The A&D market for upstream oil and gas properties has historically been driven largely by the health and strength of the public markets. When the stock market sold off in late 2008 and early 2009, public company oil and gas reserves valuations followed suit.

As a result of the decline in “retail” reserves valuations, there was an implied lack of wholesale-to-retail reserves arbitrage. This, in concert with hampered credit markets, essentially put the A&D asset sale market on hold.

But minimal A&D transaction volume and grass-roots drilling activity are not consistent with growing reserves levels—a goal for oil and gas company managements. Over the last several months, as commodity prices have increased, oil and gas company stock prices (and reserve values) have recovered significantly. The result? The upstream asset sale market has begun to heat up.

In particular, crude oil prices recently have risen to respectable levels (driven for the most part by the weak dollar) and have stabilized well above $70 per barrel. Though buyers continue to be discriminating, the stable—if not improving—oil-price environment has helped increase the demand for PDP (proved developed producing) heavy crude oil deals with relatively longer reserve-to-production (R/P) ratios (up to 12 years or more).

Anecdotally, the discount rate for proved developed producing (PDP) cash flows appears to be coming down from as high as 15% to the 10% to 12% level, but the proved undeveloped (PUD) discount still appears high. Buyers that have significant cash reserves (i.e. strong balance sheets) do not seem willing to pay up for undeveloped upside, or at least anywhere close to what was being paid in the second and third quarters of 2008.

When looking at the increased number of closed transactions over the last several months, however, and the third quarter in particular, we can infer that sellers are perhaps coming to terms with today’s buyers and ultimately getting their price.

Valuation metrics. Are valuations easier to determine today? In the first six months of 2009, there were only five publicly announced, majority oil transactions valued between $10 million and $2 billion. In the third quarter alone, there were nine such transactions (and only four gas transactions).

When stable commodity prices, in this case crude oil, are coupled with significant transaction activity, the end result is a good sample set of valuation metrics. The R/P valuation tool developed by Energy Spectrum Advisors (ESA) has been used as a vehicle to help both buyers and sellers arrive at such valuations by revealing the direct relationship between an asset’s proved R/P and the net production multiple received.

To illustrate, ESA plotted all of the oil-heavy transactions announced in third-quarter 2009 where purchase price, proved reserves and the net production multiple were publicly disclosed. The x-axis represents the proved R/P while the y-axis represents the net production multiple paid, or price per barrel of oil equivalent per day ($/BOE/d), for each transaction.

A regression line, or line of best fit, has been incorporated to help illustrate the correlation between each of these recent oil transactions. A perfect correlation between proved R/P and $/BOE/d would be represented by a R2 of 1.0. In this case, the R2 is 0.76, which is still indicative of a relatively tight correlation. This suggests that for the first time in over a year, both buyers and sellers may be able to more accurately assess value of upstream, oil-heavy assets because of the tight correlation between proved R/P and net production multiples paid for recent oil transactions.

ESA then compared the actual purchase price for each of the oil transactions shown with the valuation it would have predicted using the R/P valuation tool. The valuation tool’s prediction on average was within approximately 5% of the actual purchase price. In almost half of the cases, the valuation tool was within 2% or less of the actual purchase price.

The take-away is that crude-oil-heavy deals are closing at valuation levels consistently related to the asset’s reserve life or R/P. Longer-life, PDP and cash-flow-heavy oil assets are currently the asset of choice, and sellers seem to be getting their price, eliminating the perception that the market is a buyer’s market. With E&P stock prices (and reserve values) recovering and commodity prices (primarily oil) stabilizing at respectable levels, the A&D market and closed-transaction volume should continue to improve.

—B.J. Brandenberger,

Energy Spectrum Advisors Inc.

(energyspectrumadvisors.com)