Energy sector attracts investors despite credit crunch

The US subprime lending crisis has erased billions of dollars from the balance sheets of many of the world’s biggest financial institutions, but investment capital remains widely available to US oil and gas companies. Skittish investors are increasingly fleeing risk and viewing the oil and gas space as a safe haven.

In addition, the growing focus on global warming is attracting investors’ attention to renewable energy and carbon trading.

In the midst of roiling financial markets, alternative and traditional energy sectors appear to be robust.

Lending to the oil and gas sector was strong throughout 2007, even in the second-half, when fallout from the subprime debacle first appeared and began to tighten credit markets.

“The oil and gas sector was somewhat isolated from the credit crunch on the back of strong industry fundamentals, so there was not that much of a slowdown on second-half 2007 numbers,” said Diana Diquez, senior market analyst at Reuters Loan Pricing Corp. Loan volume in 2007 exceeded the record set in 2006.

“Some deals did suffer the effects of investor pullback and had to be reworked to clear the market,” Diquez noted.

Loan volume in the first quarter of 2008 is holding up, she told us. “So far this year the oil and gas sector is not doing too badly in terms of loan issuance, and volume for the first quarter might not be too far from first quarter’s almost $30 billion of issuance. But last year’s first quarter was the one that saw the lowest quarterly loan volume.”

While the subprime fallout has had a wide-sweeping impact on all sectors of the US economy, oil and gas companies are less affected by what’s going on in the marketplace, CIT Energy’s Larry Derrett commented. Derrett, managing director at CIT, said many industries have been affected by the subprime lending debacle. “Underwritings and placements totaling more than $150 billion are waiting to go to market, but because of a lack of liquidity, they’ve been sidelined.”

Regarding oil and gas, investors are more willing to play and deploy capital. “We have robust pricing in the business today,” Derrett told us. “For so many financial institutions, the oil and gas space represents a big commitment. Relationships with clients have been in place for years. Investors know that if they’re not playing in the market today, clients won’t let them play tomorrow.”

Headquartered in New York, CIT has a market capitalization of $4 billion and manages over $80 billion in assets. CIT ranks among the top 10 Lead Arrangers in the traditional middle market, $0 to $100 million, according to Reuters Loan Pricing Corp.

In the energy space, CIT is an independent finance company that arranges and underwrites financial solutions for clients across the entire capital structure.

“The energy sector is awash with liquidity,” Derrett said. “Lenders might have raised pricing, or the terms under which they offer financing might be more stringent, but producers who have solid transactions can find investors.

“Especially in the area of small caps, availability hasn’t been too adversely affected,” he continued. “Whether provided by banks or private equity, there is an abundance of funds for small producers. That’s not just because oil is at $100/bbl. Many of their investments were attractive when oil was $70/bbl.

“CIT can play all across the capital structure,” said Derrett, who eyes small and mid-cap producers. “Small producers have come to CIT Energy. They see the value in our ability to provide all types of capital. Typically, a small producer might need a 1st lien revolver, which can be available at a commercial bank. Not so necessarily for 2nd lien term and mezzanine loans and equity. We can provide financing all across the capital structure. This has helped us tremendously in the market.”

Last year, CIT Energy was advising and financing a former executive of a major oil company who was entertaining a start-up acquisition with equity financing from an equity provider and a debt underwriting from CIT Energy. Five days before closing, the equity provider bowed out. The CIT Energy team flew to New York to work with CIT’s risk management group and obtained approval for a bridge loan in one day. The CIT Energy team’s effort enabled the deal to close as scheduled.

Wall Street writedown

Last summer, major retail and investment banks – Merrill Lynch, Citigroup, Morgan Stanley to name a few – began reporting billions of dollars of losses associated with subprime lending. That prompted the first of many responses from the Federal Reserve. Accompanying a 50 basis point cut in the discount rate was a statement from Chairman Ben Bernanke cautioning that persistent upsets in mortgage markets could further weaken the housing demand and have “implications” for the broader US economy.

