"High prices cure high prices," according to the economic maxim, but if 2004 is a reliable indication, $45 oil and $6 gas may not be "high" enough. In spite of prices at levels redefining perceptions of "high," no clear evidence of a price-driven supply response appears to be forthcoming, leaving only even higher prices to battle the dragon of demand. Higher commodity prices led directly to record transaction reserve values in 2004, but the most impressive attributes in the mergers, acquisition and divestiture (MA&D) market were the magnitude of asset supply and the corporate appetites able to clear the market at ever-higher prices. As evidence mounted that current prices could be sustainable, the MA&D market's focus turned to the capture of development-drilling opportunities. This emphasis shaped not only the asset market, but also rekindled merger activity in the public E&P sector. 2004 was a good year to be holding an inventory of drilling locations or to be based in Denver and a number of well-known names were acquired when it was apparent they were both. While no super-major mergers or mergers among super-independents made headlines in 2004, the upstream value of announced U.S. merger, acquisition and divestitures as measured by Randall & Dewey totaled a robust $29.0 billion, surpassed only by the major consolidation years of 1998-2000. The implied reserve value for the $29 billion in transactions was a record $9.67 per barrel of oil equivalent (BOE). In spite of an industrywide dread of reporting double-digit finding, development and acquisition (FD&A) costs, by year-end it was the "expensive" acquisition activity that helped moderate a poor year with the drillbit for some high-profile explorers. While it was no surprise that reserve values set records, the absolute magnitude of asset transaction activity signaled a shift in the public company's reaction to high commodity prices. In the past, public companies were generally reluctant to sell assets when prices are high, preferring to liquidate one barrel at a time. As the asset market embraced Nymex pricing, more and more companies utilized the robust market to clean up portfolios created through previous mergers. U.S. asset activity set records in 2004 for both total transaction value-$11.7 billion-and implied reserve value-$9.03 per BOE. The nearly $12 billion in U.S. asset transactions was accomplished without an "Elk Hills" scale transaction to skew the data. The increase in reserve value would have been even more impressive absent the emphasis in the market for acquiring proved undeveloped reserves. Producing reserves routinely changed hands at more than $12 per BOE, with Morgan Stanley's monetization of the producing wedge in the Anadarko Petroleum Corp. offshore Gulf of Mexico sale to Apache Corp. setting the pace at $28 per BOE net of operating liabilities. Anadarko's asset sales and stock repurchase will be the test case for active asset portfolio management. No public E&P company has ever sold a greater percentage of production and cash flow absent financial distress. Continuous portfolio rationalization by the super-majors has long been the lifeblood of the asset market. Anadarko's activity was followed by EnCana Corp. and Devon Energy Corp., creating the first wave of super-independent portfolio management. MA&D outside the U.S. was once again extremely active in 2004. For the fourth year in a row, non-U.S. transaction volume outpaced U.S. activity. Russia led the way with ConocoPhillips' strategic investment in Lukoil and the forced sale of Yuganskneftegaz from Yukos. The sale of Yukos' primary producing asset highlights the risks of being the political adversary of those truly in control. Although much of the West has expressed little outrage at what seems to be an intramural expropriation, it should serve as a reminder that when oil and gas profits are high, so are the motivations of governments to take them. The Canadian market continued to supply the royalty trusts with product. The apparent tax efficiency of direct distribution has not yet moved south of the border as the E&P tax structure of choice, but 2004 did mark the first significant foray of the Canadian royalty trusts into the U.S. asset market. Provident Energy Trust's $139-million purchase of California producer BreitBurn Energy LLC may lead to a new class of competitors in the U.S., although without the inherent tax advantages they enjoy in Canada. Public-company activity M&A has long been a leading indicator of future asset sales. Merging companies (absent pooling restrictions) were generally quick to reset the bar by selling low-end and orphan assets. The resurgence of midcap M&A in 2004 should lead to moderate asset-sales activity for 2005. Westport Resources, Tom Brown, Evergreen Resources and Patina Oil & Gas not only shared a Denver homebase and Rockies focus, they were also all between $1- and $3 billion in equity capitalization. The shrinking midcap league is in need of replenishment, with all remaining members sporting crosshairs on their backs. Perhaps the most surprising aspect of 2004 was that Devon Energy took the year off without buying anyone. An 80% annualized reserve growth rate is a difficult taskmaster that would have left Devon as the only independent after another five years of M&A. Four companies dominated the buyside of the U.S. market exhibiting market savvy, creativity and extra large checkbooks. Apache, Chesapeake Energy Corp., Newfield Exploration Co. and XTO Energy Inc. represented nearly half of the U.S. asset and private-company acquisition volume in 2004. If one of these companies was in the hunt for an asset package, other prospective buyers would often read about the deal in the paper before the bids were scheduled to be opened. The rate at which the four are spending will be difficult to perpetuate if the market remains supplied at historical norms. Newfield used Denbury