A&D on the uptick
The A&D market started slowly this year. IHS Herold reports that only 17 deals closed in the first quarter, compared to 86 in 1Q08. The outlook was, indeed, bleak, as we entered the second quarter. Fortunately, someone appears to have fired a gun in mid-May, and in 2Q09, we sprinted to 39 closings.
Widespread economic uncertainty was the basis for the dearth of closed transactions in the 1Q09 appears, and buyers waiting to take advantage of distressed asset sale prices may have delayed A&D activity until well into the second quarter. Notably, almost 90% of deals that closed in 2Q09 did so after the 15th of May. Moreover, when activity did increase, the factors driving decisions to sell were not those most anticipated.
As our industry endured the storm of the global economic recession, we expected the silver lining would be a flood of distressed assets. So far, this has yet to materialize. The commercial banks demonstrated an unforeseen and unprecedented willingness to work with their clients through the first round of borrowing base reviews in 2009.
Furthermore, hedges that were put in place at last year’s record pricing also helped levered companies avoid liquidation. Nevertheless, tight capital markets and narrowing profitability margins still required some companies to rationalize assets.
Changes in the economy have made it necessary for many companies to reassess the viability of their business plans, and the most logical survival strategy has been to focus on core operations. In doing so, the monetization of non-core assets enables companies to reallocate human and financial resources to support core operations. Thus, asset sales this year have been driven more by strategic decisions than desperation. Nonetheless, motivated sellers are only half the equation—buyers also need access to capital to execute their acquisition strategies.
Fortunately, the bullish NYMEX strip is helping to make acquisition capital available. In any market, although especially now, hedging strategies are an important tool for mitigating pricing risk when making acquisitions. At the time of writing, the 12 month strip was $76.28 for oil. Pricing support at this level not only is providing companies the opportunity to obtain financing, but it also enables buyers to be more competitive when making offers.
While the industry has yet to see an abundance of distressed assets hit the market, it may still be an opportune time for companies to make acquisitions. Of course, there is still discussion of a wide bid/ask spread in the market, but some data suggest the gap may not be as wide as it appears.
Reviewing several deals that closed in the Permian this year reveals that the average price paid per flowing barrel was approximately $65,673, representing a significant decrease from record prices paid for comparable assets in 2008. Although, if we evaluate 2006-2007 data, when oil averaged $66 to $72 per barrel, we see the market was paying approximately $79,418 for producing assets in West Texas, representing a 17% higher valuation compared to prices paid for assets today (see Figure 1).
Considering oil has averaged approximately $52 per barrel in 2009, most of the perceived discount in current asset valuations is eliminated. Furthermore, many analysts recognize operating expenses have failed to decline with the same order of magnitude as commodity prices since last year’s peak—ultimately, this would suggest little, if any, discount is reflected in current valuations.
It is difficult to determine a true equilibrium price for oil, but between $65,000 and $79,000 per flowing barrel appears to reflect a valuation spread within which a seller can realize a meaningful liquidity event, while the buyer can make an accretive acquisition—these are optimal conditions for executing value creating transactions.
Barring any major market disruptions, it appears that A&D activity should continue to accelerate, as we move through the remainder of the year. Additionally, with loan covenants fully stretched, and last year’s hedges rolling off, we may yet see distressed assets on the market in the later quarters. In the meantime, strategic divestments should continue to drive the market.
About the author
Jason Reimbold is a vice president in the Houston office of The Rodman Energy Group where his focus is A&D advisory. Rodman & Renshaw LLC( Member FINRA, SIPC) is a full service investment bank with offices in New York, Houston, and Calgary. He can be reached at [email protected].