WoodMac: Majors buying into shale gas plays

Oct. 11, 2010
North American large caps and smaller exploration and production companies now dominate the largest and most economically attractive US shale plays, but the majors and large cap foreign firms are moving in through mergers and acquisitions, said Wood Mackenzie Ltd., Edinburgh, in its latest corporate analysis.

North American large caps and smaller exploration and production companies now dominate the largest and most economically attractive US shale plays, but the majors and large cap foreign firms are moving in through mergers and acquisitions, said Wood Mackenzie Ltd., Edinburgh, in its latest corporate analysis.

According to that report, upstream M&A spending in US shale gas totaled $21 billion in the first 6 months of 2010, equivalent to one third of global upstream M&A spending in that same period.

Luke Parker, manager of WoodMac's M&A research, said, "Through the first half of this year alone, in excess of 35 tcf of shale gas resource changed hands at an average cost of 60¢/Mcfe. This expenditure is equal to the total US shale gas M&A expenditure for 2008 and 2009 combined—which was $19.7 billion and $2 billion, respectively."

The independent energy research firm expects that level of activity to continue over the next couple of years with large caps and majors doing the acquiring.

"The ingredients required for continued high levels of M&A activity in US shale gas remain in place," Parker said. "The drivers that make shale gas so attractive—world-scale resource, robust economics, access opportunities, and limited aboveground risk—are as strong as ever."

He said, "In a wider upstream oil and gas sector characterized by dwindling opportunities and increasing risks, the emergence of such an attractive resource—competitive with other global opportunities by every measure—has been a game changer."

Parker said, "There's scope for intraplay and sector-wide consolidation, facilitated by mounting pressures on existing players to evaluate and restructure their portfolios as strategic priorities evolve. Key among the various pressures that will influence the market, at least in the near term, is the continued disconnect between oil and gas prices and a depressed Henry Hub futures market."

Meanwhile, gas-weighted independents with weak balance sheets or hedging positions are beginning to look increasingly vulnerable to larger players. WoodMac reported shale gas offers a good fit for the large caps and majors, playing to their technical capability, financial strength, and long-term view, all of which are prerequisites for those looking to build a material position. "Hence this peer group will continue to dominate the large-scale deal activity," company officials said.

Robert Clarke, unconventional gas research manager for WoodMac, said, "The magnitude of the US shale gas resource is extraordinary. We estimate the total resource potential of the 22 shale plays we currently analyze is approximately 650 tcfe, equivalent to a resource life of 32 years based on total US gas production in 2009. Shale gas production is set to increase from 17% in 2010 to 35% in 2020 of total US gas supply."

Despite increased interest, the M&A market for shale gas doesn't seem to be overheated. WoodMac analysts said underlying valuation of recent deals suggest buyers are factoring long-term Henry Hub gas prices of $6.50/Mcf, broadly in line with the firm's gas price forecast.

Activity levels are expected to remain high. "While the land-grab is largely over, the corporate landscape across the major resource-holding basins—the Marcellus and Eagle Ford in particular—remains fragmented," said the report. For incumbents, the desire to amass large contiguous acreage positions has driven incremental consolidation. For new entrants, the scope of ambition sets a floor on the size of the deal. Exposure to multiple plays makes strategic sense, allowing for transfer of best practices and learning between plays and also spreading the risk, according to the report.

Recent M&A activity in US shale gas "has been dominated by an influx of larger, mainly overseas players," the report said. Many of the acquiring firms "differentiate themselves on the type of technical and project management capabilities that are critical to the successful exploitation of shale gas plays." Many plan in the process to master skills and technologies that can be transposed to international shale gas opportunities.

Emerging trends

According to WoodMac, a number of emerging trends will increasingly shape future M&A activity in US shale gas: a strategic shift toward oil investment driven by the continued disconnect between oil and gas prices and a depressed Henry Hub futures market; emergence of new shale gas plays, fulfillment of existing leasing commitments to drill up acreage; and increased availability of private equity capital.

"As low gas prices and increasing costs squeeze cash margins, there is mounting pressure on existing players to evaluate and restructure their portfolios. This is currently supporting liquidity in the asset market. Should the difficult environment persist, gas-weighted independents with weak balance sheets or hedging positions will look increasingly distressed and potentially vulnerable to take over. Now, perhaps more than at any time in the recent past, we see a convergence of factors that could lead to significant consolidation across the shale gas sector," WoodMac said.

Deal activity has evolved with the relative cost of supply for each play. Last year the Marcellus shale emerged as the new low-cost source of supply with the largest resource potential, and investment swung toward the Northeast. The Barnett shale historically had been the main focus of activity although other big shale plays—Haynesville, Fayetteville, and Woodford—saw high levels of spending in 2008.

"Most recently, the Eagle Ford shale has come to prominence. This liquids-rich play was proven in late 2009, and the first $1 billion-plus deals confirm its current status as the shale du jour," WoodMac reported.

Deal activity is driven by consolidation that has tended to follow a familiar pattern, WoodMac said. "Small firms enter plays early to capture substantial land positions. In some cases companies have unwittingly found themselves sitting on legacy acreage hitherto unknown for its shale gas potential. In others, companies have grown by design through aggressive leasing. Once the commercial potential of a play becomes evident, these companies or their positions are bought out by larger firms.

