For the North American energy company on the prowl, seeking natural gas reserves especially, the Western Canadian Sedimentary Basin is stocked with pearls ready to be shucked. But for the company unshelled, there's no place to hide. The merger marauders moved in quickly in the first six months of 2000, scooping Canadian energy companies so fast that the survivors and the overtaken are still bobbing in the wake. More than C$10 billion in assets changed hands as takeovers turned the Canadian oil patch into a bargain paradise. That compares with C$2.9 billion through the first half of 1999, according to Sayer Securities Ltd., a Calgary M&A consulting firm. Targets didn't have a chance because huge commodity price run-ups and consequent cash flow turned undervalued performers into sitting ducks. At press time Canadian spot gas at the key AECO-C storage hub operated by Alberta Energy Co. was about C$5.78. Gas for export to Ontario was about US$5. "An extraordinarily high volume of [M&A] transactions have occurred and are occurring," explains Mike Tims, chief executive of the financial house Peters & Co. "It's reflected in a strong consolidation of the oil and gas industry and the oil-service industry." Increasingly, U.S. exploration and production companies are looking at potential energy company targets and strategies on a North American basis. The market has seen U.S. companies buy some of the most prominent Calgary E&P companies. More recently, Canadians have made some significant purchases in the U.S. Rocky Mountain region. In both cases, the goal has been to add more gas reserves to the company portfolio, based on expectations of vastly increased gas demand and worries about deliverability shortfalls in the next few years. Another huge driver behind the urge to merge? E&P companies must continually expand because growth is something the market demands. Yet, there's also a new emphasis on return on capital employed, coming from the companies themselves and from institutional investors wanting better returns on equity. "Everyone is more focused on it now," adds Tims. "Another driver is strategic positioning. Now companies are trying to position themselves for natural gas development soon to come in the north, in the oil sands, heavy oil, and the East Coast [Maritimes]." Any merger or acquisition completed now can be seen as a critical transaction as companies try to prepare themselves for the coming decades. Tims senses that if companies don't move now, they won't have the necessary tools to go forward. "The question really becomes, how many more U.S. companies decide to increase their strategic position in Canada? How many of the Canadian companies feel they need to be bigger and stronger to fit into the super-independent class?" And how many of the smaller companies, thwarted in their strategies, will decide to put themselves up for sale? There are enough interested players and enough remaining opportunities to provide several ways to run in this cycle, notwithstanding the already high volume of deal activity. Even though there are many compelling reasons to do a deal, the pace of M&A activity recently-and the size of the deals-still impresses those in the know. "I've never seen anything like this in any of the 20 years I've been in the business," says Tom Budd, president, Griffiths McBurney & Partners. "I've never sold so many companies. They're feeling the pressure." There's a major difference this time around in Canadian oil-patch M&A. Typically, as companies merge or are taken over, a reasonable number of new start-ups appear on the scene to take their places, and the capital is available from Bay Street to fund them. No longer. "There haven't been any measurable start-ups and there's no capital. We'll have a gap down the road," insists Budd. "The pendulum always swings too far in both directions. We're paying the price for lofty valuations in the early 1990s. There are some tremendous bargains out there." Budd believes the mergers that occurred early in the year weren't necessarily done by buyers with legitimate interests in the oil and gas sector, but rather, were made primarily by investors playing the takeover game for the undervalued companies that could easily be bought out. This is a time when investors aren't as concerned about a company's management quality, growth prospects, financial returns or productivity. "With that sentiment in the marketplace, a number of companies are feeling the pressure to sell," says Budd. "If the interest doesn't come back to the market, we'll see an ever-increasing gap over valuations between the smaller and larger companies." As shareholders search for more liquidity, frustrated companies will initiate friendly deals, and more hostile takeover attempts could be made. "With a lack of true sustainable interest, and no additional capital coming into the sector, companies can't use their paper to acquire because they're at a cost-of-capital disadvantage," Budd notes. Every company is vulnerable, but those with the most to lose are the smaller ones whose stocks are trading too low. Too, this is a period of global consolidation where the stock market's demand for size precludes few companies from takeover. Even the larger Canadian energy companies are trading at lower valuations, and for American companies especially, this makes for an inexpensive entrance into the Canadian market and all the natural gas reserves available. Too many investors have lately stayed away from the energy sector, lured instead to the sexy swoon of the high-tech and telecommunication stocks. Equity and debt issues have dried up, as they have in the U.S., leaving Canadian oil and gas stocks parched prey. Financings dipped an