Within just a handful of weeks this spring, three publicly traded Rockies producers-Tom Brown Inc., Westport Resources and Evergreen Resources-announced they were being acquired for a collective $6.3 billion. The buyers, respectively, were EnCana, Kerr-McGee and Pioneer Natural Resources. At press time, a fourth producer was bid on-Prima Energy, by Petro Canada. Since then there have been rumblings within Denver's oil and gas community about which operators in the region will likely be bought next. There is the sense that these four mergers trumpeted this spring are only the vanguard of Rockies M&A mania. That's not a surprising appraisal. With recoverable gas resources estimated to be anywhere from 279 trillion cubic feet (Tcf) to 500 Tcf, the Rocky Mountain region is the last great onshore gas frontier in the Lower 48. Throw into the mix tight domestic gas supply/demand fundamentals and recent $6-plus prices for the commodity and it's a good bet that more North American independents-and perhaps even a major integrated oil or two-are likely to seek an immediate or expanded Rockies presence by acquiring operators already expert in the region's basins. Which oil and gas companies are likely to be suitors? And which Rockies operators are likely to be their targets? To find out, Oil and Gas Investor recently talked with four leading industry experts. Participating in the discussion were Fred Julander, co-chairman of the natural gas committee of the Colorado Oil & Gas Association and president of Julander Energy Co. in Denver; Ray Deacon, principal, equity research, First Albany Capital in Denver; John Olson, senior vice president and chief market strategist for Sanders Morris Harris in Houston; and Fadel Gheit, senior energy analyst for Oppenheimer & Co. in New York. Investor Why so much recent M&A activity in the Rockies? Julander The Rocky Mountain region is finally being recognized as a world-class natural gas province. By some estimates, there's as much as 400- to 500 Tcf of recoverable gas in the area-on par with the gas-resource potential of Indonesia and Malaysia. Also, larger-cap companies that want to be in the Rockies-a region not easy to understand-have concluded that the best way to break into it in a hurry is to acquire the assets and expertise of existing producers that already understand the Rockies very well. Deacon According to the estimates we use, there are about 279 Tcf of recoverable gas resources throughout the region, which is still huge. And many large-cap producers-with short-lived reserves and high-decline-rate wells onshore the Gulf Coast or in the Gulf of Mexico-are trying to buy longer-lived Rockies gas reserves with more predictable production that can be grown using only a small percent of their cash flows. In addition, drilling, completion and well-stimulation technologies have advanced to the point where a lot of the Rockies' unconventional gas plays, such as tight-sands gas and coalbed methane (CBM), now have very attractive rates of return. Olson A lot of the recent upstream M&A activity we've seen has to do with the industry's strategic vision of where future North American gas reserves are to be found. And both the Rockies and the Western Canadian Sedimentary Basin are considered the primary gas resource base for the next 25 years. In addition, at recent Nymex gas prices of $6-plus, the economics of Rockies exploration and development look very attractive. Indeed, if one looks at current forward oil and gas price curves on the Nymex and adjusts them down to a market-driven level, the wellhead revenues for the entire E&P industry in this country during the next five years will likely run about $170 billion annually. This compares with an annual $145 billion during the past four years and an annual $83 billion during the 1990s. On the demand side, nearly 200,000 megawatts of gas-fired, electric-generating plant capacity has been brought onstream in the U.S. during the past four years. And if those new plants are run full bore, they would need an additional 30 billion cubic feet (Bcf) of gas supply daily. So the fundamentals and economics are in place for producers to capitalize on the potential of the Rockies' gas basins. Gheit As we see it, buyers are motivated by their windfall profits from record oil and gas prices, the huge amount of free cash flow they're generating and the lack of attractive investment opportunities. Meanwhile, sellers are motivated by fears that if oil and gas prices eventually cool off and return to more sustainable levels, the party will be over and they'll have missed the opportunity to sell at the top. We don't share the view, however, that higher commodity prices are driving industry consolidation. If anything, the pace of M&A activity should accelerate with lower oil and gas prices as unit-acquisition costs decline. Investor From a buyer's perspective, which oil and gas companies would tend to benefit from acquisitions in the Rockies? Gheit I doubt that the large integrated oils would be interested in establishing a core presence in the Rockies because they need large-scale opportunities and acreage. The more logical buyers would be large-cap independents like Apache, Anadarko, Burlington, Unocal and XTO Energy. Investor Why Apache? Gheit Unlike Burlington or Anadarko, it doesn't have a presence in the Rockies. Also, since it has already made major oil acquisitions in the North Sea and is expanding its oil operations in Egypt, it needs more of a natural gas balance domestically. In addition, the company has the strongest balance sheet among its peers and continues to generate large cash flow. Investor You said integrateds wouldn't be all that interested in the Rockies. Are there any exceptions? Gheit It would be a brilliant move on the part of ConocoPhillips, heavily weighted towards oil in Alaska, to expand its presence in the onshore U.S. via a Rockies natural gas acquisition. That would diversify its risk profile, reserve mix and earnings stream. Also, Royal Dutch/Shell, which has just revised downward its reserves by more than 4 billion barrels of oil equivalent, may want to revisit the idea of expanding in the Rockies after attempting to do so a few years ago with its failed bid for Barrett Resources. Olson I'd agree that, by and large, the major oils aren't going to be all that interested in the Rockies simply because they don't spend tiny amounts of capital drilling tiny wells. Take ExxonMobil, for instance, which admittedly has a big presence in Wyoming's Greater Green River Basin. This is a company, however, that has about $31 billion