Oil and Gas Merger Model: Synergy Calculations
In this lesson, you’ll learn about revenue and expense synergies specific to oil & gas companies in M&A. We’ll start by covering why revenue synergies are especially problematic for natural resource companies, and then go through an example of how you could calculate expense synergies based on units of production – and why neither Exxon Mobil nor XTO expected substantial synergies in this deal.
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Oil and Gas Merger Model: Synergy Calculations
In this lesson, we’re going to get into the synergies associated with this transaction between Exxon Mobil and XTO. Remember that synergies are just one of our acquisition effects. If we go back to our merger model, in addition to the forgone interest one cash, the new interest on debt, and the amortization and depreciation expenses, the synergies are up here, and they’re listed as an additional acquisition effect.
The other ones in the previous lessons, we went in and fill them in, or at least what we could fill in so far, based on what we’ve completed in this model. We have numbers in place for around half of those right now. The synergies, though, are going to require a separate schedule because they’re somewhat independent of the rest of the model. Rather than trying to incorporate them into our 3-Statement Merger Model for Exxon Mobil and XTO itself, we’re going to look at them in a separate schedule and look at them by
taking in some of XTO’s financial information and modifying it based on information that we find in press releases and equity research surrounding this deal.
To get started, you’re probably familiar with the concept of synergies already, if you seen basic merger models, but just to recap and to go over the basic types . . . I’m going to zoom-in so you can see this a little bit better. Basically, synergies are situations where 1 + 1 = 3: You buy company, and rather than just adding in the company’s revenue to your own revenue, you actually get something extra. In the case of revenue, for example, you may earn additional revenue from up-selling products, from cross selling products, from gaining new customers to sell products to from the seller, and these all apply to standard, normal companies. We are going to look at this for oil and gas, specifically, and see why revenue synergies
are a little bit problematic; but that’s just the basic concept for now.
Then, of course, you can have expense synergies, where you save money by reducing expenses, head count, buildings, operating leases, and so on. We will look at both of these. I’m going to start at the revenue side first and explain why revenue synergies are actually quite problematic to look at for oil and gas, and natural research companies. Then we’re going to move into expense synergies, and look at why those can also be also problematic, but why those are not quite as questionable to include in this model, and we’re actually going to go in and make some estimates for expense synergies.
First off, on the revenue side: if you think about it . . . let’s go over to XTO’s production instead. If you remember how this is working, basically, we’re projecting their average daily
and annual production, in terms of natural gas, NGLs and oil, and we’re looking at the market prices for gas, natural gas liquids, and oil. We’re looking at the hedging factor, so how much they’re hedging their own prices and using that to determine in large part what the revenue is. Basically, what it comes down to is that we’re taking the Market Prices for Gas, Natural Las Liquids, and Oil multiplied by a few factors to take into account, Pre-Hedging Price Deferential and Hedging Amount that they’re using multiplied by the Production Volume to get to our revenue.
If you think about it, the analogy for normal company would be that instead of production, we would have unit sales. Let’s say that we are Microsoft for example, and we’re selling Windows and Office to computer manufacturers and individual consumers. In that case, what we could do is assume, for example, that the average selling price
for Windows and Office goes up as the result of an acquisition. Maybe the unit sales go up even though they already have a monopoly. Let’s just say for the sake of argument that unit sales could potentially go up because they can get access to new customers from an acquisition.
For oil and gas companies, both assumptions, either assuming an increase in the unit price, the market price for gas, natural gas liquids, and oil, or assuming an increase in production volumes; both of those are quite problematic. For the market price assumption, the problem is that oil and gas companies have no control over the market prices that they receive for their products, the energy that they produce. Remember that oil and gas and any type of natural resource is global market and everything is determined by supply and demand. In this case, a company like XTO, or even a huge company like Exxon Mobil is very, very small in the global scheme of things. If you look at, for example, oil and gas companies in the Middle East – OPEC,
Saudi Arabia, production from that area of the world – they would have a little bit more power to determine prices by restricting supply since they comprise so much of the average daily supply in the world. But even there, it’s not like a country such as Saudi Arabic can go in and say, “Now oil, rather than being $61 per barrel or $75 per barrel, we’re going to increase the prices, and now it’s going to be $100 per barrel.” No one party in a market like this actually has enough power to do that. Compared to other industries, oil and gas companies really have no control over the prices they will receive or very, very limited control, if any. That’s why we can’t really assume anything, in terms of the average realized price going up or down.
