The (Almost) Sure Thing
As the year winds toward a close, investors can find holiday joy in stock prices that have bounced back rewardingly. As Doris Day sang in “Che Sera, Sera” “The future’s not ours, to see” but stocks look poised for a prosperous New Year. Before the media began trying to make us worry about falling into another Depression, we used to also fret about oil prices. They’ve been quiet this year, rising from $60 a barrel to $70.
Short-term factors like the weather, strength of the dollar and supply issues all contribute to well-publicized energy price fluctuations. Meanwhile, rising global demand continues to meet a dissipating supply of traditional oil and natural gas supplies. Despite efforts for conservation and development of alternative sources, upward price pressures persist for oil and natural gas. The result is continuing support for prices of well-managed energy companies.
One of my longtime favorites, XTO Energy (XTO-$47) just got a takeover bid from Exxon (XOM-$68). The deal calls for .7098 shares of XOM for each share of XTO. The companies expect closing in the second quarter of 2010. That’s a current arbitrage spread of 3.2%, which on a closing in six months, is an annualized return of 6.4%. Two XTO dividends bump the spread to 3.4%.
Interest rates are still low and the annualized return beats the yield on government bonds. The principal risk in any merger arbitrage is that the merger will collapse or be delayed; the principal cause of such problems usually arises from difficulties obtaining approval from government regulators. In this case, Exxon is the world’s largest privately owned energy company and the deal will need antitrust clearance in many jurisdictions. A regiment of antirust lawyers is already doubtlessly spending their holidays on this issue and I expect these concerns have been anticipated to a substantial degree.
One unusual complication is a provision in the merger agreement that permits Exxon to pull out of the deal if Congress passes recently introduced legislation restricting drilling techniques used by XTO and other companies to extract oil and gas from difficult fields such as shale by hydraulic fracturing or “fracting.” This process involves pumping water or other chemicals at high pressure into underground oil and gas fields. It has been in use in this country for decades but increasing exploration efforts in recent years have raised concerns of possible ground water contamination.
The proposed legislation would close a loophole in a 2005 energy bill that exempted “fracking” from federal regulation. I believe it unlikely that a busy Congress will pass this bill before the closing of this merger. Even if it does, Exxon would probably not view its passage alone without additional restrictive regulations as constituting a sufficient regulatory burden to stop the merger.
In the event the merger should collapse, XTO stock, up seven points since the announcement, would promptly drop pending further developments. XTO has a stellar growth record on its own and would be able, given time, to see its earnings growth again reflected in its stock price. As often happens after a broken engagement, other suitors might also arise for XTO.
Until closing, XTO’s stock price will trade in harmony with Exxon’s. The merger spread will ultimately narrow with stockholder approvals and widen on news or rumors of problems. XTO traded at $70 last year and Exxon might even increase its bid in the event of delays.
XTO yields 1%, Exxon 2.4%. I view this as an attractive opportunity to enhance portfolios with a sizable blue chip stock at a slight but significant discount.