THIRD QUARTER 2008

After reaching a record high of $147/barrel in early July, crude oil prices fell during the third quarter and ended the quarter at $100/barrel.¹  (In mid-November oil has fallen below $60/barrel.)  The drop in oil prices was primarily attributable to reduced demand due to concerns about slower global economic growth and turmoil in the financial markets.  Additionally, the reduction of fuel subsidies to consumers in emerging market countries, such as China and India, negatively impacted demand, as fuel subsidies in these countries had reduced the effect of higher oil prices on consumers by keeping fuel prices artificially low.²  A large portion of growth in oil consumption in recent years has come from China and India.  As China continues to phase out its subsidies, however, there could be further downward pressure on oil prices.  Finally, strength in the U.S. dollar versus other developed market currencies was a factor in lower oil prices.³  The dollar strengthened as investors moved into U.S. Treasuries amid instability in the global financial system following the failure of several major U.S. financial institutions in September.

Natural gas prices also fell during the third quarter, due to a combination of increased inventories, reduced demand from U.S. manufacturers (a large consumer of natural gas), and significant production increases driven by increased drilling and exploration activities.⁴  In early July, natural gas prices reached their highest levels since Hurricane Katrina in 2005, topping $13/mmbtu.  For the third quarter, NYMEX natural gas prices averaged $9/mmbtu, a 23% decrease from the second quarter’s average price of $11.60/mmbtu.  Prices declined 45% by quarter-end.⁵  Despite hurricane damage to production infrastructure in the Gulf of Mexico in September, natural gas prices declined on concerns about decreased demand due to slower economic growth.  Continued growth in U.S. natural gas production, driven by growth in unconventional reservoirs (tight gas sands, gas shale, and coal bed methane), which has been the result of higher prices and new drilling technologies, could put additional downward pressure on prices in the coming months.

Merger and acquisition activity in the energy sector slowed during the third quarter of 2008, driven by lower commodity prices and tighter credit markets.  In total, there were 29 deals in the U.S., totaling approximately $12.6 billion in value, down from 42 deals in the second quarter of 2008.⁶  During the third quarter, acquisition activity was concentrated in the mid-continent region and involved large deals by XTO Energy, BP, and Chesapeake Energy.  Overall, lower commodity prices and tighter capital markets could contribute to a slowdown in merger and acquisition activity in the fourth quarter and into 2009.  Nevertheless, the overall environment remains favorable for small energy companies backed by private equity energy groups.  Their limited reliance on the capital markets to finance growth and their practice of underwriting acquisitions using commodity price assumptions well below spot prices should prove beneficial.  Additionally, private equity energy groups fund their management teams on an incremental basis over time as acquisitions are identified for purchase, reducing the impact of volatility in the commodity markets and the risk of putting money to work at a “peak” in commodity prices.  Finally, while recent declines in commodity prices should create more attractively priced acquisition opportunities in the upstream oil and natural gas area, the exit environment will likely slow over the coming months.     

¹ Quarterly Review: September 2008.  EnCap Energy Capital Fund.  (September 2008).

^2-4 Quarterly Energy Update.  Federal Reserve Bank of Dallas.  23 October 2008

^5-6 Short Term Energy Outlook – October 2008.  Energy Information Agency.  (October 2008).