Gains from Diversification Within Energy Firms

 

Takeaway

  • The previous trend toward diversification seems to be heading in the direction of disintegration.

Written in collaboration with Nathan Swem

Most companies go through periods where they see benefits of diversification and periods where diversification is seen as unattractive. This is clearly apparent when we consider the recent behavior of oil and gas companies. ConocoPhillips (COP), Marathon (MRO), Williams (WMB), El Paso (EP), and Sunoco (SUN) are among the companies who have announced or completed splitting transactions over the past year. These cases are especially interesting since each of these companies participated in significant M&A transactions over the 90’s and early 2000’s to build themselves into large diversified energy conglomerates.

There is clearly a tradeoff between the benefits of diversification and the benefits of being more focused. The most frequently discussed benefit of diversification is that it lowers the volatility of the firm’s cash flows, allowing the firm to increase its use of debt financing (for a given target credit rating), and as a result, it may lower its cost of capital. A second benefit is that a diversified firm may be better positioned to shift resources in response to changes in prices. For example, E&P companies are currently shifting resources from the production of natural gas to oil because of more attractive pricing. An E&P company that was purely focused on natural gas would find that shift more difficult.

Offsetting these benefits of diversification are advantages associated with being viewed by investors as a “pure-play,” which may create value when investors are segmented and have different beliefs. For example the shale revolution may be creating higher investor interest in pure-play E&P companies, resulting in a new pool of dedicated money to pursue investments in E&P companies. By creating new publically traded pure-play E&P companies the management teams of COP, MRO, EP, and WMB are creating securities that this new pool of money can invest in. Similarly, the newly created pure play downstream companies may be of interest to those investors that are especially optimistic about the prospects of refineries.

In addition, a pure-play company can potentially be better managed than its more diversified counterparts. A newly independent company will issue detailed SEC financial disclosers which can shed more light on operations that were previously obscured within the larger company. This improvement in available information, along with having a separate board or directors and investor base might raise the bar for management performance resulting in more aggressive corporate actions and more streamlined operations. Investors might be especially willing to embrace this line of reasoning if the integrated conglomerate were lagging peers in capital efficiency metrics and relative valuation.

While the tradeoff between the benefits of diversification and focus is clear, what is more difficult to understand is why diversification is sometimes in fashion, while at other times the sentiment swings towards more focused firms. One possibility is that the divergence of opinion, which drives the demand for pure play investments, has a tendency to run either hot or cold. Another possibility is that there are times when various business segments are seen by their managers as being substantially undervalued, and the attention created by a spinoff puts a spotlight on the undervalued assets, allowing the managers to realize full value.

The largest of the recent spin transaction is ConocoPhillips. The previous decade witnessed a trend towards diversification; an example of which was the 2001 purchase of Tosco by Phillips, which then merged with Conoco (to become ConocoPhillips) and later acquired Burlington Resources. This series of transactions created what is now the third largest integrated energy company in the US by market capitalization, with substantial oil and gas reserves as well as substantial refining assets. However, ConocoPhillips is now considering a move in the opposite direction, with a proposal to split into two companies, one which is primarily a refining company and the other which is primarily an Exploration and Production (E&P) company. This proposed split is at least partially motivated by the success of the recent split by smaller integrated peer company Marathon into “Marathon Oil” (ticker MRO) and “Marathon Petroleum” (new ticker MPC).

Judging from the market reaction Marathon’s transaction has been highly successful. In the period between announcing and completing the split transaction Marathon (MRO) stock outperformed a representative basket of stocks (60% E&P stocks and 40% Valero as a proxy for refiners) by over 25%. This outperformance was helped by the fact that Marathon stock traded at a significant valuation discount versus peers before the transaction announcement. Marathon’s cash flows were roughly 60% E&P and 40% refining related which made the split transaction materially transformational. Finally, Marathon’s refining operations are in highly desirable markets with exposure to the Brent-WTI spread. Therefore, the newly created pure-play refining company (MPC) is considered best-in-class.

In contrast ConocoPhillips stock (COP) has performed in-line with a proxy basket since the day of the split transaction announcement. This more muted reaction might reflect several factors including the fact that COP’s cash flows are 80% E&P related and only 20% refining, suggesting that COP’s split transaction will be less material than was the case for Marathon. In addition, starting in 2009 ConocoPhillips announced a series of transformational strategies and transactions as part of a “shrink to grow” initiative, suggesting that the advantages of a more focused firm may have already have been substantially incorporated into COPs share price.

Two of the country’s largest midstream companies Williams (WMB), and El Paso (EP) have also announced split transactions this year. Both stocks enjoyed a period of relative outperformance after the initial announcement. The success of the IPO of pure-play pipeline company Kinder Morgan Inc. (KMI) was likely a motivating factor for these transactions. Kinder Morgan is a large pure-play pipeline company, and after going public in February 2011 KMI stock has enjoyed a significant valuation premium to both Williams and El Paso. Within three months of Kinder Morgan’s IPO both Williams and El Paso announced plans to spin off E&P operations into separate companies and become large pure-play pipeline/mid-stream companies which will more closely resemble Kinder Morgan.

Finally, after spinning off petroleum coke operations into a separate publically traded company Sunoco (SUN) recently announced plans to further de-diversify by divesting refining operations. This will result in Sunoco becoming a more “pure” petroleum marketing and logistics company.

In summary, it is obvious that the recent split transactions in the energy industry have many company specific drivers. This is reflected by the different market reactions to the various transactions. However, it is difficult to ignore the contrast between the recent series of very large split transactions with the series of very large M&A transactions of the 90’s and early 2000’s. Does this about-face represent a fundamental change in the benefits and costs of diversification or is it simply a change in market sentiments.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Sheridan Titman

Walter W. McAllister Centennial Chair in Financial Services, McCombs School of Business

Sheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic...

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