At a recent industry conference, the mood was ebullient and optimistic. Speakers touted large transactions and joint ventures as bellwethers of a productive operating environment heading into 2014.

That view is not necessarily wrong, but it’s not universally right, either. A large international transaction involving a U.S. company is certainly cause for optimism, but more often it’s just a data point. And if you’re an independent, the parallels are even less apparent.

What is the acquisition and divestiture climate right now for smaller operators? If it’s not as rosy as it appears for mega-cap operators (those companies with enterprise values greater than $50 billion), is the forecast dire? An analysis of the data most applicable to U.S. companies and the drivers of the current climate suggests two points: A&D activity for independents is muted, yet there is cause for optimism.

A rogue wave

A cursory review of U.S. E&P transactions of the past three years would suggest that deal activity is booming.

There were 18 large E&P acquisitions by public companies in the U.S. from early 2009 through year-end 2012, accounting for nearly $98 billion in activity. They were fairly evenly split between liquids-heavy and natural gas-heavy assets. Only two were executed by foreign acquirers (Statoil ASA and BHP Billiton).

The only telling characteristic of the transactions described is that, of the most speculative deals (those with less than 50% developed assets), half of the targets were gas-heavy (greater than 50% gas holdings). That accounts for three transactions and does not a trend make. But, for those three deals, the buyers obviously held a bullish belief on gas prices and acted accordingly. Here, we’ll describe the effect of low natural gas prices on the bulk of the sector.

Extremely large transactions have become standard-bearers for the larger A&D climate. CNOOC’s $15.1-billion purchase of Nexen, which closed in February 2013, turned heads and signaled coming infusions of Chinese capital into U.S. companies. But, Nexen is a Canadian company that operates under a host of different regulatory considerations than an American company, and Asian investment in U.S. E&P companies actually declined 78% from 2011 to 2012, when the Nexen deal was announced.

Chinese investment did increase in North America in 2012, to $18.5 billion, but to put that in perspective, the U.S. Energy Information Administration (EIA) estimates domestic drilling and completion capital expenditures will hover around $250 billion annually through 2015. Joint ventures will likely continue to be the route for Asian companies to access U.S. resources, but at a scale that is complementary, not overwhelming, to the U.S. A&D market.

Similarly, ExxonMobil’s $500-billion joint venture with Rosneft was seen as a precursor of a more active acquisition trend. It may eventually be that catalyst, but the heads-up agreement is focused on Black Sea and Arctic development and was consummated with a $3.2-billion infusion. While the agreement may reach $500 billion, the companies involved confess that, at least initially, tens of billions of dollars will be invested. Those are still enormous sums of capital, but are a far cry from the $500 billion that dominated headlines.

The fact is, there are too few data points from large transactions to discern a pattern, and any inference of an A&D trend is subjective (i.e., if a mega-cap company is performing a particular transaction, its rationale must be sound, and the industry at large will follow its lead).

Let’s cast the net a bit wider and see if a better picture of the A&D climate emerges by studying announced deals greater than $10 million by U.S. E&P companies. At first glance, 2012 seemed like a banner year for deals. The $78.3 billion in transactions represented a 33% increase over 2012’s values, and a 45% increase over those in 2011. But the number of transactions executed in 2012 (123) was on par with the number of those performed in 2008 (124). So, larger-sized transactions were occurring, albeit at a historically precedented rate.

The outlook for 2013 is far less optimistic. Through the second quarter of 2013, U.S. deal activity is on pace to perform 96 corporate and asset transactions valued at $34 billion, a 22% decline in the number of transactions and a 57% decline in value compared to the same period in 2012. Historically, fourth quarters are strongest for A&D activity, and the trailing 12-month data is encouraging. But 2013’s data does not signal the A&D surge that some would suggest. Smaller companies in particular have more to fear from a subdued A&D market, and have been dealing with a constricted environment for some time.

Divestitures’ crucial role

For the most part, smaller operators are farmers of oil and gas production. They acquire mineral rights, test the targeted play for economic viability, acquire a funding partner as necessary, produce the assets, and divest proven production to the appropriate buyer—similar to a farmer harvesting a crop.

That last stage of the independent operator’s life cycle is crucial. A mega-cap company’s operating cash flow historically is 154% of its projected capital expenditures. For a sub-$200-million enterprise-value operator, that number is 27%. Acreage, testing, and drilling and completion spending requirements have risen so high that operators are forced to sell producing assets to fund future development programs. The lack of a robust divestiture market places those operators at risk.

The Oil & Gas Asset Clearinghouse maintains a helpful database of its divestiture transactions; this represents the small transactions that are the lifeblood of U.S. onshore independents. Of course, there are outliers inhabiting the data set (undeveloped leases, for example), but the trends are telling. Divestitures marketed through the Clearinghouse have declined precipitously since their all-time peak in 2008, falling 37% to the trailing 12 months ending in second-quarter 2013. That’s a dramatic drop over an extended period of time and encompasses the entire category of small divestitures in a high-oil-price environment.

High oil prices may be a factor in the recent decline of divestitures. The revenue created by oil production for small companies has been enough to fund development to some degree, but it’s not sustainable in and of itself. Additionally, the continued slump in gas pricing has made the acquisition of small, gas-heavy producing assets challenging.