One thing we could potentially do is remove the effect of hedging. The reason is that Exxon Mobil does not really use any hedging. They do not actually make use of derivatives in the same way XTO Energy did, so we could go back and remove this effect, but the problem is that if we go in and look at equity research
surrounding this deal. I’ve pulled up an equity research report from JP Morgan. Let’s just do a search for ‘hedging’. On page 7, I just did a search twice for this, it says that, “XTO’s price hedge will be left to run off, but some of its debt may be opportunistically retired.” They’re not actually announcing plans to cancel any of the derivatives that XTO already has in place, so it would not really be accurate to remove the effect of hedging, but that would be one way in which the revenue side of the picture might change. That’s really the only possible change we can make, but we’re not going to bother with that because according to the press releases and the research around the deal, they have no plans to do anything.
Then on the production side, it would be more viable to assume an increase in production as a result of additional scale. Remember that Exxon Mobil is a global company. They have revenue coming in from almost everywhere in the world whereas XTO is more limited to the US and North America. We
could go in and assume, for example, that the average daily production goes up by 1%, 2%, or something in that range. The problem with that kind of assumption though, is that if you assume that production goes up, it’s not like as with the Microsoft example or standard company, it’s not as if they can suddenly make this change overnight. Even when they have a huge company like Exxon Mobil behind them, it still takes time to get oil and gas projects up and running. Even if we want to go in and, let’s say for example, that we want to make production increase by 5%, due to increase scale and increase geographies, more opportunities around the world. It is still going to take time to actually implement this. Usually, oil and gas projects like this have a development cycle of at least 5 to 10 years. Sometimes a bit less than that, sometimes more than that, depending on the region and the type, but the bottom line is that they’re not going to see any immediate near-term synergies from increase production.
Even with a normal company, revenue synergies are problematic to assume, but with an oil and gas / natural resources company, or a mining company, they’re even more problematic because you have no control over market prices. All you can really do is change the hedging positions of the company that you are buying, and beyond that with production, you do have some control over that. You could increase production, but it takes time to get up and running; it’s not going to happen overnight.
In the year 2010, 2011, and 2012, the first 3 years after the acquisition takes place, we are not going to see much, in terms of the benefit for increased production. That is why we’re not going to look at revenue synergies in an oil and gas merger model like this. In real life, you’ll are going to see the same thing, that hardly anyone really takes revenue synergies seriously, especially for an acquisition like this, and especially in this type of industry. The more viable one to look at are the cost synergies.
There are a couple categories of cost synergies. I’m going to zoom-in once again, to explain this a bit more. We can reduce headcount, so we can lay an employee, maybe some G&A functions, for example are redundant, and we no longer we will need them if we have Exxon Mobil as our parent company now because they’re global, they’re huge, they have hundreds of thousands of employees, most likely. We could consolidate operating leases on buildings. Maybe if Exxon Mobil has headquarters in one of the cities that we’re based in, we no longer need to have two separate buildings; we can consolidate them and save money. We can also reduce CapEx, or somehow modify CapEx, because maybe they have some overlap with the projects that we’re working on, so we no longer have to spend quite as much on CapEx as we would of if we had remained separate entities. Then we can also just reduce generic G&A or production-type
Expenses. For a normal company, remember that production expenses are similar to Cost of Goods Sold (COGS). It’s just that for an oil and gas company, they’re labeled production instead, but it’s really referring to the same concept; the cost of producing one unit of energy from the ground.
Let’s do some investigating and see which of these are viable to look at in this particular model. Let’s go back once again to equity research. I’m going to up to the top and scan through this and show you key points to look at. First off, they’re confirming once again that the deal is going to be dilution reaffirmation of near term EPS and return dilution, so it matches what we already have in our model. They have no cost synergy targets, no near-term CapEx synergies, and no clarity on ”sustaining the capital needs of the acquired portfolio.” It looks like they’re not setting specific targets. Let’s keep reading and see if we can find anything else that JP Morgan has mentioned, in relation to this deal.
They’re mentioning how Exxon Mobil’s shifting to unconventional gas as a result of the acquisition. We already know that from the model and from how XTO operates. Again, they’re saying once again that management guided to simply add to the 2010 CapEx for XTO to Exxon Mobil’s 2010 Guidance, and that’s exactly what we’re doing in this model. We are not going to assume anything; we’re not going to assume any type of synergies just to be consistent with real life.
The other issue is that if we went in and assumed CapEx synergies, it will actually get quite complicated to flow through the model because the CapEx is going to in turn affect the PP&E, it’s going to affect the depreciation expenses, as well, so it would require changing around quite a bit of our operating model and that is actually one reason why CapEx synergies is not quite particularly common. Another factor is that if you think about it, the CapEx synergies are not really going to directly impact the earnings per share because CapEx is not an income statement item. It will indirectly impact it, in that the depreciation expense, which does show up on the income statement,
may be less after the synergies have been taken into account, but it certainly has less of a direct impact than something like revenue synergies or saving money on operating expenses.
