A lot of money has been committed to mergers and takeovers in the oil & gas industry in just the past week.

The first deal was the $1.7 billion merger between Denbury Resources Inc. (NYSE: DNR) and Penn Virginia Corp. (NASDAQ: PVAC) announced on Monday. The next day Chesapeake Energy Corp. (NYSE: CHK) revealed an offer of $4 billion for WildHorse Resource Development Corp. (NYSE: WRD) and Thursday saw the biggest offer of all: Encana Corp. (NYSE: ECA) will pay $5.5 billion for Newfield Exploration Co. (NYSE: NFX) and assume $2.2 billion in Newfield’s debt.

Earlier in the third quarter, BP plc (NYSE: BP) paid $10.5 billion for all the U.S. shale assets owned by BHP Billiton plc (NYSE: BBL), the biggest oil patch deal of all so far this year.

What’s driving the merger and acquisition machine? One big reason is a company’s balance sheet. Smaller companies may have trouble maintaining a strong balance sheet as they continue to invest (by borrowing) in more exploration and production.

Rising interest rates make debt service from cash flows more difficult and without the scale and efficiency of a larger company, costs cannot be wrung out fast enough to maintain both debt service and increased production.

Shareholders rarely respond positively to companies that buy up other companies because they would rather see purchasing businesses maintain financial discipline in order to generate additional free cash flow that can then be returned to shareholders by means of higher dividends or share buybacks. Long-term strategic shifts, like Chesapeake’s acquisition to lift the higher-margin liquids share of its overall production, are particularly unwelcome.

According to a report in the Journal of Petroleum Technology, at last week’s Deloitte Oil and Gas Conference, Andrew T. Calder of the Kirkland and Ellis law firm told the assembled crowd:

Even the largest companies right now are very nervous about doing a large transaction because they’re scared their stock is going to get absolutely hammered. We’ve been involved in deals that have fallen apart as a result of the stock market reaction. [This is why] public companies are looking for another avenue to make these transactions that may not simply rely on going into the public markets.

Angelo Acconcia, senior managing director at private equity firm Blackstone, applauded Chesapeake and Encana for “making the right decisions.” He added:

They realize that they’re not necessarily going to get appreciated by the public markets today, but they have more information than the public markets, they have a better understanding of their business, and they’re going to make the right long-term decisions. That accountability, while negative today, will prove out to be a winning strategy.

Time will tell whether Chesapeake and Encana made the right decision. But there’s little doubt that the exploration and production business is a buyer’s market right now. Just look at Newfield’s $2.2 billion debt and estimate how much it was going to cost the company to borrow more to continue drilling.

The value of Newfield’s real assets was being stomped on by rising debt. If it slowed down its drilling program, it would have trouble making its debt payments and have to borrow even more at a high interest rate. Encana picked up some 3 billion barrels of resource for a relative song.

The other area ripe for consolidation is oilfield services. There are far too many small and medium-sized businesses and this is quite evident in the cost of capital for these companies. Citi’s vice chairman and global head of energy in the corporate and investment banking division, Stephen Trauber, told conference attendees:

[Small and medium-sized services firms] have a very high cost of capital, they’re very cyclical, and they tend to be the one area of energy that banks loath to lend to because of their cyclicality. It’s a very tough sector to lend to. It’s a sector where they’re not earning great rates of return for investors.”

On top of that, Trauber noted that these companies have a history of over-leveraging when times are good and sticking the banks with bad debt when times turn bad.

The list of small and medium-sized exploration and production companies that could be acquisition targets is probably headed by Oasis Petroleum Inc. (NYSE: OAS), which currently has a market cap of around $3.4 billion. Carrizo Oil & Gas Inc. (NASDAQ: CRZO) has a market cap of around $1.7 billion and recently closed on the acquisition of about $215 million in Delaware basin (Permian) assets from Devon Energy.

There is a long list of oil and gas companies of roughly the same size as Oasis and Carrizo, and whether or not they are acquisition targets depends largely on where the company’s assets are located, how many de-risked well locations remain, and how cheaply the estimated total resource can be acquired. Purchasers probably won’t even worry too much about long-term debt for the right property.

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