In a fitting conclusion to the decade just past, industry conditions at the end of 1999 were worlds apart from those at the beginning of the year. The merger boom of 1998, which roared into 1999 averaging nearly a major announcement per month, had calmed down as oil prices rebounded, leaving a new landscape and new opportunity to greet the new decade. The 1990s saw the creation of the supermajor and the emergence of the superindependent. Unlike the '80s, when large independents were born of small majors, the superindependents of today grew to prominence primarily through mergers and acquisitions. The merger, acquisition and divestment (MAD) market of 1999 continued to explode, powered by the wave of company mergers that began in 1997. The upstream value of announced U.S. merger deals, as measured by Randall & Dewey Inc. (R&D), totaled $47.3 billion, down significantly from the 1998 record of $82.1 billion, but considerably higher than the balance of the decade (see Figure 1). While, as expected, no Exxon Mobil- or BP Amoco-scale transactions were announced in 1999, we did see the trend truly go global with the marriages of Repsol-YPF and the creation of TotalFina-Elf. As commodity prices declined, they forced downward the implied average reserve acquisition cost, as measured in dollars per barrel of oil equivalent reserves ($ per BOE). Even so, 1999's average of $7.63 per BOE was the second highest calculated by R&D this decade, having been nudged higher by the implied value of U.S. E&P assets embedded in the large corporate mergers. Lower commodity prices caused a significant fall-off in the aggregate dollar value of oil and gas property sales, from $7.9 billion in 1998 to $4.7 billion in 1999, the lowest level of asset activity since 1996. Last year we predicted that in 1999, the first true buyer's market in the U.S. would emerge since mid-1992. In many ways, evidence that a buyer's market was developing began to surface in late 1998 and continued through mid-1999. Failed sales, retraded deals and thin participation were the notable hallmarks. Perhaps the clearest sign that a buyer's market was developing was the dramatic return of Apache Corp. to the large-scale asset acquisition market, with its buy of certain Shell Oil offshore properties. Apache's discipline, market timing and ability to consummate scale transactions in favorable competitive environments continue to be impressive. Although prices have rebounded to levels that generally create increased appetites for assets, the lack of favorable response by the capital markets will continue to keep a soft cap on the asset market-in many ways perpetuating buyer's market conditions into the arms of an increasingly healthy industry. Figure 2 divides the U.S. upstream transaction market between stock purchases or exchanges (mergers), and asset transactions (reserves or properties). The largest announced stock transaction was the BP Amoco-Arco merger, which was still pending regulatory approvals at press time. The largest U.S. asset deal was Apache's purchase of offshore properties from Shell Oil. As in the past, the implied reserve value of stock transactions surpassed the values in the asset or property market. This premium declined from the 1998 record, as it was less dominated by highly valued supermajors and reflected deals consummated at the lower E&P equity values the industry suffered in 1999. The slower deal pace for assets in 1999 was no surprise, given commodity price volatility. Few companies chose to sell into early price weakness. Fewer still were confident they knew the "right price" at which to sell or buy towards the end of the year, when oil prices reached new highs. As a result, E&P companies that historically have counted on acquisitions to fuel their reserve and production growth have paused to retool and rethink their expectations for this year and beyond. The expectation of longer-term strength in gas prices began to influence valuations as the average reserve value for asset transactions in 1999 actually exceeded the 1998 average. The recent peak year for asset deals and dollar value remains 1997, which was a period of relatively robust E&P equity valuations. Although commodity prices have returned to healthy levels, stock valuations have not recovered their previous luster. Until they do, we find it unlikely that asset valuations will return to 1997 premiums-even if commodity price expectations remain strong. As asset deals generally require new industry capital, the well-capitalized companies should take advantage of this temporary condition, which serves to limit competition for asset opportunities above $100 million. We may be entering an era that allows well-capitalized independents to achieve significant growth with limited competition and robust industry fundamentals. 