Macquarie experts scrutinize industry

The lower oil price environment has already begun to alter the supply and demand dynamics in that market. Some producers are becoming stressed, increasing the need for structured financing solutions. Other projects are becoming more attractive, which results in new customers looking for the products and services which we provide. Our business is well positioned to capitalize on opportunities such as these as the market continues to change.

We believe, once prices settle down a bit, companies will start transacting again and there should be quite a bit of M&A activity that will lead to attractive finance opportunities. Additionally, we are already seeing some relief in capital costs that should result in more drilling activity soon.

OGFJ: As a large international bank that is in multiple industries around the globe, is Macquarie better insulated against a down market than certain regional banks that focus mainly on oil and gas?

We are also diversified by geography - we've 28 offices around the world - and the diversity of our operations, combined with a strong capital position and robust risk management framework, have contributed to our firms' 45-year record of unbroken profitability.

OGFJ: Macquarie's energy trading operation is impressive. You are ranked as the third largest trader of natural gas in North America, behind only BP and Shell. Could you give our readers a brief overview of what Macquarie trades and how many traders you have? Is this your only energy trading floor, or is energy trading activity going on elsewhere as well?

O'KANE: The firm participates in markets covering all major energy commodities, including oil and refined products, natural gas, and power. We have more than 275 front-office employees, many of whom have specialized expertise in areas such as meteorology, engineering, and logistics. We have a global presence, spanning 10 offices with major hubs in Houston, London, and Singapore.

OGFJ: This business is obviously seeing a lot of activity and changes in the energy landscape, due in part to the development of new drilling technologies and completion techniques in tight oil and gas plays. Oil and gas markets are known for their volatility. What does this mean for clients and managing their risk?

O'KANE: In an uncertain price environment, adequate risk management can make or break a project, or even a company. Our product offerings allow clients to protect themselves from risks inherent in these industries, and our physical capability allows us to structure solutions in unique ways that are ideal for energy exposed clients.

BECK: We hedge as much of the price risk as we can in most of our project finance and stretch debt transactions. That has hugely benefitted our clients of late.

OGFJ: Paul, you are responsible for the firm's balance sheet with respect to its upstream capital activities. Your group, Energy Capital, is a provider of debt and equity capital to energy and resources firms globally. Talk to us a little about what you do in the E&P sector and how this has changed in the last six months or so due to the steep decline in oil prices.

BECK: We provide capital up and down oil and gas companies' balance sheets from traditional senior reserve-base loans to both public and private equity. The foundation of our effort comes from our technical staff with 16 petroleum reservoir engineers, geologists, and techs in our worldwide group (offices in Houston, Calgary, London, Sydney, and Singapore). This gives us the ability and confidence to fund capital into riskier projects than most banks would not find attractive from a risk-reward perspective - basically, projects that have a high dependency on development drilling. In the current price environment, the financings that we find are good fits for us may include a whole or partial refinancing of corporate debt coupled with a commitment for further drilling. Or it may be a simple development drilling project with a company that has otherwise become capital constrained. This may be funded through a project debt or equity structure.

OGFJ: Are the global capital markets significantly different than those in the US, and to what extent are they are impacted by the general economy?

BUTCHER: The recent commodity price volatility has shifted the mentality of both issuers and investors in the US capital markets. Last year we saw many E&P IPOs at valuations reflecting the then commodity price outlook while others accessed high yield debt markets to fund acquisitions and exploration activity.

However, E&P operators have been cautious in the recent commodity price environment, reducing capex budgets to match operating cash flows and selectively accessing capital markets to enhance liquidity and balance sheet availability.

With a range of views on valuation, the sector remains volatile but active. Moving forward, we anticipate operators to opportunistically access capital markets with clear use of proceeds to selectively enhance liquidity, pre-fund 2015 drilling capex needs and provide acquisition financing.

OGFJ: In general, how would you describe credit availability at this time? Have the qualifications tightened significantly?

BECK: I believe credit availability has decreased, but not necessarily due to a tightening of qualifications, but more a result of low commodity prices feeding into the financing equation. Most credit providers are looking for coverage and return - both negatively affected by low oil and gas prices. Offsetting this to some extent will be lower costs. Additionally, during this low price period, some capital providers may be willing to bet some of their return on a price recovery, but I wouldn't expect anyone will assume a price recovery is necessary to get their principal investment back.

OGFJ: Is the midstream sector somewhat immune to the difficulties caused by low commodity prices? After all, production in North America continues to increase even as prices decline, so midstream operations must still be going full bore building pipelines, gathering lines, processing plants, etc.

NICHOLAS GOLE: Midstream investors are somewhat insulated from swings in commodity prices. However, in recent years we have seen a shift towards acreage dedication contracts, rather than minimum volume commitments, so investors are exposed to production levels in the region. As a result, midstream investment in core producing areas with existing volumes should be fairly insulated from the current commodity price environment, whereas midstream players that have recently invested in build-out strategies for more marginal plays will be more heavily impacted.

OGFJ: In light of activity in the midstream sector, has the firm increased its resourcing in this space?