abrupt 65% or C$2 billion in the first six months of this year, compared with the same period in 1999. Sayer Securities says that treasury financings totaled C$1.15 billion in 148 transactions, compared with C$3.32 billion in 146 transactions in the same period in 1999. Surprisingly, the record of more than C$4 billion of debt and equity issues occurred in 1996, even though commodity prices were lower then than they were this year. The price of West Texas Intermediate crude soared 87% in the first six months of 2000 (averaging $28.79 per barrel). Natural gas prices jumped 53% to C$4.07 per thousand cubic feet. Ironically, these outstanding commodity prices have failed to attract anything remotely close to the kind of investor activity the "new economy" enjoys. Strong cash flow was the savior for some oil-patch blue bloods as they awaited a shift in investor sentiment. Others didn't have that luxury. "A number of companies, even though not underperforming, are putting themselves up for sale," notes Frank Sayer of Sayer Securities. "It's not driven by the marketplace, but by the companies themselves. This is a new trend." Some companies are simply standing up and insisting that they won't accept existing, undervalued stock prices, and instead prefer to just sell out. "It's a very hot market, where the underperformers, whether small, middle or large, are getting cleaned out. A whole lot of small and medium-size companies are disappearing. There's not an equal number of guys to replace them." If there's going to be any uncertainty about return, investors and bankers prefer to put their capital into the high-tech and new media stocks where they anticipate big bucks if the stocks pan out. They sidestep energy. "Institutional investors refuse to recognize the underlying value of our industry," complains Brett Wilson, managing director and chief operating officer, FirstEnergy Capital Corp. The banks are even wary of providing credit for oil producer's vital hedging programs, which could protect them from volatile market fluctuations. All of this means that the trend towards consolidation in the oil patch will continue, and the gap between small and large companies will widen even more. There are now 10 companies worth more than C$5 billion, and a bulge of smaller companies, but the midsize companies are disappearing. "The question mark is whether the smaller guys have fire in their bellies to grow their start-up companies to midsize," says Martin Molyneaux, E&P analyst with FirstEnergy. The prices paid per barrel of oil equivalent have increased, but there is still a noticeable gap between sellers' expectations and those of buyers, just as in the U.S. "The prices per barrel are going northwards," notes Molyneaux. "During the last 12 months, the increase has been more significant on gas reserves than oil." While the number of transactions of any real size hasn't been that great, the deals that have closed definitely created value. "Unquestionably they have," Molyneaux adds. "In the last year, if Canadian Natural Resources were to buy BP's western Canadian assets, it would be worth C$500- to C$700 million more, at a minimum." Last summer, Canadian Natural undoubtedly got a bargain when it paid C$1 billion for those properties. Just this June, Canadian Natural continued its takeover trend by acquiring Ranger Oil Ltd. with a C$1.6-billion offer, rescuing it from an earlier hostile effort by junior Petrobank Energy and Resources. In April, Anderson Exploration did exceptionally well when it waded into Hunt Oil Co.'s hostile bid for Ulster Petroleums Ltd. As white knight, chief executive J.C. Anderson offered C$1.2 billion, debt included, for Ulster. Today that equation looks incredibly accretive. Last August, Poco Petroleums was swept away by Burlington Resources in a C$3.7-billion deal that wears very well indeed. Just this June, Husky Energy Inc. was formed when Husky Oil Ltd. rushed Renaissance Energy with a C$4.4-billion proposal it couldn't refuse. Once a bellwether stock for the condition of the Canadian oil patch, Renaissance hit hard times, even though its assets are particularly attractive. Analysts call this the cash-cow deal, given Renaissance's tax pools and C$900-million cash flow. At press time, HSE debuted on the Toronto Stock Exchange at a price higher than many analysts expected, closing at C$13 on healthy volume. "This deal enables Husky to move to the next level," adds Tims. Ken Croft of HSBC notes that Husky reached a large critical mass instantly, with prospects of greater rates of return in the future. Renaissance had been Canada's most active driller for years, and it owned a significant leasehold. Armed with C$1.15 billion, Calgary-based Alberta Energy Co. Ltd. decided to head south and acquired McMurry Oil Co. out of Denver. Canadian Occidental Petroleum Ltd. also did an American deal, with a twist. It bought back 15% of itself from parent Occidental Petroleum, in what was almost a corporate move, sending its stock soaring. At press time, PanCanadian Petroleum Ltd. offered C$702 million (US$475 million) for all the oil and gas assets of Montana Power Co., which is exiting the E&P game in favor of telecom. Even though there has been considerable consolidation in the oil patch so far this year, there remain E&P companies that want to voluntarily become part of something bigger One thing's certain: with money so tight, and investors wanting much more, the urge to merge will continue as the market strives to mine undervalued gems. Once those savvy investment funds that bought undervalued energy stocks start to outperform their peer groups, money managers will rush to the oil patch.M Sydney Sharpe is a columnist for the Calgary Herald.