?Despite the chaos in the financial markets in 2008 and falling commodity prices, full-year results for energy-sector deal flow in the U.S. totaled nearly the same amount, at $47.3 billion, as was completed in 2007’s much healthier environment.

?One of the best things that can be said about 2008 is that it’s over. The double feature began with a “feel good” movie during the first six months as commodity prices rose, followed by a long horror movie. Events of 2008 in the broad markets severely affected oil and gas pricing as energy investors and speculators rode the bubble before running for the exits in July.

Thereafter, the broad financial markets and ailing economy piled on to drive oil prices down more than $100 per barrel from the summer high of $147. Natural gas followed suit, down more than 60% from its summer high amid bearish worries about the spring shoulder months.

The oil and gas business has seen a handful of downturns since 1986. Unlike movie sequels, which generally are worse than the original (e.g. The Godfather Part III, Rocky V, Police Academy 8), the industry seems to improve upon reentry from a downturn. It gets a little smarter and a little more conservative.

The questions today are where pricing will settle, how wide ranging the negative impacts will be and how long the downturn will last. Are we one hour into a 90-minute Disney film, or just settling in for a four-hour blockbuster?

The perfect storm

September 2008 was a turbulent month in many ways. While Hurricane Ike caused a great deal of physical damage, the bankruptcy of Lehman Brothers, on top of the rescue of Fannie Mae, Freddie Mac and AIG, shook the capital markets to the core, freezing credit for the rest of the year. Banks hoarded cash to maintain liquidity. The Troubled Asset Relief Program (TARP) got off to a dubious start, as no money was specifically used for troubled-asset relief. Instead, the money was passed out to or forced upon banks.

By December 2008, a U.S. recession had arrived, and evidence showed it had been under way all year. Wall Street’s Gordon “Greed is Good” Gekko was wrong. Greed proved bad. Now many are thinking of “going to the mattresses,” but not in the mafia terminology of The Godfather. Instead, with short-term Treasuries for a time trading below 0% interest, the underside of a mattress seems like the safest place for money.

Despite all the chaos, full-year results for energy-sector M&A deal flow in the U.S. clipped along, with $47.3 billion of transactions completed during the year. Shockingly, this is about the same amount as was completed in 2007’s much healthier environment. As always in this resilient market, companies found ways to complete deals. Though battered and bruised, the food chain is alive and well.

Throughout the year, deal valuations reflected commodity prices in real time, rising during the first half and falling sharply in the second. Deal volume, on the other hand, lagged the commodity-price curve by about one quarter. Volume was high, even in third-quarter 2008, as commodity prices began to tumble and then plummeted sharply in the fourth quarter. This is a normal time lag: buyer valuations reflect futures curves of the day, but since it takes three to six months to complete a sale, the volume lags the market.

The sharp drop in commodity prices jolted asset buyers and sellers. Almost every company that began its sale process as the market peaked in the summer was crushed when bids were received later in the year. Buyer valuations fell so sharply—with “the perfect storm,” a triple whammy of falling commodity prices, growing risk aversion and closed capital markets—that sellers chose not to give assets away. Fourth-quarter deal flow demonstrated this pullback, with the lowest quarterly sales in more than three years and sharply decreasing valuations.

The list of projects pulled from the market is illuminating. Public announcements of these include Encore Acquisition Co.’s corporate sale, the Contango Oil & Gas sale of Gulf of Mexico assets, and portions of Forest Oil Corp.’s packages. (In the lattermost, one package was sold for a reduced price.) Perhaps the most interesting failed sale was Denbury Resources’ decision in October to break an agreement for Conroe Field with undisclosed sellers and forfeit its $30-million deposit, a wise decision considering the lack of relief in the commodity and capital markets as yet.

One deal that was downsized significantly due to difficulty in receiving financing was Antero Resources’ farm-in of Dominion E&P’s Marcellus shale acreage. The deal was reduced from $552 million for 205,000 acres to $347 million for approximately 114,000 acres.

During the second half of 2008 more than two dozen packages were either pulled from the market or, three to six months later, are still being negotiated for sale at sharply reduced prices. The challenge today is that the bid/ask is completely displaced as sellers fondly recall the valuations of mid-2008 and risk-averse buyers focus on today’s futures.

