Deal of the Year: Making the Elephant Dance

The companies of Rex Tillerson, chairman and chief executive officer of ExxonMobil, left, and Bob Simpson, XTO founder and chairman, had engaged in many deals through the years.

Don’t say goodbye to XTO yet. The nimble unconventional-gas leader lives on within energy giant ExxonMobil following its acquisition… and has clout to leverage.

In the end, the biggest deal in a decade hinged on a single phone call, but it was in fact four decades in the making.

Many in the industry considered it a surprise when the world’s largest oil and gas major, ExxonMobil Corp., announced a $41-billion merger with Fort Worth, Texas, independent neighbor XTO Energy Inc., which recently topped the list as the No. 1 natural gas producer in the U.S. And yet the companies had quietly courted each other for years.

The resulting marriage has been named Oil and Gas Investor’s M&A Deal of the Year.

While the all-stock transaction is short-term dilutive to ExxonMobil, Rex Tillerson, chairman and chief executive, takes a longer view of the complementary combination, its biggest acquisition since merging with Mobil Corp. in 1999.

“As we look to the future, XTO’s strengths, combined with ExxonMobil’s advanced research, project management, operational capabilities and financial strength, will create significant synergies and unconventional resource development that are unmatched in the energy industry,” Tillerson said on a conference call.

The acquisition, which closed at the end of June, took the energy giant from a small introductory position in onshore U.S. shale gas, to a dominant stake in five of the preeminent gas plays—the Barnett, Haynesville, Marcellus, Fayetteville and Woodford shales—with 1.25 million acres.

“ExxonMobil’s move seems to be a clear statement from the most highly regarded technical managers in global oil that unconventional natural gas is a global game-changer,” observes Paul Sankey, research analyst with Deutsche Bank in New York. “This is an expansionary move into a new mega-theme.”

Barclays Capital’s Greg Pipkin, an advisor to the deal, says, “This deal validates North America as a legitimate shale-gas region, and that natural gas will be a major source of energy for decades.”

Barclays Capital’s Greg Pipkin, an advisor to the deal, describes the impetus for the transaction as a large global company buying a growth engine focused on unconventional natural resources. “This deal,” he says, “validates North America as a legitimate shale-gas region, and that natural gas will be a major source of energy for decades.”

The Irving, Texas-based Exxon describes XTO as “purpose built” around these types of resources and seeks to extrapolate the nimble independent’s U.S. success internationally.

“What we’re doing here is beyond just the resource base of XTO alone,” says Tillerson. “It’s about creating additional value by applying their expertise on additional plays that we have acquired around the world.”

XTO founder and chairman Bob Simpson, discussing the deal in a conference call, sees the handoff similarly. “In reviewing our future path, we realized that we needed to look at options to take what we have achieved and bring it to a new level. ExxonMobil is ideally placed to build on our success and open new opportunities for the development of unconventional resources on a global basis.”

Former XTO president Vaughn Vennerberg, above, says that ultimately, XTO’s motivation to do the deal was about adding shareholder value.

A Good Fit

Former XTO president Vaughn Vennerberg extolls the merger as bringing together two highly complementary organizations.

“We felt that our two organizations were a good fit because ExxonMobil’s principles and business values were similar to our own,” says Vennerberg. Both companies focused on a strong safety culture, a commitment to increasing shareholder value, maximizing technology and technology development, “and the development of specialized expertise through our most important resource—our people. ExxonMobil immediately recognized the value of our people.”

The people were as important to ExxonMobil as the resources, he says. During the transition planning period, ExxonMobil worked closely with XTO’s management to make sure they understood how important they were to the future success of the new organization.

“XTO personnel will enhance ExxonMobil’s global operations due to their experiences in domestic unconventional resource operations. We’ll continue to do the things that have made us so successful and now have opportunities to apply what we’ve learned on a global basis. XTO will now have a larger horizon in which to apply its skills and technical expertise.”

Vennerberg says that ultimately, XTO’s motivation to do the deal was about adding shareholder value, and it determined that the best way to reach its highest potential was to join a firm such as ExxonMobil.

“This would enable us to grow and continue what we have been so successful doing in the past. By joining with ExxonMobil we’re able to add additional scale, technology and financial capacity that ExxonMobil is known for.”

Origin of a Deal

The seeds for the deal started some 40 years ago when ExxonMobil CEO Tillerson and Jefferies & Co.’s Jack Randall, co-founder of the asset advisory firm Randall & Dewey, were classmates at the University of Texas. Both were in the civil engineering program and in the marching band, Tillerson on drums and Randall on trumpet. They knew each other well and remained in touch through the years.

Bob Simpson started privately held Cross Timbers Oil Co. in 1986 with $35 million in investor money. The company went public in 1993 and changed its name to XTO Energy in 2001. XTO’s bread and butter was to buy cast-off properties from the majors and enhance the value.

XTO held more than 250 million acres in unconventional resources in the U.S., including prominent positions in five major shale-gas plays and one oil shale.

