Despite the current low and relatively uncertain oil price environment, which may, in fact, go lower, the Permian Basin and its sub-basins, Delaware and Midland, along with the Eagle Ford Formation, are attracting increasing interest from E&P investors and operators. Primarily concentrated in Southwestern Texas, as well as parts of Southeastern New Mexico, the region is drawing consideration from investor groups that include large-cap E&Ps, private equity-backed companies, privately-owned family-run producers, and international buyers. We believe this interest is largely driven by the lower breakeven pricing of these basins, but, more fundamentally, astute investors are attracted to the regions’ stacked pay zone plays as oil prices recover.
It has been estimated that there is approximately $100 billion backing 250+ operating and management teams looking for new investment opportunities. These conditions usually drive investors to become more aggressive and eager to deploy capital – whether by taking more risk, lowering their capital costs, or making more aggressive assumptions on future oil prices or drilling costs. Some investors are chasing deals, but many are still sitting on the sidelines while current and long-term oil prices remain under review. And yet, with all of this capital, the deal flow since October 2014 has come to a virtual standstill. Operators continue to believe that oil prices will bounce back to $75-80/bbl, and wish to use those metrics for valuation, while capital providers refuse to go beyond strip pricing, although they will accept some reductions in drilling costs or associated expenses. These contending positions have created a bid-ask spread that has led to an industry impasse in today’s oil price environment.
The Permian Basin and Eagle Ford, however, offer equity investors the additional upside of stacked pay zones. Having acreage in stacked pay zones provides potential to increase output from wells that operators have already drilled. This increases the drilling inventory and drillable acreage, and improves spacing. Operators are expecting to retain some value of production, if they choose to sell, for the future upside of their investments in unconventional plays as basins like the Permian and Eagle Ford shift to counting the drillable locations an operator has, as opposed to the net acreage position. This shift has caused their acreage to multiply and their net effective acreage position to be greater than their actual net acreage. We believe that operators with a challenged balance sheet, but with a good upstream portfolio and strong management team, are primary candidates to be absorbed by a larger operator or investors. Further, operators who can maximize the NPV of their assets by acquiring contiguous acreage across stacked plays and high-grading their operations on core development areas will be the ones who can push through low oil price cycles, such as the one we have been experiencing since the fall of 2014.
Access to multiple benches of production, combined with horizontal drilling and hydraulic fracturing technology improvements, has further driven appetite for acreage in the region. Last year, the average acreage values were selling at an estimated $10,500/ net acre for the Eagle Ford and $26,900/ net acre for the Permian’s Midland Basin. In 2014, Delaware Basin A&D activity was slower, with only a few deals transacting, with undisclosed price tags. The lower interest in the Delaware Basin is likely due to, among other factors, the non-uniform geologic setting which makes drilling and completing stacked lateral wells more challenging. However, the average transaction in the Delaware Basin through May of 2015 is estimated to be $11,900/net acre. In comparison, Midland acreage has been selling for $16,500/net acre through the same period. This year Eagle Ford acreage has been selling for $42,000/net acre, based on disclosed transaction values, with Noble Energy’s acquisition of Rosetta in May as the basis of this value.
Going forward, operators and owners will need to seek creative financing solutions as they face decreased borrowing bases and lease expirations for non-HBP acreage positions. Although the acreage acquisition cost is high in the Permian and the Eagle Ford formation, many companies are facing expiration issues for their non-HBP positions. Accordingly, some operators will have to decide between losing some of their existing upstream portfolio base versus giving up some future production upside by bringing in more development capital to continue drilling and capture leaseholds. In certain asset sales, the buyer can let the seller keep some upside production which may incentivize the seller to close the deal faster. By factoring in the potential returns at “deal close exit,” lowering the return hurdles at the per well basis and the project development levels may decrease stalled deals in the market and help close the bid-ask spread.
Investment banks, including CohnReznick Capital Markets Securities (CRCMS), are also expecting additional A&D transactions to happen this quarter as companies cut budgets and reorganize structures, while improving their operational strategy by focusing on core assets. We support the idea that the momentum in E&P M&A will increase as operators gain confidence in the volatility of oil futures in the near-term. By high-grading, operators are drilling more efficiently on a per well basis and increasing their returns on their core production wells. These wells generally have higher IP rates and lower declines than their non-core wells. Operators with questionable acreage compared to their peers, we suspect, are poorly positioned in this oil price environment. They likely will have to sell their acreage below their preferred price point, and may also need to raise equity over the next 12 months. However, some of these operators do have leverage. Companies with good acreage and positive cash positions will be winners in the current commodity price environment. Our economic analysis shows that buoyant plays to lower oil prices with breakeven oil prices in the $35-$55/bbl range are the Delaware Basin and the Eagle Ford, while the Williston Basin requires higher oil prices in the range of $55-$75/bbl to receive a minimum 10% IRR.
Article Sources: U.S. Energy Information Administration (EIA); CRCMS Analysis & Calculations
By Sam (Yinglin) Xu and Evan Turner, CohnReznick Capital Markets Securities LLC
