Throughout recent history, several market shocks and associated commodity cycles have impacted the A&D market. Each cycle has been slightly different in severity and longevity. However, one constant remains—steep declines in commodity prices disrupt A&D market dynamics, resulting in depressed activity levels. It happened during the last one in 2009 when the market registered a paltry $14 billion in announced deals, and it’s already happening in 2015 with first-quarter totals of just under $1 billion, a 91% drop when compared to the $11 billion announced during first-quarter 2014.

Asset supply interrupted

The bid-ask spread is one of the primary reasons deal activity slows to a relative halt during a commodity price swing. Two recently announced deals by Midstates Petroleum and Resolute Energy shed some light on how far valuations have fallen and the magnitude of the divide that buyers and sellers are attempting to bridge.

In October 2014, Midstates Petroleum announced an agreement for its DeQuincy assets in southern Louisiana for $90 million. Although oil prices had already fallen below the triple digits exhibited during the summer, by the end of November spot prices fell by more than 25%, contributing to the termination of the deal. In March 2015, Midstates announced it had come to terms with Pintail Oil & Gas for the same assets at a revised purchase price of $44 million, representing a 51% drop in valuation relative to the October announcement.

Highly coveted assets like those in the Permian Basin are not immune to the bid-ask spread either. In March 2015, Resolute announced it had signed a $42-million deal for assets in Howard and Martin counties. Although not a large transaction, the assets included 2,200 net acres prospective for horizontal development in the Wolfcamp A and Lower Spraberry, and offset active developments by Encana and Element Petroleum. At an implied undeveloped acreage multiple of $13,000 per acre, the deal traded at a 37% discount when compared with a 2014 average northern Midland Basin undeveloped acreage multiple of some $30,000 per acre.

Another variable that heavily impacts asset supply is the continued strength of the capital markets. This year is off to a torrid pace with 23 follow-on equity deals totaling $8 billion. The same pattern was present in 2009 as companies seeking to shore up balance sheets tapped both debt and equity markets as an alternative to selling assets in a low commodity price environment.

In addition to a public market solution, private equity has also stepped in to form partnerships with public companies including Linn and Rex Energy. In both instances, creative partnerships were formed to pursue on-lease developments rather than selling assets outright.

Private equity fuels demand

So what about the demand side of the equation? With the majority of companies focusing on cash preservation and cost-cutting initiatives, some traditional buyers are out of the market. However, that deficit has been more than absorbed by private equity. This comes as no surprise as private equity was the dominant force in 2014, accounting for $24 billion in acquisitions, or nearly 42% of overall market share. That represents a significant increase from the 9% private equity accounted for just two years prior in 2012.

What is surprising and staggering is that estimates place the amount of energy-dedicated private-equity funds at between $60- and $100-plus billion. In support of those estimates, The Economist recently noted that Blackstone and Warburg Pincus have raised war chests totaling $13 billion. If you then account for leverage, total purchasing power balloons to more than $20 billion—and that’s just two firms.

The combination of growing demand and limited supply is creating a scenario where heightened levels of competitive tension (deals experiencing more than 70 signed confidentiality agreements) are pushing valuations to higher cash-flow multiples and partially offsetting the commodity price-driven bid-ask spread.

Going forward, we expect asset supply in the near-term to be characterized by deals with similar attributes to what’s currently available from sellers like Anadarko and Encana—noncore, gassy, PDP-weighted assets.

Longer term, and assuming commodity prices continue trading within a stable band, we expect a pick-up in deal activity during the second half of 2015 and into 2016 due to the market’s acceptance of the “new normal,” additional balance sheet stress, fall borrowing-base redeterminations, and a growing backlog of postponed deals.

—Daniel Rojo, Wells Fargo, 713-346-2737, daniel.rojo@wellsfargo.com.

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