While battling internal decline curves, many companies turn to acquisitions to cover their losses. In 2002, a relatively mild year for U.S. reserve acquisitions, 135 producers-most of them publicly held-produced 205 million barrels of oil equivalent (BOE) more than they found, according to a recent study by John S. Herold Inc. and Harrison Lovegrove & Associates. Yet, the group posted a 265-million-BOE net gain in proved reserves thanks to acquisitions, which totaled 470 million BOE in 2002 net of sales. With acquisitions, they finished the year with 0.7% more U.S. reserves; without the purchases, they would have reported a 4.9% net loss. The math was the same in Canada, where 58 producers reported 2.4% fewer reserves at year-end 2002. Without purchases, their losses would have been larger-a whopping 10%. "The mission to survive is driving the North American E&P sector into the acquisition arena because, simply, the exploration effort is not yielding enough success," says Art Smith, chairman and chief executive officer of Norwalk, Connecticut-based Herold, an independent E&P research and analysis firm. Herold recently completed its 36th annual analysis of E&P-company performance. The 2002 study group included some 200 companies based in the U.S., Canada and abroad, most of them publicly held and collectively having operations all over the globe. Smith adds, "This trend is exacerbated by any steep step up in exploration activities-drill aggressively and finding costs shoot out of control." Thus, acquisitions have become a primary means of North American reserve replacement. "There are only two [methods] when you get down to it: you have to drill for it, or you have to acquire it," says Geoff Roberts, executive vice president, business development, Centurion Exploration Co., Houston. From this conundrum has sprung a plethora of A&D service firms. "Acquisitions have become a much more routine operation for companies. The number of transaction advisors working the U.S. is up tenfold from 10 years ago. It's simply become a standard in the [oil and gas] industry." Roberts was a founder in the 1990s of asset-broker Madison Energy Advisors, which he sold a few years ago. At the time of Madison's formation, corporate- and asset-transaction advisors Randall & Dewey Inc. and Albrecht & Associates, and property-auction firm The Oil & Gas Asset Clearinghouse, were among the few non-investment-banker A&D advisors. Now there are dozens. The aging North American basins are indirectly a factor in the growth of the A&D business. "When you're not able to maintain your reserve levels, you have to drill more or acquire more, and if there are more companies acquiring, there are more people to make money on the process, whether that is as a seller or as an intermediary," Robert says. Public companies are particularly under pressure. "Reserve replacement is one of a handful of key performance metrics analysts look at, so a company feels great pressure to replace reserves every year." Contributing to the growth in the acquisitions business is the availability of North American reserves often at prices cheaper than the anticipated costs and risks of drilling. "Judging from historical North American transaction data, buying [reserves] beat finding over the past few years," says Shannon Nome, a Houston-based E&P analyst for J.P. Morgan Securities. North American finding and development (F&D) costs averaged $1.74 per thousand cubic feet equivalent (Mcfe) of reserves booked in 2000-02, compared with 92 cents for reserves purchased in asset transactions and $1.29 for those gained from buying whole E&P companies, according to her analysis. "We attribute the rise in drillbit finding costs to the maturation of the North American resource base," she says. 2002 was a particularly cheap year, Nome adds. North American corporate purchases had an average price of $1.12 per Mcfe; asset purchases averaged 98 cents per Mcfe, according to the analysis. "Distressed selling by the energy merchants in 2002 may help explain the lower transaction valuations." Sales by CMS Energy, Enron, El Paso and Williams contributed 34% of total 2002 asset transactions in her study. Lloyd Byrne, an E&P analyst for Morgan Stanley, New York City, says, "Each day, management has a choice for its capital-buy [growth], build it or give it back. A combination of all is generally sought." He believes that buying growth is likely to accelerate for several reasons: • Buying reserves and production is often less costly than drilling for them. • The ability to hedge the purchased production mitigates price risk, while drilling, which carries yet-unknown production volume, does not offer this option. • There are many willing sellers. • And, buying another company may actually