent. The cost is manifest in a dilution of shareholder capital, by issuing more CVX shares to Noble investors. In a region beset by geopolitical tension and blessed with abundant, untapped solar irradiance, it remains to be seen whether that was shareholder money well spent.

Seb Kennedy | Energy Flux | 17th August 2020