A&D Roundtable: Return of the Upside for E&P Companies

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As hundreds of A&D professionals gathered in Dallas for Oil and Gas Investor’s A&D Strategies and Opportunities Conference, we snuck three of the leading practitioners of dealmaking far, far offstage for a private conversation. On hand were Chris Atherton, CEO and president of EnergyNet; B.J. Brandenberger, partner at TenOaks Energy Advisors; and Matt Loewenstein, director at Detring Energy Advisors, to discuss the twists, turns, megadeals and surprises in 2021 and how the market is taking shape for the year ahead.

What’s your assessment of the A&D market today? How have things changed?

ATHERTON: We’re seeing sellers bring a lot more quality assets to market. I think in the past six months or so, the bid-ask spread has narrowed significantly, and the deals are getting done. The publicly traded E&P companies are definitely buying again, which is a positive sign. The private equity portfolio companies have been able to sell and make an exit when that market was really closed for them for the past couple years, so I think you’re seeing a lot more processes come to market and kind of private equity [portfolio companies] and maybe accept company stock as a portion of the consideration for the sale.

My take is I still think that there’s probably more consolidation to happen, and maybe not a lot of it, but I wouldn’t be surprised to see two or three more kinds of megadeals between the next 12 to 18 months. The sub-$200 million, sub-$250 million market seems to be very active right now. There’s deal flow. I think that the market remains very active.

I think [for] the large, the majors and the super independents, a $1 billion deal doesn’t do much good for them. They need to do a $5 billion deal or a $10 billion deal. With some of these processes out there, I would imagine there’ll be consolidation among the private equity groups … and then I think the sub- $250 million market will remain pretty hot and active going into 2022.

BRANDENBERGER: It’s a feeding frenzy out there right now. The market is flooded with assets. The commodity price uptick has spurred activity. For sellers, the deal-on-deal competition is fierce because buyers have so many deals in their pipeline to evaluate. The quality of assets in the market has also improved considerably.

We have several new buyers in the space that have capital. I think that’s one thing I’ve been surprised by is the number of new entrants who are well-funded. I feel like the closing rate on transactions has been higher overall this year, albeit lately we’ve seen the heavy backwardation of the strip cause sellers to reconsider and hold on to their assets if they think commodity prices will continue to climb.

I’d echo a lot of what Chris is saying, the market for assets less than $250 million is alive and well. Larger deals are prevalent, but there are only so many groups with access to that type of capital.

Who are your buyers?

BRANDENBERGER: We’ve seen a little bit of everything in the middle market space. We’ve seen institutionally backed teams that have longer time horizons on their capital. It’s not three-to-five-year capital but more seven-to-10 year-plus type capital coming in there with lower return thresholds.

We are also seeing family offices in a more meaningful way. We’ve sold to multiple family offices who either had an existing team in place or who were backing a team that they’re familiar with. You of course have several old and new private equity-backed groups out there who are being very acquisitive. Those are probably the three buyer types we’ve seen the most in our space.

LOEWENSTEIN: I think if you look at the three groups here, we’ve been extremely active in the middle market space. I’d say that never really went away in the middle market in 2020 as you’d expect with the quantity price of volatility that was a larger bid ask spread. We definitely see narrowing today, but in the middle market the capital has been there. Transactions were closing in 2020, and I think 2021 is going to be a breakout year for deals in our size range. When you look at the question comparing the larger market to sub-$250,000 market when you look at the $500 million, $1 billion A&D deals, we obviously haven’t seen as many of them. To B.J. and Chris’ point, there are fewer buyers, but also if they want to pay for upside that they have to use stock. In our space we’re seeing the cash market, and it’s generally guys that are able to describe value to the upside is pricing.

BRANDENBERGER: Matt brings up a good point there. We’ve seen more involvement from the private equity sponsor in the data room, which is interesting. Historically the management teams would do their evaluation, and then get board approval, etc. Today we see the private equity sponsors in the data room working the assets early in the process too, which we are supportive of because it eliminates a layer of potential uncertainty.

Why are they doing that?

BRANDENBERGER: Several PE (private equity) shops have their own technical folks in house when historically that wasn’t the case. They’re doing some of their own technical evaluations to see if it matches up with the management team to make sure they’re on the same page early in the process. This PE involvement may allow the portfolio company to be more aggressive out of the gates, and it lends itself to instant buyer credibility knowing that the sponsor has assessed and signed off on the technical evaluation upon submitting an offer.

ATHERTON: Yeah. I would agree with that. We’re seeing that as well. It’s comforting. I think part of the issue can be, and B.J. alluded there, these guys used to have three deals they’re evaluating, and now they have 20 or 15 that they’re screening. I think if the private equity team or the sponsor, whoever the sponsor is, we just try to make sure they’re aware that their management team is looking at the deal, and about to make a bid, or making a bid I’m sure there are instances where, well I think to the PE shops, in the data room, and then in the weeds throughout the process it’s good that they’re doing that. They look at the portco’s (portfolio company’s), the management teams’ evaluation, they look at their own evaluation, and it makes it easier to submit an offer and feel comfortable and aggressive and ready to close and sign the check.