improve the buyer's debt profile. Examples of the lattermost are the Magnum Hunter-Prize Energy merger in early 2002 and the Devon Energy-Ocean Energy merger in early 2003. Prize brought Magnum additional credit capacity, which was needed to continue Magnum's longer-lead-time deepwater Gulf of Mexico exploration program. Buying Ocean with stock increased the equity portion of Devon's total capitalization, thus reducing the percentage of debt. The right deals Acquisitions that are purely commodity-price plays-deals where the buyer simply models his offer on a higher future commodity price than the seller will bet-are less likely to be successful. "While high prices can make us all look like heroes, there are cheaper and less risky ways to make commodity-price bets, such as hedges and options," says Vic Hughes, chief financial officer of Mount Pleasant, Michigan-based Gastar Exploration Ltd., and a former sellside E&P securities analyst. Gastar is focused on exploration, currently drilling for deep Bossier gas in East Texas and for coalbed methane in the Powder River Basin in Wyoming and in Australia. "You don't fight a decline curve with acquisitions," Hughes says. "Buying new properties doesn't change the decline curve on existing assets. Hopefully the knowledge gained from your existing assets can be leveraged to create competitive advantages on acquired properties. You buy companies and properties where you can apply that model." He adds that strong corporate discipline is the key to a successful acquisition program. "While some acquisitions work because of high commodity prices, getting lucky once doesn't mean you will get lucky again. Companies need to have the right metrics to monitor what goes right and what goes wrong in acquisitions. What gets measured gets done." Oklahoma City-based Chesapeake Energy Corp., an aggressive acquirer, has managed to grow organically as well-a fact obscured by the many headlines about its hefty purchases. Its total reserves grew 24% during 2002, when including purchases, according to the Herold analysis. Excluding purchases, however, it still grew reserves 8.4%. "Along with XTO Energy, we're right at the top of the industry in terms of organic production growth during the last two or three years," says Aubrey McClendon, Chesapeake chairman and chief executive officer. XTO Energy, also an active buyer, increased its reserves 13% in 2002 net of purchases, and 26% when including purchases. McClendon says none of Chesapeake's acquisitions have been to make year-end reserve-replacement numbers. "We've never had to do something like that. We really drill too many wells, we're too diversified, and we are too conservative in our forecasting to ever miss a production target these days." (For more on this, see this month's cover story.) Hughes says that cost-effectively growing an E&P company from North American acquisitions alone is extremely difficult. "North America is a very mature play and a lot of mature property acquisitions are just swapping dollars. A company needs competitively advantaged exploration or exploitation to stay in North America." Or go abroad. Smith says, "The allure of low-cost, prolific new ventures is diverting [the surplus of upstream free cash flow] and virtually all are overseas projects." Hot spots include Russia and West Africa, and gaining the majors' capex attention too are liquefied natural gas (LNG) projects around the world. "It's a pronounced change," Smith says. "The super-giants have been gradually withdrawing from North America for years; now they're sprinting away." ExxonMobil and ChevronTexaco reported net U.S. reserve losses in 2002 of 4.5% and 9.8%, respectively, according to the Herold study. ConocoPhillips had 13.4% total growth but a good deal of this was the result of acquisitions. Royal Dutch/Shell, which wants to increase its U.S. gas profile, managed to grow its U.S. reserve-holdings 5.5% without purchases and 8.1% when including purchases. BP managed to hold its own with the drillbit in 2002 but the giant oil actively pared its U.S. reserve-holdings in 2003. In Canada, ExxonMobil's and Shell's reserves declined 2.4% and 5.6%, respectively, in 2002. Neither made purchases in Canada that year. (ConocoPhillips' 2002 figures are distorted by merger results.) Byrne is a believer in the long-term viability of E&P companies that have exposure abroad. He views the most desirable E&P equities as those of niche players and those with international assets. While building an international program can be difficult one well at a time, buying an existing program can be fruitful, he adds. "While risk may be higher [abroad], so is reward." Smith expects that Herold's analysis of 2003 year-end reserve reports will show a declining reinvestment in