Complete the following price sequence: $2.46, $5.90, $2.89, $4.85....The ability to predict the likely answer will help define success and failure in the North American mergers, acquisitions and divestitures (MA&D) market. The prices listed are the average near-month natural gas futures contract traded on the Nymex each December in 1999, 2000, 2001 and 2002. However, if you relied on this as an annual guide to the following year's prices, you would have expected $2.80 in December 2000 rather than the $5.90 actual, $4.97 in December 2001 rather than $2.89, and $3.45 in December 2002 rather than the $4.85 just experienced. "Buy low and sell high" is a useful maxim, but these days, recognizing "high" and "low" is more difficult than at any time in recent memory. And in the competitive arena of the MA&D market, price perception drives strategy, execution and results. 2002 was a year of transition in the U.S. MA&D market. Unlike the spot markets, longer-term price expectations were relatively stable throughout the year for both buyer and seller. This resulted in an active but not speculative asset transaction market. Corporate M&A activity waned as energy equity prices slumped in concert with the broader market decline. The liquidation of the merchant energy sector's E&P portfolios, in addition to debt-reducing sales from 2001's active M&A players, provided ample opportunity for those who were ready to strike. With no "majors" left to be combined into "supermajors," transaction activity and volume seemed slight when compared with the consolidation wave that began in the late 1990s. The upstream value of announced U.S. merger and acquisition deals, as measured by Randall & Dewey Inc., totaled $10 billion, down significantly from previous years. Asset activity drove and defined the market in 2002: Of the $10 billion, 65% of the value was in asset transactions rather than stock mergers or stock purchases. During the past 10 years, the U.S. asset transaction market has been remarkably stable in the $4- to $5 billion range when unusually scaled transactions such as Elk Hills and Altura are excluded. The 2002 total of $6.5 billion represents a 30% increase from the "normal" volume. The reserve value for asset transactions averaged $5.54 per barrel of oil equivalent (BOE) in 2002, down 10% from the 2001 figure of $6.19. With sellers once again eyeing robust prices, 2003 average reserve values may surpass 2001 levels. Worldwide upstream transaction activity totaled $40.6 billion in 2002. Not only did non-North American activity exceed the U.S. measure, but for the first time since the evolution of the A&D business in the early 1990s, transaction volume outside North America exceeded that of U.S. and Canadian volume combined. This occurred in spite of an increasingly active Canadian market spurred by E&P consolidation and the rapid expansion of the acquisitive royalty trusts. The trusts were the most active buyer segment in the Canadian asset market this past year. This capital structure and its U.S. cousin, the master limited partnership, have yet to significantly impact the U.S. A&D market. But in Canada, the tax-efficient nature of the structure combined with relatively lofty unit valuations have led to increasingly higher asset valuations and seem to have put the more conventionally structured competitors at a relative disadvantage. MLPs such as Kinder Morgan Energy Partners have expanded rapidly in the U.S. midstream market, but only time will tell whether upstream MLPs will approach the same level of market relevance. Who was divesting For the asset-hungry, 2002 provided a banquet of supply in terms of scale, location and quality of assets. The most significant reversal of fortune occurred in the merchant-energy sector, as companies that had been expanding their E&P exposure rushed to liquidate these assets when extreme leverage and lack of market confidence conspired in an Enron-led collapse. The transporter/downstream segment contributed 25% of the year's transaction value, with Enron, Williams, El Paso, Mirant and CMS as the leading net sellers. In the previous two years, this segment was a dominant net buyer. One of the more aggressive buyers, Calpine, in 2002 announced efforts to monetize a portion of its E&P business, but no transaction has been announced. At year-end, additional sales were being contemplated throughout the segment, which should help provide a steady supply of assets into an environment where commodity prices are relatively high. Several companies that were active acquirers in 2001 trimmed their sails and improved their balance sheets through asset sales in 2002. Devon cleaned up its international and domestic portfolio in the aftermath of the Mitchell and Anderson deals. Kerr-McGee shed a number of high-operating-cost assets both in the U.S. and North Sea, to reduce debt from the HS Resources merger. Burlington continued a multiyear effort to refocus its activities on core development areas by exiting the Gulf of Mexico Shelf. Such Shelf exits are becoming more and more common as assets mature and scale investment opportunities diminish. Fortunately, the market for these types of regional exits remains relatively strong when compared with low-end Gulf of Mexico asset dispositions, which are dominated by buyers with affiliated entities in the salvage-and-abandonment business. One of the more interesting transactions of 2002 was the three-way trade between XTO Energy, CMS Oil and Gas, and Marathon. Trades can be difficult to execute. One reason is that unlike a cash acquisition where the buyer and seller agree on the value of one set of assets, in a trade the two parties have to agree on the relative value of two sets of assets. A three-way trade requires each party to focus on their ultimate objectives for the transaction in order to create a win-win-win situation. In this case, CMS desired cash, Marathon wanted to consolidate its portfolio through trades, and XTO wanted to expand its position in East Texas and the San Juan Basin. Companies gone For some notable names in the E&P business, transaction activity in 2002 marked the end of the trail. EEX ended its uphill battle to remain the largest undercapitalized deepwater player by agreeing to merge into Newfield Exploration. Unocal announced it would save more money rolling up its investment in Pure Resources than it saved in creating Pure. Denbury Resources took advantage of the opportunity to buy the Mississippi assets of long-time rival Coho Energy from the bankruptcy estate as part of Coho's ultimate liquidation. The acquisition of Enterprise Oil Plc by Royal Dutch/Shell all but eliminated the ranks of public multibillion-dollar U.K.