Industry struggles with low prices, lack of capital

With the economy in severe contraction, one mid—sized independent E&P company recently told its shareholders, “We are deferring major capital allocation for drilling our inventory of exploitation and exploration opportunities until drilling costs decline, commodity prices rebound, and/or the ability to access capital economically improves.” This is not an uncommon theme these days, and in some cases, cutbacks have been dramatic — amounting to drilling budget reductions of 75% or even more.

The impact of low commodity prices has been two—fold: cash flow has ebbed and the value of reserves has been reduced. The latter is the basis for an E&P company’s credit standing, and a lowered credit rating increases the cost of capital — provided it is available at all.

Although some analysts are hopeful the bottom of the cycle has already happened, others believe it may not come until late in the year or even sometime in 2010. If you put 20 analysts together in a room, you will likely get 20 different opinions as to when the recovery might occur and what is required to bring the energy industry back from the abyss.

And, if you think producers have it bad, oil service companies are in even rougher waters, says Marshall Adkins, managing director of Raymond James’s energy practice. He foresees a “very tough environment” for service companies for “at least the next six to 12 months.”

“Historically, service companies perform better than E&P companies in the up cycles and more poorly in the down cycles,” says Adkins. “There will be a lot more pressure on them in the coming months — a lot more strain on their balance sheets.”

Adkins, a three—time winner of the Wall Street Journal’s “Best on the Street Analyst” award, also sees an increasing disconnect between oil producers and companies that are mainly natural gas producers. “Long term, demand for oil will grow and outstrip supply. However, the fundamentals are different for gas. The poor economy has reduced demand while the shale plays have helped bring a lot of new gas to the marketplace. Companies that are heavily invested in natural gas will generally not perform as well [as oil producers].”

“Historically, service companies perform better than E&P companies in the up cycles and more poorly in the down cycles. There will be a lot more pressure on them in the coming months — a lot more strain on their balance sheets.”— Marshall Adkins, Raymond James

Adkins, who believes oil production probably peaked in 2008, sees “pretty good earnings” in 2009 and 2010 for offshore oil producers, particularly those in deepwater. He says that non—OPEC oil production will drop off significantly in the next few years, which will increase demand significantly even if the global economy fails to rebound quickly.

As stated earlier, many companies — particularly the independents — have slashed their drilling budgets in part due to lack of capital or lack of capital on reasonable terms. The consensus among analysts and capital providers interviewed for this article seems to be that banks are still pulling back, although capital markets are still open and there are some private equity deals being done. Banks that are lending have retrenched into their core customers.

In a recent interview with Oil & Gas Financial Journal’s Mikaila Adams, Quantum Energy Partners’ Wil VanLoh said, “Of the 20—plus banks we talked to recently, I would only characterize about three or four as really being ‘open for business.’ That’s pretty staggering.”

“Of the 20—plus banks we talked to recently, I would only characterize about three or four as really being ‘open for business.’ That’s pretty staggering.”— Wil VanLoh, Quantum Energy Partners

VanLoh, a co—founder and CEO of the private equity firm, added, “The second lien and term B markets are completely dead. I don’t think you can get a deal done in the private market for that right now. We’re telling our portfolio companies that they have to look at everything they’re doing right now in terms of passing their return hurdles based on 100% equity financing.”

Quantum’s $1.3 billion Fund IV is fully committed, but the firm has only “pulled down” $300 million to date, leaving $1 billion available. For now, the private equity firm will continue to “hunker down” while the industry is in turmoil.

Although there have been relatively few distressed sales of assets, VanLoh expects we’ll start seeing this happen in the second quarter.

Rivington Capital’s Christopher Wagner notes that private capital providers, like virtually every other source of capital, have experienced a significant contraction over the last five months. “Having said that, we believe good opportunities (drilling and acquisition) with strong and sound fundamentals are still attracting capital. We continue to see bright spots in the market, and I believe private capital providers will be the beneficiaries of these opportunities.”

Asked whether or not private capital providers like Rivington have adopted a “wait—and—see” attitude about investing, Wagner says, “No one wants to be early in this process only to have commodity price erosion damage future economics. As we begin to approach the commodity cycle bottom, I think you will see many more private debt capital providers get back in the market. The private debt markets are very resilient — when the high—quality opportunities come, the markets will be ready.”

Wagner says he thinks private equity is a completely different story. “Even if the private equity markets were open, few independents are excited about issuing equity in this environment. I believe most of the private equity activity over the next 12 to 18 months will be conducted through investments made by those firms prior to September’s meltdown.”

Will Franklin, recently named a managing director with Lime Rock Partners’ Houston office, says a lot of capital has been raised but that private capital firms have been “pretty busy with their existing portfolio companies.”

Franklin believes that new funds will be very difficult to raise in part because some investors feel they are overexposed to energy and are trying to rebalance their portfolios. “Companies operating in the Haynesville or Barnett shale plays will be okay, but those in the Rockies will have a harder time,” he suggests.

“The vintage funds going back to 2004 and earlier are depleted or nearly depleted, but more recent funds still have cash available,” says Franklin. “All of this will go towards equity financing, but not all will go to start—ups.”

“Institutionally, we’re pretty bearish on 2009 and don’t really expect to see a recovery until the second half of 2010. We’re in for a tough year — or longer,” he concluded.

“Selected private equity groups appear to be serious about investing private equity now, but the majority are on hold.”— Keith Behrens, Energy Capital Solutions

Keith Behrens, a principal and managing director at Dallas—based Energy Capital Solutions, is a little more optimistic. He says there is “a record amount of private equity available for upstream companies,” but these groups are generally waiting on the sidelines to see if the borrowing base season unfolds in a way that causes buyers’ and sellers’ valuation expectations to narrow.

