In the dynamic U.S onshore A&D market, more than $28 billion of assets have traded hands thus far in 2011, primarily driven by resource-play transactions. Companies with significant resource-play exposure are witnessing challenging and expensive operating environments, so they are looking to sell out entirely or bring in partners to share in the capital burden the resource plays require. Despite the seemingly high totals so far this year, the onshore U.S. A&D market has been noticeably quiet. Just eight transactions account for $16.4 billion, or approximately 58% of total onshore deal flow.

Conventional assets have been especially scarce. Most private companies looking to opportunistically sell conventional oil assets did so in the second half of 2010, ahead of a feared capital gains tax increase that never materialized. When possible, companies are holding on to their natural gas assets with the hope of an improved gas price environment. Public sellers of conventional assets have largely opted to take advantage of a relatively strong capital-markets environment instead.

Capital markets

Liquid equity and debt capital markets have contributed to the modest supply of assets changing hands thus far in 2011. In many instances, public companies that would have otherwise been forced to sell assets to pay down debt, or fund drilling in resource plays, are instead tapping the equity and high-yield-debt markets. For example, EOG Resources Inc. and Continental Resources Inc.—both of which rarely issue equity—raised capital in first-quarter 2011 via follow-on equity offerings, despite owning a portfolio of high-quality non-core conventional assets they could have opted to sell.

Other public and private companies, such as SandRidge Energy Inc. and Vess Oil Corp., are taking advantage of strong investor demand for yield products by dropping assets into trust structures. For example, with the initial public offering of SandRidge Mississippian Trust, SandRidge Energy was able to quickly raise proceeds to fund development of its Mississippian oil play in Oklahoma, while retaining significant long-term upside in the assets through ownership of the trust.

Additionally, many private-equity sponsors are rolling up portfolio investments into a single entity that can be taken public at valuations greater than what buyers would likely pay in the A&D marketplace. An example is the recent $1-billion merger of Broad Oak Energy Inc. and Laredo Petroleum LLC, both portfolio companies of private-equity firm Warburg Pincus.

Liquid equity and debt capital markets have contributed to the modest supply of assets changing hands thus far in 2011.

Buyer demand

An unprecedented amount of public and private capital is driving buyer demand for the scarce supply of assets. Buyers continue to be bifurcated between two sub-groups targeting specific types of assets: conventional assets and resource plays.

Conventional-asset buyers are mostly financial buyers, including E&P MLPs and private-equity-backed portfolio companies. E&P MLPs are enjoying very low costs of capital and a constructive equity-financing environment, enabling aggressive bidding on low-decline asset packages featuring high PDP (proved developed producing) reserves and long reserve life. Furthermore, these MLPs are primarily concerned with growing distributions to unit-holders and are largely commodity agnostic.

Private-equity sponsors have generally taken a contrarian view on natural gas prices and are very hungry for operated, conventional gas assets with substantial run room that are non-core to public sellers. The E&P private-equity universe is comprised of more than 225 U.S.-focused management teams backed by more than 40 experienced financial sponsors—with an estimated $40 billion of capital ready for investment. Private-equity demand is also being supported by creative public-equity exit opportunities. Buyers hunting for resource plays are comprised of majors, internationals and large-cap independents looking for largely undeveloped acreage positions with significant room to run. Majors can afford to take a longer-term view on commodity prices and have been the primary buyers of gas resource-play assets in the Marcellus, Haynesville and Fayetteville shales. ExxonMobil and Chevron have acquired nearly $10 billion of such assets in the past 15 months.

Internationals continue to acquire resource-play assets through nonoperated acquisitions or by entering into joint-venture (JV) agreements with independents. SandRidge Energy recently entered into a JV agreement with Atinum Partners (Korea) in its horizontal Mississippian play for $500 million. However, JV activity appears to have slowed considerably from the flurry of transactions seen over the past several years.

Corporate M&A activity is also being driven by the majors' and internationals' appetite for untapped resources and the massive future capital expenditures associated with developing these plays. BHP Billiton recently announced the acquisition of Petrohawk Energy Corp. for an enterprise value of $15.1 billion and a per-share premium of 65%.

Large-cap independents such as Concho Resources Inc. and Marathon Oil Corp. are being rewarded for oily production growth stories in the public markets and have been aggressively chasing low-PDP conventional oil assets and liquids-rich resource-play assets in the Permian, Eagle Ford, Bakken and Niobrara.

Conventional oil valuations are being driven up by U.S. public companies’ aggressive pivot to oil/liquids assets, while conventional natural gas valuations remain near multiyear lows.

Valuations

A&D valuations are being driven by strong demand and the disparity of public-equity valuations between oil-weighted companies and natural gas-weighted companies. As of August 3, 2011, oily companies were trading at an 82% premium to gas-weighted companies, based on daily production estimates for 2011. With this disparity in mind, public-company buyers have been aggressively bidding for oily assets and pushing up asset valuations, while the valuations for natural gas assets remain relatively low.

Conventional oil assets are trading for record prices and command a nearly 115% premium to conventional gas assets. For example, as we head into the second half of 2011, conventional oil assets in the Permian, Midcontinent and Rockies regions are trading at more than $120,000 per daily flowing barrel, or PDP discount rates of between 10% and 8%.

Conventional gas assets in the Midcontinent, Permian, Ark-La-Tex and Rockies areas, and mature resource assets such as in the Barnett and Fayetteville shales, are trading at $7,000 to $10,000 per daily flowing thousand cubic feet on average, or at PDP discount rates of 12% to 10%.

Strong margins and optimistic outlooks for oil prices are allowing buyers to risk proved reserves more aggressively for oily assets, and even assign value to undeveloped drilling locations beyond proved reserves.

Valuations continue to evolve in the U.S resource plays as more acreage becomes de-risked. Sellers in liquids-rich resource plays with established type curves and widespread horizontal development, such as the Eagle Ford condensate window and core Bakken acreage, are enjoying valuations of more than $10,000 per undeveloped acre.

In established gas resource plays such as the Haynesville and Barnett, valuations have stabilized in the range of $5,000 to $10,000 per acre. Newer liquids-rich resource plays such as the Bone Spring/Avalon and Mississippian that are characterized by focused horizontal drilling efforts to de-risk and hold acreage positions are witnessing valuations of approximately $4,000 to $8,000 per undeveloped acre.

Market outlook

While the 2011 A&D market has been noticeably quiet, asset supply will pick up for the remainder of the year and into 2012, barring continued uncertainty in the equity market. The primary driver will be resource-play development requirements.

Challenging resource-play operating environments will push smaller companies with significant exposure to these plays to sell their positions altogether—or to seek partners that will share in meeting these plays' capital burdens. Majors and internationals remain hungry for resource-play assets and are the logical developers of these assets in the long term, given the immense capital required.

Large-cap independents will look to divest non-core, conventional natural gas assets and use the proceeds to fund resource-play development, or to acquire oily conventional assets to feed investor appetite. Capital-markets volatility will limit public companies' ability to rely on equity and debt offerings to fund capital expenditures or repay debt. Buyers will bid up for conventional assets as demand continues to far outweigh supply, especially for oily assets.

Scott Richardson is co-founding principal of Houston-based RBC Richardson Barr, an upstream asset advisory firm and affiliate of RBC Capital Markets. Joe Passanante is an associate with the firm.