In the 1990s, the company began doing deals with ExxonMobil, some of which were represented by Randall’s firm (later sold to Jefferies), and the two companies developed a history of doing smaller deals together.

Following XTO’s $215-million purchase of Exxon properties in the Permian Basin in 2005, Randall suggested to Tillerson that he should get acquainted with Simpson. “You guys need to get to know each other,” said Randall. “You never can tell what’s going to happen.” The two went quail hunting together in South Texas.

Says Randall, “It made Rex comfortable that this company they were doing deals with knew what they were doing, and it made Bob comfortable with Rex.”

In 2007 and 2008, XTO went on a $12-billion buying spree, greatly expanding its reserves and particularly broadening its reach into U.S. shale-gas reservoirs. When it bought Hunt Petroleum for $4.2 billion in the summer of ’08, XTO gained a large position in some assets in which Exxon was the operator. (This deal was named Oil and Gas Investor’s M&A Deal of the Year for 2008. For more, see “Good Hunting” at OilandGasInvestor.com.)

Exxon, too, had desired the properties, and discussions of rationalization ensued. Based on those discussions, in November of that year, Randall, who sat on the XTO board of directors, told board members he thought Exxon was “watching” the company closely.

“Exxon had its eye on XTO,” says Randall. “We did not know it for a fact, but we suspected it. We had a history of doing deals together, and the companies were obviously getting comfortable with one another.”

Soft Gas Ahead

In the meantime, the environment was changing for independents like XTO. Prolific shale-gas plays quickly overwhelmed the desire for other types of gas reservoirs, but the capital intensity to develop the highly technical reserves, combined with depressed gas prices, challenged all operators. A growth company by design, the $40-billion XTO found it difficult to continue that pace in the current environment.

“The shales were a game-changer,” Randall says, “but they are capital-intensive to exploit.”

The company could have survived and thrived, but needed a river of capital to develop its 10,000 existing drilling locations. “In a languishing gas-price environment, that’s hard to do. It was going to be harder and harder to keep that growth going.”

In other words, limited value added in a soft gas-price environment. Barclays’ Pipkin says XTO foresaw increasing taxes, regulation and oilfield service costs that would put pressure on margins and returns, and “the best returns in the shales go to companies with the lowest cost of capital.”

In the summer of 2009, Randall and Simpson met to discuss the future of the company, and decided it was time to seek a merger partner with deep pockets. “We felt like to thrive in the new environment, we needed to be paired with somebody that had a lot of financial muscle,” Randall says.

Says Simpson, “We recognized that the potential of the opportunities before us could best be reached if we could find an organization that could bring additional shale technology and financial capacity to the work we have been doing.”

And yet they were not seeking to sell for cash; they wanted shareholders to be able to participate materially in the exploitation of the portfolio XTO had amassed. Thus, a desirable company stock was important. “We knew no one could or would pay us cash for all of the upside,” says Randall.

They narrowed the list to two companies, including Exxon. Randall called his old friend Tillerson, and the two met in Exxon’s offices in Dallas to float the trial balloon.

Post merger, ExxonMobil has more than 8 million acres of unconventional resources worldwide that are largely undeveloped, which XTO’s team of 300 engineers, geologists and geophysicists will be mobilized t

Filling the Need

Randall couldn’t have known that Exxon had been evaluating the need to establish a position in U.S. shale gas based on its extended energy projections. When ExxonMobil peered 30 years into the future, as reflected in its “Outlook for Energy 2009” report released the week before the deal announcement, it saw natural gas as the No. 2 fuel behind oil—surpassing coal—with projected global gas demand growing at a faster clip than oil or coal, at 1.8% annually.

“We think there’s going to be significant demand for natural gas in the future,” Tillerson says. “It’s going to grow at a substantially faster rate than oil and coal.”

That demand will largely be driven by global power generation. Gas is well suited because of its lower environmental impact and its flexibility to handle varying load demands, according to the report.

“That’s what underlies our outlook for strong growth in gas demand all over the world. Our view is that unconventional gas is going to play (a significant role) in meeting that demand.”

Globally, ExxonMobil has vast swaths of mostly raw acreage prospective for shale gas, some 7 million acres spread throughout Poland, Hungary, Germany and Argentina. In Canada, the company is the largest Horn River Basin leaseholder. Most of its gas holdings in the U.S., however, were conventional. Its unconventional positions included 145,000 acres in the Marcellus, and 50,000 each in the Haynes­ville and Eagle Ford shales.

Barclays’ Pipkin says that ExxonMobil was interested in doing a large U.S. shale deal to fill this void, and “XTO was No. 1 on their list.”

“You guys need to get to know each other,” Jack Randall, above, co-founder of the asset advisory firm Randall & Dewey, now part of Jefferies, told ExxonMobil head Rex Tillerson. “You never can tell what’s going to happen.”

“If we were going to continue to be a material participant in U.S. gas markets in the future, which we think are going to grow strongly, it had to be in the unconventional,” emphasizes Tillerson. “So the question was, do you go out and acquire acreage yourself and build an organization, or do you try to do that in a more significant and material way? This opportunity came to us to get a material position.”

