Chris Simon: “The companies that are going to be successful (buyers) are those that are going to go beyond…the engineered valuation.”

It may seem unlikely that Permian Basin entry and bolt-on costs will decline, but the largest independents and the super-majors are holding out for this before sweeping in or consolidating, according to Chris Simon, managing director and co-head, A&D, for Raymond James & Associates Inc.

“Some of the larger companies I’ve talked to have thought the price of the play is a little steep, given the equity performance you’re seeing from some of these pure-play (stocks) and even some of the large independents,” Simon said in a DUG Permian 2014 post-presentation Q&A session in Fort Worth in May.

“Given where the forward oil curve is, perhaps they’re waiting in the wings to see if there is an equity correction—because we’re pretty fairly valued in the equity price. Our research group, which makes a lot of oil and gas calls, has been predicting some softness in oil prices for the last several years. It hasn’t happened because world events have interrupted some supply elsewhere and caused that prediction to get kicked down the road.

“They’re still predicting some softness next year. Will it happen? I tend to take the ‘over’ on it, personally. I don’t think the fundamentals are there for them to be in an immediate rush to that, but I think there is a real possibility in the medium term.”

Darrel Koo, senior associate, energy research, for ITG Inc., noted, in a Q&A session as part of a play-economics panel, “A lot of consolidation has already happened. There are a few elephants in the room. Endeavor (Energy Resources LP) is one of them. They own 500,000 net acres—essentially checkerboard with Pioneer (Natural Resources Co.) out there. It is one of the most attractive positions held by a private operator, but it is a large bite size, to say the least.”

There may be more room for consolidation in the Delaware Basin, rather than the Midland Basin. “It’s less known basin than the Midland.”

Striking deals with private operators—many of whom are multi-generation owners of leasehold HBPed by verticals in the basin’s conventional formations—will need to be creative, said Benjamin Shattuck, upstream analyst, Lower 48, for Wood Mackenzie. “The Endeavor/XTO (Energy Inc. deal) is a great example.”

In this, ExxonMobil Corp. unit XTO is to gain operating equity in 34,000 gross Endeavor acres in the Midland Basin in Midland and Upton counties. Endeavor will continue to operate its HBPed, shallow production; XTO will drill and operate horizontal wells in the Wolfcamp formation.

Shattuck said, “They were very savvy…to include only horizontal development of the Wolfcamp. You will find that throughout the Permian. Most of these legacy privates you are talking about have been in these families’ hands for generations now. The owners are very savvy and have been around the oil and gas block. They will want to monetize to the fullest what they can.

“Do we expect it to happen? Absolutely. Do we think it will be some sort of trend that emerges over the next year or so? Probably not. There is not an incentive for those companies for that right now.”

Raphael Hudson, director, upstream research, for Hart Energy, noted that private operators have other options as well, such as to IPO. “There have been several of these transactions. RSP Permian (Inc.), Athlon (Energy Inc.) and Diamondback (Energy Inc.’s plans to IPO a mineral-rights unit, Viper Energy Partners LP) are a few recent examples.

“Consolidation may not be the only way in which this sort of investor organization of the sector shapes up.”

Simon noted that many legacy, vertical operators lack experience with drilling horizontal wells that cost five times more and are a more challenging engineering feat. “They’re trying to make that decision as to whether they are going to develop it themselves. But they’re not that experienced and will have some learning curve. Do they JV? Or do they sell? It’s a decision as to what their corporate life is to be. I expect a number of them are going to sell.”

Amongst the largest, prospective, new-entrant buyers, such as super-majors, they will seek an operator that not only has Permian Basin bulk but also has a record of operational excellence. They may even be open to buying a non-pure-play operator, such as Pioneer or EOG Resources Inc., which have holdings and experience in other shale plays as well.

“They’re going to want to make a big entrance rather than buying a billion-dollar company, particularly if they don’t have the expertise,” Simon says. “We’ve seen that in the Bakken with the Statoil (ASA)/Brigham (Exploration Co.) deal. BHP (Billiton Ltd.) has gotten into the Eagle Ford and other places (via its purchase of Petrohawk Energy Corp.).

“We’ve seen those big steps. I think that’s more likely. Now, there could be consolidation among the small independents, private or public. But I think the equity market is a bit strong right now for them to get too aggressive on that.”

For Permian players, however, equity valuations only continue to grow. “Yes, but there comes an end. There will be a saturation. I think the IPO market is still very strong. There is one (Parsley Energy Inc.) active this week.” Parsley priced the following day at $18.50 a share in an oversubscribed 5-million-share offering. Shares were trading on June 4 at $24.92.

“Will you see some more IPOs coming out of the Permian? Probably. Will you see as many as we’ve seen already? Maybe not. Not every management team is ready for prime time, so not everyone has that option. And some management teams are ready for prime time but they don’t want to be a public company. It’s not always the path for groups of assets and management teams.”

A great deal of the equity market’s interest in owning a piece of the Permian is the basin’s stacked pay, he added.

“The companies that are going to be successful (buyers) are those that are going to go beyond the net asset valuation or the engineered valuation. I’m an engineer by background, so that kind of sends shivers up engineers’ spines in evaluating properties but (our research group says of the) stacked-pay nature of the Midland Basin, ‘Imagine the Eagle Ford with four additional Eagle Fords and that’s what you have in the Permian.’”

Pioneer chairman and chief executive officer Scott Sheffield, who presented earlier that morning, used a multiplier of 12 in estimating the hydrocarbon potential. Bob Reeves, Athlon president and CEO, who presented that morning as well, used a multiplier of eight to nine. “It’s hard to get your arms around that but we understand, on the road shows for these pure Permian players, that—when they talked about these net effective acres, where if they had 100,000 acres but they had four proven, potential benches in the Wolfcamp—the investor groups weren’t batting an eye.

“…If you’re going to look at it based on today’s reserves and performance, that’s one thing, but I think the real successful (buyers) are going to have the vision to see that this has great potential and (decide that) ‘If we’re going to compete here, we’re probably going to have to stretch a bit in an acquisition setting.’”

Gene, CEO of Brigham Resources LP, which has put together leasehold in the Delaware Basin, said in a Q&A session among fellow private-operator presenters, “There are other ways to compete.”

Among what Brigham brings to the bargaining table, in addition to its deep Bakken experience, is that it’s ready to drill, he said. “We are operating (as a start-up to date) from a relatively low level of activity so, if you want to see your acreage developed quickly, we can bring rigs in immediately…

“With one of the bigger companies, who knows when that acreage gets developed? In a lot of instances, a lease bonus of $30,000 is a lot but so is 25% of that future revenue stream.

“We can tell a lessor that we will bring the rig immediately. That is one way we attempt to level the playing field.”

–Nissa Darbonne, Author, The American Shales; Editor-at-Large, Oil and Gas Investor, OilandGasInvestor.com, Oil and Gas Investor This Week, A&D Watch, A-Dcenter.com, UGcenter.com. Contact Nissa at ndarbonne@hartenergy.com.