Resources' offshore assets to help balance the purchase of Inland Resources' longer-lived Uinta Basin assets. XTO struck deals with ChevronTexaco and ExxonMobil, continuing its tradition of purchase and exploit from the majors. Apache took out Anadarko's shelf production with the help of a Morgan Stanley-led volumetric production payment and Chesapeake bought everyone else. Chesapeake's purchases of Bravo Natural Resources, Greystone Petroleum, BRG Petroleum and Hallwood Energy also illustrated two trends for 2004. The first was the predominant trend of private-company sales to public-company purchasers (at least for significantly scaled transactions) and the second was the increased focus on acquiring future exploitation opportunities, such as long-lived gas. On the private side, several 2003 sellers reemerged with new names attempting to recreate past successes. The most active private buyer was Dallas-based Merit Energy, which followed up an active 2003 with an even greater 2004. Reserve costs The high cost of buying current production, coupled with the equity market's desire to see "organic" production growth, gave rise to increasingly aggressive purchases of assets with solid exploitation potential. Where once proved undeveloped (PUD) reserves were significantly "haircut" relative to producing reserve values, PUD reserves garnered full fare in a few high-profile purchases. The growing influence of the value of development potential could be seen in the value of asset prices relative to current production rates. In 2003, we noted the occasional deal breaching the $50,000-per-barrel-per-day level. In 2004, a number of transactions brought $80,000 BOE per day with multiple $100-million deals posting metrics in excess of $100,000 BOE per day. The impact of rising oil and gas prices have been moving equities higher since the summer of 2001, but that pace of increase has been swamped by the increase in median values in the asset market. From mid-2003 to the end of 2004, asset transaction value per BOE per day increased more than 50%. Where the gap between these curves had once illustrated an arbitrage available to public E&P companies, that gap has now closed. Unless buying shorter-reserve-life production, most companies are faced with paying a higher price per barrel in an acquisition than they are being valued themselves in the equity market. In certain cases it was viewed as cheaper to buy a company than buy assets, which led to the increase in M&A activity in 2004. The closing of this gap between asset value and equity value also influenced the portfolio rationalization decisions of Anadarko, EnCana and Devon. While public E&P companies remained the most active buying segment of the U.S. market in 2004, the make-up of the selling segment was much more broadly distributed. Fund-sponsored, private companies as well as long-held family operations were motivated by price extremes to sell all or significant portions of existing assets. The super-majors tested the capacity of the market to execute the multibillion-dollar sale in one closing. As the equity market pays for perceptions of growth, most public E&P companies have been reluctant sellers, but the premiums being paid in the asset market proved difficult to ignore. Early indications of 2005 suggest a continued diversity of asset supply. Nymex pricing Academic studies will attempt to prove that the Nymex forward curve is a poor predictor of oil and gas prices over time. However imperfect the utility as a predictive tool, Nymex pricing has become the standard price path in the asset market. The ability to hedge multiyear pricing has resulted in a market that requires near compliance with the commodity market's view of the future. While volatility in the front months and spot markets remains relatively high, the intermediate-term contracts have been muted enough to lead the asset markets comfortably higher. As prices remain outside historic norms, price-risk mitigation remains an important tool in today's market. Well-capitalized companies, whether public or private, have the ability to hedge at the bid date rather than on the close, giving them a bidding advantage over the newer start-ups. Although the quarterly mix of assets (long-lived versus short-lived) distorts the correlation, the longer-term relationship between Nymex prices and asset values is unmistakable. As the market moves to a uniform external price view, those bold enough to anticipate a divergent price path will have opportunity to place their bets in the asset market. From the early releases of reserve-replacement costs reported by the independents it is hard not to argue that the MA&D market will continue to focus on exploitation opportunity. Producing reserves are increasingly bid down to single-digit returns, leaving the exploitation wedge as the only source for generating returns. The price advances during the past four years have well rewarded the active acquirer. The equity markets continue to support acquisition activity; but the days of immediately accretive, core-area purchases seem further in the past. The rule of the jungle of the public E&P company will remain "eat or be eaten" and those that are unable to eat from the asset banquet may move toward a corporate transaction. Continued robust asset supply is likely a function of commodity-price perception. A moderate pull-back in oil and gas prices will likely result in a temporary respite as sellers reassess their value expectations. Advancing prices will support ever-higher equity values and produce the balance-sheet strength required to mount an aggressive buying campaign. This will reward the asset owners who have resisted the temptation to sell-so far. Gregg Jacobson is managing partner of Caymus Capital Partners LP, the manager of Caymus Energy Fund LP. David Rockecharlie is managing director, corporate finance, at Randall & Dewey, a division of Jefferies & Co.