"Ladies and gentlemen, this is your captain speaking. I am turning on the fasten-seat-belts sign. We've had some reports of turbulent air ahead. I know this is hard to believe as you look out the window: the sky is cloudless and blue...." The first-half 2000 merger and acquisition (M&A) environment can be compared with a jet plane cruising along at 600 miles per hour at 37,000 feet. So far the flight has been fast and smooth, though it has recently encountered a few pockets of turbulence. It does not seem logical. How can it be a beautiful, clear day but with such bumpy air? This is what the upstream M&A environment seems like at this time. Has there ever been a time in the indus- try when oil and gas prices were so high but capital markets so very spotty? High commodity prices generally translate into high stock prices, but that is not so today. Equity values are up for most of the independents, but many have merely recovered the value they lost during the crisis of 1998. The average stock of the large independent (more than $1 billion market capitalization) was up approximately 40% in the last 12 months (through July 2000). But, there is a wide range of returns from this peer group, from greater than 100% to less than 0%. This gap will continue to create scenarios where the strong acquire the weak. High commodity prices would seem to create a seller's market, but companies are reluctant to part with the superb operating cash flows resulting from $30 oil and $4 gas. This is beginning to negatively affect the asset deal flow in the market. The longevity of high prices is also beginning to cause mismatches between seller and buyer (and banker) expectations. Companies with a trading mentality love the uncertainty and volatility (that's where there is the potential to make the most money), but unfortunately most E&P managers do not. E&P-utility deals The energy stored from the slow first-half 1999 M&A environment was fully released in the first half of 2000, with $32 billion in upstream value for deals announced in the U.S. (more than $50 billion worldwide). As usual, a handful of deals both dominated and defined the market. You may have heard of the 80-20 rule; for deal-making it's more like the 95-10 rule (95% of the dollar value exists in 10% of the deals). The year began very quickly with the January 3 announcement that Equitable Resources Inc. agreed to buy Statoil Energy Inc.'s Appalachian-based reserves-approximately 1.2 trillion cubic feet (Tcf)-for $630 million. The long-lived reserves will be used for fuel supply to power plants. Shortly thereafter, another upstream-utility convergence deal was announced, the merger of El Paso Energy Corp. and Coastal Corp., with a transaction value of $16 billion. The resulting company will have 5 Tcf equivalent (Tcfe) of proved reserves in the U.S., making it the second largest gatherer of natural gas, and ranked in the top five in every sector of the wholesale natural gas and power arena. In other convergence transactions, Dominion Resources Inc. and Consolidated Natural Gas Company (CNG) completed their merger in January. The resulting company retains the Dominion name and has more than 3 Tcfe of reserves, a great deal of natural gas storage and electric generating capacity, and serves retail electric and gas customers. Finally, NiSource Inc. acquired Columbia Energy Group in a $6-billion stock deal. Large independent E&P deals Consolidation within the independent E&P group continued, with a couple of large mergers. Anadarko Petroleum Corp. purchased Union Pacific Resources in a $7.2-billion stock deal, which was a little surprising as Anadarko has historically not been an aggressive acquirer. The merger creates a large player in the North American natural gas market and combines Anadarko's expertise in exploration with that of UPR in exploitation drilling and operating. The merged firm boasts 11.6 Tcfe of proved reserves. Devon Energy followed up its PennzEnergy acquisition of last year with its acquisition of Santa Fe Snyder for $3.5 billion. This is a continuation of Devon's ongoing acquisition program and places Devon squarely in the large independent peer group. Another active historical acquirer, Apache Corp., continued its "laser shot" program, announcing an acquisition of Collins & Ware for $320 million and an acquisition of Anadarko Basin assets from Repsol YPF for $149 million. These seem to follow the Apache model of tightly focused acquisitions in nonbid situations. (At press time, Apache did it again, buying Gulf of Mexico shelf assets from Occidental Petroleum for $385 million.) Pure Energy Inc. was formed by combining the assets of Titan Exploration Inc.'s and Unocal Corp.'s Permian Basin operations. This was one of a number of transactions in which Permian assets were involved-almost 35% of Permian production has changed ownership in the last year. With continued portfolio rationalization away from the Permian by larger companies and strategies to focus in the Permian by others, it is expected that the basin will be one of the most active areas for asset deals in the next few years. Non-U.S. acquisitions First-half 2000 activity in Canada was also up sharply from 1999. The two largest transactions announced were privately held Husky Oil's acquisition of Renaissance Energy for US$3 billion and Canadian Natural Resources' purchase of Ranger Oil for US$1.1 billion. According to Cameron O. Smith, senior managing director, Cosco Capital Management LLC, these deals were part of the greatly increased deal flow in Canada. Some 16 deals for US$6.6 billion were announced in the first half, versus eight for US$1.25 billion in all of 1999. U.S. companies sponsored three of the other transactions in 2000, says Smith. These are the purchases of Tri Link Resources, Calahoo Petroleum and Northrock Resources for an aggregate