Tillerson, Simpson and Randall met in late August for dinner at the Fort Worth Club to discuss a strategic combination, setting in motion a three-month negotiation. Barclays and Jefferies were retained as financial advisors to XTO, while JPMorgan Securities Inc. advised Exxon through the process.

The deal was struck in mid-December 2009, and closed in late June.

The acquisition brought ExxonMobil a resource base of 45 trillion cubic feet equivalent (Tcfe), with 14 Tcfe proved, and production of 485,000 barrels of oil equivalent per day, increasing its total production by 10%. The merger almost tripled ExxonMobil’s U.S. gas production, from 1.3 billion cubic feet per day to 3.7 billion.

On both an equity premium valuation and when compared with the price per barrel equivalent proved, the deal value of the ExxonMobil/XTO merger falls in the median of other major transactions in the past decade.

Combined, the company is far and away the largest producer of natural gas in the U.S. with 6% of the market.

In addition to marquee positions in the five big shale-gas plays, XTO’s portfolio featured significant positions in the Freestone trend of East Texas, the San Juan, Raton and Uinta basins in the Rockies, and some 450,000 net acres in the Bakken shale. The company also had small offshore positions in the shallow-water Gulf of Mexico and the North Sea.

Exxon paid 0.7098 share per XTO share, giving XTO shareholders the flexibility to ride the upside with the assets and avoid a taxable event, or to cash them in. The valuation represented a 25% premium as of the announcement, a good price, per Pipkin, as it captured “most of the foreseeable future for XTO.”

Brain Trust or Bust

The biggest concern for both companies was keeping together XTO’s crackerjack machine for exploiting shale gas. Just a few years before, ConocoPhillips lost the brain trust behind Burlington Resources when the brightest minds bolted following its acquisition.

“Numerous hours were spent figuring out the right plan,” says Pipkin.

To mitigate this outcome, Exxon established XTO as a separate division, still in Fort Worth and retaining the brand for at least two years, while rolling in its own international unconventional holdings. Exxon’s Jack Williams heads the division, with former XTO chief executive Keith Hutton as executive vice president. The remaining XTO executive team remains under contract for a year.

Tillerson assures that the XTO team will be encouraged to do the things that made them successful. The 3,300 employees were prom­ised business as usual in the U.S. for a time, plus the opportunity to take their talents to locales overseas. “We believe that’s going to be exciting for the people at XTO,” he says. “They’re going to have a much larger horizon now in which to apply their technical skills and expertise.”

Additionally, the division’s $4-billion capex and drilling plans for 2010, established pre-merger, are unchanged, with 70 rigs running.

And much of the post-merger integration is going to be reverse integration, Tillerson says, with considerable knowledge of processes passing from XTO to the ExxonMobil base organization. “Benefits are going to migrate both directions.” To that end, Exxon dispatched a special integration team to the XTO offices to study work processes and how to integrate those into the global portfolio.

Jefferies’ Randall believes the XTO employees will like the arrangement. “They should see this cross-breeding as making the elephant dance. The good news is—that is what the guys at the top want to happen.”

nd the strategy is masterful, he says. “Being able to use the Exxon muscle to get these unconventional gas positions around the world, and then to turn it over to a group like XTO is smart thinking. It’s playing to both groups’ strengths.”

XTO’s track record has been driven by acquisitions, and that mission remains unchanged, according to Tillerson. They’ve been given “some latitude and some authority” to continue making acquisitions. He says the company is evaluating acreage on the market that “is fairly substantive” and adjacent to existing operations. “We are looking opportunistically.”

Vennerberg points out that picking up acreage at a good value is one of XTO’s core strengths, and he anticipates no change. “We expect to bring forward quality opportunities.”

Other ‘Big Things’

The move by ExxonMobil propels the world’s top gas producer to the pinnacle of U.S. natural gas producers, a politically savvy strategy as climate legislation looms in Congress with a deference to the clean-burning and relatively environmentally friendly fuel. The domestic gas-come-lately energy giant will likely become an influential voice in the debate.

“To the extent that climate change legislation creates advantages or disadvantages for fuel choices,” says ExxonMobil’s Tillerson, “natural gas clearly is a competitive fuel as a price for carbon might be put in place.”

And the big unit might not be done. Deutsche Bank’s Sankey notes that one element to the all-stock strategy is that ExxonMobil has talked about making not one, but two major deals. “By making an all-stock deal, the company is in a position to make a second major acquisition, should the opportunity arise. The company is talking about chasing other ‘big things’ in unconventional gas without being specific.”

But for now, the biggest deal in a decade is “the best major marrying the best independent,” says Jack Randall.

“They had something we needed, which was a great balance sheet and the ability to bring a lot of financial muscle to it, as well as advanced research. And we had something they needed, which was a great position onshore U.S. gas and the personnel needed to exploit it. There were complementary strengths and weaknesses.
“It’s going to be a home run for both companies,” he concludes.