Is It Deal Time Again in the Oil Patch?

Published: July 16, 2006

WHEN Anadarko Petroleum announced last month that it would pay $21 billion to acquire Kerr-McGee and Western Gas Resources, shares of other domestic oil and gas producers climbed. Anadarko offered an overall premium of more than 40 percent above market price for the companies — suggesting to many investors that other drillers were undervalued and that more deals were in the offing.

“What we’re looking at is the prospect of bigger acquisitions,” said John E. Maloney, chief investment officer at M&R Capital Management.

Everyone, it seems, had a different nominee for the most likely target. UBS urged investors to buy shares of Nabors Industries. John Kilduff, an analyst at Fimat USA, cited Murphy Oil as a potential buyout candidate.

And Kurt H. Wulff, president of the energy research firm McDep Associates, who correctly predicted this year’s run-up in oil prices, named Encore Acquisition as his favorite takeover possibility.

Encore, founded in 1998 by I. Jon Brumley, the former chief executive of Mesa Petroleum, has specialized in buying oil and gas fields and coaxing more production from them. Based in Fort Worth, the company has attractive properties in the Cedar Creek Anticline of Montana and North Dakota, Mr. Wulff said, along with the prospect of improving earnings as it increases recovery rates from its wells.

But when asked if Encore had been approached by any potential buyers, Mr. Brumley replied swiftly: “No. We haven’t been approached.” Nor was Mr. Brumley convinced that Anadarko’s thrust heralded a surge in buyouts. “I feel like that’s a unique deal,” he said. “I just don’t know if it signals there’ll be a lot of deals or not.”

That is the high-stakes question: Are the Anadarko deals pricey exceptions, or do they reflect a broad undervaluation of the domestic driller industry?

One who sees the deals as an aberration — and such skeptics are hard to find these days on Wall Street — is Benjamin Dell, oil and gas analyst at Sanford C. Bernstein. “After every deal, everyone jumps on the bandwagon without actually thinking it through,” he said.

The Anadarko deal was “an expensive mistake” and did not set a benchmark for industry valuations, in Mr. Dell’s view. “Often you see a lot of M & A activity when people believe the current environment is sustainable,” he said. Mr. Dell says he does not believe that current oil prices are sustainable, but he is in the minority for now.

Bulls argue that energy stocks are undervalued because they reflect the fearful assumption that oil will fall well below its current price — which closed on Friday above $77, amid fighting between Israel and Hezbollah in southern Lebanon. “The stock prices are not reflecting the underlying commodity prices,” Mr. Kilduff said.

Oil, meanwhile, is becoming harder to find even as demand rises from China and other industrializing nations.

“It’s just cheaper to buy oil than to drill for it,” said David Dreman, chairman of Dreman Value Management. A self-proclaimed contrarian who often resists prevailing investment currents, Mr. Dreman is willing to be swept along on this wave. “I’m not a contrarian on this,” he laughed.

An exceptionally warm winter has left natural gas looking “somewhat cheap relative to oil,” he said, and he favors the stock of the Apache Corporation, which is based in Houston and has both natural-gas and oil holdings.

Mr. Maloney favors ATP Oil and Gas, a much smaller producer that is also based in Houston. At $40.62, the stock is selling at less than four times this year’s expected operating cash flow of $11.50 a share, he said. (Over the last decade in this industry, he said, more customary multiples of operating cash flow have been seven or eight.) By 2008, he added, “operating cash flow could grow dramatically” as new North Sea gas fields begin production. Mr. Maloney says he has owned the stock for over a year, initially buying in at less than $15. Since the Anadarko deal, he said, he has added “thousands of shares.”

ATP could fetch as much as $73 a share if it is acquired, Mr. Maloney said. Even without a deal, ATP is worth roughly $60 a share in his estimation — assuming that oil remains roughly at its current price.

The Chesapeake Energy Corporation, based in Oklahoma City, is also undervalued, Mr. Maloney said. At $29.47 a share, Chesapeake sells for just over four times estimated 2006 operating cash flow of $7. It could fetch $50 a share in an acquisition, he said, or about $40 without a deal — again, assuming that energy prices stay put at current levels. Chesapeake has benefited from selling its gas in the futures market at prices higher than the current $5.50 per million B.T.U.’s. “On average, they’re getting $8-plus from futures contracts,” Mr. Maloney estimated.

There has also been considerable insider buying of the stock. In June, the company’s chairman and C.E.O., Aubrey K. McClendon, bought more than one million shares on the open market at prices between $27 and $30.

Much of Mr. Maloney’s enthusiasm is based on his reading of the supply-and-demand equation. Noting the difficulty of finding new reserves “in places that are politically and economically stable,” he sees a shrinking cushion of energy supply over demand. “Everybody thinks these prices are a huge aberration and I just don’t think that’s the case,” he said.

If Mr. Maloney and other price bulls are wrong, investors loading up on oil stocks now may face serious disappointment. Michael Lynch, president of Strategic Energy and Economic Research in Amherst, Mass., described himself as “one of the last bears” and says he expects oil prices to tumble. “I think oil will be under $40 a barrel a year from now,” he said.

Prices have stayed high because of geopolitical concerns, Mr. Lynch said, but he sees demand growth as slowing. The Energy Information Administration also recently detected a slowing in global oil consumption growth, though it still expects the world to consume 1.7 million barrels a day more than it did last year. Mr. Lynch expects growth in consumption of only about 1 million barrels a day “or a little less ” over an estimated 83.7 million daily barrels last year.

Investors who stock up on presumed takeover targets face another risk: In the blur of a consolidating industry, it is often difficult to distinguish hunter from prey. Late last year, for example, Mr. Wulff speculated in an interview in Barron’s that Anadarko was a likely target — not an acquirer. Its stock has fallen since the announcement. “I’m disappointed Anadarko was the buyer,” he said. “I thought it would be the seller.”

In one sense, smaller companies are a safer bet because they are less likely to be buyers. But the smaller drillers, warned Mr. Dell at Bernstein, present another risk because they would suffer sharper declines if energy prices turned down.