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E&P companies likely to drive further M&A

MERGERS and acquisitions (M&A) activity in the European oil and gas sector is likely to concentrate on exploration and production (E&P) companies and less on big integrated firms, says a new report. It claims independent companies Cairn, Soco and Venture are the most likely targets for take-over. The least likely are Dana and Tullow.

"European oil and gas has been largely overlooked in the recent frenzy of corporate activity being seen in other sectors," says the report from UBS, an investment bank. "This comes despite some attractive valuations, a supportive macro environment and an abundance of cash-rich potential acquirers."

However, European majors have typically made acquisitions at the bottom of the cycle. As a consequence, with oil prices holding steady at around $60 a barrel – relatively strong compared with prices seen during the merger mania of the late 1990s – the sector's larger firms are holding fire.

That leaves smaller E&P firmsas the most likely generator of any increase in M&A activity in the next year. "E&P corporate activity is typically less cyclical, is less likely to meet political resistance and, unlike the integrated companies, E&P [firms] are in a size bracket that might potentially interest private-equity investors," UBS says.

The industry's struggle to raise reserves and production organically is also likely to result in continuing M&A activity in the E&P sector. Inflated finding and development costs have increased the competitiveness of acquisitions. Furthermore, the E&P sector's proved and probable reserves are, at an average of $10.80/b, "considerably cheaper" than the average price of $16.25/b paid in 2006.

Another factor, says UBS, is the disparity between forward commodity prices, averaging $68/b over the next three years, and today's E&P equity prices, based on an average of about $50/b. Some E&P acquisitions, it adds, are competitive with the returns on offer at some of the industry's largest upstream projects.

The likeliest acquirers are majors struggling to replace reserves, the larger companies from energy-importing countries, private equity firms seeking new market opportunities and other E&P companies seeking greater scale.

Meanwhile, UBS says the comparable lack of oil and gas activity in M&A activity at the top end of the market over the past year is the result of the "industry taking a less optimistic view of its long-term operating environment". And the bank says this is unlikely to change. In an M&A boom across all sectors that has seen European transactions total $1.7 trillion dollars in 2006 (up by 41% from 2005), integrated oil companies are not likely targets. This is because of regulatory and political issues – among them governments' worries about security of supply and the drive for downstream deregulation – a lack of synergies among the main players and because the companies concerned are too large to attract private-equity buyouts. Statoil's proposed merger with Hydro is the exception to the second of those factors.

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