-based independents. And it was generally a bad year for any company with its name on a building in downtown Houston. The possible exception was Howell Corp., which went out on a high note through its acquisition by Anadarko Petroleum. Chesapeake Energy remained on a Midcontinent tear, making clear its desire to be the buyer of choice and to limit competing parties' likelihood of transaction success. At what point will Chesapeake be saturated with gas? Its shareholders hope never to find out. Although merger activity continued to embrace Alberta, it was much more restrained south of the border. The list of U.S. public independents remains long and disparate in spite of the wave of consolidating activity in recent years. The lack of merger activity in 2002 was influenced by the weak equity markets in general, and more specifically by the lack of valuation follow-through from previously consolidated entities. The demonstrable benefits from economies of scale remain for the most part undemonstrated. In a few notable cases, the reserves of the combined companies ended 2001 lower than the reserves of each component part. Unfortunately, one plus one sometimes equaled 1.8. 2003 and beyond If currently elevated commodity prices translate into higher equity values we should see another consolidation wave as managements and shareholders seek transaction premiums near a perceived market top. If commodity prices stay high, but equity prices do not follow, cash acquisitions of the under-appreciated small-cap E&Ps may follow. The supermajors will likely add strategic acquisitions of targets in the $5- to $10 billion range rather than test the limits of the Federal Trade Commission in the creation of a super-duper major. The MA&D market in 2003 will be dictated by commodity prices and commodity-price expectations. Obviously, the potential for war disruptions in the Persian Gulf and the currently unresolved Venezuelan situation create enormous uncertainty in the crude oil markets. A relatively cold winter (at least compared with last year's record warmth) is causing the forward gas markets to reflect prices in a range above any annual realizations over the past 15 years. The "high" price scenario may in the short run defer asset-sales plans for companies that covet the cash flow, but should ultimately result in a moderate supply of fully priced assets coming to the market. One primary source is likely to be private companies acting opportunistically and recreating the market environment of the first half of 2000. We expect the integrated group (both majors and supermajors) to take advantage of relatively high prices to clean up their asset portfolios-witness the recent BP sale to Apache and the announcement by Shell that it will sell some North Sea assets. Traditionally, the majors have sold an average of 1% of their North American assets each year. In some cases, pooling of interests put those programs on temporary hold. With the last remaining pooling-restricted major, ChevronTexaco, coming out of pooling limitations this year, a steady supply of assets into the market may be on the horizon. In the past several months, a number of companies have successfully sold equity on the heels of an acquisition announcement. This is a very positive development for the MA&D market. The positive equity market reception to Apache's recent acquisitions reinforces the observation that it is possible to aggressively acquire in a high commodity price environment without creating the impression of paying "too much." (Apache did hedge a significant portion of the production in the first two years to assure a base expectation of investment return.) If commodity-price perceptions drive strategy and execution in the MA&D market, how can buyers and sellers reach agreement, given the current volatility and price trajectory? One answer is that longer-term price expectations have been relatively stable (at least as expressed on the Nymex). Consider the "third-year strip" for natural gas during the past 2.5 years. For most of 2002, this intermediate-term expectation has remained in a relatively narrow range, from $3.70 to $4. Most transactions during the next few months will require the buyer to honor the near-term price path quoted on the Nymex while reverting to a longer-term view in the $3.70 to $4 range. Only at the height of the California energy crisis in the spring of 2000 has the transaction market reflected longer-term gas price expectations north of $4. For buyers with an aggressive price view, the opportunities to aggregate and consolidate should remain plentiful in 2003. For prospective buyers with a more conservative view, the desire and ability to hedge may determine when and whether they should strike. Either way, transaction opportunities should be abundant in 2003, as the industry continues to wrestle with the new definitions of "high" and "low." Gregg Jacobson is vice president, petroleum advisory, with Randall & Dewey Inc., a Houston-based acquisition and divestiture advisory firm.