?Public independents and upstream MLPs have been active buy-side participants in the A&D market, particularly during the run-up in commodity prices over the last few years. The typical buy-build-exploit-sell business model of many private independent oil and gas companies relied heavily on an ultimate sale to a larger public company.


However, the credit crisis and the associated energy-demand destruction have caused a dramatic and painful decrease in commodity prices. The subsequent decline in stock prices of many of the traditional oil and gas asset buyers is stopping the previously successful business model in its tracks as the number of completed acquisitions and their associated multiples have plummeted.


Analysis of producing-property acquisitions and commodity prices in 2008 by Energy Spectrum Advisors (ESA) suggests that, in general, the number of oil and gas deals purchased by public companies, as well as the multiples paid, corresponds directly to commodity prices. When public companies limit their activity in the marketplace, as happened in fourth-quarter 2008, the number of successful transactions and their associated multiples are reduced.


The 12-month Nymex strip for both oil and gas were taken at the beginning of each quarter and compared against the number of the publicly announced, majority oil/majority gas transactions between $10 million and $2 billion for each respective quarter. A gas deal with an R/P of 15 years in the third quarter 2008 would, on average, sell for approximately $16,400 per thousand cubic feet equivalent per day (Mcfe/d). Based on fourth-quarter 2008 metrics, the same deal would trade for about $13,000 per Mcfe/d, or at a 20% discount.


Of the 38 gas deals closed in the first three quarters of 2008, almost 85% were bought by public companies. Only two of the six gas deals that closed in fourth-quarter 2008 were purchased by public companies.


Similarly, more than 85% of closed oil deals in 2008 were bought by public companies. Sale multiples for oil deals trended upward during the first half of 2008, but ESA was unable to assess average sale multiples in the second half of 2008 due to the limited number of closed oil deals.


Studies suggest that greater than 90% of the movement in energy-sector stocks can be explained by the movement in commodity prices. Thus, when prices are on the rise, so are energy stocks, which enables and motivates the larger public companies to actively pursue acquisition opportunities and ultimately grow their reserve base. In contrast, as commodity prices decline, so does the market’s confidence in the energy sector, which inevitably causes stock prices to follow suit.


If the market is not giving public companies credit, much less a premium, for their producing and upside reserves, these companies may lack the incentive to grow their reserve base via acquisitions. Why should these companies turn around and acquire additional reserves if the market is indifferent? They likely won’t.


To illustrate, in the third quarter of 2008, all 12 publicly announced gas transactions were purchased by larger public companies. Commodity prices reached record highs. Stock prices at the beginning of the third quarter were at an all-time high for most if not all of these companies, and the result was strong sale multiples and an aggressive buying environment. In the fourth quarter, stock prices for the same companies dropped an average of 55%, commodity prices dropped 65%, and only two of the six closed gas transactions were purchased by public companies. Sale multiples tumbled, and the buying environment was extinct.


Given the disruptive state of the current capital markets, this environment is expected to continue as risk spreads are widening. Anecdotal evidence suggests that each tranche of capital, including senior debt, mezzanine debt and equity, is beginning to require returns comparable to their more risky junior counterparts, thus translating into a notable increase in today’s aggregate cost of capital for borrowers.


For buyers of assets to deliver an adequate rate of return to such capital providers, they will likely adapt to this increase in the cost of capital by valuing assets appropriately, albeit lower than some sellers would prefer.


In the “peak oil” environment the energy market was all about supply shortage. Today, the market is all about lack of demand, which has crushed commodity prices, hammered energy stocks and caused buyers to shy away from the acquisition market. The market will eventually come full circle and force us to yet again wrestle with supply shortages and the ensuing price upswing. Until then, sellers must either accept the reality of depressed asset valuations in today’s market or hold on to their assets with hopes of capitalizing on the next run-up in commodity prices.
—B.J. Brandenberger, Energy Spectrum Advisors Inc. (energyspectrumadvisors.com)

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