Asset demand in the upstream A&D market has strongly shifted toward oil/liquids-weighted assets due to the disconnect between prices for crude oil and natural gas. The ratio of the two-year forward strip for crude oil price to natural gas price has increased since the beginning of 2009 from 8.5:1 to more than 25:1 as of mid-December 2011. The traditional energy-content relationship has been 6:1.

Asset acquisitions. Shifting demand to oil/liquids-weighted properties has skewed valuation metrics away from the energy-content relationship and more toward the pricing relationship. Conventional oil/liquids assets traded at an average 94% premium over conventional gas assets in 2011. For oil/liquids assets with substantial remaining oil in place or multipay potential (i.e., the Permian Basin), the valuation premium was even higher.

The oil/liquids-weighted premium was even apparent for assets in the same general plays. For instance, three deals with liquids content in the Barnett shale (EnerVest/Encana, Premier Natural Resources/Carrizo, and EnerVest/Talon Oil & Gas) on average traded at a 40% premium to another Barnett deal with little liquids content (Legend Natural Gas/Range Resources).

Outright acquisitions of resource-play positions were also dominated by oil/liquids-weighted assets. Nearly 70% of the $16 billion in resource-play acquisitions were for positions in oil/liquids-weighted plays—mostly in the Eagle Ford, the Bakken, the Bone Spring/ Avalon, and the Utica shales. The valuation premium for conventional oil/liquids-weighted assets and the overwhelming demand for oil/liquids-weighted resource plays further reflect the market’s belief the oil/gas price relationship will remain skewed for the foreseeable future.

JVs and corporate deals. Demand for joint ventures has also been dominated by oil/liquids-weighted plays like the Utica and Eagle Ford. Of the nine large joint-venture deals (more than $500 million) announced since June 2010, eight deals have been in oil/liquids-weighted plays. Joint-venture opportunities of this magnitude and in these coveted plays are fleeting, however. The added complication of corporate acquisitions has been deemed acceptable by some acquirers seeking a large position in such plays that have been de-risked.

Two corporate acquisitions—BHP Billiton buying Petrohawk and Statoil buying Brigham Exploration—were announced in 2011 where the main target was a large, premier position in an oil/liquids-weighted resource play (Petrohawk’s Eagle Ford shale position and Brigham’s Bakken/Three Forks position).

These deals require a massive amount of development capital over the next few years and can only be funded by either national oil companies (NOCs) or major integrated energy companies. Not surprisingly, the majors and NOCs prefer to allocate their future capital to higher-return oil/liquids-weighted assets.

Future outlook. Activity in the A&D market suggests that buyers believe natural gas prices will remain soft in the near term, given that: 1) assets are acquired with a forward-looking rather than current view; and 2) valuations and demand are tilted toward oil/liquids-weighted properties.

The number of available conventional oil/liquids deals is decreasing as few sellers are willing to part with these assets . The majority of deal volume in the near future will likely come from undeveloped acreage sales or joint ventures in some of the burgeoning oil/liquids-weighted plays where such opportunities still exist, namely the Utica and Bone Spring, along with conventional gas assets being sold by public companies to finance development of such plays.

As some of the other oil/liquids-weighted arenas become more developed, conventional asset buyers will start to aggregate maturing positions in these plays similar to what has happened in the oldest U.S. resource play, the Barnett shale. Barring a fundamental shift in end-user natural gas demand, the oil/natural gas pricing disconnect should continue well into this decade—and therefore, so will the market’s appetite for oil/liquids-weighted assets.