In an environment of fairly consistent commodity pricing—with long-term pricing expectations of about $8 per million Btu and a steady climb to $100 per barrel oil—U.S. upstream deal flow was $48.9 billion in 2007. During 2007, there was a healthy balance in the upstream deal flow between the supply of and the demand for properties.


Sellers provided the supply through large-scale strategic sales, noncore pruning of large portfolios, and exits by the private-equity-backed companies seeking liquidity events.


Buyers continued to keep their demand high with expectations of outsized returns to investors. Private-equity investment, the continued strategic reshaping of public-company portfolios, and the emergence of the upstream master limited partnerships (MLPs) all played a big part in 2007 in driving the demand for assets.


With 2007 being the first full year for the upstream MLPs and the role they played in the U.S. deal flow, it is timely to focus on MLP deal flow.

Supply side
On the supply side of the transaction market, strategic reshaping by Dominion Exploration & Production and Anadarko Petroleum Corp. contributed more than $18 billion in assets and helped feed MLP demand. Both companies sold for strategic reasons.


Dominion’s parent decided to almost completely exit the E&P business. (It retained its Appalachian assets which provide key natural gas supply to its pipeline system.) Anadarko continued its program of optimizing its portfolio while raising after-tax cash to pay debt associated with its 2006 purchases of Kerr-McGee Corp. and Western Gas Resources.


Both of the sales were well timed to take advantage of newly emerging buyers in the market. Dominion attracted a large private-equity group, a foreign buyer, a public company seeking growth and an MLP. Anadarko was able to attract multiple MLPs, foreign buyers and publics seeking growth.


Dominion sold its assets in four major deals: its Gulf of Mexico package to ENI for $4.76 billion; Permian Basin assets (with a sliver of Michigan and Alabama assets) to Loews Corp.’s E&P entity HighMount Exploration & Production LLC for $4.03 billion; Rockies, San Juan and South Texas assets to XTO Energy Inc. for $2.5 billion; and Midcontinent assets to Linn Energy for $2.05 billion. The sales raised a total of $13.3 billion pre-tax cash.


Not to be outdone, Anadarko carried out a similar-size sale during the second half of 2006 and the first half of 2007. No company has ever sold so much in so many packages in such a short period of time. But in a different approach than Dominion, Anadarko created tighter-focused regional packages, taking advantage of heightened interest by regional players and wading right into the voracious appetite of the existing MLPs and those companies planning to create upstream MLPs. During 2007 Anadarko announced the upstream sales of almost $5 billion.


Anadarko sold Permian Basin assets to Apache Corp. for $1 billion, deepwater Gulf of Mexico assets to Nippon and Mitsubishi for a combined $1.2 billion, Midcontinent and Gulf Coast assets to Exco Resources for $860 million, Rockies assets to Encore Acquisition Co. for $810 million, Austin Chalk assets to EnerVest Management Partners and EV Energy Partners for a combined $728 million, and West Texas assets to Chesapeake for $310 million.


An active M&A participant, Plains Exploration & Production had another busy year reshaping its portfolio and its transactions were oriented toward gas. It completed two major acquisitions—the first was of the Piceance Basin-focused assets of Laramie Energy for $945 million and the second a cash and stock acquisition of Pogo Producing Co. for approximately $3.7 billion.


In December 2007, Plains announced a partial sale of 50% of its interests in Piceance Basin and Permian assets to Occidental Petroleum Corp. for $1.55 billion. Oxy will operate the Permian properties and Plains will continue to operate the Piceance properties. Commensurate with the sale to Oxy, Plains also announced a sale of its San Juan and Barnett shale properties to XTO in a $200-million deal.


In an example of a private-equity-backed company finding an attractive time to exit and a public company seeking growth, Leor Energy LP decided in November to sell its Deep Bossier interests in Amoruso Field in East Texas to EnCana Corp. for $2.55 billion. This followed a 30% acquisition EnCana made to enter the field at the end of 2005 and an additional 20% acquisition it made for an announced price of $243 million in 2006.

Upstream MLPs
The structure everyone was talking about in 2007, the upstream MLP, hit its heyday and contributed mightily to the busy acquisition year. This group in mid-January consisted of nine entities and had an enterprise value of approximately $13 billion. Fewer than two years ago, this group did not exist, yet it completed more than $7 billion in acquisitions during 2007.
These tax pass-through vehicles allow higher valuations to be placed on appropriate assets than that of a taxable entity. The MLP structure is well suited for a burgeoning group of investors: those seeking yields. MLPs are designed to provide this as long as they hold the appropriate kinds of assets.


In the case of an upstream entity, this translates to assets with a high percentage of proved develop producing (generally greater than 70% PDP) and long reserve-to-production ratios (generally greater than 15 years). With those characteristics, these types of entities will have low maintenance capital requirements with a high percentage of slowly declining cash flow available for dividends.


It is no surprise that all upstream MLPs are not created equally and the market is starting to sort out this fact. Yields varied during 2007, with the average peaking just above 5% (just above Treasury yields) in the middle of the year finishing 2007 at 8.5%, more appropriately reflecting risk.


