?The upstream A&D market in 2008 was a tumultuous roller-coaster ride that began with strong capital markets, unprecedented commodity prices and frothy valuations. Yet it ended with a price collapse, sliding valuations and the closure of the capital markets. All in all, 2008 was a tale of two halves.
Supply. The first half of the year saw a blistering pace of A&D upstream assets traded with $32 billion sold through July. This huge first-half volume was largely driven by “Obama”-related selling (fear of rising capital gains tax) by private and private equity-backed companies along with heavy East Texas/Haynesville selling (trying to capture $20,000+/acre valuations). The year was headed for $60 billion of assets sold, far surpassing the record $45 billion of assets sold in 2007, when market turmoil set in.
With commodity prices collapsing and the subsequent closing of the capital markets, the remainder of the year saw only $12 billion of assets traded—nearly one-third coming from a single deal between StatoilHydro and Chesapeake Energy Corp. Furthermore, RBC Richardson Barr estimates some $20 billion of assets were proactively pulled from the market in the fourth quarter.
Beginning in August, potential buyers headed for the sidelines, leaving sellers with little option. The result was a landscape of failed deals totaling more than $11 billion.
Commodity prices. After first-half 2008 experienced price levels of $140-plus oil and $13-plus gas, the second half saw oil prices drop nearly 70% and gas nearly 60% to end the year at $44.60 and $5.63. Furthermore, after seeing modest differentials in the first half, the average natural gas differential to Henry Hub pricing by the fourth quarter exceeded $2 in the Rockies and Midcontinent and more than $1.50 in the Permian.
As a result of reduced realized prices along with prohibitive service costs, operators began laying down large numbers of rigs. The active fleet of rigs in the U.S. is currently down more than 20% since its high level at the end of August and should continue to drop at an even more dramatic pace as long as commodity prices are suppressed and service costs continue to be misaligned.
E&P capital. Accessibility of E&P capital mirrored the A&D market. From 2004 through 2008, public E&P capital (equity and debt) grew year over year to the point where at the end of 2007 and the beginning of 2008 there was $2 of capital for every $1 of assets in the marketplace.
However, the capital markets shut down completely in the early third quarter with the onset of the subprime meltdown and resulting bank failures. Third-quarter 2008 saw only $8 billion raised in E&P capital while the fourth quarter saw only $1.6 billion from three debt deals. With essentially no capital available to fund acquisitions, the A&D market dried up.
Valuation metrics. Valuations began to decline toward the end of the third quarter and continued through the fourth quarter. While premiums continue to be paid for high-quality assets, sinking commodity prices and the closure of the capital markets have pushed down metrics for more marginal assets or have rendered them not marketable.
With sellers’ expectations reflecting valuations achieved in the first eight months of 2008 and buyers’ perceived values considerably more bearish, large bid/ask spreads influenced the high number of failed deals in the latter half of the year and continue to hamper A&D activity. Valuation metrics will likely remain modest through the first half of 2009.
Expectations for 2009. Several industry trends will proliferate through the E&P space in 2009. Some E&Ps will experience significant 2008 year-end reserve write-downs as a result of lower commodity prices, and these revisions will also cause industry F&D (finding and development) costs to increase to well over $4/Mcfe.
Lower commodity prices will continue to force a decrease in rig counts, capital-expenditure reductions and increased headcount reductions.
A large supply of assets is expected in 2009 as a result of distressed sales and public E&Ps selling conventional assets to fund shale-play development. In terms of buyers, private-equity-backed companies (historically sellers) and the majors and international oil companies should be dominant in 2009.
Private-equity companies, flush with approximately $35 billion of E&P capital, should be able to exploit the large supply of assets on the market with little competition from publics. Majors and internationals will likely continue to acquire large acreage positions, especially in shale plays, and should continue to purchase relatively large nonoperated positions to leverage and absorb personnel and technical expertise. Financial distress and low valuations should result in an increase in corporate M&A. Utilities may begin spinning off their E&P assets.
Valuations are currently off about 50% from first-half 2008 levels, and RBC Richardson Barr expects those levels to remain through the first half of 2009. Distressed sellers will finally capitulate and begin selling higher-quality assets in the second half, resulting in improved valuation multiples. Additionally, an influx of E&P capital—as witnessed by recent offerings from Devon, Sandridge, Petrohawk, Chesapeake and Whiting—while currently very expensive, should begin to fuel more A&D transactions in the latter part of the year.
—Scott Richardson and Craig Lande, RBC Richardson Barr & Co.,
(713) 585-3300