of cash flow annually, capital spending of $13- to $15 billion a year, dividend payments of $7 billion a year and stock buybacks of $6- to $7 billion annually. So it needs to spend at least $1 billion in a new area, and preferably $5- to $10 billion, for any investment to be meaningful. It's fair to say that if a major oil were to focus on the Rockies, it would need to buy one of the large-cap independents there. Investor Then you see larger-cap independents as the more logical buyers. Olson Yes. But what may surprise many is that we could see land drillers like Nabors or even offshore drillers like Ensco and Global SantaFe seeking diversification through upstream acquisitions in the Rockies. We've already seen Unit Drilling successfully transform itself into Unit Corp., which now derives 75% of its earnings from E&P. Deacon I'd agree that Royal Dutch/Shell might still be interested in the Rockies. It would appear it has about a three- to four-year gap in gas-production growth between now and the time its large LNG projects come onstream. Looking at the larger-cap independents, EnCana is likely to continue to be active in Rockies merger activity beyond its recent purchase of Tom Brown. Both the geology and prospects in the region are very similar to those it has done well with in Canada. Also, EOG Resources seems very intent on growing in Utah's Uinta Basin. In addition, by the end of third-quarter 2004, Devon will have enough cash on hand to repay all its debt maturities due through 2006. This would leave it in a position to become more active in the Rockies on the drilling or acquisition side. Currently, the Rockies accounts for only 13% of Devon's annual gas production. Investor Which Rockies operators might be the most attractive targets for such large caps? Deacon Western Gas Resources and Ultra Petroleum. Western Gas has the best asset base in Wyoming's Powder River Basin and one of the strongest growth profiles there. As it develops its CBM assets in the Big George play, we could well see its reserves tripling, from 684 billion cubic feet equivalent (Bcfe) to 2 Tcf. Also, it has a sizeable acreage position in the Pinedale Anticline in the state's Greater Green River Basin and remarkably low finding costs-43 cents per thousand cubic feet equivalent (Mcfe) during the past few years. In the case of Ultra Petroleum, it has a very large, contiguous asset base in the Pinedale Anticline where it's experiencing even lower finding costs-37 cents per Mcfe-and very high rates of return on its wells, in some cases north of 200%. Typically, their wells are paying out in less than a year. What's not priced into Ultra's stock, however, is the company's growth potential from deep drilling in the Pinedale. Recently, it began drilling its first 20,000-foot well to test the Rock Springs formation. If that well comes in, it would further boost the company's asset value and attractiveness. Julander I'd have to agree that Western Gas Resources, which recently announced a 2-for-1 stock split, would be an attractive buyout candidate. It has an extensive resource base in Wyoming, a great gathering and pipeline infrastructure system throughout the Rockies plus a great staff. And yes, Ultra Petroleum, because of its preeminent position and growth potential in the Pinedale Anticline, would be a major takeover target. Still another Rockies producer likely to be on buyers' radar screens is Patina Oil & Gas. It also has a great resource base, principally in Colorado's Denver-Julesberg (DJ) Basin. Indeed, even Rockies-focused Bill Barrett Corp. will be a takeover target from the day it goes public. Investor Which larger-cap independents would likely be the buyers of such producers? Julander XTO Energy would be a definite possibility. It's a great growth company and the Rockies is a region to which it should have heavier exposure. And Kerr-McGee may not be through with its Rockies M&A activity. If it's smart enough to buy HS Resources and Westport Resources, it clearly understands the growth potential of the region. Also, Burlington Resources may very well want to expand its Rockies presence beyond the Madden Deep play in Wyoming's Wind River Basin because it, too, is starting to understand the region's potential. Investor Fadel, what about the large premiums for Rockies producers? That's not simply for proved reserves, is it? Gheit No. Buyers are really paying up for reserve potential-both probable and possible. However, one has to wonder about the investment returns on some of these acquisitions in a more realistic commodity-price environment of $25 oil and $4 gas. In such an environment, those acquisitions might not generate a return above the cost of capital, especially without significant reserve additions. Deacon EnCana, which paid $48 per share for Tom Brown-about a 26% premium to where the stock was trading prior to the announced merger-was likely paying up for its ability to accelerate the value of some of Tom Brown's proved undeveloped (PUD) reserves. Also, it was giving some credit for probable reserves. Going forward-with fewer growth producers available to be acquired-we'll see an acceleration of the premiums paid. Julander A buyer might finance an acquisition on the basis of proved and PUD reserves. But the premiums being paid for Rockies producers are linked to their probable and possible reserve potential-and their grass-roots exploration programs. Investor Might the Canadian Rockies also be attractive to buyers? Deacon Royalty trusts, which are paying in excess of $2 per Mcf for proved reserves, are the most aggressive buyers of properties in western Canada right now. So it would be very difficult for U.S. upstream companies to compete in that market. Investor John, what about midstream companies as potential upstream buyers? Olson Some gas distribution companies like Questar, National Fuel Gas, Energen, Dominion and Oneok have been diversifying into upstream development plays and could become more visible in the Rockies with their cash flow surplus. But bear in mind that the basins in the Rockies aren't without their challenges. They are among the highest-cost basins in the country-with the permeability and porosity in formations there only a fraction of what are found in formations in the Gulf Coast. This means an operator has to drill a lot of small wells to come up with the equivalent of just one good Gulf Coast well. Deacon Questar has been by far the most active midstream player in the Rockies and has articulated a very coherent strategy for growth there. So it's a potential buyer of more upstream assets.