Ever since Colonel Edwin Drake's discovery well in 1859 in northwestern Pennsylvania, the Appalachian Basin-stretching more than 1,000 miles from Tennessee to New York and with an expanse of some 185,00 square miles-has drawn a crowd of successful hole-punchers.

How successful have they been? In the intervening 148 years, the region has produced more than 70 trillion cubic feet equivalent (Tcfe) of gas. Indeed, the Appalachian Basin today accounts for nearly 6% of all U.S. natural gas reserves and about 3% of gas production.

But what's more fascinating is a 2002 U.S. Geological Survey estimate that the remaining undiscovered resource potential of the region is in excess of 75 Tcfe. So the basin still has plenty of legs left.

"High natural gas prices and technological advances have spurred renewed interest in the country's oldest producing basin," says Shannon Nome, E&P research analyst for Deutsche Bank Securities in Houston. She notes specifically that success in unconventional coalbed-methane (CBM) and shale plays elsewhere in the U.S.-in places like the Barnett shale, the Rockies, Midcontinent and Arkoma regions-have driven technology transfer to Appalachia.

Nome emphasizes that natural gas production from the region is priced at a premium to other U.S. markets due to its proximity to high-demand East Coast markets. "Also, finding and development costs are low, and operating costs are similarly favorable when compared to other regions. As well, the relatively new application of horizontal- and deep-drilling technologies has shown the potential to increase well recoveries 20-fold."

The analyst believes that as more producers put capital to work in the basin and results continue to garner investor attention, the region's key players-among them Range Resources, Exco Resources, Dominion Resources and Chesapeake Energy-stand to enjoy outsized share-price appreciation.

Thus, does this mean the market is going to see increased M&A activity in Appalachia? There's a case to be made both for and against such activity.

Sylvia Barnes, Houston-based managing director for Merrill Lynch & Co. and Merrill Lynch Petrie Divestiture Advisors, cites, as does Nome, the attractive gas-pricing differentials for the region's natural gas. "Year to date through early October, Appalachian Basin gas prices have averaged more than 80 cents above Henry Hub while Rockies gas has sold at an average $2.89 discount to Henry Hub."

Another plus for the Appalachian Basin: in general, reserves there are longer-lived, lower-risk and more predictable, plus well connections are relatively close together and not very costly, so assets in the region are attractive both from an upstream and a midstream perspective, she points out.

However, there's a flip side to the coin in terms of the potential for future M&A activity in this venerable old basin. "There's a finite universe of sizeable transactions in Appalachia because it's a fragmented, mature basin, with a patchwork quilt of many small, private independent operators and ownership interests," says Barnes.

"Also, it's a complex basin with challenges in terms of topography, laying pipeline, building roads, gaining lease access and dealing with a unique regulatory environment. So one has to be patient and willing to work on both small and large deals. Very simply, there aren't going to be a lot of large transactions in the region."







That said, in 2006 and 2007, there have been several large M&A transactions in the region involving some of Appalachia's bigger players. This includes such buyers as Range Resources, Exco Resources and, among the master limited partnerships (MLPs) or limited liability companies (LLCs), Linn Energy and EV Energy Partners, both based in Houston.

With strong commodity prices, there have also been a number of recent large sellers. Case in point: Equitable Resources' $147-million sale of about 66 billion cubic feet equivalent (Bcfe) of proved reserves to a private partnership. In this 2005 sale, Merrill Lynch Petrie was the advisor to Equitable Resources.

"We were able to successfully sell the company's properties at a relatively high multiple for Appalachian reserves-$2.23 per thousand cubic feet equivalent (Mcfe) versus an average multiple of $1.83 prevalent in 2006 and 2007," says Barnes. "The driver in this deal was that the buyer was interested in acquiring very long-lived, relatively low-risk, predictable, hedgeable reserves."