After eight months, nine rate cuts and three term fund auctions by the Fed and a $150 billion stimulus package from Congress, matters are worse, measured not just by continuing reports of subprime-related losses.

“You can’t have a major dislocation in one area of the credit market and not have an impact in other areas,” said Sterling McDonald, CFO at Houston-based Evolution Petroleum (NYSE:EPM). “It’s moving beyond the mortgage market into the muni market, and it could go elsewhere. It hasn’t moved to oil and gas, but it could.”

Evolution Petroleum Corp., which began operations in 2003 as Natural Gas Systems Inc., is a $140 million, small cap oil and gas production company. Evolution Petroleum acquires known resources and is actively engaged in multiple development projects for EOR, horizontal drilling of bypassed resources and unconventional gas resources.

Principal assets include the 13,636 acre Delhi Field Holt Bryant Unit in northeast Louisiana, which has already produced 190 million barrels of oil through primary and secondary recovery methods and is being redeveloped using CO2 injection. The company projects there is another 210 million barrels of oil in place.

Evolution Petroleum expect that net cash flows, current working capital of $20 million and cash flows from the Delhi CO2-EOR project will be used to fund its Giddings Field bypassed resource development, unconventional gas development, and new projects spanning all of the company’s initiatives.

“We have no debt, and we’re using our flush working capital to seed our projects,” McDonald said.

But most small caps need money, he commented, and if investors become more worried that small and micro-cap companies could be denied credit, their equity prices could suffer.

“Fortunately, we’re not in that position,” he said.

“The energy sector is awash with liquidity.” – Larry Derrett, managing director, CIT

Large company deals have already faced a pullback in line with the general slowdown in private equity from the peak period of 2006 and early 2007.

“Seven of the top ten private equity deals in history took place in that time period,” observed Jon McCarter, partner in the Transaction Advisory Services Group at Ernst & Young’s Energy Center. One was an energy deal, the $13.5 billion Kinder Morgan leveraged buyout, which included more than $12 billion in debt.

That deal would face a far different environment today “The credit crunch, which started in the third quarter 2007, has impacted private equity dramatically, especially, the mega-deal.

“Because debt markets have tightened with the credit crunch, deals with over $1 billion in leverage have stopped,” McCarter observed. “Banks that fund buyouts typically would securitize that debt to large institutional investors, but since the credit crunch, banks still have much of that debt on their balance sheets. Buyers of that paper have become much less active.

“In June of 2007, before the credit crunch, more than $400 billion in financing was scheduled for pending transactions. Only about one-third was ever sold to investors. Many deals were canceled because of financing difficulty, and more than $200 billion remains unsold to the market. Until that works itself through, mega private equity deals won’t be back in a significant way. When they do come back, activity levels are not likely to approach the recent peak, but will be more like those in 2004 and 2005.”

“The M&A market, the debt market, they all have cycles. We saw the peak in 2006 and early part of 2007. Now we’re seeing the other side of the market for private equity.”

In contrast, private equity financing in the energy sector is still active, especially for deals involving $300 million or less. “Regarding E&P, oil prices are very high, and those deals aren’t reliant on debt. Most investors aren’t comfortable combining commodity risk and debt. Instead of backing LBOs, private equity now finds management teams that have previously built an E&P company and gives them money to replicate past success. Those deals involve less debt, and we’re seeing them all along the oil and gas sector,” McCarter said.

It’s not only banks and institutional investors that are rethinking strategy in the new credit climate. Hedge funds have also been impacted, said Peter Fusaro, chairman and founder of Global Change Associates.

Fusaro is also a co-founder of the Energy Hedge Fund Center, which now tracks 631 energy hedge funds.

