In the speed version of the classic board game Monopoly, all the players buy every property they land on the first time around the board. As soon as all the lots are bought, a heavy round of haggling follows, where competitors scramble to swap or buy the properties that will give them the best advantage.

Banks lending to the oil and gas industry say that phase has come to the real-life world of upstream acreage, with producers of all sizes making asset deals to consolidate holdings.

That urgent reshuffling is taking place against a backdrop of potential rising interest rates. Stock and bond markets reacted strongly to recent announcements by the Federal Reserve that it was considering tapering down fiscal stimulus, but so far lenders in the oil patch say the impact on deals has been minimal. That could change, however, if rates were to be increased sharply.

The other variable is the inflow of private-equity money, which continues apace. Bankers say the influx is good for producers and good for them, as it supports deal-making. But it, too, could dwindle if interest rates were to climb.

“Markets continue to be open for oil and gas lending,” says Sylvia K. Barnes, managing director at KeyBanc Capital Markets and group head of oil and gas investment and corporate banking. “It is still an attractive space for investors, despite the choppiness of the broader markets.”

KeyBanc has current oil and gas loan commitments of $1.4 billion to 39 clients, a sharp rise from $900 million to 27 clients in the third quarter of 2011, when Barnes and several colleagues joined the group.

Granting there are many factors that affect bank lending to the upstream and midstream sectors, Barnes believes the key driver is “there is a lot of pressure now on the companies that seized big acreage. Now that the land rush is mostly over and they have the opportunity to exploit their holdings, they realize it is going to cost billions and billions of dollars.”

She notes that, “Today there is a focus on drilling and completion costs, on technical expertise, and on access to capital markets. In general, that favors the larger companies that tend to have more in-house capability and can command better terms from the service companies, but there are always opportunities for smaller companies, and multiple opportunities for banks.”

KeyBanc works with buyers and sellers, but in the current circumstances Barnes says “on the whole it is a sellers' market for good positions. There is a hunger for high-quality assets, and we have many clients seeking those. In contrast there is a buyers' market for marginal properties.”

In both cases she says that recent prices and valuations for deals currently in the works are reasonable. “In general the market is efficient. There are not really any big arbitrage opportunities.”

That said, Barnes observes there are distinct differences in assessment of reserves by one or another company, not as buyer or seller, but based on completion techniques and technical expertise. “Different companies have different skill sets and will work a position differently. We see that especially in the Permian. Even though that is an old basin, there is a steep learning curve and multiple horizons. We are also seeing a steep learning curve in the Utica.”

As she looks out over the second half of the year, Barnes says coolly that “the smartest hedge is not an interest rate position, it is a low-cost structure. Upstream is all about margins, growth and access to capital. The game-winning stories that lenders want to hear are cost reductions, focused operations, technical expertise, and the ability to manage capital, not just raise it.”

Geological risk

Keith Behrens, managing director and group head of energy investment banking for Stephens Inc., notes that one of the challenges for dealmaking right now is the desire for buyers to see more of a producing asset component versus an upside component that had recently been required.

“In the past, private equity would back a lot of heavy acreage deals with not a lot of drilling necessary before the asset could be sold. Now the buyer universe has contracted a bit and the buyers are requiring more drilling to be completed to pay maximum value. It used to be that you could drill a few wells and flip the acreage. Now, not so much.”

Behrens suggests that with some of the challenges seen, notably in the Niobrara and the Utica, but also in noncore areas of other shale plays, there is some geological risk coming back into the equation. “It is very difficult to pick up core quality acreage in the Bakken or Eagle Ford, and if a producer is in fringier areas, sometimes things work and sometimes they don't. Companies are attempting to extend plays in all the basins, which is great, but it is also more challenging.

“Also, some companies do better in certain types of plays. What works for one company in one horizon of one basin may not work for a different producer, or different horizon, or different basin.” The net result is that buyers are looking for more production history to take some risk out of the equation.

Stephens is active across the board in debt, private equity, M&A and A&D, with private and public clients. One recent debt transaction Behrens notes was with ERG Resources, a “uni-tranche” debt deal, as he describes it. “Our mezzanine debt sources will advance more against a reserve base than most banks usually will, because they have the opportunity to earn more of a return for the additional risk they are taking on,” he says.

“In many cases, the clients do not want to go to the equity markets, because they do not want to dilute their ownership and have not moved their drilling program along enough to reach full value.”

Private equity, he notes, “in some cases is still pursuing early-stage deals these days, where they will provide capital to initiate or accelerate a drilling program. That goes back to my previous statement about how you have to drill up more acres to turn a deal. We have several deals in this market in the works right now, and expect several closings later this year.”

Behrens says he has seen more A&D at the asset level than M&A at the corporate level. And even within A&D, some geographic areas are out of favor. Many of the big companies that were historically buyers are now selling in certain areas. The less desirable regions are primarily where results have been less predictable.

He adds that there have even been a few transactions involving dry-gas assets where there was little or no liquids component to the production to help raise the value.

