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This Hot Oil Play Keeps Getting Hotter

Image source: Getty Images.

Acquisition activity in Texas' legendary Permian Basin continues to catch fire as producers position themselves for the coming rebound in the oil market. Over the past week alone there have been two notable multibillion-dollar deals in the region at increasingly stunning per-acre valuations. That said, there is a method to the madness of the increasing premiums drillers are willing to pay for land.

Drilling down into the latest deals

The priciest transaction of the industry's recent buying binge in the Permian is RSP Permian's (NYSE: RSPP) $2.4 billion acquisition of privately held Silver Hill Energy Partners and Silver Hill E&P. Those companies combined to control 41,000 net acres in the Delaware Basin portion of the play and currently produce 15,000 barrels of oil equivalent per day from 58 producing wells. That said, the draw for RSP Permian was not the current production but the 1,950 total undeveloped locations. The company sees the superior economics of those future wells enabling it to grow production by an astounding 86% next year. That is why it is willing to pay an implied per-acre value of $58,500 for those locations, which is the highest per-acre purchase price in the Permian this year and is almost double the average price paid for acreage in the Delaware.

Meanwhile, SM Energy (NYSE: SM) is becoming one of the many serial acquirers in the Permian after recently announcing its second Midland Basin acquisition in just the past two months. Its latest transaction is for privately held QStar, which it is purchasing for $1.6 billion, picking up its 35,700 net acres for $45,000 an acre. That tops the price SM Energy paid not more than two months ago for land in the region, spending $980 million in August to acquire slightly less than 25,000 net acres at an implied value of $39,500 per acre. Both deals are well above the value range of $25,000 to $35,000 that prime drilling land in the Midland Basin was fetching earlier this year.

For SM Energy, these transactions are truly transformational. Its first Permian deal transformed the company from a no-growth producer back into a growth company. Analysts at KeyBanc, for example, revised their view on the company from a forecast that it would deliver 2% oil production growth in 2017 and a 1% decline in 2018 to a view that it could deliver 15% oil growth next year and 20% in 2018. The company's latest deal transforms its future even more toward growth because SM Energy simultaneously sold its declining Bakken shale position to Oasis Petroleum (NYSE: OAS) for $785 million in cash. In doing so, it is trading lower-margin no-growth assets to Oasis Petroleum in exchange for the higher margins and faster growth offered in the Permian Basin.

What's driving these deals?

For both RSP Permian and SM Energy, the one factor driving their decisions to invest billions of dollars in bolstering their position in the Permian Basin is to create substantial scale. RSP Permian, for example, noted that the transaction "creates substantial scale with combined current production of approximately 50 MBoe/d, over 100,000 net surface acres, over 500,000 net effective horizontal acres and over 3,600 net drilling locations with substantial additional upside from tighter spacing assumptions." Meanwhile, SM Energy similarly noted that it has "established a position as an outstanding operator in the Midland Basin, and with this acquisition we also establish significant scale."

While that scale enables the companies to drive costs lower due to economies of scale, and lower service and transportation costs, it can also drive up drilling returns. In SM Energy's case, the QStar acquisition brings in acreage that is contiguous with its current position. That is crucial because it now enables SM Energy to drill longer horizontal laterals on those blocks:

Source: SM Energy investor presentation.

The ability to drill longer laterals is significant because they are proving to be a key to driving up drilling returns. That is evident by looking at Chesapeake Energy (NYSE: CHK), which is one of a growing number of producers finding that drilling longer laterals can significantly boost drilling returns compared to shorter wells. For example, Chesapeake Energy can earn a 25% rate of return by drilling a 5,300-foot horizontal well in the Eagle Ford shale, with that rate surging to 65% when it drills 10,500-foot wells. The company is seeing similar success with longer laterals in the Haynesville shale, which is why Chesapeake recently spent $87 million to enhance its acreage position in that play. Because of how compelling those longer laterals are, drillers will likely continue making acquisitions to increase their scale by acquiring contiguous acreage positions.

Investor takeaway

Acquisition activity in the Permian Basin is accelerating as producers build scale positions in that key oil growth play. That is because drillers are finding that scale drives down costs and drives up returns. As a result, there will likely continue to be a steady stream of M&A across America's shale plays as producers reposition themselves for the next up cycle.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.