US$800 million by, respectively, Seneca Resources, Samson Canada and Unocal Canada. "Many more crossborder transactions are rumored," Smith adds, "as U.S. companies take advantage of price-to-cash-flow multiples roughly one-third higher than those exhibited by Canadian peers, not to mention a U.S. dollar with almost 50% more purchasing power." In other arenas, three half-billion-dollar asset deals are of interest. Chevron announced it was buying another 5% of the Tengiz Field from the government of Kazakhstan for US$450 million, Kerr-McGee Corp. acquired Repsol's entire North Sea operations for US$555 million, and Conoco agreed to purchase Norsk Hydro's assets in the U.K. North Sea for US$540 million. Meanwhile, ENI SpA acquired British-Borneo Oil & Gas for US$1.2 billion. Mega-spinoffs The ramifications of the megamergers continued to reverberate throughout the industry. BP alone triggered a great deal of M&A activity in the first half. The $26-billion acquisition of Atlantic Richfield Co. was finally closed, more than one year after it was announced. Prior to closing, the Federal Trade Commission required the sale of Arco's Alaskan business, which was acquired for $7 billion by Phillips Petroleum ($6.5 billion plus up to an additional $500 million tied to an oil pricing formula). The purchase nearly doubles Phillips' reserves, from 2.2 billion barrels of oil equivalent to 4.1 billion BOE. The purchase also fits the strategy announced last year by Phillips to focus on E&P. In the first half of 2000, it announced a chemical joint venture with Chevron and is selling its processing and marketing joint venture to Duke Energy Field Services. BP and Royal Dutch/Shell Group sold their interests in Altura Energy to Occidental Petroleum for $3.6 billion. The deal was yet another step in Oxy's makeover. To expand and focus its E&P business, it has sold or traded noncore assets and purchased long-lived legacy assets worldwide. The Altura Energy purchase gives Oxy a third U.S. core area to go with its Elk Hills and Hugoton positions. Recent liquidity injections from a Chevron litigation settlement and sale of its stake in Canadian Occidental helped fund this deal, with the balance funded through BP and Royal Dutch/Shell financing arrangements. BP also purchased Vastar Resources, for $83 per share, acquiring the 18% of Vastar publicly held shares it did not already own via its acquisition of Arco. Interestingly, the original offer of $71 per share caused a skeptical market reaction, as shares immediately traded higher. Vastar had enjoyed an excellent track record, with a five-year shareholder return of approximately 23.5% per year. (It will be interesting to see what former Vastar senior managers choose to do now. At press time, ex-Vastar chairman and chief executive Michael E. Wiley agreed to become chairman and chief executive of service company Baker Hughes.) High, low and high-again oil and gas prices have set the tone for the entire business; companies and their employees are whiplashed. Volatility has affected everyone in the business, both financially and emotionally. According to a recent Salomon Smith Barney capital spending survey, as oil and gas prices recovered, the planned rate of increased capital spending lagged that of previous price recovery periods. Prior to the recent sharp increase in price, oil had risen above $25 per barrel in 1990 and 1996. In the years immediately following those high price environments, the industry planned to increase capital spending 18% to 19%. With the recent price increase and the latest survey early in 2000, the industry planned to increase worldwide capital spending only 11%. This is a notable change in practice that is beneficial in terms of encouraging improved returns rather than growth, but it has severe ramifications for the industry's ability to replace reserves and grow production. This change in industry practice has occurred for a number of reasons. The industry is responding more slowly to increased prices because of scars of the past, and $10 oil is still fresh in everyone's memory. The industry is also defocusing on growth and now focusing on competitive returns. Since the price upturn of 1996, return on capital for the upstream industry has been approximately 7% to 8%, well below anyone's weighted average cost of capital. This "destruction in value" is reflected in the laggard average shareholder returns of the industry. In the last five years, the major oils' shareholder returns averaged 16% per year; the large independents', 8%. The S&P 500 and Dow Industrials have averaged 26% and 27% per year, and the Nasdaq, 40%. Capital spending also may not have recovered as quickly as in the past due to the need to digest the megamergers and other large deals. Companies need to move prudently to be sure they understand their new assets and optimize their portfolios. There is also an emerging personnel shortage in the industry, which dampens the ability to increase capital spending. Skilled people are needed to effectively manage large capital programs, or companies will continue to spend money poorly, yielding inadequate returns. Second-half outlook What is likely to happen in the second half of the year and why? The overall effect of lower spending will be lower reserve additions and less production growth. This puts additional pressure on companies to find other ways of growing, which will necessitate more mergers and acquisitions to fulfill growth targets. This adds potential liquidity to the M&A market in the near future. As usual in this business, commodity price has a tremendous influence on strategic directions and activity levels. For a view of expected future pricing, Madison Energy Advisors, Inc.'s Quarterly Pricing Poll (QPP) results are shown in the table. The July 1, 2000, QPP highlights the widening gap between