XOM - APA's Acquisition Of Callon Petroleum - An Opportunity For CPE Shareholders

2024-01-07 09:30:00 ET

Summary

• APA Corporation has announced the acquisition of Callon Petroleum in an all-stock deal valued at $4.5 billion.
• The stock price of APA Corporation fell following the news, while Callon Petroleum's stock price increased.
• The deal is part of a trend of consolidation in the energy sector, with more mergers and acquisitions expected in the future.
• The deal should unlock approximately $150 million in cost savings and the combined company has already committed to use some of these savings to fund shareholder returns.
• CPE stock appears to be a buy right now, as it is trading at a discount to the proposed deal price. Thus, anyone buying the stock will receive some gains.

APA Corp.-Callon Petroleum Merger

On Thursday, January 4, 2024, APA Corporation ( APA ) announced the acquisition of Callon Petroleum ( CPE ) in an all-stock deal valued at approximately $4.5 billion, including debt. As is fairly typical in merger deals, the stock price of the acquiring company fell on the news and the stock price of the target company increased. Over the past five days, Callon Petroleum shares are up 5.98% and APA Corporation shares are down a comparable 5.16%:

I will confess that this deal came as something of a surprise, although it is hardly the only example of consolidation in the energy sector that we have seen recently. After all, Exxon Mobil ( XOM ) has been attempting to acquire Pioneer Natural Resources ( PXD ) for a few months now. Seeking Alpha's ticker page for Pioneer Natural Resources provides headlines of a number of other companies in the energy sector that are shopping around for either purchasers or targets:

I can see headlines that both Callon Petroleum and Endeavor Energy Partners were potential targets in deals back in December, as well as a headline pointing out that mergers & acquisitions activity in the energy sector are expected to pick up. If this indeed proves to be the case, then it is unlikely that the deal between APA Corporation and Callon Petroleum will be the last that we will see.

It makes sense that we would start to see an increase in merger activity in the energy sector. As I have pointed out in a number of previous articles and blog posts, such as this one , the traditional energy sector has been undervalued for a very long time as the sector has boasted the lowest price-to-earnings ratios in the S&P 500 Index ( SP500 ) for a number of years now. This is shown clearly here:

(data per GuruFocus as of January 6, 2024)

As I have pointed out in various previous articles, many companies in the energy sector have been very aggressively shoring up their balance sheets and have been generating a copious amount of cash flow. It makes sense that they would use these strong financial positions to acquire undervalued companies, and the energy sector is full of them. As such, it seems quite likely that we will be seeing more deals like the one that was just announced between APA Corporation and Callon Petroleum. Of course, if the market starts valuing energy companies in line with other sectors, there may not be as much in the way of dealmaking, but that seems unlikely since many market participants shun anything with a connection to the production of oil and gas.

Let us have a look at this deal and see what it means for investors in both APA Corporation and Callon Petroleum. After all, the week's stock price action has already shown that there could be an opportunity to make some money from the deal.

About The Announced Deal

The press release on Seeking Alpha states:

Under the deal terms, each Callon common share will be exchanged for a fixed ratio of 1.0425 shares of APA common stock, representing an implied value of $38.31 per share based on APA's closing price on January 3; APA expects to issue ~70 million shares in the transaction.

As this is an all-stock deal with a fixed exchange ratio, the exact value that shareholders in Callon Petroleum will receive varies depending on the price of APA's common stock. This could be important considering that APA's stock price fell following the announcement of this deal. As of the time of writing, APA trades at $34.34 per share. Thus, a 1.0425 exchange ratio values Callon Petroleum at $35.80 per share right now. That is a slight increase over the $35.12 per share that Callon Petroleum currently has, so this deal assigns a 1.94% premium to the shares today. That is not an especially attractive premium for a deal, but it is also still a premium. Thus, Callon Petroleum shareholders should still get a bit more profit than they got earlier this week simply by holding their shares until the deal goes through. Of course, that assumes that the shares of APA continue to trade around the same level and there is no guarantee of that. This is, unfortunately, one of the biggest problems with all-stock deals. The share price of these companies is almost certainly going to exhibit a very direct correlation until the deal goes through or another buyer comes in with a higher bid.

A direct correlation between the share prices of these two companies would hardly be unusual, however. This chart shows APA Corporation and Callon Petroleum's stock price from January 1, 2021, until December 29, 2023:

As we can see, the share price performance of the two was very similar overall from about the middle of 2022 through the end of 2023. Callon Petroleum was considerably more volatile prior to that though, which could be caused by it being a smaller company and the market in 2021 being dominated by "meme stocks" and similar strange phenomena that were caused by far too much liquidity in the capital markets. In short, though, the returns provided by these two stocks over the two years prior to 2024 were remarkably similar. That actually makes the fact that these two stocks are now basically locked together because of the terms of this deal a bit easier to stomach.