“We’ve seen oily properties be cash cows for operators who’d rather hold onto them at high prices than sell them, and those with gas production don’t want to sell at what they perceive is the bottom of the market,” says Ron Barnes, executive vice president of The Oil & Gas Asset Clearinghouse. Surprisingly, two commodities at opposite ends of the price spectrum have paralyzed the market for small divestitures, forcing some smaller operators to hold assets, seek funding from outside sources, enter into joint ventures that potentially reduce their upside, or shift to more modest development programs entirely.

Although annualized projections of divestitures for 2013 by The Oil & Gas Asset Clearinghouse predict another decline in transactions, there is cause for optimism. Values per auction lot at the company for the fiscal year have been up, exceeding 2012’s total in the first three quarters of fiscal-year 2013. An uptick in fourth-quarter divestitures would create a year-over-year increase in transactions from 2012. Any data that creates a consensus for continued high-oil-price stability, be it global economic recovery or moderated supply, sets up operators for a robust A&D environment in 2014. For all operators, withholding production from the A&D market can be costly.

“At some point, operators have to determine if it’s worth it to add staff or sustain the increased cost of monitoring noncore, declining wells and working interests, particularly if they’re adding to their well counts,” says Barnes.

Obviously, any sustained uplift in gas prices will allow current production owners to clear the decks and spurn a more robust A&D market. Those potential sellers who’ve sat on the sidelines with noncore, oil-heavy production may soon reach the point where they clean house to streamline operations and fund future development.

New players’ impact

Two potential catalysts for growth in 2014 aren’t often discussed in regard to A&D but may make an impact. The first is master limited partnerships (MLPs). On the scene since the 1980s, MLPs have established themselves as reputable players in the industry, providing stable production, growing revenue through acquisitions, and distributing a predictable yield to justify their share prices and market values to investors.

Given the declining nature of hydrocarbon production, E&P MLPs face even more pressure than their midstream brethren to increase production to meet yield targets. The high drilling and completion costs that challenge independents are also making it difficult for E&P MLPs to grow production organically. The effect of their acquisitions on the A&D market is important. By the end of second-quarter 2013, the 12 public E&P MLPs had already outspent their entire 2012 acquisition budget as a group. More importantly, MLPs accounted for 35% of all U.S onshore acquisitions in the first half of 2013.

MLP appetite for production won’t decline in the near term, regardless of oil prices. Breit-Burn Energy Partners LP’s acquisition of $860 million of Whiting Petroleum Corp.’s production effective April 2013 is a poignant example. When Whiting acquired similar reserves in 2005 in Oklahoma’s Postle Field, oil was at $60.53, implying a valuation of $77,660 per flowing barrel. But the day before BreitBurn announced the 2013 deal, oil was priced at $91.18, implying $112,539 per flowing barrel for acquired production.

Because stock deals create dilution that adversely affects yield to investors, most MLP acquisitions are done with cash and appropriate leverage. Whether or not MLPs can continue to fund acquisitions in this price and lending climate is a separate discussion, but they are avid buyers in the marketplace and are effecting significant transactions.

A second potential catalyst for increased A&D activity is consistently higher gas prices, but that prospect is a bit murky. The EIA is predicting gas prices of $4.02 per thousand cubic feet (Mcf) for year-end 2013 and $4.35 for year-end 2014, a welcome hike from recent prices. The U.S. accounts for more than one-fifth of global natural gas consumption and has had the largest increase globally in 2012, to more than 25.5 trillion cubic feet (Tcf), according to the EIA.

An increase in gas-powered electricity generation has been predicted for the past few years as a potential savior for moribund gas pricing. However, the expectation of higher gas prices has begun to affect gas-fired plant construction. While gas-fired plants are cheaper and faster to build than coal-powered plants, the EIA reports gas-powered plants are expected to decline from 30.3% of the U.S.’s electricity production to 27.6% in 2014. Coal plants, unsurprisingly, will reap some of the benefits of the gas-powered constriction, rising 1.7% in production during that same period.

While the decline in gas-powered electricity generation in and of itself will not halt a rise in gas prices, it will certainly moderate prices. The hope is that a reliable upward trend in gas prices will free up market participants to boost A&D activity across the board.

Conclusion

The tendency over the past couple of years has been to interpret discrete transactions as indicators of a burgeoning A&D market climate, but that is not always true.

The changing of hands of producing assets is a sure sign of a healthy industry, as smaller companies create value, pass on production to appropriate buyers, and use the proceeds to fund future development. But for large transactions that garner attention, the tendency to assign optimism to broader A&D activity is misplaced, as more often than not those deals’ characteristics are not systemic.

Smaller operators, which make up the bulk of the U.S. upstream sector, are finding the A&D market to be slow, but not idle. Continued high oil pricing coupled with a surge in gas pricing may well be on the horizon (if not already under way), leading to a robust A&D market for the industry as a whole—not just for large companies—in 2014.

Scott Cockerham is a partner at Parkman Whaling LLC, an energy investment and merchant bank in Houston. Prior to joining Parkman Whaling, he worked at Deutsche Bank and Goldman Sachs.

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