exploration and development in North America. "Everything indicates that North American upstream cash flows are better than ever but the plow-back isn't." At press time, the firm was in the midst of analyzing the majors' reinvestment in the U.S. and Canada; the figure may be less than 40 cents per dollar of cash flow, he says. Worthy of note: The trouble with reserve replacement is not unique to North America, according to the Herold analysis. The entire study group-approximately 200 companies with operations collectively worldwide-finished 2002 with 2.2% fewer reserves than it began the year with, when excluding purchases. Meanwhile, also worthy of note: at least five producers had no trouble in 2002 with the reserve-replacement riddle. Forest Oil, Evergreen Resources, Pogo Producing, Columbia Energy and Questar grew reserves without purchases. Cottage industry The increased reliance on purchases to grow has created new North American E&P industry dynamics. The job title "business development" manager or vice president has become customary in the past decade. The annual Who's Who in E&P A&D, compiled by Oil and Gas Investor and A&D Watch newsletter, has some 500 participants. Roberts estimates there would have been half as many a decade ago. "Bigger companies always had A&D people. Smaller companies had ad hoc groups work on deals," Roberts says. "The role of business development has become much more standard and formalized, and recognized as a stand-alone function within the average E&P company. It has become a well-defined career path and well-defined business model." A contributor to the genesis of the business development role is another fairly recent development, he adds. "There hasn't always been this many companies built upon the acquire-and-exploit business plan. That has exploded in the last decade." Hughes notes that buying reserves is not a simple answer. "You pay a high cost in management time and corporate dollars to acquire properties in this business and management better track those acquisitions over time to see that they really work out. While it usually is the bad deal you make that kills you, to fully evaluate your corporate acquisition program, you've also got to track the good deals you don't do." Byrne says winners in times of consolidation are those with the ability to reinvest cash, through niche asset bases or savvy reallocation. "Neither is plentiful," he adds. What's to come? Currently high commodity prices have dampened the corporate-merger scene. The only North American corporate purchases valued at more than $1 billion in 2002 and 2003 were Devon's of Ocean, Unocal's of Pure Resources, Canadian Natural's of Rio Alto, the PanCanadian-Alberta Energy amalgamation that resulted in the formation of EnCana, and the closing of the Conoco-Phillips mega-merger. Asset purchases have been cheaper than whole-company deals, with which investors across all industries have become disenchanted. More than 60% of all industries' mergers have not resulted in increased shareholder value in the past 30 years, according to Anthony S. Fell, chairman, RBC Capital Markets. Nome cites three reasons why asset purchases are less expensive than buying whole companies: • Size. "Asset transactions are typically smaller than corporate transactions, and they are often not as efficiently priced." • Content. "Non-E&P assets may have inflated corporate purchase prices somewhat." • And, seller motivations. "Many of the major asset divestitures during the past couple of years came from distressed energy merchants." Byrne expects rising F&D costs and declining recycle-ratio trends in North America to spur another round of consolidation. "Some larger-cap companies [with a greater than $3-billion market cap] are better positioned than others. A few can afford to wait and bet on cyclicality. Most can't." Meanwhile explorationists remaining on the task of finding new, economic U.S. and Canadian reserves are under tremendous pressure, Smith says. "It will be an exploitation game and some additional attention to deeper reservoirs in existing areas. The 'old geology' is getting new attention." He adds that exploration in North America remains economic, despite rising F&D costs. "In the U.S. and Canada there is infrastructure, so you can get it to market, and tax policies and royalty rates are favorable. We expect another renaissance of independent activity in coming years." The business in North America of using M&A to replace reserves is not likely to grow much more in the next 10 or so years, however: it's already grown plenty, says Roberts. "In the past decade, we've seen M&A mature and establish itself as a routine component of most E&P companies' growth strategy. It has already permeated all corners of the E&P world."