The 15-Percenters

Another $20 billion in U.S. E&P asset sales are expected by year-end—about half as much as in the first three quarters of 2012 combined—and a great deal of it is expected to be motivated by owners’ interest in capturing the current federal capital-gains-tax rate.

The 15% rate—as a result of the Bush tax cuts of 2003 and the lowest since at least before 1978 when it was as much as 35%—is to expire on December 31, growing to 20% thereafter. Plus, after 2012, there will be an additional 3.8% hit—a “Medicare tax” as part of 2010 federal healthcare legislation.

To put the numbers in perspective, the additional 8.8% rate represents a 59% increase in tax liability, explains investment banker Raymond James & Associates Inc. in a client advisory.

For example, on a $10-million sale, the 2012 tax liability is $1.5 million, netting the seller $8.5 million. At the 2013 rate, the net is $7.6 million.

“If we reverse the math, it means that you would have to sell the business for $11.15 million in 2013 to generate the same aftertax profit you would receive if you sell it for $10 million in 2012,” the firm notes. “This computes to an 11.5% increase in the sale price, which, in reality, may require years to achieve in order to net the same after-tax proceeds.”

One producer who has put his private-equity-backed assets on the market has done the math. He admits that, normally, he would bulk up his portfolio via additional drilling and giving the wells more time online to prove forward-production expectations. But waiting might bring less profit—not more.

“You could hang on and, say, sell at the end of the first quarter of 2013. You’d have more production-rate data and longer type curves, but you could end up giving it all back if capital-gains taxes are at 23%.

“You give back everything you gained in uplift—in the form of capital-gains taxes—by hanging on longer.”

With the possibility of a party change in the White House and Senate in January, could selling be premature? Maynard Holt, co-president and head of E&P investment banking for Tudor, Pickering, Holt & Co. Securities Inc., says of tax-driven exit plans, “If you own something oily and look up and see that oil prices are awfully high right now and that this tax rate is next to nothing, you’re thinking, ‘I don’t know what’s going to happen next year, but I’m not sensing anything good. So, why wouldn’t I sell the company?’”

The growing complexity of U.S. oil and gas exploration is in play as well, he adds, as producers tap reserves horizontally and with multistage fracture stimulation. Perhaps the E&P business that has been put into tax play has been in the family for generations. To date, it’s been managed for cash flow, but wells may cost some $8 million each now. The owner either needs to scale up to drive down costs or exit.

“When you put this tax bogeyman on top of it, it does feel like it’s time to test the market,” Holt says. “I don’t know what will happen the day after the election but it can be extremely (meaningful).”

Scott Richardson, principal of M&A advisory firm RBC Richardson Barr, says, “The tax issue is…the No. 1 driver of deals right now. And, to get a deal done by year-end means you’ll have to be in a data room (by now). So data rooms will be at an all-time busy level.”

Assets on the market in this quarter will primarily be oily and privately held, says Chris Simon, managing director and head of asset A&D for Raymond James. This year, by early September, 67% of oil-weighted deals were sold by private E&Ps on a deal-count basis and 81% on a deal-value basis. Among buyers, public E&Ps won 42% of the deals, representing 70% of deal value, he says.

For gas-weighted properties, public E&Ps have been the most active sellers, while MLPs and private-equity firms have been the most active buyers, he adds.

The privately held seller whose package is already in a data room says, “There is a lot of uncertainty right now in commodity markets and the taxing market. It’s a very difficult time to plan out very far because you just don’t know what the next four years are going to bring.”

He isn’t waiting for the November election results to make a decision. “We need to be sold by the end of the year.”