In 2016, it seemed every Permian Basin transaction had unmistakable momentum: each successive, high-price deal built on the last like Joe DiMaggio’s streak of 56 consecutive hits.

But the year also had the feel of the dot-com boom to David Deckelbaum, senior E&P analyst at KeyBanc Capital Markets.

“Back in the 2000s, every Thursday or so there was a new tech IPO and you just played it because the last one worked the week before,” Deckelbaum said at the KeyBanc breakfast in February.

Each time a Permian deal came on deck, the stakes were raised. “That was the logic going into it. You do it because it works,” Deckelbaum said.

E&Ps are digesting deals and not every company fared equally well at the M&A buffet. Permian E&Ps that made deals and bolt-ons have seen market performance up 14%.

But companies that hoped to trade one basin for the Permian have been “universally punished,” Deckelbaum said.
To date, those companies’ market performance is down roughly 6%.

Timing mattered, too. Permian acquirers in 2014 and 2015 have seen a 43% relative outperformance since 2015. In 2016, perhaps due to skepticism or deal weariness, outperformance from most acquisitions was “non-existent” and has been negative so far in 2017, he said.

All of that A&D spending now requires shifting into overdrive, with E&Ps ready to spend more cash flow than they have—just as they did before the industry fell into commodity-price purgatory.

In 2017, U.S. E&P budgets are set to increase 45% year-over-year to more than $65 billion.

E&Ps may have no choice but to drill. David Tameron, a senior analyst at Wells Fargo Securities, noted that in the past six months more than $20 billion has been spent in the Permian Basin.

“In order to justify the lofty acreage prices that we’ve seen, spacing and timing of development were crucial,” Tam-eron said.

Acreage prices upward of $30,000 per acre “become difficult to justify without tight well-spacing, rapid development pace and strong commodity prices all working in tandem,” Tameron said.

“The takeaway here is that pulling cash flows forward through accelerated drilling is, in many cases, necessary to justify lofty acreage prices.”

Scott Hanold, an analyst at RBC Capital Markets, said in a March report that he was “a bit surprised at several [E&Ps] willing to outspend for more growth. Any incremental free cash flow likely gets spent.

“Focus now turns to integration, execution and infrastructure buildout,” he said.

This may all seem counterintuitive. After all, public companies were supposed to arbitrage private company’s value on deals.

Generally, the theory was that acreage purchased at $30,000 per acre was worth $50,000 to a public company with technological and capital advantages.

At the beginning, that was true, Deckelbaum said. In the early days of the Permian land rush, the upside for a public company buying private E&Ps’ assets was close to 70%. Now it’s shrunk to roughly 35%.

Making the math work on deals has become increasingly tricky, particularly as prices have inflated. Consider a $3-billion company that buys an asset at a 30% discount.

A $1-billion deal would require an equity raise—and goodbye arbitrage.

“There’s your 30% [arbitrage] that’s gone,” Deckelbaum said. “And now you’ve got to accelerate.”

Basin hopping has also cut out large amounts of production from some companies. SM Energy Co., for instance, has purchased $2.3 billion in Permian assets and divested $2.7 billion in noncore assets.

Perhaps more importantly, the company sold 65,000 barrels of oil equivalent per day (boe/d) for 7,500 boe/d volumes in the Permian.

In a long-term market, entering a new asset requires kicking up growth. But high-grading a portfolio comes with its fair share of friction.

“At the end of the day, all of this is inevitable. E&P is a very difficult inventory management game,” Deckelbaum said.

And with an average of 11 years of economical inventory at the current strip, prices must rise, new technology must be deployed, or “everyone needs to buy stuff,” he said.

For some companies, that means scrambling for inventory in the Permian or picking up areas in the Powder River Basin, the East Texas Eagle Ford and other seemingly forgotten regions.

But that’s the rub, too, Deckelbaum said. The markets frown on non-Permian deals.

“You get killed,” he said. “But you need to buy something non-Permian.”

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