Clay Brett is a partner at Baker Botts and a leading authority on private energy investment.
Valuations across major basins are experiencing a very divergent bifurcation as value rushes back toward high-quality undeveloped properties. Geographically, while activity is ongoing in the major non-Texas basins, the Permian and the Eagle Ford offer a clear valuation premium independent of the mix of developed and undeveloped inventory.
Across basins, in both public and private M&A, the market is very clearly placing a premium on undeveloped locations, and the anxiety of the publics with respect to their depth of inventory is palpable. As a result, companies and asset packages in the major basins with significant undeveloped upside are enjoying a seller’s market and would be expected to trade way north of proven developed producing (PDP) PV-10 value, with the excess value attributable to acreage.
In contrast, wellbore and low-to-no-upside deals still trade at a deep discount rate, as buyers must cleave all their base case return from declining production value. Facing a subscale buyer, prices will suffer from the buyer’s diseconomy of scale and an internal equity return hurdle in excess of 20%, which manifests itself in the bidder’s PDP discount rate. As a result, scaled PDP buyers with a low cost of capital balance sheet, utilizing a borrowing base or securitizations, continue to enjoy a significant advantage.
What some may call a bifurcation in value, others may simply call a PUD (proven undeveloped reserves) premium, although one struggles to find a consistent discount rate applied to PDP. These developments have created a number of interesting deal dynamics to note:
- The allocation of value across the properties under a production sharing agreement becomes a highly material transaction item, shifting from its typical role as a ninth inning schedule delivered by the buyer, and allocation of value can become disruptive to a transaction if the allocation a seller suggests may be able to obtain a more interesting valuation for its undeveloped properties elsewhere.
- Significant value allocation to proven undeveloped reserves (PUDs) also creates more complexity to the operation of tag-along and preferential rights, and the consummation of transactions including of tag and preferential rights, leading buyers deeper into diligence to identify these material issues earlier than usual , with more flexible financial resources and deal strategies to accommodate them.
- Acquisition financing has resurfaced to become a very popular way for credit funds to participate in the market, particularly in PDP-heavy transactions, as the entry point on PDP collateral has remained relatively cheap. Alternative financing is generally as freely available and competitive to E&P as it has been in recent cycles, as a preponderance of financing sources compete to deploy capital into the current interest rate environment.
- Market practices regarding bring-down title thresholds between acquisition financing players (PDP-based) and buyer-borrowers (PDP + PUD) are divergent, where the buyer-borrower will have a higher scope of defect in a production-sharing agreement (PSA) title defect mechanic (and thus more sensitive closing defect threshold) than the closing conditions to the acquisition financing, which will require verification of a threshold level of PDP value (85%-90%).
- Financing covenants lag behind M&A market practices in the covenants’ lack of value attribution to undeveloped properties, suggesting that credit participants will be forced to become more aggressive and flexible to keep up in the marginal market for partial monetizations.
- Good title to undeveloped properties becomes a new source of risk to sellers and buyers as the land function has been de-emphasized at some E&Ps over the last decade in favor of an as-needed, when-needed focus on drill-site title opinions. Sellers must attend to their land values ahead of a sell-side process to present a clean picture of undeveloped leasehold.
- The technical methodology of reserve engineering firms to limit PUD attribution to immediate adjacencies to existing PDP wells does not reflect market valuation practices and may serve an obfuscating purpose in a deal context. The market is clearly laying down locations across the observable reservoir and the market is paying for these locations regardless of reserve classification, calling into question the role of third-party reserve reports as a bedrock valuation framework for both M&A and financings.
- Representation and warranty insurance continues to be a popular means of addressing post-transaction risk, but it is more difficult to satisfy due diligence requirements in a transaction with large undeveloped value attribution, as the scope of diligence to satisfy an insurer may be more extensive than prevailing industry practices.
We traverse through 2024 with green shoots of global industrial activity, creating a tailwind for oil prices that should continue to drive M&A activity generally. A long-term WTI curve above major basin breakevens remains very strong for both acquisition and development activity. The structural logic behind the developed/undeveloped divergence does not show any sign of abating today, and many believe that only another sharp cyclical collapse or a sea-change in the near-term role of hydrocarbons would cause the market to recalibrate in a way that obviates this divergence. All signs point to market strength and sustained transaction trends of the nature discussed here.
