Illustration by Patrick Merewether

While domestic E&P A&D activity is running hot at the midpoint of the year with $27 billion in deals announced at press time, much of that activity is fueled by private- and public-equity-backed companies taking advantage of the current political and economic environment by exiting now.

“Every time there’s a Hillary (Clinton) or Obama ad on TV, we get another call from a private company that is very fearful that capital gains are going from 15% to 28%,” quips Scott Richardson, principal of Richardson Barr & Co., soon to be merged with Royal Bank of Canada.

Obama is on record for increasing capital gains taxes from the current 15% to a range of 20% to 28%. Democratic candidate Clinton, before suspending her campaign, stated she might leave them alone but would not increase the rate to more than 20%. Republican candidate Sen. John McCain has said he would not change the current rate, but still garners skepticism in the oil patch if he is paired with a Democratic-controlled Congress.

“We’re seeing a lot more private-company divestiture activity this year than we have in years past,” Richardson says. “When we’re talking to companies, they almost all cite that they would rather sell with capital gains being 15%.” Record commodity prices contribute to that motivation as well, he adds.

Examples of private-company exits in 2008 include that of New Orleans-based Taylor Energy Co. LLC for $1.1 billion; Shreveport’s Will-Drill Resources Inc. for $659 million; Dallas’ Headington Oil Co. LP for $1.85 billion; Midland’s Henry Petroleum for $565 million; Dallas-based Hunt Petroleum Co. for $4.2 billion; and assets of Samson Investment Co. in Tulsa, Okla., for an undisclosed amount.

“These are sellers that you don’t typically see sell assets. We’ve always seen private and public companies sell assets, but we’re really seeing a whole lot of tax-driven private-company divestitures this year. We expect to see that trend continue for the next five to six months.”

Already $16 billion in private-company asset divestitures have been closed or announced through the first week in June, compared with $7 billion for the whole year in 2007. Private-equity-backed companies, also motivated by tax implications, make up another $4 billion year to date, while public companies—typically the more active players—have banked only $7 billion is asset sales this year.

Private companies and private-equity-backed companies tend to be more tax driven than public companies, Richardson says. “That is dominating the market this year. A lot of them are very allergic to taxes.” Public companies are more motivated to sell assets by a change in business strategy than by tax considerations.

Ken Olive, president of The Oil & Gas Asset Clearinghouse, which markets properties via auction and negotiated transactions, sees the same trend with privately held companies, particularly the smaller independent producers.

“We’ve been told first hand by numerous clients that their primary motivation for selling is to take advantage of the current capital-gains structure and mitigate the financial and liquidity risks that may come with a new administration, particularly if both legislative branches and the executive branch become controlled solely by the Democratic Party,” he says.

“We’re seeing a significant increase in supply by ‘the Obama factor’ that kicked off at the end of last year. If you don’t believe it, go to Midland, Texas, and talk to producers there. They are all selling because they’re convinced there’s going to be some negative tax implications in terms of capital gains or windfall-profits taxes regardless of the outcome of the upcoming elections.”

Some of The Clearinghouse’s biggest transactions this year were driven by that concern. “We’re seeing more of the private-asset guys driven first and foremost by the lower capital-gains treatment. They are looking at 15% and thinking it may go up to 28%, so ‘If I’m going to sell, sell now.’ That’s driving a lot.”

Bill Britain, president and chief executive of Amarillo, Texas-based online oil and gas property auction house EnergyNet Inc., concurs that independent property owners are “very concerned” that both the legislative and executive branches in Washington are left-leaning politically, and particularly if conservatives lose further seats in Congress.

“The No. 1 concern is that the capital-gains rate is going to go up if a Democrat gets elected (to the White House). It’s just a matter of how much, and they are moving properties ahead of that. You will see that accelerate.”

Many of the sellers moving properties through EnergyNet are mom-and-pop and small operator/owners who have held properties a long time and want to avoid owning properties in that tax environment. “They’d rather just cash out; take their capital gains and get out of the business.

“We’re seeing a lot of urgency. People want to get it done this year because they’re afraid next year’s taxes could be worse,” Britain says.

EnergyNet sold as many properties through May 2008 as it did all of last year. Britain attributes that to a combination of the fear of a changing tax regime combined with sellers wanting to knock the top off of high commodity prices and others who are now re-entering the market after holding out for a premium price from master limited partnerships (MLPs), now largely absent as acquirers.

Bigger players

In contrast, Houston-based advisory firm Jefferies Randall & Dewey managing director Bill Marko doesn’t see the same trend. “I’ve had a lot of people say ‘that’s interesting,’ but people aren’t reacting to it yet. Most agree that a tax change is a distinct possibility, but I haven’t seen people purposefully enter the market yet based on that.”