“We have seen some pull back on capital from existing funds due to the subprime market,” Fusaro told us. “We have seen closures of several funds due to poor to negative returns last year. We are seeing more pull back on commodity hedge funds. Regionally, we are now seeing more commodity fund launches in Europe as opposed to the US. That might be temporary.”

Global markets watch the US economy

Fed Board member Fredric Mishkin said as recently as March 4, “The US economy is facing substantial challenges. The housing sector continues to weaken, production and spending in other parts of the economy have decelerated, the labor market has softened noticeably, and the turmoil in financial markets has led to a reduced availability and a higher cost of credit to many households and businesses.”

Gross domestic product rose only 0.6% in the fourth quarter, Mishkin told the National Association for Business Economics (NABE), adding that the economy has “relatively little” momentum in the first quarter. In addition, inflation pressures have emerged, partly the result of rising crude oil prices, he noted.

“Bank capital has continued to flow to oil and gas since the credit crunch.” – Jim Allred, head of US Oil & Gas, Societe Generale

In a separate survey of NABE members, more than half said they view the combination of subprime loan defaults and excessive indebtedness as a threat to the US economy. The 259 members responding also indicated growing concern about capital markets.

“Because debt markets have tightened with the credit crunch, deals with over $1 billion in leverage have stopped.” – Jon McCarter, partner, Ernst & Young’s Transaction Advisory Services Group

Ironically, in March of 2006, when oil prices were $77/bbl, 23% of respondents counted energy prices as a threat to the US economy. With oil currently around $100/bbl only 5% say energy is a threat.

Neither recession fears nor credit market tightening appear to be curtailing bankers’ commitment to oil and gas lending.

Although the credit market is very tight in general across all industry groups, that’s not the case for energy, according to Jim Allred, head of US Oil & Gas at Societe Generale.

“The investment outlook continues to be good entering the first week of March 2008, Allred said, repeating a message he has been sounding since December.

“Bank capital continues to be available to the oil and gas industry,” he stated unequivocally. “We would expect to grow our commitments to the oil and gas business in 2008. “If there is an impact on the energy sector from the subprime shakeout, I haven’t seen it yet. It has not affected the capital flow to oil and gas.”

Allred doesn’t discount the seriousness of the subprime debacle. “It’s gotten bigger than I expected,” he acknowledged. “The impact, however, is being felt in sectors outside oil and gas,” he explained. “Pricing is a little less favorable to our clients, but bank capital for the industry is still growing. For other industries, bank capital is growing at a slower pace than for oil and gas.”

“There are no better investment opportunities than in traditional oil and gas, and in that space, it’s hard to beat the United States of America.” – Cameron Smith, founder, COSCO Capital Management LLC

Since news of the subprime debacle rippled through Wall Street, loan volume for the oil and gas sector has grown at nearly twice the rate of capital available to other sectors. “Bank capital has continued to flow to oil and gas since the credit crunch,” Allred observed.

Some types of loans, though, aren’t widely available as a result of credit tightening. Equity bridge loans, for example, have rarely been made since the mortgage mess emerged. In the past, it was common to find bridge loans that exceeded the net present value of oil and gas assets. The current flight to quality is restricting those loans, if they can be negotiated, to a level less than the net present value of acquired properties.

Oil and gas banks have supported producers for decades, and it’s easy to see why, Allred continued. Banks lend on cash flow projections, and the projections have rarely if ever looked better, thanks in part to commodity prices being so strong.

“In the case of oil and gas, prices have risen dramatically in the past six to eight months. That has bolstered our client’s cash flow,” he said.

The investment climate is such that Societe Generale has closed on a number of deals in just the last few months. For example, Allred and his team funded Abraxas Energy Partners’ $140 million acquisition of oil and gas properties from St. Mary Land & Exploration. Societe Generale acted as sole lead arranger and administrative agent on this financing transaction.