Bumpy transitions

Ralph Eads, vice chairman of global oil and gas investment banking at Jefferies & Co., concurs that the M&A market, especially at the corporate level, has been slow. But he suggests that it is not just a focus on reshuffling assets, but also a reticence by a young crop of leaders among the larger companies.

“We are seeing significant backlog in the oil and gas market, as the asset transactions have slowed. There is not a great deal of confidence in the industry, despite the increase in interest rates, which reflects stronger general economic readings. The first half was the slowest six months in M&A in the last seven or eight years.”

He says one of the reasons for the M&A slowdown is that there is a very conservative philosophy among the majors and large independents. “About half of them are going through C-suite changes—Shell, Oxy, Encana, Chesapeake, Talisman, Hess, Marathon—among others. And some transitions have been bumpy. The new executives are taking a very conservative approach as they start. We have lost a generation of entrepreneurs at the CEO level.”

Another factor, one that actually makes new executives even less likely to be ambitious and creative, is the rise of activist shareholders. “They have been remarkably effective,” Eads observes. “They want value returned to the shareholders, despite the fact most companies can generate very strong portfolio returns.”

A third factor is the sheer volume of work needed to exploit current unconventional holdings. As other financiers have noted, producers of all sizes have knowingly bitten off more than they can chew, and are now exerting themselves to get the plum properties into production and rationalize the rest of the portfolio.

“It is not geological risk that is constraining activity,” Eads says. “Companies are challenged by the scale of the execution job they face. They are consolidating their holdings, try-

ing to figure out how to do the large drilling and completion programs necessary to develop their holdings. Across the board the industry is in digestion mode, including the international players, the national oil companies and sovereign wealth funds.”

For the North American producers, private equity continues to provide important lifting power, Eads says. “That is good for the industry, and critical to meeting domestic energy needs. The industry still needs a great deal of capital, and the returns are quite good, probably the best of any large asset class in the world. In the absence of the strategics increasing activity, private equity is showing up to take their place.”

Second verse, same as the first

Just because there has not been much corporate-level M&A, that doesn't mean there have been no big deals. BMO Capital Markets was recently involved in financing the $1-billion acquisition of Chesapeake Energy assets by Exco Resources that was announced in early July.

“All the discussion about tapering quantitative easing has had some notable effects on the credit markets, particularly high-yield bonds,” says Tod Benton, managing director and US head of energy for BMO Capital Markets. There are more deals in the works, and he doesn't believe that a modest increase in rates will seriously hamper M&A activity in the space.

Benton is also quick to note that the absence of big M&A deals has not translated to an absence of interest. “There is constant chatter about corporate-level deals,” he says, suggesting that with equities under pressure lately, those discussions are likely to increase. “But corporate-level M&A is still only 10% or less of the overall M&A/A&D market these days. We are active on both the sellside and the buy-side. A&D has been very robust.” Some notable clients include Halcón, Merit Energy, Hilcorp and SM Energy.

Among the deals under way, most are liquids related, although Benton says there has been some master limited partnership activity in natural gas. “They are primarily concerned with cash flow,” he notes, and a flowing gas well is just that. “People are willing to pay for producing gas assets but not so much for upside potential.”

The Gulf of Mexico has seen some recent activity, with Talos acquiring the Helix E&P assets and Apache's recent announcement that it is looking to sell assets in the Gulf. The unconventional shale plays also remain interesting. The Utica shale is active with producers delineating the best areas; financing is available if they are in the right place, Benton says.

“We have continued to see private equity jump in and that tends to be positive for the sector.”

Over the second half of the year Benton expects to see more of the same. “Absent the wheels falling off the credit markets, the second half is likely to look a lot like the first half.”

Deals are getting done

Amid all the conditions and contingencies and things to keep an eye on, Jay Boudreaux, managing director at Simmons & Co. International, says it's important to bear in mind that “commodity prices are relatively stable and that buyers and sellers are finding common ground. Deals are getting done.”

He confirms that there has been significant A&D activity in emerging plays, especially among properties with substantial economics. In the first quarter, A&D activity was in line with the norm, but in the second quarter it was down significantly.

“In the second half of the year we project activity to return to normal levels. There is continued interest in liquids-rich positions with strong economics, especially stacked pay and multiple horizons.”

Boudreaux does not expect an accelerating economy or possible rising interest rates to hamper transactions. “The cost of capital and its availability to exploration and production are not likely to see any dramatic change, but we will continue to watch developments.”

The rub for some transactions is the need for sellers to demonstrate more production from acres on offer. “We are seeing buyers require more well results on packages they are looking at,” says Boudreaux. “There are still PUDs (proved undeveloped reserves) on offer, but the percentage of PDP (proved developed producing) is increasing.”

Overall, “We have done significant work in emerging resource plays, and that continues to be an active market, especially for bolt-on acquisitions.”

For more on investment banking trends, see OilandGasInvestor.com.