M & A looks hot--and energy hotter still: a number of factors coming together have M & A experts talking about a banner year, especially for the energy industry, where volatile commodity prices have spurred buyers and sellers to pair off.

This is a hot time for mergers and acquisitions. And among industries to watch for M & A activity in 2006, few are expected to be more sizzling than the oil-and-gas sector, which is riding the spikes in prices coming from events like Hurricanes Katrina and Rita and the Mideast political tensions.

Boasting two of the biggest takeover plays of the year in 2005--ConocoPhillips' $35.6 billion purchase of Burlington Resources and Chevron Texaco's buyout of Unocal for $18.9 billion--the petroleum business helped pace a global M & A climate that, according to Dealogic, hit $2.9 trillion in deal volume last year. That's the highest total since the record year of 2000, and a 38 percent increase over 2004.

As oil prices hover above $65 a barrel and natural gas fetches $8 to $10 per million cubic feet (mcf), many involved in the oil industry expect this year's M & A dollar values to overtake last year's. "We're in the third year of the biggest bull run in commodity prices we've ever seen," says Rick Roberge, the Houston-based head of energy transaction services at PriceWaterhouseCoopers. "I expect 2006 to be the best year ever," he adds, "and even if prices come down, it could spur more deals as sellers get desperate."

Adds Patrick Keeley, senior managing director and group head of energy and natural resources at Friedman Billings Ramsey in Arlington, Va.: "It's a seller's market--and the only question is who will pay the most."

It's not just oil and gas, of course. Many of the factors that are driving corporate combinations and deal-making in the energy sector are at work across a range of industries, including utilities, retail, aerospace & defense, health care and financial services. For such sectors, this year should not only equal last year's excitement, say industry experts, analysts and financiers, but it could overtake the all-time-best year of 2000, when $3.5 trillion in M & A volume was recorded.

"There's a greater degree of confidence in the international economy, and growth prospects are good," says Doug Petno, a managing director and head of energy investment banking at JP Morgan Chase. "That gives boards of directors confidence that acquiring new assets will mean growth, new products and new regional exposure. So while every deal has its own rationale and every transaction has a different motive," he adds, "we're witnessing a global phenomenon, one that is happening across many sectors."

Not every sector will prove an M & A barn-burner this year. Much of the airline industry is floundering, as a recent Standard & Poor's report asserts. Packaging companies are "hunkering down" in the face of steep commodity prices. And, following SBC Communications' $21.2 billion acquisition of AT & T Corp., the telecommunications industry is expected to be relatively dormant.

[ILLUSTRATION OMITTED]

But in the broader context, the stars are aligned for a banner year. "Today's M & A market is ripe with opportunity," is how Dan deBrauwere puts it in a recent memorandum. A division president at Bank of America Business Capital, deBrauwere cites several major catalysts for the phenomenon, including the proliferation of financing mechanisms and creative capital structures. Among key drivers:

* Wide-open debt markets. Interest rates have been rising, yet are reasonably low by historical standards. And, according to a Federal Reserve survey last October, the percentage of banks loosening their credit standards is at its highest level in 10 years, while default rates continue to decline.

* Supply and demand. Cash-rich strategic and financial buyers--such as private equity firms and hedge funds--are competing aggressively for acquisitions. In addition, many businesses have been using their cash hoards to pay down debt, return dividends and buy back stock. Having successfully wrung excess costs out of their businesses, however, such companies are poorly positioned to use their cash to generate internal growth and are on the prowl for "bolt-on" acquisitions.

* Jumbo buyouts. The sudden emergence of "mega-funds" topping $10 billion is re-configuring the deal landscape. Private equity firms are increasingly "clubbing"--teaming up on deals--which allows them to pool their experience and to spread risk and, for the first time, compete head-to-head with corporations "for virtually any size transaction," deBrauwere notes. In the first half of 2005, the Financial Times reports, private equity's stake of global M & A value rose 43 percent, and more than two-thirds of those deals topped $1 billion.

* Dispersion. Not only is M & A activity distributed across a wider variety of industries than in the past--media, telecom, technology and finance were the dominant M & A sectors during the Roaring Nineties--but geographic distribution is greater. In Europe, M & A volume shot up 49 percent in 2005 to $1 trillion, according to Dealogic; deal volume jumped 46 percent in the Asia-Pacific region, hitting a record $474.3 billion.

[ILLUSTRATION OMITTED]

In the oil and gas business, these forces are all in evidence. And they are joined by other important engines of M & A growth. Most notable is the increasing scarcity of oil and gas reserves in North America, which is forcing companies to explore not just in remote and harsh locations, like the Arctic Circle, but in politically unstable regions of the world. Further driving up prices is the petroleum thirst of fast-growing economies like China and India, which is causing many experts to reckon that price increases may be permanent.

This is especially true for natural gas, says Arthur Smith, chief executive at John S. Herold, a Houston-based industry research firm. "Natural gas prices, which had been at $2-$3 mcf for most of the 1990s, have experienced a "'step-function' increase," he says. "That means that

the price rise has not been gradual: prices have jumped--as high as $15 mcf after the hurricanes--and they have stayed up."

Noting that acquirers are paying top dollar, Smith adds: "Acquisitions are a way of life in the oil-and-gas business. Every company is looking at its competitor as a potential M & A candidate. There's an ongoing exercise in the boardroom to come up with deals that makes sense."

Competition from overseas is also playing a major role in boosting sales prices. Witness Chevron's purchase of Unocal last year. To win Unocal, it had to beat out Cnooc, a company 70 percent-owned by the Chinese government, which had issued a higher bid. In response, Chevron ratcheted up its offer and sweetened it with a higher cash component.

