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Shopping in the shale

The US unconventional oil and gas sector remains a hotbed of M&A activity. Anne Feltus pinpoints the next targets

DEVELOPMENT of the US' vast unconventional-gas deposits has taken a decidedly conventional turn. The long-term opportunities the plays present have attracted the attention of the big multinational energy firms, which are finding that the choicest acreage has already been leased by independents.

Historically, companies have gained access to otherwise unattainable resources through mergers, acquisitions and joint-venture partnerships, and the oil industry majors are no exception. And their advances might be welcomed by shale-gas players that have seen cash flows dry up and stock prices plummet because of prolonged, low natural gas prices.

Wooing the shale players

Until recently, the majors had only a mild interest in US shale-gas deposits, looking offshore and overseas for growth opportunities, leaving unconventional assets to the independents. While gas prices were high and with the advent of hydraulic fracturing (fracing) and horizontal drilling technologies, small to medium-sized operators could make a profit on these plays and they began accumulating sizable portfolios.

All that changed when gas prices dropped. Meanwhile, as access to high-quality reserves offshore and overseas has become costly and limited, the majors have begun looking at domestic opportunities to replenish their reserves. US onshore unconventional-gas plays have become even more appealing since the Deepwater Horizon incident in the Gulf of Mexico led to greater restrictions on offshore drilling. Foreign energy companies have also begun shopping in the shale, in part to acquire the expertise to develop their own countries' unconventional reserves.

These factors have set the stage for industry consolidation. ExxonMobil took the lead by spending $41bn to buy XTO Energy, which had amassed an impressive shale-gas portfolio, at the end of last year. Others, such as Shell and Total, have followed suit. Joint ventures have also become more common, as big companies with deep pockets link up with smaller players lacking operating capital.

With these trends set to continue, several US shale-gas producers stand out as attractive candidates for the majors to pursue:

CHESAPEAKE ENERGY

A pioneer in shale-gas development, Chesapeake ranks as the second-largest US gas producer and is the country's most active driller – accounting for one in eight wells drilled in third-quarter 2010. The Oklahoma-based company has assembled one of the most enviable shale-asset portfolios in the business, with a total of 2.8m net acres and strong positions in the Barnett, Fayetteville, Haynesville, Marcellus and Bossier plays. These properties have provided 20 consecutive years of production growth.

Although Chesapeake has accumulated a crushing debt load, it has plans for improving its bottom line. To generate more cash flow and boost its return on capital, in 2008, it began transitioning from a gas-only to more balanced gas-and-oil growth model, a move chief executive Aubrey McClendon called "the single largest strategy shift in Chesapeake's history". To implement this strategy, the company has acquired about 2.4m net acres in a dozen large unconventional oilfields, including 0.55m net acres in the liquids-rich Eagle Ford Shale trend of South Texas. By 2015, it expects oil and natural gas liquids to represent 25% of its production.

The company also plans to sell minority positions in some of its oil plays. In addition, it has signalled that it will announce a joint venture in the Eagle Ford Shale – most likely with an Asian investor – by year end, continuing a trend that has linked the company with big-name partners such as BP, Statoil and Total.

But the stock market has not taken notice of these measures; Chesapeake's shares have plummeted by 24% since the beginning of the year. Undervalued by more than 30%, according to at least one analyst, they could be a bargain for a buyer interested in gaining a sizable, high-quality stake in the US' foremost shale-gas plays.

RANGE RESOURCES

The Marcellus Shale has it all: gas reserves estimated at around 500 trillion cf, excellent economics and an advantageous location close to large population and industrial centres. Range Resources discovered this prolific play in 2004 and began buying the best positions at a fraction of today's value. It is the leading landowner in the area with about 1.3m acres under lease.

"We estimate 20-27 trillion cfe of net unrisked upside potential on our existing acreage, or enough to grow the company's proved reserve base by as much as eight times," says Range.

