"Most of the companies and properties that are being bought share three key attributes," said analysts J Marshal Adkins and Wayne Andrews of Raymond James: "1) a long-lived reserve base; 2) a multi-year inventory of drilling prospects; and 3) a moderate risk profile.
Recent deals, such as the rumored Burlington purchase, focus mainly onshore. In 2004, two regions received most of the attention: the Rockies and the Permian Basin. Onshore resource plays also have drawn interest, such as the Barnett Shale in North Texas.
The largest domestic E&P deal in 2005 was Chesapeake Energy's $3.1 billion purchase of Columbia Natural Resources, which is solely focused on the Appalachian Basin, a region prized for its stable production, deep prospects and close proximity to the premium Northeast market.
Other major onshore deals in 2005 included the following: Cimarex's $2.1 billion purchase of Magnum Hunter, whose core area is the Permian Basin; Occidental's $1 billion purchase of ExxonMobil's Permian Basin assets; and El Paso Corp.'s $0.8 billion purchase of Medicine Bow Energy, which is focused on the Rockies.
Although the bulk of the transactions recently have focused onshore, at least one large deal was concentrated in the Gulf of Mexico. In September, Norway's Norsk Hydro announced the $2.3 billion purchase of Spinnaker Exploration. That record setting price implies a value of $7.51/Mcfe of proved reserves, which is more than 50% above the average for offshore producers.
"From a strategic standpoint, this transaction may signal a shift in the kinds of E&P companies that are viewed as attractive takeover targets -- or more likely, an expansion in the universe of potential targets," said Adkins and Andrews regarding Spinnaker. "In 2004 and the first half of 2005, the E&P companies that were acquired -- for example Westport, Tom Brown, Evergreen, Patina and Medicine Bow -- were mainly Rockies focused with resource play opportunities and long-lived reserves. Spinnaker, on the other hand is a Gulf of Mexico pure play with a reserve life of 6.6 years.
"Given that Gulf of Mexico pure plays tend to trade at very low EBITDA and EPS multiples, they often represent highly attractive value opportunities for potential acquirers. More fundamentally, Gulf of Mexico operations also provide very rapid payout rates and excellent free cash flow generation." The analysts also noted that the Spinnaker deal is another example of international interest in the U.S. E&P sector. Other international companies that have purchased U.S. assets recently include Statoil of Norway and Nippon Oil from Japan.
"Why all these deals all of a sudden? In one word: growth! With natural gas averaging over $8.50/Mcf [and hitting $15/MMBtu on the New York Mercantile Exchange last week] and oil over $55/bbl, large cap E&P independents are making excellent financial returns," including larger than expected free cash flow.
Most E&P balance sheets are now in good shape, the analysts said. The major challenge is finding places to drill. "As a result, acquiring mid- and small-cap peers or assets from the majors remains a very popular means for large-caps to enhance their growth outlook for the next five to 10 years."
The Raymond James analysts said the U.S. has few growth areas left. Only the Barnett Shale, Appalachia and the Rockies have outstanding potential for long-term growth. New completion techniques also have made the Permian Basin more attractive.
All this M&A activity bodes well for U.S. drilling. The analysts predicted capital spending would grow 20-25% this year with drilling taking 30% of the total.
"We believe the recent spurt of deals bodes very well for U.S. drilling activity over the intermediate term, especially in the geographic areas that have been the focus of the M&A trend," they said. "We look for the U.S. rig count to continue to post meaningful increases as the large independents continue to ramp up drilling programs on their acquired assets."
Until the economics change, the acceleration of M&A activity, which started in 2004, is likely to continue. Today's E&P acquirers still have arbitrage opportunities between the reserves that they buy and the low value of those reserves in the current equity markets. A buyer can gain "not only from the growth opportunities that come with the acquisition but also from near-term accretion -- to earnings, cash flow and/or net asset value per share." According to the Raymond James analysts, the equity markets continue to under price E&P companies, leading to a high probability of continued consolidation in the industry.
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