Exxon (XOM) stock is off highs ahead of Q3 earnings on Oct. 27. Investors are excited about Exxon's recent bid for Pioneer Natural Resources (PXD) which should produce a powerful free cash flow generator.
On Oct. 11 Exxon announced it had entered an agreement for an all-stock deal to buy all the shares of Pioneer. The exact deal is this: every PXD shareholder will receive 2.3234 shares of XOM common stock when the deal closes. It is foreseen to close sometime in the first half of 2024, assuming the Biden Administration approves the deal.Pioneer is a large oil shale producer in the Midland Basin region of Texas and Oklahoma. The deal is worth about $57.2 billion. This is based on the 233.14 million shares PXD shares outstanding at the end of July and today's price of $245.28 PXD price. However, there may be more shares outstanding as of Oct. 11., so its possible it is closer to $60 billion.
Nevertheless, the combined Exxon group will now have 45% of its global oil production from the U.S. It represents a major bet by Exxon that the U.S. will need substantial amounts of oil production in the coming years.
Free Cash Flow Generation Will Surge
The combined company will produce substantial amounts of free cash flow (FCF). For example, in Q2, Pioneer generated $742 million in FCF and paid out 75% of the prior quarter's FCF as dividends. Exxon produced an astounding $5.0 billion in Q2, and is on track to potentially generate a much higher number in Q3.
This means that the combined company could potentially deliver $23 billion in free cash flow at the Q2 operational levels. It could be substantially higher if the high oil prices in Q3 remain.
This will be more than enough to cover the capex, dividend, and buyback requirements of the combined company, even if oil prices drift lower.
This is why XOM stock has held up reasonably well since the deal was announced.
Shorting OTM Puts in XOM Stock for Income
One good effect of the deal is that it has raised Exxon's put option premiums. That allows short sellers to generate extra income.
For example, the Nov. 10 expiration period put period shows that the $100 strike price puts trade for 44 cents. That represents a 0.44% income yield (i..e, $0.44/$100 strike price).
This works out to an annualized expected return of 7.48% for investors who repeat this trade every 3 weeks for a year (i.e., 0.44% x 17x). Obviously, the premiums won't stay at the same level each time, but this shows how profitable the trade is for income investors.
Moreover, there is substantial downside protection as the stock would have to fall almost 8% before short put play would be exercised (i.e., investors would have to buy the stock at $100).
The bottom line is that this type of trade will work well for existing investors in the stock as a way to enhance their existing income yield (Exxon stock has a 3.35% dividend yield today). In total, it's possible that the short put investor could make about 11% - i.e., 7.5% from short put plays and 3.35% from dividend income.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