It’s not just the traditional E&P plays that appeal to investors. “We are seeing a shift of capital to the green financial markets,” said Global Change Associates’ Fusaro. “We see more fund launches particularly in alternative energy, cleantech, weather, water, forestry and carbon. Particularly carbon funds which are starting to scale. Many of these funds are also trading the energy commodity complex.”

“When you have $100/bbl oil, get out there and drill it!” – Tim Rochford, CEO and co-founder, Arena Resources Inc.

In February, three top financial institutions unveiled climate change guidelines for advisors and lenders to US power companies. The Carbon Principles were developed by Citi, JPMorgan Chase, and Morgan Stanley in consultation with environmental groups, Environmental Defense and the Natural Resources Defense Council, and power companies American Electric Power, CMS Energy, DTE Energy, NRG Energy, PSEG, Sempra, and Southern Co. The banks noted it was the first joint consultation with power companies and environmental groups to develop a process for understanding carbon risk around power sector investments.

Separately, US and European institutional investors attending a United Nations-led conference agreed to invest $10 billion in clean technology over the next two years. Some 50 investors managing over $1.75 trillion in assets endorsed the plan, which will also analyze the impact of long-term carbon costs in the range of $20 to $40 per metric ton of CO2 on carbon-intensive investments such as new coal-fired power plants, oil shale, tar sands, and coal-to-liquid projects.

Greening the oil field

With the investment community setting the pace, more pressure will fall on the next US president, whether Republican or Democrat, to address global warming. Evolution Petroleum CFO McDonald hopes the next administration will move energy policy beyond the usual debates over offshore drilling, ANWR development, and vehicle fuel economy standards and create a climate that encourages investment in advanced oil production technologies that also help the environment.

“We have a valuable tool at our disposal,” he said. “About half the oil still sits in the reservoirs of abandoned or marginally producing fields. There are mature fields all across our country that are amenable to enhanced oil recovery methods. We have a tremendous opportunity to go back after that, especially through CO2 floods, but we’re constrained by the amount of CO2 that’s available.

“If the government is worried about the greenhouse CO2 gas that’s in the atmosphere, they should sequester it and let us put it to work increasing domestic oil production. Increasing oil production domestically and helping the environment worldwide…that’s a supersized whopper of a policy,” McDonald said.

Money is lining up for renewable projects, Ernst & Young’s McCarter confirmed. “There are debates on whether those projects will be successful, whether they will be able to move the needle on expanding supplies, whether they will be economically viable in a low-energy price environment, but even with those uncertainties, very smart people in private equity and M&A are looking at all sorts of projects—biodiesel, coal-to-liquid, wind, solar, and to a lesser extent, ethanol. There is more money looking to be put to work than I’ve ever seen.”

Investors are no doubt aware of the greening of the energy sector, but for many, activity still centers on traditional E&P companies. COSCO Capital Management LLC founder Cameron Smith admits he “considers alternative energy projects all the time.” But Smith is hard pressed to find anything better than oil and gas, and he predicts the subprime shakeout will have very little impact on private capital available to oil and gas, particularly from long-term equity investors.

Smith could think of only one fund out of the sixty COSCO monitors which has been impacted by the subprime events, and that’s on account of its funding source, a hedge fund, having made too many bets outside the energy business.

“There’s no shortage of private capital available for investment in energy,” he continued. “There’s as much today as there was six months ago and 20 times what there was five years ago.”

COSCO has an ownership position in 20 exploration and production companies and funds in the US, Canada, and Australia for which it has helped secure financing. Since 2000, the company has raised more than $1.7 billion through private placements, two-thirds of that as venture capital for private E&P start-ups in North America.

Most recently, COSCO arranged a $40 million private placement of equity for Lake Ronel Oil Co., in Tyler, Texas, investing a half million, itself, in the deal. The financing, which closed in January, linked a single professional investor to fund the decades-old, family-run, private company’s E&P operations.