“Selected private equity groups appear to be serious about investing private equity now, but the majority are on hold,” he adds.

Jeff Barry, director of Warwick Advisers, a Houston—based oil and gas capital consulting firm, has a somewhat contrarian view of the situation.

“People who were running in public capital markets discredited themselves with their former customers, whom they took to calling ‘counterparties’ and traded against them….Right now there is no clarity as to real opportunities and real valuations, so the money sits in cash and treasuries.”— Jeff Barry, Warwick Advisers Corp.

“A year ago, there was an enormous and disproportionate quantity of capital in the produced commodity end of the supply chain, and this was driving up NYMEX prices,” says Barry. “The quantity of capital that was focused at the opposite end, exploration and production, was relatively difficult to obtain except for a narrow segment of the sector (if you compare capital flows into various segments of the supply chain), mostly shale gas developments.”

Barry went on: “Deployment of this capital was tied in with bank financing and hedges, both of which have significantly evaporated. Many people have not psychologically adjusted to returns generated from efficient operational capabilities — not leverage. So, right now, it appears to me that people who were running in public capital markets discredited themselves with their former customers, whom they took to calling ‘counterparties’ and traded against them. And the private equity people wait for lenders to step in and leverage their investments to increase their rates of return. Now everything is constrained as people go through a new learning curve about oil and gas markets. Right now there is no clarity as to real opportunities and real valuations, so the money sits in cash and treasuries.”

Scott Kessey, a managing director in the Houston office of Rodman & Renshaw, reiterates what most private capital firms have said — an abundance of capital has been raised and some firms are “good to go,” but most are being cautious.

“People are justifiably a little skeptical right now. However, private capital has shown its ability to weather these cycles better than the public side.”— Scott Kessey, Rodman & Renshaw

“You have to be careful not to bite the hand that feeds you,” says Kessey. “Investors expect a good return on their investment, so in this environment it may be wise to wait until the dust settles before making a commitment.”

Kessey points out that some private equity deals are still being done. For example, in November, Houston—based Carrizo Oil & Gas Inc., which is publicly traded on NASDAQ, entered into a private equity agreement with Avista Capital Partners in order to acquire and develop acreage in the Marcellus shale play. Each agreed to commit $150 million, and Carrizo will serve as operator of the properties.

Carrizo’s CEO S. P. “Chip” Johnson made this comment on the deal, “This new combination of Avista’s financial resources and Carrizo’s technical strengths will allow us to expand our activities in the Marcellus shale to our mutual benefit, while at the same time conserving Carrizo’s capital for our ongoing Barnett development program through 2009. We view the Marcellus shale as one of the company’s potential core growth areas and source of future shareholder value.”

Avista Partner Robert L. Cabes Jr. added, “Carrizo’s demonstrated expertise in the exploitation of gas shales, gained during the development of the Barnett shale, along with its existing land position in the Marcellus, makes them the ideal operating partner for Avista, which has offices in New York and Houston. We believe this is an excellent ground floor opportunity and we look forward to the successful growth of this venture in the years to come.”

Nevertheless, deals such as this one have been the exception since the financial crisis struck the energy industry with full force last fall. “People are justifiably a little skeptical right now,” says Kessey. “However, private capital has shown its ability to weather these cycles better than the public side.”

Asked about acquisition and divestiture opportunities, Kessey noted that the bid and ask spread is still pretty wide, so few A&D deals are being done. However, he expects this to change starting in the second quarter. “We expect to see more motivated sellers and more opportunities,” he adds.

Interviewed during NAPE in early February, Carl Tricoli, founder and managing partner at Denham Capital Management, commented: “When you look back at what happened in 2009, the world changed in a matter of six weeks. During the fourth quarter, we decided to take a deep breath and reassess the market. Our intuition is that there are going to be some great opportunities that come out of all this chaos, so let’s make sure we have enough dry powder, let’s make sure we don’t make any mistakes.”

Tricoli added, “Hedge funds have diminished, and we all know what’s going on with the banks. However, we still have plenty of capital available. We’re excited because we anticipate more opportunities in the current economic environment. In this kind of situation, we expect to see companies that might not normally raise private capital at all coming to us.”

When will the energy industry emerge from the current doldrums?

Energy Capital Solutions’ Behrens is one of the more optimistic among those quizzed. “I believe the first half of the year will be slow, but that things will open up in the second half of the year when buyers’ and sellers’ valuation expectations narrow, which will lead to investment of some of the capital sitting on the sidelines. Commodity prices should begin climbing later this year or possibly early next year, and this combined with lower service costs that we are already seeing will lead to an economic turnaround.”

Rivington Capital’s Wagner has a more pessimistic view: “When compared to the last seven years, the private capital markets will be chaotic all year as providers weigh the cost benefit of getting into the market versus deal metrics. Generally, we believe deal activity will be down significantly for both debt and equity.”

He adds, “If there is no relief on the cost side of the equation, the energy industry needs commodity price improvement to mount a sustained turnaround….We will, at a minimum, see $60 crude and $6 gas within the next 24 to 36 months. I think that sets the stage for an economic turnaround. If we find relief on the cost side, that timeline could be truncated significantly. In reality, it will be some combination of the two working in tandem over the next 24 months that will get us there.”

As an adviser rather than a provider, Jeff Barry has a somewhat different view. He believes capital providers invested in companies with significant debt issues will have to make additional equity investments or face losing equity value in restructurings and foreclosures. He says they need to restructure and reorganize operations before the banks take action. Those with no debt issues in portfolio companies should have a “neutral but survivable” year.

Barry concluded, “I believe it will take two or three years for the oil and gas sector to emerge through price inflation from this disastrous situation.”