The evolution of an E&P company is on-going. Are large-cap E&Ps getting too big and too complex? Is the business of growth too hard, too complex and too volatile-in geology, politics, currency, weather and more-for the generalist to grasp?

Does this lead to a loss of transparency, a higher risk premium and compressed equity multiples? Focus commands a premium.

Moreover, as top-line growth decelerates, large-cap E&Ps are being forced to drill bigger, higher-risk prospects, buy bigger and take on incrementally more risk. Devolving into a company with mid-single-digit-or less-growth quickly transforms a company into a commodity proxy. Who wants fixed-income returns, with commodity risk?







The reason for investments in E&Ps is to compound one barrel into multiple barrels. The process then needs to repeat itself. Companies that cannot do so at acceptable returns must consider alternatives.

This box has led to M&A in the past. However, in some cases today, de-merging may be a more viable strategy. Split into several companies, shed noncore assets, focus investors, increase transparency, magnify the skills of management and lower corporate risk by using internal expertise to capitalize on more traditional "singles" and "doubles."

This makes smaller finds and reasonable exploration more meaningful again. This can lower risk, increase growth and boost valuation in the marketplace.

There are several E&Ps to highlight, with Talisman Energy Inc. being one example, where the sum of its parts outshines the whole by some 45%. Talisman has the assets and the management acumen to de-merge.

In the 1970s and 1980s, E&Ps were largely smaller-cap, limited-liquidity investments that spun out of railroad companies (e.g. Union Pacific Resources and Burlington Resources), integrated oils (e.g. Kerr-McGee and Unocal), pipeline companies (Panhandle Eastern's roll-out of Anadarko Petroleum) or utilities (e.g. EEX Corp. and The Houston Exploration Co.).

Many others had one-well, one-field origins. Most were small and midcap companies with significant growth potential. Singles and doubles made a difference to their net asset value and return profiles.

Fast-forward and the market capitalizations of the top 10 producers since 1993 have grown almost eight times. Some large-cap E&Ps' market caps now exceed those of the domestic integrateds that were acquired in the 1990s. Today, the large-cap E&Ps are between $15- and $40 billion in market cap, and are increasingly challenged to grow economically and repeatably.

Several recent company announcements have made this clear. This is not a new problem; it has only been masked by rising commodity prices in recent years. If the commodity is going to continue to go up, buy the commodity.

However, a company that can compound at acceptable returns provides a "commodity-plus" return profile. This has driven a "haves and have-not" thesis on the group.

Top growers include Chesapeake Energy Corp., Talisman, Canadian Natural Resources, EOG Resources Inc. and XTO Energy Inc. Bottom growers include Pioneer Natural Resources, Forest Oil Corp., Pogo Producing Co, Newfield Exploration Co. and even Anadarko Petroleum.

What's so difficult about being big? The problem is that each successive acquisition has to be more meaningful and/or each exploration success bigger to drive the same amount of growth.

In the acquisition market today, competition for assets is more intense and wallets are bigger. Are managements willing to offer PV-8 to buy 2P (proved and probable) reserves off the forward curve? That's what the market is generally demanding.

In the acquisition market today, the slower-growth E&Ps' cost of capital/return hurdles are generally disadvantaging them relative to their competition-national oil companies, such as CNOOC and Statoil; more focused growers, such as XTO; and supermajors, such as Total SA. How does a producer compete for big assets consistently?

In the exploration market, potential for billion-barrel discoveries has fallen annually. Yet that size discovery is increasingly what is needed to move the needle. Generally speaking, billion-barrel projects are becoming "logistical projects" with long lead times, and extensive project-management skills required.

Examples of these include the Canadian oil sands, Venezuela's heavy Orinoco oil, the extremes of Sakhalin Island and liquefied natural gas. This is largely the domain of the supermajors. Getting smaller and going back to singles and doubles that again have impact may make the most sense for others.

In fact, the landscape is littered with companies whose limited reinvestment opportunities led to "strategic sales." When Phillips Petroleum announced its merger with Conoco in 2001, its market cap was more than $20 billion. Arco's was more than $25 billion when agreeing to merge with BP in 1999. Burlington Resources' was $32 billion when signing its merger deal with ConocoPhillips in 2005. And, Unocal's was more than $15 billion when agreeing to merge with ChevronTexaco in 2005.

But selling may not be the only option for under-valued opportunity sets. What about going back to E&P roots and de-merging?

De-merging consists of splitting into smaller companies in a tax-efficient manner, removing the "conglomerate discount," improving transparency, empowering employees, and making smaller discoveries/successes more meaningful again.

Are there any companies that can pull that lever? There are several in the E&P universe. Talisman Energy, for example, has the assets and the management acumen to accomplish it. And while it may not be easy, the reward is likely worth it.







When considering parts of the whole for de-merger, the characteristics to look for are high-quality assets that are trading at a discount to the sum of the company's parts; operating areas that can be easily segregated into smaller, more-focused groupings; and establishment of smaller companies that are self-funding, with exploration upside, strong, experienced management teams in all regions, and underappreciated skills, such as deep technological drilling, that deserves a premium, not a discount.

Benefits would include extracting value with better transparency and operational focus; empowering personnel in a market in which human capital is increasingly difficult to retain; and lowering the cost of capital, making the company more competitive as an acquirer, and allowing for the complement of opportunistic acquisitions when available.

Making smaller, more realistic (lower-risk) exploration successes (or acquisitions) will move the needle once again, forcing the market to recognize value. If the equity market doesn't, the corporate market is more apt to.

What are the risks?

Size. De-merging would create multiple entities, all of which are smaller than the whole. Smaller companies tend to have less financial stability and more limited access to financial markets.

Concentration. Sharpening operational focus implies a more concentrated asset portfolio, which would increase the repercussions of execution failures in any given region.

Employee retention. Retention of key employees is a top priority in the E&P space today, and major strategic initiatives can be accompanied by defection of employees who feel alienated by the process.

De-merging empowers employees, pushes down decision-making and allows them to participate in the risk/return tradeoff that generally drives superior performance.

De-merging may give some parts of the existing business a sizzle that can turn into steak.



Lloyd Byrne is an upstream analyst with Morgan Stanley based in New York. He can be reached at 212-761-8343.