BUTCHER: Midstream is a key practice area for us on the investment banking side, and we continue to invest in the business. We've a broad offering including M&A, project finance advisory, capital markets, and principal capital. Market activity remains high in the sector and our team is very active across a number of deals.

GOLE: Despite the recent decline in commodity prices, we continue to expand in the energy infrastructure sector as demonstrated through our continued hiring efforts as well as my own recent relocation from New York to Houston. The goal here has been to increase our focus on the energy infrastructure space. In particular, our success in the Freeport LNG transaction has led to transaction activity on a number of other LNG projects.

OGFJ: What is the role of private investment in midstream in today's low-price environment?

BUTCHER: There are significant amounts of private capital looking to deploy in the midstream and energy infrastructure space. We have deep relationships with many pension funds, insurance companies, and infrastructure funds globally, and we are actively working with them to evaluate the best investment opportunities available in the current environment.

One interesting trend we're seeing increasingly is upstream E&P companies looking to bring private infrastructure capital into their midstream assets for liquidity or to fund expansion capex. We're working on a number of situations like this at the moment.

OGFJ: Does Macquarie provide any other forms of financing to industry participants?

GOLE: Macquarie has a merchant-banking model, in that we can provide a very flexible range of financing solutions to clients to help facilitate transactions. For example, various parts of the firm can provide equity, mezzanine, or senior financing to help clients in a range of situations. But importantly, we can also provide development capital to support clients taking on new projects.

O'KANE: Macquarie's range of capabilities also allows us to provide less traditional sources of structured financing to customers. For example, our ability to trade in physical commodities markets allow us to do things such as financing crude inventories for a refinery, or financing gas in a pipeline until such time as it is needed by a utility.

OGFJ: Natural gas producers have been looking forward a long while to the prospect of being able to export gas in the form of LNG in order to take advantage of higher commodity prices outside North America. Can you talk a little about Macquarie's involvement in LNG export projects and the timetable for exports to commence? On the regulatory side, is permitting still too slow? Any sign this will improve?

O'KANE: We identified early that exporting LNG would be attractive as a result of the changing market landscape where supply and demand regions have dramatically shifted as a result of shale gas. Our longstanding relationship with Freeport LNG is one example of where we were able to help a client take advantage of this opportunity.

GOLE: We worked side by side with Freeport LNG to help provide a comprehensive solution for the company's $11 billion terminal located in Quintana Island [south of Houston in Brazoria County, Texas]. Construction has begun on this project, and it is expected to be in commercial operation in 2018.

In addition to the terminals under construction, there are a number of LNG export projects being discussed. But we anticipate only a handful of these will commence construction in the next few years. The outcome will be largely based on the ability of projects to obtain commercial agreements to support financing, as opposed to any fundamental regulatory hurdles.

One of these projects is Jordan Cove LNG, which we are advising on the development of an LNG export terminal in Coos Bay, Oregon.

OGFJ: From a macro perspective, who will be the winners and losers from the current downturn? What trends in M&D&D do you expect to see?

BUTCHER: While commodity price downturns are a headwind to E&P earnings, they can create compelling consolidation opportunities for well-positioned players. Operators with strong balance sheets, ample liquidity, and hedged production are positioned to emerge from the downturn with enhanced scale, improved operating cost structure and higher-quality assets.

Conversely, highly levered companies with inadequate liquidity will struggle to survive in a persistently low commodity price environment. E&P producers that have recently accessed debt capital to fund largely undeveloped acquisitions may struggle to meet obligations and honor drilling commitments, and ultimately may not be able to hold newly acquired positions, which would drive motivated divestiture activity.

For the short term, we expect A&D transaction volume to decrease significantly given the near-term uncertainty in commodity prices. The bid/ask between buyers and sellers will likely remain wide until commodity prices stabilize. If prices stay down through the second quarter, we expect to see transaction activity pick up as companies look to adjust to lower borrowing bases.

OGFJ: If low prices continue through 2015 and beyond, how do you expect the overall composite of operators and participants to evolve? Will we see a major shake-out in the industry? Please describe the scenario you envision.

BUTCHER: We expect to see accelerated consolidation within the industry as small/mid cap names seek an exit via corporate M&A. Consolidation will likely include stock-for-stock deals, as well-capitalized mid/large caps opportunistically consolidate small/mid cap names seeking production and reserve growth, cost savings, and high-graded drilling activity via enhanced scale. We anticipate private equity sponsors to opportunistically target over-levered or non-core asset divestitures by strategics, providing a constructive outlet for funds raised by financial sponsors over the previous few years.

Additionally, we see a continuing change in the buyer landscape. The amount of private capital available in the oil and gas industry has continued to increase in recent years, becoming a significant portion of the market for assets. At the same time, low commodity prices will put pressure on public companies' and MLP's ability to finance acquisitions. Ultimately, the landscape of the industry is highly contingent on where commodity prices stabilize. However, we believe a small number of well-capitalized operators are clear winners and are well poised to act as consolidators in the industry.

O'KANE: In the refinery sector specifically, increasing capacity in Asia is already shifting demand centers for crude. A continued low price environment would result in a fundamental shift in production regions, further altering the global flow of products.

