A version of this story appears in the September 2017 edition of Oil and Gas Investor. Subscribe to the magazine here.

Even a year removed from QEP Resources Inc.’s (NYSE: QEP) acquisition of 9,400 net acres in Martin County, Texas, its $58,617 price per acre still shocks E&P players in the Permian and across the country. The magnitude of that deal’s price has been dissected throughout the industry, but it’s a byproduct of production portfolio concentration, not a catalyst.

Range-bound, sub-$50 oil and a flat forward curve have forced operators of all sizes to act like small independents: focus on fewer properties, eschew capital-intensive exploratory programs and divest noncore assets to help fund subdued operations. While the adoption of trimmed-down portfolios has tightened bid-ask spreads and allowed A&D activity to reconvene over the past year, its effect on climbing purchase prices is even more striking.

Many operators wonder how long and how high prices can ascend, especially in lower lifting cost areas like the Permian. But even with the shuffling of sellers’ respective noncore properties, there’s only so much acreage to go around. At some point, the industry expects to reach an inflection point that leads back to portfolio diversification, true exploration and expanded sourcing of capital.

The Diversification Cycle

Smaller operators have long lamented the seemingly insurmountable advantages mega, diversified majors have historically held, because they will drill with enormous sums of readily available capital and are ambivalent to pressure to sell assets to fund future operations. But this downturn has been an equal opportunity antagonist, and upstream companies across the board spent 2015 licking their wounds, waiting until they could pare down portfolios, cancel expensive new drilling programs and right-size general and administrative costs to account for the persistence of lower oil prices. That belt-tightening, rather than the availability of public capital and private debt, has led to large EBITDA surpluses for companies in the four largest cohorts.

The continuing concentration of portfolios is part of an emerging diversification cycle. No one contributor to financing dynamics operates in a vacuum. The industry has seen operations shrink through recent downturns, but a few developments have set this one apart and charted a trajectory that could become cyclical.

First, the extension and legs of this downturn require a look back to 1986 to find a price regression this persistent. The other commodity price drops this century were brief by comparison. Now, consistent, low-cost shale development coupled with substantial foreign production speak to a moderate recovery, not a supply-strangled rocket to $80 oil.

Second, alternative investors (private equity, mezzanine lenders, hedge funds, etc.) are a considerable force in financing operators. In the run-up to year-end 2014, energy private equity raises stood at around $35 billion annually, but the advent of the downturn saw a rash of new capital enter the ledgers of alternative investors to take advantage of discount pricing. As wide bid-ask spreads undermined A&D activity in 2015 and part of 2016, and reserve-based lending tightened, the amount of alternative capital sitting on the sidelines ballooned to more than $100 billion.

Now that capital can be deployed, the thirst to invest alternative capital is certainly contributing to higher asset valuations. Similarly, lower lifting costs for Permian and Delaware assets are garnering more attention than other parts of the country as attendant drilling programs can be profitable at lower spot and slowly rising prices for oil.

Importantly, operators seeking to pocket alternative investment capital must seriously weigh sponsors’ desires to invest in concentrated areas. From outside the four walls of an investment, it is easier for a private equity firm to monitor and manage the efficiencies and prospects of a Permian company drilling Wolfcamp and Spraberry wells than one with operations in a half-dozen states.

Third, traditional capital outlets have not returned to their former funding levels. While public offerings of debt and equity have shown positive signs in 2017, moribund oil prices have kept operators from turning the public markets into the ATM they were in 2014. Similarly, that same pricing malaise has hamstrung reserve-based lenders who cannot justify borrowing base increases without sustained, buoyed price decks.

This financing climate has led prudent E&P companies to the retrenchment of their asset portfolios, and rightly so. In times of cheap money and high oil prices, a bull can take the risk of picking up acreage to attack a new bench in another basin, or even move offshore. But these times call for caution, and strategic moves made in 2015 and 2016 have constructed portfolios for the foreseeable future. Like a game of craps, the point has been set. We’re in for a few more rolls of the dice.

Turning An Aircraft Carrier

It’s overly simple to observe contraction in the downturn and assume that those decisions come at easily or were quickly enacted. Withdrawing from a field can be a painful experience. Aside from laying off employees at the field and corporate management levels, building leases, vehicles, equipment and a host of other assets that enable field management have to be liquidated or reassigned.

Those actions are logistical in nature, and in a distressed market they are designed more to arrest a burn rate than to generate excess capital.

However, relationships are also tested by withdrawing from a market. Royalty owners, joint venture partners, nonop working interest holders and former employees are not likely to view a selling party with open arms should reentry into a market become possible. Realizing capital efficiencies from withdrawal and putting some distance between former stakeholders force those operators who concentrate portfolios to commit to staying put for a legitimate period of time.

Additionally, companies exit areas when their prospects for a market turnaround seem exhausted. When fresh capital and commodity price projections look bleak, a defensive stance has to be taken. That choice is not quickly or easily reversed.

The Inflection Point

The set of conditions that has propelled upstream companies to restructure as basin specialists is now in full swing. Hiccups in the price of oil may delay some A&D transactions, but they are occurring broadly among a host of participants. However, it is important to understand where we sit in the diversification cycle and recognize that diversification will occur again, once certain directional trends are established.

First, and unsurprisingly, the prices of oil and gas have to trade in a range for a sustained period that engenders confidence in investing in lower-margin basins while learning curves are reestablished. A quarter in bull territory may be enough to justify those investments.

Second, traditional growth capital has to become available en masse. To some degree, that is already happening, as reserve-based loan providers are seeking new business after managing non-pass credit into 2017. As public markets reopen, portfolio expansion by issuers will be encouraged by shareholders seeking justification for their investment. Will that temper alternative investment in the space? Not necessarily, but in order to be competitive those funds may have to sacrifice geographic specialization for capital placement with appropriate risk-weighted returns.

Third, current elevated asset pricing trends have to continue. When the Permian and Delaware outpace sale prices per acre onshore by a wide margin, it’s only a matter of time until a smart technical team makes a case to acquire acreage and expand into the Powder River Basin. Currently, financial sponsors are willing to bankroll pricier acquisitions, given repeatable and profitable performance of those assets.

Fourth, and related to the previous point, associated operating expenses have to continue to climb in hot areas. At $80 oil, oilfield services (OFS) companies commanded a 35% pricing premium. Only through constrained bandwidth can OFS providers charge higher rates. That lever is currently being tempered in West Texas by OFS groups flooding the area. But eventually, contract drillers, frack companies, water providers and more will make it prohibitively expensive to continue focusing solely on one area.

Conclusion

As an industry, we’ve seen operators justifiably pull back from diversified operations to focus on concentrated acreage positions. Such retrenchment has been a boon to A&D activity in the space, but this condition is not permanent. More than likely, it may be a couple of years before an inflection point is reached, and real diversification can take place.

Commodity prices, available traditional capital, and finding and development costs will all contribute to diversification, but in the end, such a movement will begin at a granular level, with individual companies. Technical confidence in expansion will vary greatly, to say nothing of the speed and capital required to diversify. If an established Eagle Ford operator needs $100 million and a year to move into the Piceance, a mega operator likely needs two years and billions to move into deepwater drilling. Regardless, watching the shift unfold will be interesting.