Although its $17 billion bid still fell $1.5 billion short of Cnooc's $18.5 billion offer--and the Chinese were prepared to go even higher--Chevron's lower bid prevailed. The political backlash in the U.S. caused the Chinese to withdraw their offer. "There was an incredible firestorm over the Chinese," says one industry observer who asked not to be identified.

"This was on the [front page] of USA Today, and it became coincident with high gasoline prices, national pride and national security. But the average American didn't realize that most of Unocal's reserves are in Asia."

Yet the deal with arguably the greatest geopolitical implications was ConocoPhillips' pricey purchase of Burlington Resources at $92 a share in cash and stock, the biggest deal in the energy industry since Chevron merged with Texaco in 2001. (The largest deal announced last year was Procter & Gamble Co.'s $57.2 billion takeover of razor-blade company Gillette Co.)

The premium paid by ConocoPhillips, the third-largest domestic energy firm, raised eyebrows across the industry, setting off fears that it could bump up prices for future asset sales, dilute stock values and pile unsupportable debt onto future acquisitions. At least one perturbed investor, Robert Marcin, the founder of Defiance Asset Management, fumed in a column on TheStreet.com that the cash-and-stock transaction was a "big, expensive, risky bet."

But executives at ConocoPhillips have vigorously defended the deal to both Wall Street and the business press. The combination with Burlington gives the Houston company access to a "long inventory of prospects" in the most promising land basins in North America, Jim Mulva, chief executive at ConocoPhillips, wrote in an email statement.

"We acknowledge we paid a full price for Burlington Resources," Mulva asserts, "but we are acquiring extremely high-quality assets." He adds that while "some people refer to Burlington as a company with 'mature' assets, we simply don't agree."

And, there is more to Burlington's assets than meets the eye, say backers of the deal. What critics overlook, says JP Morgan's Petno, is that "unlike exploring for reserves in unstable places like Nigeria, Ukraine, Venezuela or Iraq, there is virtually no geopolitical risk in North America." Petno, whose investment banking team advised Burlington on the merger, adds: "ConocoPhillips got scale, critical mass and reserves with very low risk."

Constance Helfat, an expert on corporate strategy at Dartmouth's Tuck School of Business who studies the oil industry, says that too often, investors focus only on the value of natural resources at current and projected prices but give short shrift to the talent and expertise that a firm like Burlington brings to the table. "Oil and gas is a business where a lot of different types of knowledge are useful," Helfat says. "Light crude is different from heavy crude, and extracting natural gas from new wells is different from wells that have had a run-through. So while the deal was pricey, you're not just getting low-risk reserves but knowledge. And that means the price could be reasonable."

If consumers reflexively fear that bigness equals market power--and higher prices at home and the pump--the view of at one big industrial user is that such mergers are generally benign. It takes a gigantic company to develop costly oilfields in Alberta's oil sands, says Rick Vaccari, vice president for planning and development at Sempra Energy, a big San Diego utility. Similarly, he says, only a huge operation with billions of dollars invested in capital equipment is capable of liquefying natural gas from South America, shipping it in a tanker to the U.S., processing it back into a gaseous state and injecting it into a pipeline for transmission to an end-user.

"We view things that make the supply of oil and gas more abundant as good for us," Vaccari says, "because they bring the price down."

It isn't only companies with oil and gas reserves, meanwhile, that are hot properties. Ben Guill, the Houston-based president of First Reserve Corp., a private equity firm headquartered in Greenwich, Conn., says that a stampede is on among purchasers hunting for all manner of corporate assets, especially in the "midstream" business of pipelines, transmission, storage and delivery. "A lot of mega-assets are for sale," he says, and the prices aren't cheap. "We're seeing new energy funds and some of the traditional buyout firms" entering the fray.

First Reserve, which specializes in management buyouts in the energy industry, often buys divisions carved out of several different energy companies and cobbles them together into a new concern. The firm's long experience and industry savvy typically give it a leg up when evaluating deals and negotiating prices. "Yes, they're bidding up prices," Guill says of his spirited competitors, "but the fairway is broad. There are so many different sectors, and the types of companies we buy are not on everybody's radar screen. That gives us a huge advantage."

Examples abound of companies in which First Reserve sensed value that others did not, but two recent acquisitions stand out. One is a division hived off by Halliburton Co. that specializes in well-testing services. A second is Chart Industries, a Cleveland supplier of engineering equipment and cryogenic systems used in liquefied natural gas (LNG) processes--about which Guill is especially bullish. "We understand the sector, and we think this is where growth will be," he says of LNG.

First Reserve, which currently has more than $3 billion invested in an array of holdings and boasts a 30 percent historical rate of return, is gearing up for another shopping spree. This year, says Guill, First Reserve plans to raise another $5 billion, which would be its single largest LBO fund ever.

But the firm is a seller, too, and is riding a generally bullish market for initial public offerings. Last August, for instance, the $652 million IPO of Dresser Rand--one of its portfolio companies--came off without a hitch. As the energy industry stays hot, more such transactions could be in the pipeline.

Paul Sweeney is a freelance business writer in Austin, Texas, and a frequent contributor to Financial Executive. He can be reached at 512.499.8749

RELATED ARTICLE: takeaways

* The merger arena looks to be very active in 2006 across a broad range of industries, among them utilities, retail, aerospace & defense, health care and financial services.

* The energy sector is especially hot, riding the surge in crude oil and natural gas prices. Observers expect lots of activity even if prices start to drop.

* M & A volume isn't just surging in the U.S. It reached record numbers last year in both Europe and Asia.

* Financing by private equity, including hedge funds, has boosted the markets. Some private funds are slugging it out with major corporations for deals.