OGFJ: How is Macquarie positioning itself across the value chain as a result of the market volatility?

O'KANE: Our capabilities allow us to provide financial, physical, and structured financing solutions customized to each customer's needs, whether they are in distress or looking to take advantage of the current market conditions. Our global coverage is critical to our being able to capitalize on opportunities across markets and geographies as they arise.

OGFJ: Can you compare and contrast the current market conditions - including M&A&D activity - to the low-price environment in 2008-2009?

BUTCHER: Both 2008 and 2014 were record years of US onshore E&P M&A activity followed by dramatic declines in commodity prices. Currently, there is a very low level of activity, which is similar to what happened in the first quarter of 2009. The key difference that we are seeing currently is that demand for assets is much higher than early 2009. The rapid rebound of oil prices in the second half of 2009 made acquisitions during that time very lucrative, and there are many buyers, both strategic and private equity, looking to capitalize on what they see as a similar situation.

OGFJ: Does this mean 2015 likely will see an increase in M&A&D activity?

O'KANE: Increased activity is likely in 2015, as distressed market participants seek out structured financing or pursue asset sales. Other participants that hedged before prices fell may be looking to monetize those positions and reposition themselves for the current environment, potentially through deleveraging or making strategic acquisitions.

BUTCHER: As prices stabilize, M&A activity will increase though they will probably still be down on 2014 activity. We're going to see action around distressed operators as well as consolidation plays, and private capital looking to take advantage of the dislocation.

OGFJ: Which plays do you think will see the greatest level of M&A&D activity? Drilling and completion costs are higher in the Bakken, for example, than in some other shale plays. Does than translate to more activity with smaller players and over-leveraged participants forced to sell assets?

BECK: It really comes down to the economics of the specific areas of each play. We believe the "core" areas of most these shale plays still provide decent economics while areas outside the cores are currently not economic at these prices. I wouldn't think there will be much A&D activity in non-core areas for the time being. And some over-leveraged companies may be forced to sell their core acreage and production.

BUTCHER: Outside of core plays, capex reductions will focus on lower performing assets. The focus is moving to improving efficiencies and reducing costs in core areas. Pure play companies have been hit the hardest in the Bakken and Eagle Ford, but it's unlikely they'll sell off core assets unless forced. The first wave of activity is going to be non-core assets that distressed companies can monetize while retaining their core focus areas for reserve growth and replacement.

OGFJ: Ultimately, what will happen in a prolonged commodity downturn environment?

O'KANE: Lower prices persisting over the longer term would ultimately lead to fundamental shifts to the flow of crude oil and products around the globe, leading to declines in some areas and increasing the need for new infrastructure and investment in others. At a macro level, lower prices could be an enabler to future economic growth, but could also lead to unrest in countries facing significant cutbacks as a result of lower prices.

BECK: It's hard for me to believe commodity prices will stay low for a prolonged period of time. Nevertheless, the US has drilled for and produced a lot of oil and gas at prices much lower than what we are experiencing now, and I have to believe that won't change going forward.

OGFJ: Finally, one year from now, what do you think the NYMEX WTI crude oil price will be? What do you think the NYMEX Henry Hub natural gas price will be?

VIKAS DWIVEDI (Oil & Gas Strategist, Macquarie Securities): We believe the balance of this year will be extremely volatile with periods of sharp price rallies and equally rapid price declines. By year-end, we expect WTI prices to be approximately $70 per barrel. We expect US crude oil inventory builds to average between 0.5 and 1.0 million barrels per day through at least the middle of 2015. As the year progresses, annualized crude oil production should slow from its recent 1.0 million barrels per day rate. We expect US production growth to finally stop growing in 2H15, and overall production may even decline slightly by YE15. In the process, the significant global and domestic oversupply will be reduced to a more manageable level allowing a price recovery back to the $70 range. A higher price than $70 would be possible if not for the large domestic and global inventory overhang that will persist into late 2015 and even into 2016.

By YE2015, we expect the 12-month forward curve for NYMEX natural gas to be at $3.25 per MMBTU. Our modeling indicates that the balance of 2015 will be characterized by persistent oversupply resulting from continued production growth that has not been slowed by low prices, slow demand growth, and even logistical constraints. While we do expect significant demand growth, beginning in 2016, there is very limited demand growth in 2015 as a result of new projects startup schedules. In fact, by the end of summer 2015, the US natural gas industry may be facing a significant inventory problem. If natural gas storage reaches the maximum capacity of approximately 4.2 trillion cubic feet, it will create an overhang for 2016 forward prices that could take at least several months to work off. Our $3.25 price expectation is anchored by our view that demand growth in 2016 will be a source of optimism. Additionally, forward prices may be buoyed by the potential for the first deceleration of gas production growth in five years as a result of lower wet gas drilling and lower associated gas production growth.

O'KANE: It is worth reiterating that our business is not dependent on directional moves in prices. We are a client-centric business, and while our clients' needs may change as a result of market conditions, our range of capabilities allows us to provide valuable products and services regardless of where prices are at.

OGFJ: Thank you all very much for your time.