Very little value, if any, is being placed on reserves other than proved developed producing (PDP). The only viable bidders at the end of 2008 were those with cash, committed private equity or existing bank lines. Plain vanilla A&D and capital raising withered away.

The usual suspects

?In mid-2008, XTO chairman Bob Simpson proclaimed it a unique time to access financial markets. The company raised a significant amount of capital and spent more than $10.6 billion in the major gas shales and in the Bakken oil-shale play.

The projects that did get done revolved around unique deal structures and, to a large degree, were driven by the attractiveness of U.S. shale-gas plays. Joint ventures played a key role, with more than $8 billion in these deals announced. The joint venture is an attractive structure for today’s market, offering the ability for buyer and seller to align needs and wants, share risk, pay up front and over time, and combine strengths to complete deals. Expect a number of additional JVs to be attempted throughout 2009 as companies with large acreage positions seek creative ways to maximize value and continue large-scale exploration and development programs in these tight capital environments.

What deals were announced in the second half of 2008 were dominated by “the usual suspects,” as Chesapeake Energy Corp., XTO Energy Inc., Occidental Petroleum, Plains Exploration & Production and Forest Oil continued to be creative in the midst of changing market conditions.

Second-half activity began with a bang in early July when Chesapeake announced its 550,000-acre Haynesville shale JV with Plains for a total value of $3.3 billion. It was a cash-and-carry deal, with Plains paying one half in cash up-front and the balance by carrying Chesapeake’s share of drilling for the next few years to earn 20% of Chesapeake’s interest.

The deal provided significant benefits for both parties. The seller recovered a significant portion of its investment in the play and received capital coverage for a portion of future drilling costs. Meanwhile, Plains established, in one deal, a significant presence in a world-class resource play operated by a play leader.

Thereafter, Chesapeake continued to monetize its large positions in the Woodford, Fayetteville and Marcellus gas shales in three deals with a total value of $7 billion. It sold a large portion of its Woodford shale position (95,000 acres) to BP Plc for $1.75 billion. It also completed a $1.9-billion JV with BP in the Fayetteville play in which BP will earn 25% of Chesapeake’s interest in 540,000 acres for $1.1 billion in cash and $800 million in carried drilling costs. At the end of 2008, Chesapeake announced a cash-and-carry Marcellus JV on its 1.8 million acres with StatoilHydro ASA for a total of $3.375 billion ($1.25 billion in cash, $2.125 billion in carried costs). StatoilHydro earned 32.5% of Chesapeake’s interest and, through the carry, will pay 75% of Chesapeake’s drilling costs for the next several years.

The Chesapeake joint ventures are intriguing because the partners are new entrants and/or majors and national oil companies. This demonstrates the attractiveness of the shale on a global basis and could indicate the early days of a return to the U.S. by the majors. (For more on this, see “Get the Door: It’s the IOCs and NOCs,” Oil and Gas Investor, February 2009.)

Finally, utilizing other creative ways to raise funding, Chesapeake completed $1.6 billion in volumetric-production-payment (VPP) deals involving some of its Texas, Oklahoma and Kansas properties, with various parties.

XTO was even more active in the M&A and capital markets during the year. At midyear, its chairman, Bob Simpson, proclaimed it a unique time to access financial markets and complete deals, and the company raised a significant amount of capital.

During the year, XTO completed purchases in all five of the major gas shales and in the Bakken oil shale for more than $10.6 billion. Most deals were completed in the first half, but in July, XTO used the attractive markets to initiate more than $2 billion of transactions. These included a $1.3-billion purchase of producing properties and undeveloped acreage in various shales, an $800-million acquisition in the Barnett shale and multiple Bakken purchases totaling $115 million.

Also in July, Quicksilver Resources completed a $1.3-billion cash-and-stock acquisition with various parties including Chief Resources, Hillwood Oil & Gas and Collins & Ware. The purchase covered more than 13,000 Barnett shale acres with 50 million cubic feet of daily production, 350 billion cubic feet of proved reserves and more than 1 trillion cubic feet of ultimate potential.

Plains followed its massive Haynesville shale investment with a sale of its final 50% interest in certain assets in the Permian and Piceance basins to Occidental for $1.25 billion in September. Plains had sold Oxy a 50% interest in the assets in the previous December, following Plains’ midyear 2007 acquisition of Pogo Producing Co.

