The beaten-down oil patch hasn’t had much good news of late. However, that changed earlier this week when Devon Energy (NYSE: DVN) and WPX Energy (NYSE: WPX) revealed that they would combine in a merger of equals. That news jolted the oil sector by fueling speculation that more deals could be forthcoming.

The industry needs to cut costs to combat lower oil prices. Analysts thus believe that we’ll see a lot more consolidation in the coming quarters.

An image of a handshake superimposed over an image of an energy facility.

Image source: Getty Images.

Charting the path

Devon Energy’s proposed merger with WPX Energy is the second notable deal in the sector following a devastating price crash earlier this year. The other is Chevron‘s (NYSE: CVX) $5 billion all-stock acquisition of Noble Energy (NASDAQ: NBL). Both transactions have similar features, making them good templates for future consolidation.

Chevron and Devon made all-stock deals featuring relatively low premiums, with Chevron only agreeing to pay 12% above Noble’s prior closing price and Devon offering a 2.7% higher price for WPX. By taking the all-stock route, the buyers preserved their cash and avoided taking on new debt. Meanwhile, they ensured these deals would boost results on a per-share basis within the first year by offering low premiums and avoiding too much dilution. 

Another major driver of these deals is the estimated cost savings and associated improvements in cash flow. For example, Chevron expects that by combining its operations with Noble Energy’s, it can capture $300 million pre-tax in annual run-rate synergies. It expects the transaction to be accretive to its return on capital employed, free cash flow, and earnings per share one year after closing, assuming the global oil price benchmark averages about $40 a barrel. 

Meanwhile, Devon sees its deal enhancing its existing cost savings plan by $275 million by the end of next year. That has it on track to reduce its costs by $575 million overall, positioning it to generate twice as much free cash flow. Further, the deal is also accretive to its per-share metrics during the first year. It also reduces its breakeven level for maintaining its current production rate to $33 a barrel for the U.S. oil benchmark price.

Following the leaders

The deals from Chevron and Devon provide a consolidation playbook for the industry. Notable components include a financially strong buyer acquiring a financially sound target in an all-stock, low premium deal. Transactions with these features should deliver immediate results by boosting the combined company’s per-share financial metrics without negatively impacting its balance sheet.

Because of that, analysts believe that these deals should spark similar ones. For example, an analyst at Johnson Rice highlighted Concho Resources (NYSE: CXO) and Pioneer Natural Resources (NYSE: PXD) as being among the best-positioned oil companies to digest an acquisition. Meanwhile, analysts have previously suggested that any one of Pioneer, Diamondback Energy (NASDAQ: FANG), Parsley Energy (NYSE: PE), Callon Petroleum (NYSE: CPE), and Cimarex Energy (NYSE: XEC) could be an acquisition target. 

Aside from Pioneer, all those companies have completed a notable deal in the last few years. Unfortunately, most of them haven’t created shareholder value because they either paid a high premium, took on too much debt, or were too reliant on higher oil prices to deliver results.

However, with the industry needing to consolidate to drive down costs, oil companies must focus on making deals that can deliver the best results without any help from higher oil prices. That will mean following the blueprints laid out by Chevron and Devon, which both can achieve compelling per-share accretion even if oil prices remain weak.

In a trickle or a wave, more consolidation is coming

With continued oil price volatility, oil companies need to do everything they can to drive down their costs. They can quickly do that by combining with a peer and using their increased scale to reduce expenses. While prior deals didn’t pay off as much as the sector expected, Chevron and Devon have drawn a better playbook that could finally work for an industry that needs to get back on track with creating shareholder value.  

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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