Clear your dance card and get ready for a hectic transaction environment in 2010. Pick a dance partner carefully, however, because the emergence of natural gas shales has fundamentally changed the U.S. E&P business.

A year ago the dance floor was empty. Like a junior high school dance, the boys sat on one side of the floor and girls on the other. Music was playing, but no one was dancing. Debt and equity markets were somewhere between horribly expensive and completely closed. Banks were squeezing credit lines, and companies were hoping they wouldn’t get squeezed by the banks. Oil and gas prices had fallen precipitously. Operating cash flows were getting crushed, and in turn, operators were slashing capital programs.

The impact on U.S. A&D deal flow was severe. After a two-year run of some $45- to $50 billion in transactions in 2007 and 2008, only $5 billion in deals was announced in the first half of 2009.

Then, hesitantly, the dancing resumed. Oil prices began climbing as the U.S. recession abated. The world economy showed some positive signs, and the year ended with oil in the range of $80 per barrel. Natural gas spot prices, though not as high as many would like, were decent—$5 to $6 per thousand cubic feet (Mcf), with the three-year strip around $7. The capital markets began functioning again as the worst of the financial crisis abated. Taken altogether, the events meant burgeoning optimism for energy investments, especially as compared to most other asset classes.

First, a slow dance drew partners onto the floor, as deal flow climbed slowly in third-quarter 2009, with $4.2 billion in transactions. Then the music was cranked up, and by the fourth quarter it looked like a mosh pit, with a number of notable deals and a total $55 billion in U.S. A&D transactions.

Gas shales shake up the scene

The big deal of 2009, and the largest in the upstream since 2000, was ExxonMobil’s pending acquisition of XTO Energy in a $41-billion, all-stock transaction. This put the white-hot spotlight on U.S. natural gas shales. ExxonMobil is not an active acquirer, but it is a choosey one, both in market timing and type of deal executed. The company candidly stated its dual purpose: to acquire XTO’s shale assets in the U.S., and to acquire XTO’s expertise to create a platform for worldwide shale exploration, development and production. The deal drew notice from Washington to Wall Street to Main Street.

The story line for U.S. A&D in 2009 was the impact of the shale plays. Their vast resources offer the potential for enormous job creation and a positive contribution to the climate-change discussion. With the commercialization of the gas shales, the U.S. has moved from a nominal 10-year supply (based on proven reserves) of natural gas to what ultimately will be a 50- to 100-year supply.

This is a game-changer, affecting everything from coal to LNG imports to the Alaska gas pipeline to the climate-change discussion. It could impact oil imports through wider use of natural gas for transportation. For those who believe in peak oil, natural gas could turn out to be the answer to “where will we get the production to cover the exploding demand for worldwide transportation fuels?”

While the ExxonMobil deal grabbed headlines, there were a number of other notable deals in second-half 2009. Chesapeake Energy Corp. continued dancing with multiple partners, announcing a $2.25-billion joint venture with Total in the Barnett shale. This deal brings Total back into the U.S. onshore, which it virtually exited in 2005, and is the fifth multi-billion-dollar transaction (four of which were joint ventures) for Chesapeake in the shales. Total will earn 25% of Chesapeake's Barnett interests with an $800-million up-front payment and $1.45 billion in carried drilling.

Other large shale transactions announced in the second half include Enerplus Resources’ $411-million Marcellus shale joint venture with Chief Exploration & Development LLC and other parties; Ultra Petroleum Corp.’s $400-million acquisition of Marcellus shale interests from an undisclosed seller; and Talisman Energy’s C$570-million acquisition of Marcellus and Montney Basin (Western Canada) acreage from undisclosed sellers.

Indeed, foreign dance partners find the U.S. shales very attractive. In addition to the European and Canadian entrants in the last six months of 2009, previously announced shale deals include Statoil (Marcellus) and BP (Fayetteville and Woodford) with Chesapeake; Shell (Haynesville) with EnCana; Eni (Barnett) with Quicksilver Resources; and BG (Haynes­ville) with Exco Resources.

These transactions have occurred because, in general, mid- to small-sized public and private companies that assembled massive acreage positions have teamed up with larger companies that generally missed the land rush. Or, current shale owners have wanted to monetize some of their acreage while trading down risk. The larger entrants have the balance-sheet capacity and, in many cases, offer more in-depth technical services than the smaller shale operators possess.

Joint-venture structures have emerged as the deal of choice because they allow the parties to share execution risk as well as gas-price risk. With both world-class finding and development costs (nominally $1.35 to $1.75 per Mcf) and world-class resource sizes (ultimately greater than 500 trillion cubic feet), the shales have attracted worldwide attention.

Funding the Dance

The need to raise money to develop shales has driven conventional deal flow as well. Shale-focused companies are selling conventional assets in order to fund capital programs, and thus have been the early sellers in the reopening of deal flow. Sellers’ perspective is that shale returns will be superior to those for conventional assets, and the financial markets are rewarding shale-focused equities.