How much value are you seeing ascribed to upside?

BRANDENBERGER: Upside value varies by asset type. It’s a function of a buyer’s discounted cash flow analysis. For conventional assets, upside value may come in the form of a lower discount rate on your PDP (proved developed producing). For unconventional assets, it’s about the returns on your future horizontal locations and drilling program, but it’s still a function of the discounted cash flow model. You can back into a dollar per acre after your discounted cash flow analysis is complete, but it’s highly subjective. It’s very seller-dependent, buyer-dependent and asset-dependent.

ATHERTON: On the deals that are getting done, and that’s more of them, there’s a large PDP component of that deal, and the buyer and seller are able to pretty much come to terms on that portion. And then if there is some upside, I think the sellers are pleasantly surprised that they’re getting consideration for that, as well. The deals that are tough to sell are the ones that are, I would say, have only 10% to 25% PDP component, and then there’s all their big wedge of value is all upside or drilling and just getting buyer and seller to come to the same evaluation on that asset can be tough.

But I definitely think that more and more it’s not $50,000 an acre or something like that, but they are giving value to upside whereas maybe a year or two ago they really weren’t at all. They would say, ‘We’re not going to describe any value to upside, and we’re just going to give you a PDP number, and we’ll see if we win.’ I think that’s changed.

LOEWENSTEIN: I’d echo B.J.’s point that it is obviously DCF (discounted cash flow)-driven. I’d add that it’s also asset class-dependent. We’re seeing operated working interest deals where buyers are more so able to underwrite undeveloped that they see returning good returns at today’s pricing that they plan to develop near term for minerals, royalties we do see buyers describing real undeveloped value to longer-term inventory, but certainly mostly to line the site, your ducks and permit wedges. Then I’d rank in a nonoperative working interest toward the back of the pack where the market has been slower to return to really underwriting inventory, but over the past month or so I think in that market just given I feel like the Permian or even the SCOOP/STACK at $6 gas wells being drilled today are returning north of a 100%. Buyers will pay for that. Again, I think that the asset class does make a big difference in discount rates and really how far out into the future buyers are willing to underwrite the upside.

As natural gas prices have recovered this year, are you seeing value ascribed in places such as the Permian due to associated gas production?

BRANDENBERGER: When prices go up overnight, everything else just doesn’t go up along with it right away. There is typically a lag, because you need to see some consistency in commodity prices before valuations start to rise all together. Buyers still use some form of strip pricing for their evaluations. As prices rise and stay consistent, both your PDP and upside should become more valuable, assuming you can keep costs down.

LOEWENSTEIN: I think at the end of the day acreage evaluations, I think even back in 2016 to ’18 when we were seeing $60,000 per acre in the Permian. It was always discount cash flow based and continues to be, but I think buyers are underwriting much more conservatively today. I expect that they will continue to do so. We’re not going to see transactions where buyers are paying PV20 for four benches of development that a fairly aggressive development pays. I think you’re going to see again much more conservative pacing, as well as total inventory underwritten.

There’s been a lot of deal flow in the Permian Basin but obviously we’re not at the same elevated price metrics as in years past. Raymond James data showed Northern Oil and Gas actually paid the highest price per acre while ConocoPhillips deal to acquire Shell’s Permian assets was about $15,000 per acre. How much will acreage valuations rebound?

ATHERTON: Acreage prices have seemed to be for a while there that every deal we kind of benchmarked on an acreage value and what the buyer was paying for, I feel like a lot of the acreage is owned, a lot of the good rock is owned, so deals are trading hands. But I feel like the E&P companies are kind of in development mode for the good acreage that they already have. We’ve done a couple transactions primarily in the Delaware Basin where we were seeing about $15,000 an acre. We had one that was kind of an anomaly that was $25,000 an acre. These were sub-$100 million type deals, but I think it’s more online of sight on development. And there are some companies that Matt mentioned earlier, they’re just not going to be able to (develop) that acreage.

It could be good rock, but they will sell it because the public companies are intentionally trying to be capital disciplined, and not growth for growth’s sake. That acreage will trade hands. It really depends on how fast the new owner believes they can develop it, I believe.

What are you seeing in terms of conventional assets on the market? Is that still of interest to buyers or are they more committed to shale?

ATHERTON: We still sell a lot of packages that are conventional or they are mature shale. Part of this is just kind of the nature of the beast, and the type of sellers that we’re selling for these become noncore assets over time in their portfolio, but there’s a whole food chain of buyers that really feel they can do a lot of good blocking and tackling, and lowering opex and increasing production, and refracks, reworks. Things like that. In the sub-$250 million space those are a lot of the asset packages that trade, simply because for the big companies, it’s not moving the needle for them anymore.

LOEWENSTEIN: I would say Texas conventional oil is one of the hottest commodities. We’ll see 100 CAs (confidentiality agreements) and 20 bids on Texas conventional oil packages.