Forest Oil also continued its active A&D program. In August, it announced a $900-million cash-and-stock acquisition of private company Cordillera Energy Partners’ assets in North Louisiana and East Texas. In late September, Forest sold Rockies assets for $200 million as part of its announced program to sell noncore assets to fund shale-gas development.

Finally, even in a difficult environment, Gulf of Mexico deal flow continued, with more than $1 billion in transactions completed in the second half of 2008. In the deepwater Gulf, these include Chevron’s sale of K2 Field to Colombian oil company Ecopetrol for $510 million, and Royal Dutch Shell’s sale of Big Foot for $400 million to an undisclosed buyer. On the Gulf shelf, Dynamic Offshore Resources completed its acquisition of Northstar Exploration & Production for $235 million in July.

Back to the future

Over time, market volatility is going to fuel future deal flow. Price bulls see contango (upwardly trending price curves) in futures pricing as compared with the currently low spot pricing. Bears believe “you ain’t seen nothin’ yet” and look for even lower near-term commodity pricing as U.S. and worldwide economies continue to slow. As a bit of confidence returns in the financial markets, these differences of opinion bode well for deal flow. The question is, when will the capital markets open—in weeks or months?

The other question is, when will companies capitulate and accept the “new” price environment? This is somewhere in the range of $4 gas and $40 oil, $5/$50, or $6/$60. The good old days of $10/$100 are gone for a while. Once the new price environment is established, bid/ask spreads will narrow. This combined with open capital markets will lead to higher deal flow.

We are going “back to the future” as companies attempt to maintain profitability in a lower price environment. ConocoPhillips and Schlumberger recently announced layoffs. Others will follow, because costs are one thing that oil and gas companies can control. Service and material costs will also continue to fall, affecting everything from rigs to pipe to frac services to salaries.

Lower commodity prices will also lead to noncore asset sales by the large independents and majors. This has happened before—in 1987-88, 1991-92 and 1998-99. The timing does not seem to suit normal investor behavior (buy low, sell high), but the low-price environment exposes the weak assets in portfolios.

Within the current environment, buyers and sellers will need to find compensation structures other than 100% cash to overcome bid/ask displacement. These include JVs for cash plus carry, stock-for-stock mergers, cash-plus-stock acquisitions and, quite possibly, deals with future payments for price upside. All these structures allow buyers and sellers to share risks.

As mentioned previously, JVs work well in these market conditions, providing a hedge so both parties get exposure to upside while getting some protection from downside. They bring together parties with disparate needs in terms of acreage position, technical resources, rigs and capital. Finally, they can be structured in a manner to pay costs over time, which can reduce negative cash flow and the need to access capital markets.

Mergers will work when companies, and their shareholders, find reasons to complete deals in the lower-price environment and/or are in a desperate situation. With the memory of heady mid-2008 valuations, it seems unlikely that potential buyers will offer enough value today. With many valuations down between 40% and 80% since midyear 2008, stock seems too cheap to sell. Whether the stocks are indeed too cheap is a good question. But as the low-price environment lingers and companies and shareholders have to make tough decisions, there may be buying opportunities.

Those with cash are looking for bargains, a trend that began in earnest in late 2008 and continues today. Early 2009 has not brought a loosened deal flow, but a spark may ignite later in this quarter and in the next, absent new financial meltdowns. This could lead to acquisitions by some of the healthier large independents and the majors, which have a great deal of cash and stock from recent buybacks.

The script for 2009 will probably offer a role for everyone—even the audience. There will be some scary moments, some happy plot-changes, a few tragic events and tears, bouts of laughter and joy, and the potential for opportunities for all. We can only hope the outcome will be more in the vein of Rick’s comment in Casablanca (“Louis, this could be the beginning of a beautiful friendship”) and less like Carl’s report of the Dalai Lama’s promise in Caddyshack (“And he says, “Oh, uh, there won’t be any money, but when you die, on your deathbed, you will receive total consciousness”). About which Carl observes, “So I got that goin’ for me, which is nice.”

William A. (Bill) Marko is a Houston-based managing director of investment-banking and M&A-advisory firm Jefferies Randall & Dewey, a division of Jefferies & Co. Inc.

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