The U.S. energy opportunity: A deeper look at valuations

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2014 Grant Thornton LLP survey of U.S. oil and gas companiesIncreased competition has led to high valuations across the energy industry. Favorable conditions in the debt and credit markets have also facilitated an increase in deal volume, as well as higher prices. Indeed, there are more deals being completed because there is more financing available at an attractive cost of capital.

The debt markets have been increasing their proportion of energy weighting due to the capital-intensive nature of shale. With the fall in oil prices, we may see rates on new debt go up as the market is currently long energy.

Generally, the macroeconomic picture shows that multiyear market conditions overall are up, which contributes to higher valuations. E&P and energy stocks, however, have been hit hard by recent selloffs. XOP (Exploration and Production ETF) has fallen below $50 for the first time since the summer of 2012; it’s down approximately 30% (year-to-date) vs. S&P 500, which is up 12%.

While oil prices are falling now, over the past several years they have trended higher, making probable and possible reserves more valuable, which has further stimulated interest from the M&A community. It’s also led to more deal volume in exploration and production. It is important to note the forward curve has been backward-dated for some time now, reflecting market expectations that prices would fall. While reserve valuation increases have led to most of the M&A (at least of size), transactions have been centered around the ability of low-cost-of-capital buyers to acquire undeveloped shale potential that they believe has been de-risked, use their balance sheets to accelerate potential and push value forward, increasing production growth and making the transactions accretive. This is what’s led to the massive increases on acreage values for undeveloped reserve deals.

Private equity fundraising efforts seem to have contracted in the last 18 months, with some reporting the highest dry powder numbers on record and buyout funds reaching levels unseen since December 2009, when everyone was afraid to invest. In my view, this just means capital exists to get deals done and private equity will keep making acquisitions.

While private equity firms are very involved in the energy industry, strategic buyers are still playing a role. There was a time when it seemed like almost every transaction was being completed by a private equity firm, but eventually these firms seek to sell. When they do, it’s often a strategic buyer who steps up.