Let’s keep reading and see if they have anything else. No target operating cost for reductions, but intention to reduce costs. If we read through this, we can see some interesting points. “Exxon Mobil clearly believes XTO manages operating cost efficiently across the cycle, to that end, Exxon Mobil is retaining most of XTO’s 3,300 employees.” It looks like they’re not really reducing the headcount at all, and they’re actually saying, right up above, this is really interesting, “Going so far as to suggest that there will be benefits as Exxon Mobil learns best practice from XTO.” This is highly usual.
They’re saying that a company that’s worth 10 times as much as XTO, an enterprise value of $350 billion or so, is actually going to learn from a company that has an enterprise value of only around $30 billion. In this case, it looks like they’re really not assuming much, they’re not announcing much, or setting expectations for much of anything, in terms of cost synergies in this particular case. They do say at the end, “We can see how the scale of Exxon Mobil US gas shale presence and its global procurement ought to lead to a competent of cost position relative to its smaller competitors.”
Long story short, based on equity research, it seems like they’re not really assuming much, in terms of CapEx synergies or in terms of cost synergies in other areas. It looks like this deal is really about the long-terms benefits and not about trying to realize massive short-term synergies, in this case. If you go and look at press releases, you can see basically the same thing. I’m going to look at this one.
This is from around the time the deal was completing, as well, and they say the same thing. “Nearly all of XTO’s 3,300 employees are transitioning to the new organization.” Bottom line is that from multiple sources, they’re confirming that there are very minimal cost synergies going on.
To recap the different categories, we’re not going to assume a headcount reduction; we’re not going to assume anything with CapEx because management specifically said to just add together CapEx for 2010, for both Exxon Mobil and XTO. Consolidating operative leases and buildings is a little bit more viable. The problem is that we just do not have enough information. If you look at Exxon Mobil and XTO’s filings, they are not breaking it out by specific operating leases, by specific buildings, or anything like that. We could try to estimate this, but in this case, it’s very, very difficult and they’re just not giving us enough specifics to do that. The other problem is that expenses for both of these companies are on a
unit-of-production basis. Any operating leases they have are going to be embedded in G&A, which means that it’s going to get very tricky to estimate this, because then, we would have to go back and change around how our operating model for XTO’s working, and instead of making everything on a per unit basis, we would have to split this out and make some of the G&A expense on a per unit basis, and some of it we’d have to make it hard-coded, fixed number, or at least a number that is not linked to units of production.
Logistically speaking, it is quite difficult to do this. We could try to make some type of estimate, but it is not really worth it. Really, the only viable one, based on the equity research we just saw and our own knowledge, is to reduce the generic G&A and production-type expenses, so that’s what we’re going to focus on. Let’s zoom out again.
Our basic method is that we’re going to look at all of XTO’s expenses on a unit of production basis, and then we’re going to assume a net reduction in production, in
G&A to account for the fact that Exxon Mobil does have wider reach globally; they have a lot more scale, so they can probably try to introduce some type of cost savings into XTO’s operations. To get these numbers, we’re going to link everything to XTO’s production model. We are going to start with the annual production then look at the expenses, and then make our assumptions for the cost reductions at the bottom. For annual production, we’re going to go over and take the total billion cubic feet equivalent for 2010 to 2012, from the XTO’s production model. Copy that over. Then for the expenses per unit of production, we’re going to go to the production model once again, and go down to where we have our expense projection, these are all blue because these are hard code numbers. If you remember back to how we project this in the first place, in the operating model for XTO. I will copy these around.
Just to get an idea of what we’re dealing with, I’m going to sum up everything to see what the expense look like on a per unit basis. Remember that a lot of these, namely the last three, are actually capitalized expenses, and of course, DD&A is a non-cash expense. These expenses, the total looks very high compared to what we know they’re realizing for each 1,000 cubic feet equivalent (Mcfe) of energy. Keep in mind that DD&A is non-cash and the last three are capitalized, so it’s not like they’re really paying in cash $9.43 for each Mcfe.
In terms of how we’re going to reduce these, remember that the last three are all capitalized; these are just components of CapEx. We are not assuming any CapEx synergies because management explicitly said not to. For G&A, this one is possible. The accretion of the asset retirement obligation is very low to begin with, and as a result of the acquisition, this one is not going to really change. They’re still have to retire their assets sometime in the feature.