Buyers’ perspective is they can complete acquisitions for a decent price, add reserve and operational upside, and perhaps enjoy future commodity-price upside as the U.S. and world economies improve. In addition, some buyers are playing conventional assets for a contrarian approach away from the shales.

Deals involving conventional assets include Petrohawk’s sale of its Permian Basin assets to Merit Energy for $376 million; and Exco’s sale of Midcontinent assets to Sheridan Production Partners for $530 million, Appalachian (non-Marcellus) assets in Ohio and western Pennsylvania to EnerVest and EV Energy Partners for $145 million, and various Oklahoma and Texas assets to Encore Acquisition for $365 million. Other deals: St. Mary Land & Exploration Co.’s $130-million sale of Rockies assets to Legacy Reserves LP and Forest Oil Corp.’s sale of Permian assets to SandRidge Energy for $800 million.

One of the biggest announcements of second-half 2009 was Devon Energy’s decision to transform itself into a North American onshore resource company by divesting its entire shelf and deepwater Gulf of Mexico portfolio and its international assets in Brazil, Azerbaijan, China and elsewhere. Shortly thereafter, the company agreed to sell three of its deepwater Gulf of Mexico development projects to Maersk Oil for $1.3 billion. At press time, two of those proposed deals had been preempted by the partners in the fields.

Selling conventional assets to fund shale development will continue. Tremendous amounts of capital are needed to develop the shales. In the Marcellus, just to drill 20,000 acres to 80-acre spacing for development costs $1 billion; in the Haynesville, it requires $2 billion.

With companies’ acreage positions in the hundreds of thousands of acres, the huge capital investment required is far more than what is available from operating cash flows and the public and private-equity markets—hence the need to sell and/or joint venture. Developing the shales will require more than $1 trillion; if the development occurs over 30 years, an annual average of $35 billion.

Dancing to a Different Tune

What makes this such a great business is that there is more than one tune to dance to, not every company is a shale player, and a contrarian can also do very well.

Denbury Resources has completed notable deals in pursuit of a unique approach. The company sees great strategic value in CO2, both for enhanced oil recovery (EOR) in oil fields and in recovery of CO2 from industrial sites. It has backed its strategy with a $4.5-billion cash and stock merger agreement with very oily Encore Acquisition Co. In addition, Denbury acquired Conroe Field from Wapiti Energy for $410 million in cash and stock. Finally, fulfilling a real contrarian approach, Denbury sold its remaining 40% stake in Barnett shale assets to Talon Oil and Gas for $210 million, having earlier in 2009 sold the other 60% to Talon.

Other compelling deals in the second half include Hicks Acquisition’s purchase of Resolute Natural Resources for $534 million to form publicly traded Resolute Energy Corp., and Energy XXI acquiring the Gulf of Mexico shelf portfolio of MitEnergy Upstream (Mitsui) for $283 million. Energy XXI already operated the vast majority of these assets.

Banks and Bondholders

With the combination of plunging commodity prices and closed financial markets, a few companies facing distress were forced onto the dance floor by banks and bondholders. In total, the amount of distress in E&P was less than originally anticipated when the financial markets bottomed in March 2009. Energy investments were among the least worrisome asset classes for the banks, with hard assets behind the loans and optimism that higher commodity prices would return. Nevertheless, some companies were forced into Chapter 11 or restructured/sold outside of bankruptcy.

Buyers paid close attention to these distressed firms and sought assets to complement their ongoing strategies. Newfield Exploration Co. and Anadarko Petroleum are jointly acquiring TXCO Resources’ Maverick Basin assets for some $310 million. Jones Energy was the successful bidder for Crusader Energy’s assets for $289 million. Mariner Energy bought Edge Petroleum’s assets for $215 million. El Paso acquired the E&P unit from Flying J for $104 million, and Alta Mesa plans to acquire Meridian Resource Corp. for $122.8 million.

Keep on Dancing

As we head into 2010, the dance floor is already crowded with transactions and will soon be packed. Big asset sales are under way, such as ConocoPhillips’ $10-billion program, including the sale of about 10% of its U.S. portfolio. Other companies will follow suit and sell noncore assets to clean up their portfolios and/or raise money for shale and other capital-intensive programs.

The U.S. shales will continue to make a huge impact on the A&D market. Joint ventures will also remain popular, driven by buy-side demand from larger companies seeking shale entry, and acreage holders seeking to lay off capital commitments, partially monetize large land positions, and gain technical expertise.

With improving equity markets, the initial public offering (IPO) market should become active, as investors view the oil and gas asset class favorably. The IPO route may also offer a different type of exit for private-equity-backed companies, which historically have sold to serial acquirers Chesapeake, XTO, Newfield and others, and which are now completely focused on the shales.

Keep your dancing shoes handy and your dance card flexible. The year 2010 will be an exciting one for transactions, offering significant opportunity for both buyers of and investors in oil and gas assets.

William A. (Bill) Marko is a managing director in energy investment banking at Jefferies & Co. Inc., Houston.