1998 was unusual in that the independents were, on balance, net sellers. Figure 3, a graphical representation of MAD action broken out by industry segment, shows that 1999 saw a return to normalcy: the independents were once again net buyers. BP Amoco's continued mission to cut other companies' expenses led the imbalance between foreign and integrated companies. Perhaps in the future this nominal distinction will fade, but it is surprising, given the imperial history of the U.S. oil industry, that such a significant amount of U.S. reserves is now under the stewardship of companies deemed foreign. The increased participation of the transportation-downstream sector was the result of two mergers with E&P implications. Virginia utility Dominion Resources picked up Consolidated Natural Gas Co. and pipeline-marketer El Paso Natural Gas acquired Sonat Exploration (and continued this theory by buying Coastal Corp. in early 2000, thus enhancing its E&P segment even further). In both cases the acquired party had a significant E&P presence, although that did not seem to be a key driver for the merger itself. It will be interesting to see how these new owners react to the earnings volatility inherent in the E&P business. Without another supermajor merger on the immediate horizon, it is difficult to imagine aggregate U.S. merger volumes returning to 1998-1999 levels in the near future. Although we expect industry consolidations to continue, it is unlikely they will be announced at as aggressive a pace as we saw in 1998-1999. In that period, merger activity was significantly influenced by declining long-term oil price expectations. Even the strongest companies became concerned about their ability to deliver on commitments to their shareholders. The most common merger attribute? Scale-driven cost reduction, leading to the potential for achieving growth through "nonorganic" means. Although this potential exists in all price environments, it is particularly important in periods of lower prices, when organic growth through the drill bit, and other opportunities, have impaired economics. Reducing costs becomes the primary driver of near-term earnings. The relationship is shown in Figure 4, which demonstrates the notable merger activity that took place when oil price expectations were below $16 per barrel for the 60 days prior to the date the deal was announced. In an industry that has struggled to produce acceptable returns for shareholders, a fair amount of merger activity should be anticipated in order to continue the cost- reduction theme. However, healthy commodity prices will often create internal growth expectations-hopes that tend to be diluted in most potential combinations. That's why 2000 merger activity will most likely be less dramatic and less frequent than we have grown accustomed to during the past 24 months. Offsetting this trend to some degree is the fact that treatment of mergers as a pooling of interest ends this year. This change in tax treatment may motivate a few more deals. The worldwide merger activity of the past two years has effectively restocked the asset food chain at the top tier of companies. In order to deliver the expected cost reductions, and in reaction to each combination's new scale paradigm, some level of asset rationalization is anticipated in almost every instance. At what level do individual assets cease to be material for Exxon Mobil or BP Amoco-Arco? If each of the recently merged companies ultimately sheds only 10% of its E&P assets, more than $25 billion in oil and gas properties worldwide will change hands. The ultimate percentage should be significantly higher as these merged companies dig deep to deliver on promised cost savings. One possible outcome? These new assets could help create 25 to 50 new independent companies. Of course, access to capital is the key to whether this happens, and whether these assets change hands at premium values. Unfortunately, the 1998-1999 oil price collapse, subsequent equity collapse, bond defaults, multiple bankruptcies and longer-term history of poor full-cycle returns, will hamper this industry's ability to attract (and hold) lower-cost sources of capital. We work in an industry with few barriers to entry and even fewer barriers to failure. The companies that are perceived to have a track record of creating value will be given the greatest opportunities to grow. Merger activity and post-merger asset sales have not only changed the current landscape, but will continue to have a profound impact on the E&P business overall. Who will be the dominant players in the Permian Basin, once Altura Energy is sold (bids were being evaluated at press time), or Arco Permian's fate is decided? Will Unocal, which plans to roll its Permian properties into a new company, Pure Energy, ultimately manage a holding company of regional U.S. E&P firms? Who will help consolidate the Gulf of Mexico Shelf? Although it is often said that E&P equity investors desire commodity price exposure, it may be those companies most able to successfully manage price risk will, in turn, be most able to attract the incremental capital they need to fuel growth. We have long believed that the successful players in the A&D market were those with a superior ability to enhance asset value, exclusive of commodity price appreciation. A renewed focus on value growth rather than reserve growth seems to be the mantra these days. "We need to make an acquisition" has evolved into "We look at acquisitions, but they have to have the right fit and focus." Growth for growth's sake has vanished with the capital that fueled it. As companies react to the demands of the current equity market, the urge to be more judicious may ultimately create even more opportunity for the well-capitalized player. With the advent of new technology aiding information and data flow, what was already a volatile and fast-changing segment of the industry will only move faster. The ability to identify, evaluate and react to opportunity at a superhuman pace will mark the successful participant in the MAD market. When we look back from the vantage point of 2002, the 2000 market may be viewed as one where good fortune, good timing and dry powder made the difference. M Ken Dewey is a founder and principal of Randall & Dewey Inc. Gregg Jacobson is vice president of petroleum advisory services for the Houston-based acquisition and divestiture consultants.