Range plans to double production from the Marcellus Shale in 2010 and again in 2011. With that goal in mind, it recently increased its planned capital expenditures for the year from $0.95bn to $1.2bn, more than twice its predicted operating cash flow of almost $0.55bn. However, the company is already highly leveraged, with $1.86bn in long-term debt, so it plans to sell several non-core properties to make up the difference and has already sold its tight-gas-sand properties in Ohio for $323m and assets in West Texas for $182m.

Range's activities are not limited to the Marcellus. Since 2004, it has accumulated 350,000 net acres in western Virginia's Nora field, where it has more than 2,600 wells producing from coal-bed methane and tight-gas formations and it has identified another 7,000 drilling sites. The shallow depths of the field's formations enable the company to keep drilling costs to a low $340,000-0.5m a well.

The Fort Worth-based company also has about 50,000 acres in the prolific Barnett Shale play of North Texas, one of the lowest-cost, highest rate-of-return reservoirs in the country. It has boosted production for 30 consecutive quarters to a record high of 472m cfe/d in the second quarter of 2010. Range Resources could be an ideal match for a big company eager to buy high-quality assets that will pay off handsomely when gas prices, ultimately, increase.

SOUTHWESTERN ENERGY

Southwestern Energy's catch-phrase reveals its formula for success: "the right people doing the right things, wisely investing the cash flow from the underlying asset will create value". The Houston-based independent ranks among the fastest-growing companies in the gas industry, an achievement that's especially impressive because it has occurred through drilling rather than acquisition.

Between 2004 and 2009, Southwestern averaged over 40% annual output and reserves growth and replaced over 500% of its production. Last year alone, without a capital budget increase, the company set new records for production, reserves and reserves replacement.

In 2003, Southwestern became the first company to begin operations in Arkansas' Fayetteville Shale formation, a small formation similar geologically to the Barnett Shale trend. Gaining an early entry advantage, it began locking up top-quality leases at attractive prices. By year-end 2009, Southwestern had acquired the largest position in the Fayetteville Shale – almost 0.9m net acres with proved reserves of 3.12 trillion cf – and had drilled more than 1,000 wells there. As its knowledge of the area has grown, so has its operational efficiency, making it one of the lowest-cost producers in its sector.

Southwestern estimates its drilling inventory in this shale play will last more than a decade at its present drilling pace. Looking to the future, however, it has been diversifying its interests and now has about 10,500 net acres in Haynesville and Middle Bossier shale plays and 150,800 net undeveloped acres in the Marcellus. It also has midstream gas-gathering and marketing assets supporting its exploration and production operations.

In March, in a move reminiscent of its early entry into the Fayetteville Shale, Southwestern purchased 2.5m acres in Canada's Maritimes basin – its first foray outside the US and the largest land rights acquisition in the basin to date. The company's exploration activities will focus on both conventional sandstone and unconventional shale reservoirs.

Southwestern has managed to maintain a strong balance sheet with good cash flow and outstanding profitability, as well as a debt-to-book capital ratio of 31% and a debt-to-market capitalisation ratio of 9% at the end of the second quarter. Although the company's stock has taken a beating because of low gas prices, it is likely to rebound when the price environment improves. It would be well worth considering for a company interested in acquiring a well-managed company with an impressive portfolio and a strong balance sheet – all at a reasonable price.

DEVON ENERGY

Devon Energy played a pivotal role in making production from shale-gas plays both possible and profitable; George Mitchell, whose company merged with Devon in 2002, has been credited for developing the fracing technique that cracks open these almost-impermeable formations, allowing the gas to flow freely to the surface. Continuing to improve on this technique, Devon has drilled more than 2,000 horizontal wells in the Barnett Shale, where it's still the largest leaseholder and producer. Then the Oklahoma-based independent built on the expertise it had accumulated there by establishing industry-leading positions in the Arkoma-Woodford, Cana-Woodford and Haynesville shale plays in the US and Canada's Horn River play.