COSCO will soon report full-year 2007 results of its Private Capital Energy Index, a summary of capital-raising and investing activities of a select group of 23 private capital providers. Data for the first-half of 2007 show the firms had originally raised $23.7 billion, principally in closed-end funds that were still active and had more than $14 billion still available for investment. The amount raised in the first six months of last year was almost as much as in the 12 months of 2006, and COSCO suggested 2007 could be a another record-breaking year for private placement.

“In fact, the subprime issue creates even more opportunities for the long-term, serious investors in the business. The most important indirect sources of capital for the energy industry—institutional investors like endowments and pension funds—will continue to seek investment in any of the traditional closed-end funds that come to market.

“We have no debt, and we’re using our flush working capital to seed our projects.” – Sterling McDonald, CFO, Evolution Petroleum

Will COSCO be active in 2008? “You bet!” Smith stated. “There are no better investment opportunities than in traditional oil and gas, and in that space, it’s hard to beat the United States of America.”

The impact of high commodities prices is mixed, he observed. High oil prices have drawn investment interest to oil and gas companies, but robust operating results have made oil and gas producers a lot more independent.

“The downside of higher cash flow for investors is that producers don’t need more outside capital,” Smith said. “The upside is more opportunities become available for drilling, and oil and gas companies can never resist expanding their budgets!”

Arena Resources Inc. (NYSE:ARD) is one such producer, oriented toward expansion and independent in almost every sense of the word. Last year, Arena Resources conducted a registered direct stock offering, which raised about $100 million. Some of the cash was used to reduce debt, the rest to accelerate the capital budget, $116 million last year.

The company has a $150 million credit facility and a $100 borrowing base, based on operating data for the year ended 2006. “We anticipate the borrowing base will increase to $150 million based on year-end 2007 statistics,” CEO and co-founder Tim Rochford told us. When the 2007 data are finalized, Rochford expects production will have increased 47% to 1.57 million boe (barrel of oil equivalent) and reserves will have increased 32% to 55.4 million boe. Future net revenues before income taxes discounted 10% (PV-10) will have more than doubled, from $848 million in 2006 to $1.95 billion in 2007, a figure based on $88.89/bbl oil and $8.74/mmcf gas.

Rochford attributes those gains to “commodity prices that are up substantially” and “growth in reserves and production.” The CEO hopes to make similar gains this year, with a projected $218 million capex budget aimed mainly at accelerating development on their Permian basin assets, and in particular, their Fuhrman-Mascho property (22,000 acres) in Andrews County, Texas.

“We have three rigs running, two company-owned and one on a contract basis,” Rochford said. “We will spend $195 million to $200 million and drill about 220 wells this year.”

Cash flow is expected to be $150 million in 2008, nearly $70 million shy of the capex target. How will Arena Resources cover the shortfall?

“The credit facility,” Rochford answered. “We have $60 million useable on our existing borrowing base, and we anticipate the borrowing base will increase. We could accomplish our projects with the existing credit facility and cover the shortfall.

“There are also equity markets,” he continued. “We’re not shy of raising equity. We anticipate a bullish atmosphere led by bullish commodity prices. There’s plenty of opportunity if we chose to go that route and raise equity.

“If necessary, we could scale back our capex to $150 million, turn back our contract rig on 30-days notice and still provide bullish growth managed by cash flow only. But when you have $100/bbl oil, get out there and drill it!”

Then there is the stock market. “We’re only willing to issue more shares if we can bring back value multiple times over to make up for the dilution,” Rochford cautioned.

Rochford previously demonstrated his considerable public company experience as co-founder in 1989 and president of Magnum Petroleum Inc. (ASE:MPM). Magnum merged with Hunter Resources in 1995 to form Magnum Hunter Resources (NYSE:MHR), where Rochford served as chairman for two years.

Magnum Hunter Resources was subsequently acquired by Cimarex in a $2.1 billion deal in 2005.

Will Arena Resources be another Magnum Hunter?
“Time will tell,” Rochford said.