BRANDENBERGER: It’s been a popular asset for mostly private buyers for a long time. Conventional assets are enjoyable to the market really because the buyer turnouts are typically fantastic, and there are usually multiple layers to the upside story. I feel like that buyer universe has been resilient, and there are even more groups chasing it now than ever before because PDP is in vogue. That market is alive and well and could be for the foreseeable future. To Chris’ point, the operational upside and low-cost, lower-risk upside opportunities in today’s market are pretty attractive.

Turning to gas assets, we’ve seen a number of deals in the Haynesville Shale, as well as the Marcellus and to a lesser extent the Barnett. What kind of activity are you seeing in the gassy places?

BRANDENBERGER: I think you’re going to see more transaction activity in gas-weighted plays if gas prices hang in there. The appetite for gas-weighted assets has improved dramatically. You could see some continued consolidation in these plays.

We know a couple of Barnett packages that are in the works there. Mature shale gas plays like the Barnett typically get attention from buyers who are focused on buying PDP versus those who are focused on development. Haynesville and Marcellus deals could shake loose as well, but potential sellers are also seeing the long-awaited opportunity to drill at these higher prices.

LOEWENSTEIN: I think looking at the Barnett in particular over the past several years, there’s been few rigs, and to B.J.’s point, it’s a PDP-weighted market. You didn’t see a lot of assets shake loose only because there’s really no incentive for a lot of the sellers in today’s market to transact.

I think today we’re likely to see more transactions in the Barnett because opportunities like refracking have just become more competitive for capital. Then echoing B.J.’s point on the Haynesville and Marcellus, we continue to see rigs in those basins throughout 2018, ’19, ’20, but today you’re every day seeing a rig added, particularly for the privates, so we do see that activity increasing. There’s certainly a lot of capital that wants to get gas there.

ATHERTON: The Haynesville is really exciting right now. I know Rockcliff is drilling some great wells, and Comstock and others. I think we’ll continue to see consolidation there. I think there are a lot of really big companies that want to make stuff happen.

BRANDENBERGER: I was just saying that operators of gas properties have been waiting for this day for a long time. It’s a question of, ‘Do I sell? Do I drill? Do I grow via acquisitions?’ It will be interesting to watch it unfold.

ATHERTON: I’d add, you’re also seeing more mineral buyers rotate to these basins. I think going back to 2018 and when the royalties’ market was really picking up steam and starting to see a more liquid market there. All the attention was on the oil basins. Today if you look at mineral buyers, they're very active in the Haynesville (and) in Appalachia in particular.

Are you still seeing creative financing with smaller-scale deals? Or is it really more of a cash market?

LOEWENSTEIN: On the front end is how you package the assets. I think an example would be a Chevron Delaware Basin package that we’re marketing currently where Chevron has high NRIs (net revenue interests) on their leasehold, and we work with a team to split out an override and a working interest package given the differentiated cost to capital of the override buyers.

It’s packaging, to really work on the front end more so than we see structured or creatively financed deals in the market. You’ll occasionally see commodity prices kickers, but in terms of VPPs (volumetric production payments) and other structured finance type deals, we don’t see that in our market.

ATHERTON: I would add that most of the deals that are cash deals, what we found is that some of the contingency deals or we’re structuring things works well, or the instances we’ve had those discussions and try to build around it and make a deal work, and because those discussions kind of flushed out maybe a better evaluation, or better meeting of the minds between buyer and seller, and then it ultimately comes back to a cash deal. So we have to go down the road of doing contingencies and then structuring the deal in different ways that makes it work for the buyer. It makes it work for the seller, and then because of those discussions kind of flushed everything out, it turns back into a cash deal because they’re bid asset is narrowed.

BRANDENBERGER: A couple of times this year we’ve seen the seller willing to take a minority ownership in the acquiring company going forward. This allows them to roll some equity forward and continue to live to fight another day and hopefully capture more of the development and/or commodity price upside. That’s about the extent of the creativity outside your occasional commodity price driven structures that Matt mentioned.

Do you see 2022 as being as robust as it’s been this year?

LOEWENSTEIN: Yeah. I think so. I think there’s certainly pent-up demand on both the sellers and the buyers’ side of the table. I think as we … as these, the current strips season, as we continue to see kind of $70 oil flow through to the LOS (lease operating statement), it’s always a little bit of a lag, but we can see some of the cash flows, the current pricing I think there will continue to be a robust A&D market.

ATHERTON: I think if I could ask for anything it would be stability. I’ve been doing this for almost 20 years and gone through three major crashes: 2008, 2014, 2020. Those are all kind of big optimistic, the public is trying to be as disciplined as they can, and no growth to moderate growth, if that will hold. It feels to me like there are under investments going on, and that will probably cause more capital to eventually come back to the energy space, but if you can get some stability, I think that will bring investors back.

BRANDENBERGER: We’re cautiously optimistic to bullish that both A&D and commodity prices will continue this trend. We are not seeing any signs of slowing down. I think as long as we can maintain and see some consistency at these higher commodity price levels, you will continue to see transaction activity. I’m the last one who likes to predict commodity prices, but we are encouraged by the momentum.