Brett: Oil M&A Outlook is Strong, Even With Bifurcation in Valuations

Clay Brett is a partner at Baker Botts and a leading authority on private energy investment.

Valuations across major basins are experiencing a very divergent bifurcation as value rushes back toward high-quality undeveloped properties. Geographically, while activity is ongoing in the major non-Texas basins, the Permian and the Eagle Ford offer a clear valuation premium independent of the mix of developed and undeveloped inventory.

Across basins, in both public and private M&A, the market is very clearly placing a premium on undeveloped locations, and the anxiety of the publics with respect to their depth of inventory is palpable. As a result, companies and asset packages in the major basins with significant undeveloped upside are enjoying a seller’s market and would be expected to trade way north of proved, developed, producing (PDP) PV-10 value, with the excess value attributable to acreage.

In contrast, wellbore and low- to no-upside deals still trade at a deep discount rate, as buyers must cleave all their base case return from declining production value. Facing a subscale buyer, prices will suffer from the buyer’s diseconomy of scale and an internal equity return hurdle in excess of 20%, which manifests itself in the bidder’s PDP discount rate. As a result, scaled PDP buyers with a low cost of capital balance sheet, utilizing a borrowing base or securitizations, continue to enjoy a significant advantage.

What some may call a bifurcation in value, others may simply call a proved undeveloped (PUD) reserves premium, although one sometimes struggles to find a consistent discount rate applied to PDP. These developments have created a number of interesting deal dynamics to note:

• The allocation of value across the properties under a purchase and sale agreement (PSA) becomes a highly material transaction item, shifting from its typical role as a ninth inning schedule delivered by the buyer, and allocation of value can become disruptive to a transaction if the allocation suggests a seller may be able to obtain a more interesting valuation for its undeveloped properties elsewhere.
• Significant value allocation to PUDs also creates more complexity to the operation of tag-along and preferential rights, leading buyers deeper into diligence to identify these material issues earlier than usual, with more flexible financial resources and deal strategies to accommodate them.
• Acquisition financing has resurged to become a very popular way for credit funds to participate in the market, particularly in PDP-heavy transactions, as the entry point on PDP collateral has remained relatively cheap. Alternative financing is generally as freely available and competitive to E&P as it has been in recent cycles, as a preponderance of financing sources compete to deploy capital into the current interest rate environment and positive private credit fund flows.
• Market practices regarding bring-down title thresholds between acquisition financing players (PDP-based) and buyer-borrowers (PDP + PUD) are divergent, where the buyer-borrower will have a higher scope of defect in a PSA title defect mechanic (and thus more sensitive closing defect threshold) than the closing conditions to the acquisition financing, which will require verification of a threshold level of PDP value (85%-90%).
• Financing covenants lag behind the M&A market practices in the covenants’ lack of value attribution to undeveloped properties, suggesting that credit participants may compete on advance rates to become more aggressive and flexible to win deals. 
• Good title to undeveloped properties becomes a new source of deal risk as upstream assets traded for a prolonged period without value attribution to undeveloped properties, and were thus subject to relaxed diligence practices. Sellers must attend to their land files ahead of a sell-side process or they risk frustration of the process. 
• The technical methodology of reserve engineering firms to limit PUD attribution to immediate adjacencies to existing PDP wells does not reflect market valuation practices. The market is clearly laying down locations across the observable reservoir and the market is paying for these credible locations regardless of reserve classification, calling into question the role of third-party reserve reports as a bedrock valuation framework for both M&A and financings.
• Representation and warranty insurance continues to be a popular means of addressing post-transaction risk, but it is more difficult to satisfy due diligence requirements in a transaction with large undeveloped value attribution, as the scope of diligence to satisfy an insurer may be more extensive than prevailing industry practices.

A long-term WTI curve above major basin break-evens remains very strong for both acquisition and development activity, but understandably, some sellers are hesitant to take discount by selling the curve. The opportunity to harvest value from undeveloped properties is one way that the market is currently motivating sellers to transact. The structural logic behind the developed/undeveloped trend does not show any sign of abating today, and many believe that only a dramatic price collapse or a sea-change in the near-term role of hydrocarbons would cause the market to recalibrate in a way that abandons the trend. All signs point to market strength and sustained transaction activity into 2024.