About Callon Petroleum

Callon Petroleum is an independent exploration and production company that primarily operates in the Permian Basin of West Texas. The company currently has approximately 145,000 net acres in the region, with the overwhelming majority of the company's acreage in the Delaware Basin:

For those who are unaware, the Delaware Basin and the Midland Basin are the two lobes of the Permian Basin. The Delaware Basin is the larger of the two, and between the two lobes, the region represents the richest source of hydrocarbon resources in the United States. This is also the area that has been responsible for a significant portion of the production growth in the United States over the past several years. Currently, the region produces the overwhelming majority of the crude oil output of the United States:

We can also see that it is the only hydrocarbon-producing region, other than the Bakken Shale, that has seen any significant production increase over the past year. Thus, Callon Petroleum's position as a pure-play producer seems certain to attract a certain amount of attention. Pioneer Natural Resources is another company that solely operates in the Permian Basin that has been targeted for acquisition in the current consolidation wave.

Callon Petroleum has guided for a fourth-quarter 2023 production level of 104,000 to 108,000 barrels of oil equivalent per day. The company expects that roughly 60% (63,000 to 65,000 barrels per day) of that will be crude oil. The remainder of its production will be natural gas. This is something that some readers may find attractive, as natural gas prices have been much weaker than crude oil prices for a year or two. However, this weekend's snowstorm in the Northeast and the potential for this winter to be colder on average than we saw over the past year or two have had a positive impact on prices. However, crude oil is still generally considered to be more profitable than natural gas so many energy investors prefer companies to be more weighted to crude oil.

About APA Corporation

APA Corporation is a bit more diversified than Callon Petroleum. Unlike Callon, the company is not a Permian Basin pure-play, but instead has operations in the United States, the North Sea, Suriname, and Egypt:

The majority of the company's production is still in the United States, though. Thus, the acquisition of Callon Petroleum can be expected to increase its weighting to the United States and decrease its weighting to its international operations.

The merger press release on Seeking Alpha states this as well:

APA said Callon's assets will provide additional scale to its operations across the Permian Basin, particularly in the Delaware Basin, where Callon has nearly 120K acres.

On a pro forma basis, total company production exceeds 500k boe/day; pro forma average daily Permian Basin production was 311K boe/day in Q3 2023, which represents a 48% increase from APA's Permian production on a standalone basis, and APA's oil production as a percentage of boe in the Permian increases from 37% to 43% in Q3 on a pro forma basis.

Thus, we can see that the combined company will have a higher production in the United States than APA currently does on both a nominal and a percentage basis. Thus, this acquisition will somewhat weight the company's production more towards the United States than it already is, although the Permian Basin itself will still account for a minority of the company's production. I cannot see any real problems with this, as the infrastructure in the Permian is already built out to handle the production level and crude oil trades in the global market. This latter point may be important, as it means that crude oil can be exported if the demand for crude oil declines in the United States for some reason. As I discussed in a recent article though, that does not really seem to be a problem right now as gasoline consumption in the United States remained very robust in 2023 compared to 2022 levels:

Thus, there is no real reason to be concerned about the fact that this acquisition will weight APA Corporation more towards the United States than it already is. That will probably not have any negative impacts on the company's business.

Synergies And Cost Reductions

Along with the announcement of the acquisition deal, APA Corporation released a presentation to its investors that appears to be intended to make the case for why the deal should be approved. The presentation includes a slide that details how the combined company will have lower expenses than the two independent firms:

As we can see, the elimination of redundant functions is expected to result in approximately $150 million of merger synergies. It does make sense that there will be some synergies after the merger. After all, there is no reason why the combined company will need to keep two accounting or two human resources departments. The elimination of some duplicate functions will reduce the company's costs compared to what both companies are paying combined right now. The same can be said about the cost of equipment and similar things. As the combined company will be a larger entity with more purchasing power, it may be able to negotiate better deals with its suppliers or contractors than either of the companies can get separately.

Naturally, any money that the company manages to save on expense reductions should be available to use to benefit the shareholders. This could be in the form of stock buybacks, dividends, or the company reinvesting into its own operations. APA Corporation does state in the presentation though that it is committed to using 60% of the combined company's free cash flow to fund a dividend and share repurchases, so it does seem likely that we could see some of this expected $150 million in synergy savings flow to the investors in that way. This may or may not result in share price appreciation, though, as energy companies have an unfortunate problem with share repurchases not always resulting in the capital gains that we would like to see. This is partly because of the endemic undervaluation that was mentioned in the introduction to this article.

Takeaway And Call To Action

Unfortunately, I cannot really see a good way for potential investors to profit from this deal if you do not already have shares. As this is a direct share-for-share exchange, it seems likely that the share prices of both APA Corporation and Callon Petroleum will directly correlate with one another while this deal is pending. Thus, if the shares of one company go down, the shares of the other likely will as well. This is therefore very different from a cash transaction where buying the shares of the target company at below the cash buyout price is an easy way to make some capital gains.

With that said, investors who expect that APA Corporation's shares will remain at their current level or higher until this deal closes in the second quarter should buy shares of Callon Petroleum instead. Callon Petroleum is trading at a slight discount to the deal price based on the share exchange rate as already mentioned. Thus, as long as APA shares stay at their current level, a buyer of Callon Petroleum will earn a small capital gain and still end up with shares of APA Corporation in a few months. Personally, I do not see a good reason for APA shares to decline significantly over the next few months, so I am going to assign a buy rating on Callon Petroleum as a profit opportunity from the merger.

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