DD&A, we have no CapEx synergies so we’re not going to assume anything there. Exploration, this one is interesting; this one may actually go away if Exxon Mobil, for example, were a Full Cost company, then the exploration expense that is expensed on XTO’s income statement, because of their successful efforts, that will actually go away and we’d have to change that and capitalize it instead. In this case, both Exxon Mobil and XTO use the Successful Effort method of accounting, which expenses the exploration expense, so we’re going to leave this one alone and not do anything. Taxes, transportation, and other, we could actually reduce, but usually with something like taxes, it’s difficult to assume synergies because those are beyond your control. Those are up to local governments, national governments, and industry-wide regulation. Bottom line is that the safest ones to look at are production and G&A. For production, we’re going to assume they have $0.07, so really, $0.07 less per Mcfe of energy.
I’m going to copy this across for all three years. For G&A, this is already lowered to begin with, around $0.20 to $0.25 per Mcfe. I’m going to assume that this is $0.02 less per Mcfe. Copy this across.
Overall, we’re reducing expenses by around $0.09, so very, very small. We’re looking at a reduction of about 1%, but that is quite realistic. For a deal like this, seeing a reduction of, say, 10% or 20% percent is not going to be that realistic, considering that they explicitly told us not to expect much, in terms of near-term cost synergies. In fact, even what we’ve done so far, they would probably look at this and say, “This is not going to happen. We’re already efficient as is.” I’m really just doing this to show you how it could potentially work in the most likely categories in which we could assume synergies, but keep in mind that in the real world, we would probably not even see 1% of cost savings.
Now let’s look at the new total expenses per
1,000 cubic feet. Take the Old Total Expenses and subtract the Reduction that we assumed; carry this across. Now we can figure out how much our operating income is going to go up by. Remember that our production is in billions of cubic feet equivalent. Our expenses are per 1,000 cubic feet equivalent (Mcfe). 1 billion divided by 1,000 or multiplied by 1/1,000 is going to give us units in the millions, which matches the units that are operating income and other revenue line items are in.
To get this number, we’re simply going to take our reduction of $0.09 and multiply by the Annual Production in Billions of Cubic Feet Equivalent. We get an increase of about $100 million to $125 million over these three years. That may seem like a lot, but remember, going back to the merger model, XTO, the seller operating income was around $3 billion, so it’s not that much compared to their operating income, and certainly not a number that would make us look at this and say, “Wow. I can’t believe there’s so much in synergies for this particular deal.”
A very realistic assumption for the most part.
To finish this off, let’s now link to our new synergy calculation and incorporate this to our acquisition effects. I’m going to take this, go over to the synergies page, and link in to the increase in operating income. Copy that across. One other thing to be careful of, I labeled the synergies net of additional expense. On the expense side, we don’t have to worry about this, but if we assumed revenue synergies, with additional production would come additional expenses, so we would have to take into account the additional per production expenses, the additional per unit expenses as well, if we assumed an increase in production. In this case, we don’t have that so we’re just looking at the cost synergies and the increase in operating income, and everything is pretty straight forward.
If we look at how that affects the EPS accretion / dilution, overall, the EPS accretion / dilution is around ($0.26), so it’s dilutive by about
$0.25 or $0.26, by around 4%. If I took out the synergies right now, it would increase and be more like $0.27 to $0.28, so not a really tremendous effect and that’s because the scale, the dollar amount is relatively small to the seller’s operating income. The breakeven synergies without those existing synergies are around $2.5 or $2.6 billion. If I include those synergies once again, it drops around $2.4 billion, which makes sense because our synergies are in the $100 million range; that explains the difference between the $2.4 and $2.5 billion.
That’s how we would go in and assume synergies for an oil and gas company like this. Just to recap, revenue synergies are very problematic to assume in a scenario because you cannot control market prices for a natural resource company. Production could potentially increase but it’s not going to happen overnight. You’re not going to see results in a 3-year period; it’s going to take more like 5 to 10 year to see results.
Then on the expense side, it is dangerous to assume anything for CapEx and reduced headcount if the press releases have told us explicitly that there’s nothing there, so that’s why we left that out. Operating leases, we don’t have enough information. Really, all we can do is look at the general production and G&A-type of expenses, and assume a reduction to those, in this case. We already know this deal is going to be dilutive, according to multiple sources and our own model. We know that they’re not expecting much in cost synergies, so our assumptions and the numbers that we’ve calculated are consistent with what we seen press releases and equity research. That is how you calculate synergies and incorporate them into a Merger Model for an oil & gas company, or really, any type of natural resource company that’s acquiring another natural resource company.
Coming up next, we’re going to get into the next part of this model, which is to look at the debts schedule at the bottom. We’re going to combine XTO’s debt schedule with the new debt that is being issued in this deal and look at how everything is affected, and look at some of the new numbers.
After we have that, then we’re going to get into the business of combining the balance sheets and cash flow statements over the future period. Then after that, we’ll look at some deal metrics, we’ll look some additional information, and some additional analysis that we can do around this deal, and some of the metrics and the analysis that is specific to natural resource companies.