"This was first seen in the acquisitions of small Barnett-focused players by larger US independents in 2005-06. Devon Energy Corp., Chesapeake Energy Corp., and XTO Energy Corp. for example all made substantial purchases to build acreage and capture the skills and technology needed for shale gas development. Consolidation in other shale plays has followed a similar pattern, albeit much accelerated, as many of the large independents, having benefited from (or missed out on) early-mover advantage in the Barnett, adopted a more aggressive approach next time around. Many of these companies hold leading positions today," WoodMac reported.

Smaller players often move on to find and prove up the next big shale play. Chief Oil & Gas LLC, a private Dallas operator, "is a fine example of this," said WoodMac. "Having sold its Barnett interests in Devon in 2006 for $2.2 billion, it went on to build a substantial land position in the then embryonic Marcellus shale play."

WoodMac analysts said, "Once the commerciality of a play is established, those companies that were most successful in building substantial land positions have typically sought to sell down their interests in order to minimize capital commitments. The high upfront costs associated with the initial testing and subsequent full-scale development of shale gas resources are, in many cases, prohibitive. This is particularly true of those companies faced with high levels of debt and cash restraints. It is the need for capital that gave rise to shale gas partnerships: farm-in deals with a significant cost-carry component. This type of deal has underpinned much of the recent M&A activity in the sector."

Many companies are monetizing acreage through partnerships to obtain the capital for opening new shale plays, "thereby taking the M&A cycle full circle," WoodMac said. Among US independents, the latest trend is a strategic shift toward shale oil plays, resulting in dilution of shale gas exposure through disposals.

They said, "Major corporate deals have been few and far between. Royal Dutch Shell PLC's $4.7 billion acquisition of privately owned East Resources Inc. [in May] is the only notable shale gas focused takeover since 2006." ExxonMobil's $41 billion acquisition of XTO "was as much about tight gas and conventional resource as it was shale gas."

Due to its unique nature, that deal was not included in WoodMac's analysis. Still, the analyst said, "It is fair to say that the deal represented a huge vote of confidence in the long-term commercial viability of shale gas."

The "key factor" driving the development of shale gas has been the evolution and application of new technologies to tap enormous volumes previously considered uncommercial, officials said.

Technology's role, valuation factors

New technology has reduced development breakeven costs to the point that shale gas is "highly competitive with other domestic sources of supply (conventional and unconventional) and LNG imports," said WoodMac. Operators have made notable advances in reservoir modeling, pad drilling, horizontal drilling, specialized bits, and fracture stimulation treatments. "Unit costs have fallen in spite of increasingly complex and specialized well design. The manufacturing style development of large shale gas positions allows for optimization of operations," they said.

"During the early stages in the evaluation of a play, deals tend to be priced on acreage costs. As confidence increases in the likely commerciality of the play, so too does the cost of land. Once a play is established, $/Mcfe metrics based on total resource estimates become increasingly meaningful. Given the relative immaturity of these plays, $/Mcfe metrics based on proved reserves are not relevant. Deals involving assets at an advanced stage of development (only core sections of the Barnett would fit this description) are very unusual," WoodMac said. "Recent benchmark transactions highlight clear differences between plays, in large part reflecting their varying stages of development. Acreage costs in the Marcellus have reached $7,000-15,000/acre. In the Barnett, the cost of Total's January deal with Chesapeake was $30,000/acre."

WoodMac said, "Given the money that is currently pouring into the Marcellus, and with the benefit of hindsight, Chesapeake's 2005 $3 billion acquisition of Columbia Natural Resources Inc. (from Triana Energy Holdings LLC) looks inspired. Through the deal, the company secured a dominate position in the play at a cost of just $720/acre. A bold early move, the deal was arguably comparable in its significance to Devon's $3.5 billion acquisition of Mitchell Energy in 2001; the foundation for a lead position in the Barnett shale that it maintains to this day."

Proved reserve metrics are not helpful in analyzing shale gas deals, according to the WoodMac report. "Few of the deals announced outside of the core Barnett involve significant proven reserve volumes. For any that do, proved reserves tend to be attributable to peripheral shallow gas properties. Total or contingent resource is a more useful metric, although these figures should be viewed with varying degrees of risk, depending on the maturity of the play and the relative 'optimism' of the company."

Recent benchmark deals have been priced at 20-90¢/Mcfe on a total resource basis, according to WoodMac. "Deals at the lower end of this spectrum generally related to relatively immature plays (Reliance/Pioneer in the Eagle Ford, for example, while those at the upper end to more established plays (Total/Chesapeake in the Barnett, for example)," officials said.

"Potential acquirers from domestic incumbents to overseas new entrants continue to demonstrate strong appetite for deal making," they said. And the corporate landscape across the sector remains fragmented and a target for consolidation.

WoodMac officials said, "Activity will continue to be directed toward the highest returning plays, with the Eagle Ford and Marcellus shales likely to remain the primary focus of attention in the near term at least. However, with the possible exception of the Marcellus, access to the largest and most attractive plays is challenged by incumbent firms seeking to expand existing operations. For these companies, operational synergies will drive incremental deal economics. For new players, this perhaps increases the likelihood of larger corporate acquisitions as an entry mechanism."

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