the view of oil and gas companies and banks. There is almost a $5-per-barrel difference in expected price between the middle-market companies and the energy banks! This is not only true in 2000, but continues in the out-years. This gap has steadily increased from only about $1 to 1.50 per barrel for the July 1, 1999, QPP to $2 to 2.50 per barrel with the January 1, 2000, QPP. The very large current gap may chill the market for assets if buyers and sellers have mismatched expectations of price. The result of this could be fewer asset deals being brought to the market, or a higher percentage of deals being marketed but not closed. The results of the QPP also demonstrate the longer view of the industry. At almost any time, the market expects price to return to its "normal" level of $18 to $22 per barrel. This is indicated by the results from both peer groups, as they generally converge within this range. Madison has been surveying the industry for 13 years and the results are generally the same regardless of a high or low price environment. The industry still believes this is the rational price range. Historical pricing and expectations for the future set the tone for the near-term M&A environment. There will continue to be secondary and tertiary effects of the megamergers for the next few years. As Exxon Mobil, BP, Total Fina Elf, Repsol and Royal Dutch/Shell digest and then rationalize their portfolios, there could be quite a lot of M&A activity. These companies alone could contribute $15 billion to the property market if they sold only 5% of their current upstream portfolios. The round of megamergers would appear to be over, especially where U.S. downstream assets are involved. With gasoline in the U.S. selling for $1.50 to $2 per gallon and the Federal Trade Commission calling hearings to look into "price fixing" among the oil companies, it is a near impossibility that there will be any more megamergers. They certainly could not occur without wide-scale divestments. Through the megamergers, huge enterprises have been created. These companies have distinguished themselves now on sheer size, potential financial strength and true global reach. They have also distanced themselves from others in their former major peer group and have had good shareholder returns, as shown by average yearly results for the past five years versus market capitalization (as of July 15, 2000). (See graph.) Major be nimble... A great debate rages in the industry now. How should other companies respond to the challenges of the megamajors? Some of the solutions will be found in future mergers and acquisitions. The strategic focus of these may be to help companies compete with size by having tighter focus and the ability to be more nimble than the megamajors. Some companies, such as Oxy and Phillips, have already begun to address these issues with the transactions they have closed in 2000. Will there be similar responses from Marathon, Amerada Hess and Unocal? What will Texaco and Chevron do? Both have repeatedly stated they can go it alone. It is probably too late for them to merge with one another. There will continue to be mergers among the independents. From a market-capitalization-versus-shareholder-return plot, it can be seen that the gap between the better performers and the poorer performers is very large. Those with strong stock will continue to acquire those that lag the market. Those companies with single-digit annual shareholder returns are vulnerable. If the high price environment persists, there could be a reduction in the number of asset sales, both driven by assets in the market and successfully closed transactions. This is becoming a prevailing view in the industry, says John B. Walker, president and chief executive, EnerVest Management Partners LLC. "As oil and gas prices peak, you get a mismatch of buyer and seller expectations, making it more difficult to complete deals. In addition, companies are now enjoying high operating cash flows, making them reluctant to even market properties. This could lead to a decrease in the availability of properties in the market." But high operating cash flows are also allowing companies to "restock" in areas that will make them much stronger, hoarding cash, paying down debt, and even buying back stock. The combination of improved balance sheets, potential difficulty in reaching consensus on asset deals, and the continued need to grow may keep the activity level of stock deals higher than cash deals. ...Be quick The oil and gas business is changing right before our eyes. The change is not occurring at "geologic speed" but perhaps, more appropriately, at "Internet speed." The business has been shaken with the emergence of technologies competing for capital funding and the industry's mostly poor shareholder returns. Market effects combined with the price whiplash of the last 36 months have shaken the industry awake like a slap across the face, shaping the M&A market in the first half of 2000. Companies that understand these forces are already using them to their advantage-those that do not will be left wondering how their demise occurred. "Ladies and gentlemen, this is your captain speaking. We continue to receive reports of severe clear air turbulence ahead. At this time I am going to ask the flight attendants to discontinue the cabin service and take their seats. We expect to have a few moments of some very bumpy air ahead." While the skies are very clear and blue in the oil and gas industry, we should anticipate some turbulence ahead in the M&A environment. But those who fasten their seat belts and plan for it can easily avoid spilling their drinks. William A. (Bill) Marko is vice president, special projects, Madison Energy Advisors, Inc., a Houston-based oil and gas transaction advisor.

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