Three reasons why energy M&A is surging

October 27, 2010, 6:26 PM UTC

Deal activity in the U.S. oil and gas sector is going gangbusters. Here’s why.

KKR yesterday announced that it has sponsored the formation of RPM Energy, a new platform that will partner with exploration and development companies in the “unconventional resource” space (read: shale). Not only is this the latest in a series of oil & gas deals for KKR, but also is part of a much broader M&A trend.

According to data from Thomson Reuters (see below), there already has been $196 billion of M&A in the U.S. power and energy sector this year. That’s significantly more than the dollar volume for 2008 and 2009 combined (YTD), and is higher than the year-end totals for five of the past nine years. If the 2010 pace is maintained, then this could become the second-busiest year for such deals in history (just behind $260 billion in 1998).

The private equity-sponsored tallies aren’t quite in record territory, but that’s only because of a pair of record deals in 2006 (Kinder Morgan) and 2007 (TXU). If you pull out those transactions – yes, an admittedly specious data exercise – then PE-backed dollar volume in the sector is topped only by 2006 (on a YTD basis).

To learn what’s driving all of this activity, I rang the heads of energy investing at a couple of large private equity firms. They basically identified three macro trends:

1. Crude price equilibrium: Remember all that talk about oil price volatility, with barrels going for around $30 in 2002 and over $125 in 2007? Well, the price actually has settled into a steady groove over the past year – hanging out in the $75-$85 range. This seems to be a place where both buyers and sellers feel comfortable.

“Sellers got scared when prices went below $50 per barrel, and buyers didn’t want to touch anything when prices were above $100 per barrel,” said one of the execs. He added that the perfect calm could be broken if prices dip below $60 or rise above $90 (which they did, briefly, in April).

2. The rise of unconventional resources: If you’ve been reading Fortune lately, you know that the American power industry has gone gaga over shale, a plentiful type of sedimentary rock that houses a ton of natural gas. It used to be thought that shale was too dense to be drilled, but a horizontal hydraulic drilling process called “fracking” seems to have solved that problem.

Not only does shale represent opportunities for direct investment in exploration and gathering companies, but also for the variety of infrastructure plays that serve such companies. One buyout exec estimated that around $10 billion of new infrastructure per year is needed to support the burgeoning shale market.

One downside here is potential regulatory restrictions. The government has basically played catch-up on fracking, which has raised some environmental hackles due to its alleged potential for contaminating well water (the reality of such contamination is hotly contested on both sides). But, so far, investors are valuing profit potential over potential cost increases.

3. Global energy demand: The more economies grow, the more energy they require. So if you believe that Brazil, China, India, etc. are going to keep rising, then U.S. energy producers have a growing market to which they can export.