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Mega-Mergers Send Middle Market Energy Players Scrambling

Thursday, 20 Oct 2011 | 4:07 PM ET

Oil and gas companies have had a banner week.

First, Kinder Morgan announced its purchase of El Paso, making it the largest natural gas company in the US; then, Norwegian Statoilbought Texas-based Brigham Explorationfor $4.4 billion; and finally Anadarko Petroleum settled the landmark BP lawsuit for $4 billion.

While shareholders of oil giants may have cause to celebrate, smaller players, in the words of one private equity investor, "just got flanked." Mega-mergers have suddenly forced mid-sized players to reexamine their strategies.

Most are either scrambling to expand their market share, or are hoping to be the next M&A target. Either way, during a boom in US-produced shale gas, and the highest US oil production rate since 2003, the goal is to get in while the gettin's good.

Grabbing Market Share

"When you go from $40 to an $80 billion [dollar] market cap, all of a sudden the size of your projects increase. Now that Kinder Morgan has doubled in size, smaller projects will be left for the mid market companies," says Will VanLoh, CEO of Quantum Energy Partners, which provides private equity capital to the global energy industry.

The more than $25 billion in energy deals this week was driven by demand for domestic shale gas production, and the infrastructure needed to support it. This is one reason Kinder Morgan Energy Partners plans to spin off El Paso's oil and gas division, and focus on its natural gas pipeline and energy storage business.

"We love to focus on this deal, because they'll divest," adds VanLoh. "This acts as a food chain for mid-market companies to buy assets that fall off the table of these bigger mergers."

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As independent oil trader Dan Dicker told CNBC, an El Paso oil and gas exploration and production spin-off amounts to $10 billion worth of assets.

At least one other company—Esmark—would also be interested in buying those assets, says CEO Jim Bouchard. Esmark, a diversified holding company operating both steel services and oil and gas exploration, is looking to grow its oil production business by 50 percent via a planned acquisition of another oil and gas production company. Unfinalized, the deal remains undisclosed.

Ripples Up and Downstream

The general middle market reaction to the M&A news, however, is not positive. CEOs say that buying more assets right now is simply a defense against getting squeezed out of the market by giants with a larger footprint and a cheaper cost of capital.

Bouchard says this is already happening in the natural gas space.

"When the big guys put gas in the transmission line, we’ll be squeezed out. Our gas revenue will be gone, and I'm going to be down to just oil. Down the road these big players will probably continue to hurt the small independents," says Bouchard.

Because pipeline capacity for natural gas is finite, getting in can quickly become a David vs. Goliath scenario. Lately, it looks like Goliath is winning. But natural gas transmission — the act of pumping gas into a pipeline — is only one portion of a multi-part business, referred to as the secondary, or "midstream" part of the process. The first step is "upstream", when oil and gas is located and pumped to the surface.

"Upstream has become a big-player game. Its very expensive to get the gas. To do a Marcellus shale field play for example, you have to buy up to a million acres at $3,000 per acre before you put anything in the ground," says Bouchard.

The Marcellus natural gas field stretches over an expanse in Pennsylvania and West Virginia.

Effectively, much of the mid and upstream parts of the business are going to the biggest players. And this is happening at a rapid pace. M&A deals among both oil and gas companies, and energy (including natural gas) rose 13 and 8 percent, respectively, between 2009-2010, and are already on pace to rise higher this year, according to data from Dealogic.

The Middle Market - A CNBC Special Report
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The cumulative effect, according to VanLoh, is clear: "A lot of oil and gas production companies in the middle market space don't have the capital to fund these new projects."

Smaller players may, as a result, start looking downstream — the final part of the business where oil and gas is refined and transported to the consumer.

“Anywhere where you have these shale plays, there’s a lack of infrastructure to gather and process, which is creating opportunities for the midstream companies," says Don Sinclair, CEO of US midstream processing company, Western Gas Partners.

Gathering and processing opportunities do not occur upstream. Any new extraction project, however, has multiple entry points downstream. For example, processing plants must extract natural gas from the overall gas stream before it can be sold back into the petrochemical market.

Distribution jobs are also fundamental; gas must be transported from the well head to transmission lines. The question is how long these jobs will remain the on mid-market turf.

"We're seeing tremendous growth in shale development, but its still so early," adds Sinclair. "So much capital needs to be spent, and all different size companies are trying to spend that."

Though the growth in project demand is now certain, the ability of mid-sized companies to compete over the long term is not. Western Gas is very well positioned to develop midstream energy assets, because it is owned by oil giant Anadarko Petroleum.

Being purchased, as opposed to fighting for smaller projects, may be the best outcome for mid-sized players. Oil and gas, no matter how big the company, remains a lucrative sector. The price of oil is in the $80-100 a barrel range, and future expectations are bullish.

"If the economy grows over 3 percent, we'll see an oil range between $100 to $120," says Bouchard.

Typically, when growth expectations increase, that's when companies consolidate to prepare for the boom ahead.

"You'll see more and more of these mid market resource companies in the U.S. get purchased by national oil companies for sure," concludes VanLoh.

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