Greater activity for oil & gas M&A in 2009

It is no secret that the marketplace for oil and gas properties has weakened considerably since this past summer. Less than a year ago, high E&P stock prices and access to cheap debt meant almost everyone was in the acquisition hunt at some level. Now the credit crisis, slumping stock prices, and lower oil and gas prices have narrowed the field of bidders and raised the spectre of distressed sellers entering the market in greater numbers. We see a handful of factors driving the marketplace for oil and gas property prices in 2009. We also see some opportunities amidst the wreckage.

Lender Enthusiasm to Wane

As oil and gas prices marched higher, so did the pace of drilling and new discoveries. Higher prices and greater reserves bookings propelled lender enthusiasm in the E&P companies' favour. Borrowing bases for many of the E&P companies we cover continued to expand throughout autumn, even as oil and gas prices contracted. But, with oil and gas prices solidly lower and drilling activity significantly curtailed today, we think this trend faces strong head winds this spring. With reserves growth slowing and the bankers' price decks right-sizing, E&P companies could face shrinking borrowing bases as the year progresses. All else equal, this suggests more assets will need to be sold for liquidity purposes and less dry powder will be available for buyers.

A Preference for Cash Flow

Some of the weakest E&P companies are set to trip debt/EBITDA (earnings before interest, taxes, depreciation, and amortization) covenants by midyear; these companies simply carry too much debt relative to the present cash-flow generating capacity of their businesses given the reality of much lower oil and natural gas prices. Even healthy companies--in an effort to keep their credit ratings stable--have indicated a preference for higher cash flows and debt reduction. This preference is driving a wedge between the valuations for properties with strong cash flows and those less developed properties where significant investment would be needed before they started kicking off cash flow.

Distressed sellers would prefer to unload less-developed properties that would help them reduce debt while keeping cash flows strong. Similarly, buyers would prefer to acquire properties that are accretive on a cash-flow basis if at all possible in this credit environment. The cash flow preferences of both bidders and sellers (coupled with a better likelihood of finding financing for these types of deals) suggests higher valuations and tighter bid/ask spreads for proved developed producing properties. On the flip side, a less liquid undeveloped acreage market is likely to be plagued with lower valuations for at least a few more quarters. And, though bargains could be plentiful and varied, for those with cash we think the acreage market could offer some of the best value propositions in this downturn.

Buyers and Sellers Will Start to Find Each Other

Deal activity dried up considerably in the second half of 2008, and it appears likely to remain weak in the first half of 2009. Other than sellers motivated to secure a quick uplift in their liquidity position, many players are waiting to see how credit markets and oil and gas prices shake out. We think a couple of factors will start to ease this log jam in 2009. First, sellers are likely to get more aggressive. As banks begin reducing credit availability, we think weaker companies will see the need to move a bit more quickly to sell assets. Second, even if publicly traded E&P companies can't find the capacity to do deals, private equity shops and other outside capital sense opportunity and are waiting to swoop in as the deals emerge. It is our sense that more of these vulture-type investors are circling than we've seen in recent years, and they're ready to put cash to work here.

Lower Prices Will Beget Lower Prices

One impediment to deal flow picking up in the back half of 2008 was an unwillingness on the part of sellers to respect the new realities of lower oil and gas prices and tighter credit markets. Anchored to the very high prices their peers received pre-July, many potential sellers did not want to be the first to break price. Bid/ask spreads widened out in the second half of 2008 and deal flow slowed to a trickle compared with the healthy activity we became accustomed to in recent years. As distressed sellers come to market in greater numbers in 2009, bids are likely to get hit, and many of the comps (such as enterprise value/reserves and enterprise value/flowing barrel) are likely to reset at much lower levels. If the reality of these lower comps sets in (replacing the hope for a quick return to higher oil and gas prices and subsequently higher property prices), and the volume of deal activity at these levels picks up, it could set the stage for even more deal activity at these lower prices.

How the Players Stack Up

Much like we've seen in the property market, the marketplace for E&P stocks has sorted itself out on similar fundamentals. Companies with low levels of debt and less required investment when compared to cash flow are fetching nice premiums to peers less attractively positioned on these metrics. Unless a company can lay out a clear financing strategy for how it plans to fund its growth, the market is not giving it much credit. Reserves and production growth potential have taken a back seat to the liquidity preference. This means investors can pick from a wide array of risk/reward propositions. The weaker players offer considerable upside should a rebound in oil and natural gas prices occur by year-end, while the stronger hands will be able to cash in on opportunities lost on the weaker players should oil and gas prices and credit markets remain soft.

One group in a clear position to acquire and invest in a downturn are the major integrated firms. The majors require large investment opportunities with proper scale to entice them. We think recent examples where major integrated firms have shown interest provide the best examples of the types of projects and companies they may be interested in pursuing in the downturn. Integrated firms like BP and Norway's Statoil have shown an interest in the North American shale plays when they can gain access to companies with very large, high-quality acreage positions. Canadian oil sands are another place where the majors are likely to shop, with France's Total showing interest recently.

Eric Chenoweth is a Morningstar Equity Analyst based in the US.