While Jefferies represents clients of all sizes, Marko admits most tend to be larger and “the smaller guys” are more likely to respond to the tax implications. For the larger companies, “it’s covered up in the noise of $125 oil and $12 gas. People love the revenues from that. They’re making so much money right now that they’re looking at how to add production to take advantage of the price and thinking a lot less about exit.”

Still, Marko believes more people will become more aware of it coming out of summer as they did prior to the 2004 presidential election, especially if oil “rolls over.”

Clearly, record commodity prices fuel the fire, creating greater deal valuations and thus greater taxable gains. That, coupled with tax uncertainty, equals a lot of A&D activity.

While privately held and private-equity-backed sellers are driven by tax implications, “$120 oil and $12 gas doesn’t hurt either,” Olive says. “People have been nervous about commodity prices all year. You’re seeing a combination of selling because of taxes and commodity prices.”

An increase in the capital-gains tax is not the only tax consideration from a political climate perceived to be in flux. With the clamor of Democratic primary candidates for a “windfall-profit tax” to hit major oil companies’ profits, many investors harken back to the 1980s when a so-named excise tax affected producers’ profits across the board and stifled the industry for years.

“Margins may drop materially because of excise taxes,” says Olive. “Even if you have high commodity prices, next year you might have assets that have diminished in value by between 25% and 40% just based on the tax treatment.”

A history lesson

In 1980, President Jimmy Carter imposed a “Crude Oil Windfall-Profit Tax” that did not actually tax profits but, instead, levied a tax of 15% to 70% on each barrel of oil produced. Repealed eight years later, the tax produced far less revenue than anticipated, as domestic oil production dipped to its lowest point in 20 years and reliance on foreign imports increased 6%.

Olive owned royalty interests during this time. “It didn’t have anything to do with earnings,” he says. “It was nothing but a tax off the top. For every barrel that you produced net to your interest, you gave the government a percentage. It made a barrel worth less because the government took the cream off the top.”

Such a tax would specifically affect resource plays, he says, which by their very nature experience higher finding and development costs. “The reason they are so viable right now is because increased commodity prices make them financially viable to pursue.”

A scenario in which an excise tax combines with a dip in commodity prices could easily turn a resource play into a marginally economic play, forcing owners that can’t sell their position into producing at a breakeven price. “The government is not going to react quickly to grant relief in the event of a downward price movement,” Olive says. An excise tax takes away the “price buffer” the resource plays need.

He points to Alberta’s tax-regime change. “They really shot themselves in the foot,” he says.

Britain says his clients “hope against hope” a windfall-profits tax doesn’t happen again. “It was such an economy-negative factor when it was done before that people think surely they won’t repeat that mistake.”

Obama’s words

Obama, though, makes it clear in a late 2007 television ad that taxes on “windfall” profits for oil companies are part of his plan:

“Since the gas lines of the ’70s, Democrats and Republicans have talked about energy independence, but nothing’s changed except, now, Exxon(Mobil)’s making $40 billion a year, and we’re paying $3.50 for gas. I don’t take money from oil companies or Washington lobbyists, and I won’t let them block change anymore. They’ll pay a penalty on windfall profits. We’ll invest in alternative energy, create jobs and free ourselves from foreign oil.”

He reiterated his determination to implement the penalizing tax and use ExxonMobil as a scapegoat immediately after wrapping up the nomination. “I’ll make oil companies like Exxon pay a tax on their windfall profits, and we’ll use the money to help families pay for their skyrocketing energy costs and other bills,” he said.

Obama has proposed that oil companies be taxed on windfall profits from oil sold at or above $80 a barrel to help fund $150 billion of energy improvements during the next 10 years.

Olive says the flurry of A&D activity in the early part of 2008 is a result of people worried about a saturation of offerings toward the end of this year and because they want to get ahead of buyers applying a “risk factor” associated with potential excise taxes.

“If you’ve got a Democrat-controlled House and Senate and a Democratic president, the oil and gas industry in general does not bode that to be a positive wind in its face. It’s going to be a robust end of the year,” he says.

Richardson agrees the industry is more comfortable with a Republican administration when it comes to taxes, but believes high voter turnout this fall could potentially be a portent that the country is looking for change.

“There is a general belief in the industry that capital gains are never going to get better (under Obama) and there’s a general fear out there that there could be an administration change,” he says.

Rampant selling by private and private-equity-based companies motivated by a possible change in the tax regime is leading to another record-breaking year in A&D that could top $50 billion.

“People believe capital gains are going up. They want to lock in the 15% right now.”