E&P Firms Are Buying Their Way to Production and Reserves

Operators have figured out what to do with the free cash flow provided by high commodity prices. They are embroiled in a spending spree to acquire production and reserves--and have spent $17 billion so far this year to do so.

The crowd pleaser at most Civil War reenactments involves the steady cannonading that signals the start of a mock battle. The metaphor seems an apt description for the E&P sector of the oil and gas industry.

The constant boom, boom, boom originates from the growing crescendo of major acquisitions among independent E&P firms. This barrage of deals has intensified in recent weeks. More than $9 billion has been spent over the last 45 days, primarily on five major deals involving Kerr-McGee/Westport Resources, EnCana/Tom Brown, Inc., and Pioneer Natural Resources/Evergreen, as well as separate purchases by Chesapeake Energy and XTO Energy.

Step back a little and the total number of deals year-to-date tops 65 according to Houston, Texas-based PLS, Inc., an oil and gas property broker.

The accelerating trend signals the oil and gas industry is moving into a major consolidation effort that is a sure sign the current cycle is approaching its peak phase. Oil and gas mergers are not uncommon. But they seem to intensify at both ends of the cycle. Witness the major consolidation wave in the mid-1980s when oil prices collapsed. That created a generation of majors like Mobil, British Petroleum, Amoco, Union Texas, and Chevron whose formation was predicated on the theory that consolidation was the easiest way to remove costs from the industry. These companies existed until the next consolidation wave hit in the 1999-2001 era. The earlier date was characterized by a cyclical low which brought about the mega-mergers among majors, creating ExxonMobil, BP, ChevronTexaco, ConocoPhillips, largely for the same reason.

By the time the cycle peaked in 2001, consolidation had moved significantly into the ranks of the independents, which created super-independents like Anadarko, Burlington Resources, or Apache. Consolidation at the cyclical peak was based on the premise that mergers offered the quickest way to obtain reserves and production.

A similar trend may be underway currently as large independents like Chesapeake Energy Corp., XTO Energy, Inc., EnCana, Pioneer Natural Resources, and Kerr-McGee gobble up reserves--and the companies that own them.

In fact it was "deal of the week" during April as a series of major transactions unfolded. These transactions were measured in increments of billions of dollars. Kerr-McGee purchased Westport Resources Corp.; EnCana acquired Tom Brown, Inc.; and Pioneer Natural Resources bought Evergreen Resources. Meanwhile Chesapeake and XTO kept adding gas reserves in half-billion-dollar tranches.

The sudden deal flurry follows two major themes. For one, there is the scramble to get back into the U.S. land market, particularly when it involves reserves in the Rocky Mountain region. This scramble rivals the move among many operators in the mid-1990s to abandon onshore properties in order to move into the offshore environment. While the going was initially good offshore in the late 1990s, it appears a lack of quality prospects has altered the long-term viability of oil and gas activity on the OCS, and few independents have the financial deep pockets to push the play into the deepwater environment.

Facing the sobering reality of depletion curves, companies that had broadened their horizons to include offshore and international properties are scrambling to buy their way back into onshore reserves as the North American gas play strengthens. That theme applied to Kerr-McGee/Westport, EnCana/Tom Brown, Inc., and Pioneer Natural Resources/Evergreen.

An additional stimulus for the jockeying for property in the Rockies stems from the reality of Rocky Mountain natural gas plays. While the region touts large-scale gas reserves, only about half are accessible to the oil and gas industry because of various federal land restrictions. The net impact increases the value of readily accessible plays already in the hands of independents.

A secondary factor involves the nature of these gas reserves. They are considered resource plays, or unconventional natural gas. Resource plays depend on large acreage positions in order to bring costs down because of the technology-intensive nature of the extraction process. That fact was behind EnCana's purchase of Tom Brown assets and Pioneer Natural Resources interest in Evergreen Resources coalbed methane assets.

The second major theme involves divestment programs among the majors. Clearly XTO Energy is the most aggressive example of the latter, having picked up a $346 million in properties from ExxonMobil at the beginning of May followed by the $440 million purchase of ChevronTexaco assets two weeks later. ChevronTexaco had announced its intent to divest up to 60 percent of its properties (but just five percent of its production) beginning a year ago. The XTO purchase, which involved 150 properties mostly located in the Permian Basin, was part of a package ChevronTexaco brought to market last December.

ChevronTexaco is using the proceeds to acquire additional acreage offshore in eastern Canada as well as to help underwrite deepwater projects in the Gulf and West Africa. Meanwhile the company's headcount has fallen six percent to 50,000 since 2001 when the mega-major was created through the combination of Chevron and Texaco.

Clearly the majors are rationalizing marginal properties as they restructure in the wake of their consolidation spree a couple of years back.

There are two other sub-themes at work in the current deal-making frenzy. The first involves a scramble for low-cost, long-lived, onshore natural gas production. Whether the marker is price per Mcf of reserves, or price for producing Mcf, the trend is the same. Prices are headed up, with premiums available for long-lived reserves.

The second sub-theme suggests that new prospects are constrained for many E&P firms. As a result, it is easier to buy reserves and production rather than create new production organically through the drillbit.

It is not hard to find the mechanism that has stimulated deal making. The culprit is free cash flow, and lots of it. It is hard to find an operator earnings release that does not include the term "record" either in production volume, earnings, or revenues. While E&P firms promised earlier this year to be good stewards of the surging tide of free cash that has accompanied the current high commodity price environment, the fact is they are spending like teenagers headed to the mall with their parents' credit card.

How much? Year-to-date, PLS studies show those totals have reached $17 billion, or roughly two-thirds the volume inherent in mega-mergers among majors like ChevronTexaco.