More importantly, the range of yields has broadened greatly with the year-end yield of individual companies varying from just below 6% to just above 11% as the market sorts out cash individual track records, portfolios and structures.
To grow dividends and offer superior yields, MLPs need to grow. The two normal choices are either through acquisitions or through the drillbit. The latter is risky and difficult with the types of assets best suited for an MLP, so MLPs need to buy smartly.


Never shy, the first upstream MLP, Linn Energy LLC, made $2.7 billion in transactions in 2007, more than tripling its size during the year. Beside the previously discussed Dominion Midcontinent transaction, it acquired Lamamco Drilling, with assets in Oklahoma, for $552 million, and Pogo Producing’s assets in the Texas Panhandle in a $90.5-million transaction.
EV Energy Partners also had a very busy year shaping its portfolio, both through acquisitions of other company’s assets as well as from “drop downs” from its EnerVest Management Partners Ltd. institutional partnerships. In open market acquisitions, in addition to the $728-million acquisition of an Austin Chalk package from Anadarko discussed previously ($631 million acquired by EnerVest Management Ltd. and $97 million acquired by EV), EV also acquired Plantation Petroleum’s Permian assets for $160 million. In drop-downs from the EnerVest institutional funds, EV acquired Michigan properties ($71.6 million), North Louisiana properties ($96 million), and Appalachian properties ($59.5 million).


It will be interesting to see if advantages and disadvantages develop between the various MLPs based upon the ability to drop properties down, from either a public or private entity. It is a great way for a company, which intimately knows the characteristics of a property and can determine very finely whether assets are suitable to an upstream MLP structure, to carefully build an MLP-appropriate portfolio from the inside, rather than trying to compete in the open market.


But there are complexities in managing at arm’s length two different entities with two different sets of shareholders, each with its own objectives and obligations.


Other MLPs were also significant deal-makers. Atlas Energy Resources LLC and BreitBurn Energy Partners LP made major acquisitions of Michigan assets, which have ideal production and reserve profiles for MLPs. Atlas acquired DTE Gas & Oil Co., a wholly owned subsidiary of DTE Energy. The transaction value was $1.23 billion with high-PDP-percentage assets focused in the Antrim shale in Michigan.


A few months later, BreitBurn acquired upstream and midstream assets predominantly in the Michigan Antrim shale with additional properties in Kentucky and Indiana from Quicksilver Resources Inc. in a $1.45-billion cash and stock transaction. These properties also have a classic MLP fit, with a PDP ratio closer to 90%.


BreitBurn also acquired Florida oil properties from Calumet Florida LLC for $100 million and the majority interest in an institutional partnership that is managed by BreitBurn Energy Co. for its parent, Provident Energy Trust, for $92 million.
Constellation Energy Partners LLC and Encore Acquisition Co.’s MLP, Encore Energy Partners LP, were additionally active. Following its November 2006 IPO, Constellation spent almost $500 million for three coalbed-methane packages on properties in the Cherokee Basin in Oklahoma. Its first acquisition was from EnergyQuest Resources LP in March for $115 million, followed by an acquisition in July from Amvest Osage Inc. for $240 million, and in August from Newfield Exploration Co. for $128 million.


Encore Acquisition, which took its Encore Energy Partners MLP public in September 2007, reshaped its portfolio with an active transactional year. It purchased $810 million in Rockies assets in two transactions in the Big Horn and Williston basins from Anadarko. It sold its Midcontinent assets to Crow Creek Energy II LLC for $300 million. At the end of 2007, it dropped down $249 million in Permian and Williston assets to its MLP.

MLP plans
Exco Resources Inc., which recently shelved its planned $1.5-billion upstream MLP offering, spent some time rearranging its portfolio. It bought $860 million of assets from Anadarko earlier in 2007, and additional interests from a private seller in its Canyon Sand Field in West Texas for $157 million. It sold its South Texas and South Louisiana assets to Crimson Exploration Inc. for $290 million and sold an additional $105 million in assets in the Anadarko Basin.


Though not specifically an MLP-related transaction but borne of a deep examination of the MLP market, Chesapeake announced a volumetric production payment (VPP) structured sale to affiliates of UBS and Deutsche Bank for proceeds of $1.1 billion. The VPP entitles the purchasers to receive scheduled quantities of gas, free of all production costs, for a 15-year term. This transaction, done at a 6.3% discount rate, provides Chesapeake proceeds to deploy at anticipated rates exceeding 30%. Chesapeake expects to monetize more than $2 billion of producing assets in similar transactions in the next two years.
2008 will be an interesting year for the upstream MLP. The opinion of the validity of the structure is wide ranging. On one hand, this is a great structure for investors seeking yield and the PDP-heavy assets provide opportunity for premium valuations. On the other hand, it is a structure without a long-term track record that competes in the energy sector with a $150-billion midstream MLP peer group that offers more stable cash flows.


As demonstrated in the second half of 2007, the upstream peer group will increasingly be measured on individual performance metrics and be distinguished from one another based on historical performance. What will be interesting to watch is how many more companies eventually come to the market with upstream MLPs. A couple dozen companies have been thinking about it but many with filings have recently shelved plans while they await more stability in the financial markets and while they watch the current MLP group mature.

William A. Marko is a managing director with Jefferies Randall & Dewey, Houston, which specializes in public and private finance, M&A and A&D services for upstream oil and gas companies.