More recently, this fall, in a midstream Appalachian-related transaction, Merrill Lynch has been acting as an advisor to Denver's MarkWest Hydrocarbon Inc. on its $740-million merger into MarkWest Energy Partners LP. The corporate entity has, along with its Texas assets, five gas-processing plants in Appalachia with a capacity of 350 million cubic feet per day.

Still, the question remains: Will the market see more Appalachian M&A activity in 2008? "A key factor will be natural gas prices," says Barnes.

"If we had a short-term softening of gas prices, that could create buying opportunities," she contends. "But remember, there are only a limited number of opportunities in this mature, well-worked basin. It's not like western parts of the country that are more frontier-oriented and where there's more M&A activity going on, such as in the Rockies and in some of the new unconventional plays."



Consolidation opportunity

Rob Bilger, managing director for Tristone Capital LLC in Houston, is more sanguine in his outlook for upstream M&A activity in Appalachia in 2008.

"I expect the A&D pace there to accelerate, and we're already seeing some sizeable transactions," he says. The firm is acting as technical and financial advisor to EOG Resources on the divestiture of its properties in Pennsylvania, Ohio and West Virginia. Overall, the sale involves about 17 million cubic feet equivalent per day of production and proved reserves estimated to be nearly 300 Bcfe.

Bilger says that, from a buyer's perspective, many of the larger independents such as Range Resources-adept with new completion techniques and horizontal-drilling technology-are finding economic ways to exploit the basin's conventional assets, as well as its blanket shales and CBM production, more so than smaller independents in the region.

"So there's a real opportunity for larger operators to come in and consolidate interests in Appalachia."

The Tristone executive adds that the demand by upstream MLPs such as Linn Energy LLC, Atlas Energy Resources and EV Energy Partners LP for Appalachian assets is not only going to further drive consolidation in the basin, but also improve asset valuations that will prompt smaller players to sell.

Says Bilger, "For 2006 and 2007, we've seen prices paid for proved gas reserves average about $2 per thousand cubic feet, but I would expect to see that pricing level move up in the coming year."

The magnet drawing buyers? He cites, as do others, long-lived reserves, predictable cash flows, low-risk development, very shallow production-decline rates and, because of the basin's proximity to major Northeast U.S. natural gas markets, gas prices that are a premium to those of Henry Hub.

So why then is Appalachian M&A activity lighter compared with other U.S. basins? "In Appalachia, you need thousands of wells to achieve a significant amount of production; comparatively, in the Gulf of Mexico, for instance, you might need only a handful of wells to achieve the same level of output, even though those wells might have shorter reserve life."



Dramatic jump ahead

Scott Richardson, a principal of Richardson Barr & Co., an independent divestiture firm based in Houston, is also upbeat about the increased level of M&A activity likely to take place in Appalachia in 2008.

"Historically, one could probably expect to see anywhere from five to seven deals take place in the Appalachian Basin any given year, but starting in 2008, we're looking for a dramatic jump in M&A deal flow-anywhere from 10 to 15 deals per year," he predicts.

The reason? Right now, assets in this basin are receiving some of the highest valuations in all the U.S., so a lot of private companies are deciding to sell, he notes. "In 2007, we've consistently seen as much as $2.50 per Mcfe being paid for proved reserves, with prices for daily production of $15,000 per Mcfe. In addition, whereas Appalachian assets might have historically traded at five times cash flow, that multiple in 2007 has been typically seven."

Notably, whether one is talking about assets in Appalachia proper or Antrim shale assets in Michigan, 70% of the sellers this year have been utilities, says Richardson. They are selling their assets into the burgeoning upstream MLP market-a market whose growing population of entities command 10 to 12 times cash-flow multiples on Wall Street versus a five or six multiple for traditional E&P companies and hence, can afford to pay a higher cash-flow multiple to asset sellers.

Case in point: the $1.27-billion sale this June by DTE Energy, a large Michigan-based utility, of its Antrim shale assets in Michigan to Atlas Energy Resources LLC, a Pennsylvania-based E&P MLP.

