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Majors May Dangle M&A Lifeline to Independents

North American natural gas producers have watched their fortunes soar and dramatically fall to earth in recent months and some of them, now unable to access bank financing, are doing what they have to do to remain solvent. Independents starved for cash but weighted with healthy assets are forming joint partnerships, selling assets and waiting for what may be the inevitable: a land grab by oil majors flush with cash.

It's really the best -- and the worst -- of all times for gas producers. U.S. onshore production is strong, and technology has unlocked deep reservoirs of shale, tight gas and coalbed methane (CBM). But the supply growth, coming at a time of low gas prices, has forced exploration and production (E&P) companies to lay down rigs and to cut their capital budgets for the first time in years. Coupled with a topsy-turvy financial market that shuns more debt, merger and acquisition (M&A) activity is expected to rise in the uncertain months ahead.

Their probable pursuers will be the majors, which have been challenged to find new and substantive supplies of oil and gas. The landscape bodes well for growth in M&A, said Credit Suisse energy analyst Mark Flannery. Giant multinational producers, which include ExxonMobil Corp., Chevron Corp., Royal Dutch Shell plc, ConocoPhillips and BP plc, control less than 10% of the world's oil and gas reserves, he noted. Most of the proven reserves, or about 80%, is held by national, state-run producers like those in Saudi Arabia and Venezuela.

ExxonMobil may be the world's largest investor-owned oil company, said Flannery, but it produces only about 3% of the world's energy supplies.

"Big Oil has a growth problem, for sure, but is extremely well capitalized, and we now see an M&A window opening," Flannery said. The majors shrank their North American upstream businesses to move toward more attractive opportunities globally. "However, access to new resources has proven much more difficult than imagined. We think the recent derisking of large new unconventional resource plays in the U.S. means that the relative attraction of assets held by some North American independent E&P companies has increased."

Total U.S. gas reserves have grown for "nine straight years and U.S. gas opportunities are now scalable, even for Big Oil," said Flannery. Meanwhile, U.S. gas producers "have become a temporary victim of their own success with production up 9% year-over-year, or 5 Bcf/d, pushing down gas prices below the equilibrium level of $8.00-8.50/MMBtu. At gas prices in the mid $7s, most E&Ps cannot maintain high production growth rates without external capital, now significantly more difficult to obtain..."

Unable to finance their growth, "we think some independent E&Ps are now vulnerable to, and potentially open to, a sale," said the Credit Suisse analyst. "The long-term demand picture for U.S. gas is robust, led by continued growth in power demand, while the likely cost of [carbon dioxide] in the U.S. seems largely unpriced into the gas futures curve. Those majors that believe in the longer-term convergence of North American gas prices with oil prices now have a chance to get involved at a decent price, we think."

Jed Shreve, a principal with Deloitte Financial Advisory Services LLP, thinks as many as 10,000 U.S. producers of all sizes may be "well placed" for consolidation. "It's a very diverse group of companies," he said.

Big Oil traditionally is not given to shopping sprees, even when their coffers are full. ExxonMobil, BP, Chevron, Shell and ConocoPhillips plowed around 55% of the cash they made into stock buybacks and dividends in 2007, according to Rice University's James A. Baker III Institute for Public Policy. The percentage spent on acquisitions has remained in the low single digits for several years.

However, "tighter credit and a further decline in oil prices could accelerate industry consolidation and establish a baseline for energy asset valuations, which could boost stock prices above our targets," said Oppenheimer & Co. analyst Fadel Gheit.

Canaccord Adams estimated that the world's top five oil companies finished the third quarter holding collectively more than $62 billion in cash and annual cash flow of more than $232 billion. The result: more M&A, especially in plays with production in place and a "reasonably stable fiscal" environment. That is, Texas and Louisiana might be higher on a list for acquisitive-minded companies instead of in the West, where some states' more stringent environmental regulations might hamper future exploration.

"We believe that major oil companies look beyond the short-term environment, particularly for assets with long reserve life," Canaccord stated. "There will most likely be several bull market cycles for energy over that time period."

Occidental Petroleum Co.'s (Oxy) CFO Steve Chazen said his company has been looking for assets for a few months -- and even made some offers -- but it hasn't yet clinched a deal. Some of the offers have fallen through in part because the targeted companies want offers based on stock prices of six months ago, not the current values.

Oxy in December 2007 bought a stake in some onshore assets from Plains Exploration & Production Co. that included acreage in the Permian and Piceance basins (see NGI, Dec. 24, 2007). Oxy would like to buy more assets, but the timing will have to be right, said the CFO. As the energy slump and market turmoil continues into 2009, Chazen said some deals may be easier to capture as companies rethink their tactics.

Marathon Oil Corp. CFO Janet Clark said she thought there would be more activity in the M&A market. "It's just going to get tougher and tougher," Clark said. "I'm not optimistic that the banks are going to open their pocketbooks."

London-based BP, a mainstay in the San Juan Basin and across the Midcontinent, has purchased several choice gas assets in the past few months. Since January, BP has publicly built its position in British Columbia (see NGI, Jan. 28); agreed to pay $1.75 billion for Chesapeake Energy Corp.'s Woodford Shale assets (see NGI, July 21a); and purchased a portion of Chesapeake's Fayetteville Shale assets for $1.9 billion (see NGI, Sept. 8).

ExxonMobil earlier this year exercised an option to purchase an interest in Colorado's Piceance Basin that Tulsa-based Williams acquired in May (see NGI, Sept. 1). The Irving, TX-based major, with partner Imperial Oil Ltd., also this year acquired 115,000 acres in British Columbia's Horn River Basin (see NGI, May 5).

Shell Canada Ltd. grabbed a leasehold in the emerging Montney tight gas trend near the Horn River Basin in July when it bought Duvernay Oil Corp. for C$5.9 billion in cash (see NGI, July 21b). The transaction gave Shell half a million net acres in the Western Canadian Sedimentary Basin.

And Norway's StatoilHydro, already a player in the deepwater Gulf of Mexico and owner of the Cove Point, MD, liquefied natural gas facility, in mid-November agreed to take a stake in Chesapeake's Marcellus Shale play, a transaction that closed last week (see NGI, Nov. 17). Statoil paid Chesapeake $1.25 billion plus guaranteed that it would foot 75% of the expected drilling costs through 2012 for an additional $2.13 billion.

"We are not pulling the hand brake," said StatoilHydro CEO Helge Lund in a recent speech. "We will act on opportunities when we see them, as our recent deal with Chesapeake showed." It would not be a surprise, he added, "if a new wave of mergers is looming."

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