"Devon's combined net-risked resource potential in these reservoirs exceeded 40 trillion cf equivalent of gas – nearly three times the size of our entire proved reserve base," the company says.

Over time, Devon also expanded into the US Gulf of Mexico, as well as internationally into diverse locations such as China, Brazil and Azerbaijan. But, in recent months, it has reinvented itself, selling its offshore and overseas assets to focus on North American onshore gas and unconventional oil. The sales yielded $8bn, which Devon is using to buy back about 12% of its outstanding shares of common stock, virtually eliminate its debt and acquire additional onshore acreage.

Devon holds interests in almost 13m acres, of which over two-thirds remain undeveloped; these assets are around two-thirds natural gas and one-third liquids, a balance that helps protect the company from commodity-price swings. It also owns gas pipelines, and processing and treatment facilities in many of its producing areas, making Devon one of North America's largest natural gas liquids processors.

The new and improved Devon Energy has emerged as a formidable competitor. As its chief financial officer, Jeffrey Agosta, says: "We ended the second quarter with cash on hand of nearly $3bn, in a net-debt to adjusted cap-ratio at a multi-year low of only 14%. Overall, we are extremely well-positioned to continue to operate our business from a position of considerable financial strength."

But prolonged low natural gas prices have taken a toll on the company's stock price, which stands at about two-thirds of its fair value. According to Morgan Stanley, Devon has the best share-price upside potential in the industry.

ULTRA PETROLEUM

Ultra Petroleum's chief executive, Michael Watford, recently described his company's strategy as: "We make money first and we grow second." That disciplined approach to value creation led to an impressive return on equity of 44% and a 19% return on capital in second-quarter 2010, despite depressed natural gas prices. The company probably has the lowest finding and development costs in the sector – about $1.29/m cfe.

While focusing first on its money-making goal, Ultra has also made impressive strides in achieving its secondary growth goal. Although the company reduced its capital expenditures from $0.95bn in 2008 to $0.7bn in 2009, production increased by 24% to a record 180.1 trillion cfe. It is targeting annual growth of 20% for at least the next three years.

That expansion will come from Ultra's portfolio of first-class unconventional-gas assets. An important player in the tight-gas trends of Wyoming's Greater Green River basin, the company has 56,000 net acres in and around the prolific Pinedale and Jonah fields, which rank among the country's top-10 natural gas plays in terms of proved reserves. At year-end 2009, Ultra had proved, probable and possible reserves of 14.6 trillion cfe in the basin, with an inventory of over 5,500 economic, future drilling locations.

The company also has a strong position in Pennsylvania's Marcellus Shale. Since 2001, it has amassed 250,000 contiguous net acres in the play's fairway, with 1,800 net possible drilling sites and 8 trillion cfe of net resource potential.

Apparently, Ultra is eyeing other opportunities for growth. Watford says: "We have two legs to our stool now, Pinedale and Marcellus, both at significant scale and size, both highly profitable. And we're going to start scratching around looking for the third leg of the stool, one that would equal the margins we have in these two core legacy natural gas assets and give us our third legacy move forward in 2013."

With plenty of growth potential, Ultra Petroleum is well-positioned to benefit when gas prices revive. Meanwhile, its stock is trading well below its fair value, giving potential investors a golden opportunity to buy a low-cost, high-quality asset at a bargain price.

Finding the right fit

While these five companies come most immediately to mind, a whole host of other independent producers are potential take-over or joint-venture candidates, including Quicksilver Resources, Anadarko Petroleum, Apache, Rex Energy, Petrohawk and Cabot Oil & Gas. But in any partnership, a multitude of factors must be taken into account, ranging from the complementary relationship between strengths and weaknesses, to the compatibility of the companies' cultures. The benefits of consolidation are clear-cut; the question is, who will connect with whom and how?

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