Phillip A. Ellis, Mark Gallion
Booz, Allen & Hamilton
Dallas
In recent years, industry managers and observers have referred to "winner's curse" or "greater fool" theories in the acquisitions market to explain high prices paid by many companies for U.S. hydrocarbon reserves.
As a result, many companies have formed a "Catch 22" attitude toward such purchases: The main way to successfully make acquisitions is to overpay. Therefore, the only winners must be the sellers, who pocket the cash from overzealous buyers.
Managers with this perspective are allocating little time and resources to searching for and evaluating acquisitions. Instead, they either are shifting resources to traditional exploration and development or they are not building assets. They are frustrated with the time and resources they have wasted in preparing and submitting losing bids.
Some companies, however, continue to acquire aggressively.
They appear to be driven by an increasing focus on basins or plays where they are competitively advantaged and a perception that the next several years may provide a window of opportunity for acquisitions before higher gas prices drive up U.S. acquisition prices.
Who is right, the aggressive acquirers or the cautious companies? Are companies acquiring at high prices really so foolish? And is it possible to be a successful buyer in today's acquisition market?
OUR VIEW
Clearly, there are many examples of companies overpaying for reserves.
Every basin has "fool stories" about buyers betting on dramatically higher gas prices, overestimating reserves, forgetting to include overhead costs in reserve valuations, and the like, and then leaving millions on the table in competitive bids.
There is no denying that amateur buyers have been a force in the market.
But we believe the acquisition market is getting more efficient in valuing reserves, not less so.
Our analysis shows, in fact, that the variation in the average price paid for acquisitions has narrowed considerably during the last 5 years. Evidently there are fewer and fewer "fools" in the market for hydrocarbon production.
PROCESS IS CRITICAL
Successful buyers pay higher prices and still create shareholder value by going through a rigorous process of identifying and screening acquisition opportunities.
They understand where their strengths are and where not to buy, and this focuses their scarce resources on a relatively few opportunities.
If an acquisition doesn't fit the company's proven competitive strengths, there is little chance of realizing upside value. Of course, properties with the best strategic fit rarely simply appear on the market. Successful buyers therefore seek out and negotiate such deals. They avoid competitive auctions whenever possible.
Successful buyers usually dedicate a small team of financial and technical professionals that has the skills required to identify and evaluate opportunities. In many cases, these skills are brought in from outside the company and occasionally from outside the oil and gas business.
Analytical discipline is the hallmark of such teams. They know how to reject deals quickly and focus their energies on only the best deals. These teams are driven to create value rather than to do deals.
PRICE IS RELATIVE
Drilling risk usually is minimal in the acquisition market. The risk in creating value from acquisitions largely is contained in the price you pay for the property.
Why would a company pay more than what the "market" price for an acquisition appears to be?
For example, under what conditions would Company A pay $1.20/Mcf equivalent (Mcfe) for proved reserves when Company B, with the same access to the seller's data room, calculates that any price of more than $1/Mcfe would not yield its 14% hurdle rate?
One potential explanation is that Company A simply made a mistake in the valuation of the reserves. Either reserve estimates were too high, costs were too low, or forecast prices were too optimistic-the conventional "greater fool" explanation. Another is that the auction process-competitive fever-got the best of Company A-the "winner's curse."
However, another explanation is that Company A has an operational, technological, or financial edge that will enable it to capture greater value from the acquisition. There are several sources of added value that Company A may see that company B may not see, including:
- Upside reserve potential through production, development, and exploration opportunities attractive at current prices.
- Reduced operating costs by changing operational practices and consolidating operations.
- Lower general and administrative costs through consolidating overhead functions.
- Higher margins and volumes through gas marketing efforts.
In addition, Company A may pay for a financial asset that many companies fail to recognize when they bid on a property. That asset is the option to take advantage of increases in oil and gas prices.
For example, if prices increase significantly in the mid-1990s, a number of exploration and development opportunities on the acquired property would become economically attractive for Company A.
This future stream of opportunities, or options, has a value. The company would not exercise the option to drill unless prices rose enough to make the investments attractive. This is similar to a call option in financial markets.
The value of this investment option might vary versus a range of gas prices (Fig. 1). Options like this can be valued using the Black-Scholes formula for options pricing, which is discussed in most modern financial textbooks.
Sources of added value can make reserves significantly more valuable to Company A than Company B (Fig. 2). Company A can pay $1.20/Mcfe and still realize upside value of 30cts/Mcfe.
In the end, of course, Company A's aggressive price forecasts may be right. Then who is the "fool?"
IMPLICATIONS
What are the implications for company decision making in the 1990s?
- Companies need to decide whether acquisitions should be an integral part of their strategy and business plans. If yes is the answer, significant investment in time, money, and effort is required to build a team with acquisition skills and dedicated to the acquisition business.
- Successful buyers need to be successful all-around exploration and production players. The source of value added in acquisitions is in being a better explorer, better developer, better operator, and/or better marketer. If you are better than the competition in these core E&P activities, chances are you can be a successful buyer.
- Acquisition and divestiture strategies need to be based on analysis of value added. If you are competitively disadvantaged in a basin or play, your reserves should be worth more to someone else and vice versa.
- Conventional wisdom in acquisitions and other aspects of the industry should be taken with a grain of salt. Contrarian strategies can be extremely successful in buying and selling properties.
Our view is that companies can continue to be successful in the acquisition market. The true winners are companies that identify and realize the hidden value in properties and are innovative in structuring deals.
POSTSCRIPT
An earlier column (OGJ, Sept. 30, 1991, p. 42) focused on the influence of technology on gas finding costs.
It is important to note that the lessons derived in that analysis apply to oil as well as gas.
That can be seen in the relationship between the number of wells drilled in a given year and finding costs for all hydrocarbons (Fig. 3) and in an update of the summary chart from the earlier article (Fig. 4).
As was apparent, the costs we referred to in the earlier column were for successful gas wells only. As can be seen with the updated figures, the major points hold when all wells are included.
Those points are:
- Highgrading is the leading reason for reduced finding costs.
- Deflation in the oil patch economy is another leading factor.
- Technology and other factors may be important but are more difficult to evaluate.
Copyright 1992 Oil & Gas Journal. All Rights Reserved.
