Finding A&D Parity

Asset supply in the upstream A&D market peaked in 2007 and held flat in 2008, but that market has dropped precipitously in 2009.

The plummet in commodity prices in the fall of 2008 created a wide bid-ask spread that prevented many deals from getting done. Sellers wanted valuations based on historical commodity prices, while buyers were underwriting deals at or near a much lower forward curve. For those deals that did trade, public companies sold conventional noncore assets to fund development of resource plays—the main focus for most large-cap companies and majors.

The capital markets have actually been detrimental to the A&D market by allowing companies to cite delevering of balance sheets as a use of proceeds for transactions, as opposed to funding organic growth or acquisitions. Companies that would have otherwise been forced to sell assets to pay down debt have instead tapped the equity markets.

Commodity prices

In second-half 2008 both oil and gas dropped more than 75% from their highs. Although both forward curves are in significant contango, industry views on their prices are divergent.

Oil has already rebounded from its low in December 2008, more than doubling its price per barrel. Natural gas, however, continues to decline in front-month pricing, despite a reduction of more than 50% in active U.S. gas- drilling rigs. Most pundits think oil will, at worst, stay flat and likely continue to move up as the global economy improves and demand increases.

Given the massive amounts of gas in U.S. shale plays and the historically high amount of gas in storage, most experts believe that gas prices will remain depressed for several years to come.

Buyer demand

In 2009, capital availability far outpaced asset transactions as buyers and sellers failed to see eye to eye on valuations.

Previous serial acquirers who propped up asset valuations, such as Chesapeake Energy Corp. and XTO Energy Corp., have disappeared from the A&D market as they digest their massive drilling inventories. Buyer groups are now bifurcated into two sub-groups targeting specific assets: conventional assets and resource plays.

Conventional-asset buyers are comprised mostly of private equity and private companies trying to buy noncore assets from public sellers for further exploitation at relatively low valuations. Occidental Petroleum, Apache Corp. and Concho Resources, however, are examples of large-cap companies that continue to look at conventional assets—although those companies are specifically targeting oily assets in the Permian Basin.

Resource-play buyers—mostly majors and international oil companies—are acquiring those assets by entering into acreage joint ventures with independents that provide a symbiotic relationship between the buyer and seller.

Through these joint ventures, sellers—mostly large-cap publics like Exco Resources, Chesapeake and Quicksilver Resources—are rewarded for assembling premium resource-play acreage positions. They receive relatively high acreage multiples in the form of both upfront cash and carried drilling interest. They also off­load part of the massive future development capital expenditures associated with these plays to well-funded majors and internationals.

On the other hand, the majors and internationals that were late to the game in the U.S. shale land grab of 2007 and 2008 can increase their exposure to the resource plays through these joint ventures. Additionally, they can glean horizontal drilling and completion knowledge for use in projects globally from those smaller independents. BG Group, Enerplus, Talisman, Eni and Total are examples of majors and internationals that have either recently struck deals or actively pursued them in the U.S. resource plays.

Not all majors are active in this market, however. Several, including Shell and ConocoPhillips, are trying to protect their dividends and as such, are either on the sidelines or are net sellers.

Valuations

Conventional-asset valuations have dropped off by 30% to 50% from their 2008 highs, depending upon the region and commodity type. Oily assets are the preferred commodity and command a 20% premium to gas transactions.

For example, oil assets in the Permian Basin are trading at $70,000 to $90,000 per daily flowing barrel, representing a 27% discount to their high-water mark in 2008. Gulf Coast gas transactions, however, are trading at $3,000 to $5,000 per daily flowing thousand cubic feet equivalent (Mcfe), a discount of more than 50% to 2008 levels.

Put another way, most oily assets are trading hands at proved developed producing (PDP) discount rates of between 8% and 12%, while gas assets are trading at PDP discount rates of 10% to 15%.

Buyers are not attributing much value to undeveloped locations for assets of either hydrocarbon.

Resource-play valuations, however, have been mixed. While some areas have seen reduced valuations (the Woodford, Barnett, Fayetteville and Wolfberry trends), the Marcellus and Haynesville shales have returned to their 2008 levels despite lower current gas prices and a bearish outlook on future prices. These lofty levels can be explained by the economic viability of gas wells in those plays even in the current pricing environment, and the demand from (or desperation of) the majors and internationals to get into those plays.

Conventional-asset valuations have dropped off by 30% to 50%, depending upon the region and commodity type. Resource-play valuations have been mixed.

Market outlook

While this year’s A&D market has been significantly depressed, asset supply should rebound. Market sobriety has already started to set in with sellers, so the bid-ask spread should narrow and allow more deals to be consummated.

Public companies with multibasin operations will continue to sell their noncore conventional assets in an attempt to focus on fewer operating areas and develop their resource plays. As the credit markets return, private equity will be able to leverage returns such that their bids will come up enough to meet “revised” seller expectations and clear the market. The majors and the internationals will continue to pursue additional resource-play transactions.