An active player in the A&D market, Richardson Barr last year advised Houston's Petrohawk Energy Corp. on the $70-million sale of its Michigan oil and gas assets. At press time, the company was in the market with anther asset sale, this one for Tulsa's Samson Investment Co. The sale involves the divestiture of all of Samson's Michigan assets, which includes daily gas production of about 8.3 million cubic feet equivalent.

"Whether it's BreitBurn Energy Partners LP, a California upstream MLP that just made a $1.4-billion acquisition, 80% of that involving Antrim shale assets in Michigan, or Exco Resources, which has announced plans to be an E&P MLP and has been very active in Appalachian acquisitions, we're going to witness a major dramatic uptick in MLP-related M&A activity-the principal focus being on Appalachia, and to a lesser extent, Michigan," says Richardson.

He points out these regions abound with assets that have 75% or higher proved developed producing (PDP) reserves, production decline rates of less than 10%, long-lived reserves-20 years or more in the case of Appalachia-and very modest capex-reinvestment requirements. "So if one were designing an MLP, these regions are where you'd want to be."

Obviously, for sellers, given the valuations being offered by upstream MLPs-and the very real concern that the capital-gains tax environment could change for the worse under a new administration-a lot more small, private Appalachian independents are very likely to decide to monetize their assets, he says.

That's not all. Says Richardson, "I wouldn't be surprised to see some of the bigger players in the basin-the likes of Equitable Resources, Range Resources or Cabot Oil & Gas-decide to divest some or all of their Appalachian assets in order to take advantage of the asset valuations now being offered by upstream MLPs."



Unique Chesapeake deal

Cautiously optimistic about M&A deal flow in Appalachia in 2008 is Bill Marko, managing director for Jefferies Randall & Dewey in Houston.

"It's hard to gauge a niche market like this basin where you have just a handful of large operators like Chesapeake Energy Corp., Cabot Oil & Gas and Dominion Resources, then a large number of very small operators," he says. "A lot will depend on where natural gas prices are headed and also if upstream MLPs are able to cause more deals to happen. In fact, M&A activity would be more demand-driven by them looking for deals than people necessarily wanting to sell."

These caveats aside, Marko looks for healthy deal flow in Appalachia next year quite simply because the basin has probably some of the most attractive assets in the U.S. for E&P MLPs. "What this translates into is very steady cash flow for a very long period-perfect for what MLPs want."

Currently, Jefferies Randall & Dewey is working on behalf of Chesapeake on the sale of a portion of that producer's Appalachian assets. The sale, ongoing at press time, is somewhat unique in that Chesapeake isn't actually selling 100% of the assets, but rather a portion of the assets through a net profits interest.

"Chesapeake's head, Aubrey McClendon, who has studied the MLP market for some time, had three choices: He could have done an upstream MLP, retained the assets and hope he received MLP-like valuations for them, or he could have sold the assets to MLPs," explains Marko. "What he has elected to do is straddle all three options."

Effectively, Chesapeake is selling to financial buyers and MLPs a 35% net profits interest in the cash flow from the revenues of a group of Appalachian assets-minus operating expenses-for a 20-year term. The giant gas producer is guaranteeing for the first four years a volume of 30 million cubic feet per day, beyond which buyers would ride the production profile of the asset package-then after 20 years, those assets revert to Chesapeake.

With this approach, McClendon has indicated to the market that he expects to raise $550 million-while ultimately getting to keep the Appalachian assets involved. "Right now, we're doing a bit of the technical work, packaging the sale, marketing it, receiving bids and negotiating the bids received," says Marko.

Looking ahead, he stresses that recent high natural gas prices have tended to slow A&D activity in the basin. "However, at a lower price coming out of this winter, I think you'll see a lot of buyer interest, especially if buyers believe there's going to be upward price pressure. This, coupled with upstream MLP demand for assets, could cause a lot of deals to happen."

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