Sustained high prices having profound impact on oil and gas industry

“They have the expertise to evaluate and deal with the credit risks in these types of transactions,” says Fielding B. “Tres” Cochran, III, a senior partner in Houston-based law firm, Vinson & Elkins. “They have the credit appetite and capacity to be a strong counterparty for people engaged in trading. They are becoming major players in derivatives and physical trading of energy commodities.”

Hedge funds and private equity have made a beeline to the energy sector in the past 12 to 18 months, and the stampede is expected to continue in 2006, the oil and gas financial participants say unabashedly. Some people, off-the-record, are not happy about this trend, but for the most part industry veterans see the trend as good for business.

Hedge funds have been criticized for entering an industry sector when it is hot, making a large profit, and cashing in quickly. “Hedge funds are now showing a greater willingness to take longer-term return positions,” commented Tom D’Ambrosio of Houston law firm Baker Botts’ New York office.

“There is probably an increased role for hedge funds to get involved in the commodities market,” said A. Stephen Kennedy, a senior officer in the energy space at Texas-based Amegy Bank’s Houston office. “That is something we have already seen, and it is providing liquidity in the futures market for companies that want to hedge.”

Among the commercial banks, Kennedy is seeing an increase in the number providing hedging for their borrowers, which he thinks helps the borrowers avoid having to post cash or letters of credit against the commodity hedges when there would be margin calls.

“What we’re seeing with hedge funds is that they are early movers into various sectors,” he says. “They try to get in and join an up-cycle at the bottom to get the highest rates of return they can, and then when the up-cycle moves far enough where the rest of the market recognizes it, hedge funds move on to the next sector that is in the bottom of an up-cycle.”

Gary Vasey, Ph.D., head of the Energy Hedge Fund Center, Houston, thinks the 440 funds - commodity, equity, and debt - will play key roles in two principal ways: (1) smaller, longer term deals, and (2) low-risk onshore E&P deals.

“The larger companies in particular in the end will pursue a merger-and-acquisition strategy to replace their reserves,” Vasey says. “So I think you’ll see a lot of small companies being formed and a lot of independents and smaller companies being acquired across-the-board. Therefore, if you’re an investor in the industry - a hedge fund or a bank - I think oil and gas equities are going to continue to fetch a premium as well.”

A colleague of Steve Kennedy’s in the energy practice in the bank’s Houston operations, Bryan Chapman, also a senior officer with Amegy, says the hedge funds can continue to cover a “broad range of high-risk capital” that fit special situations, such as distressed debt. The funds that have been involved in commodity hedging over the past two years have done “extremely well,” Chapman thinks, mostly because they foresaw the growing tightness in the supply/demand balance, and they were able to bid up those prices.

The oil and gas part of Deloitte & Touche’s consulting practice calls the past two years’ experience in the industry the “best macro-environment in more than 20 years,” noting that while demand for both crude oil and natural gas has risen strongly and steadily, interest rates and cost inflation have been low while hydrocarbon prices have been at historic highs. As a result, the sector has produced “record levels of profitability and cash flow,” Deloitte said.

“There is no shortage of capital available to oil and gas companies, and I don’t expect that to change in the next year or two,” says Grant Ahearn, executive vice president in charge of energy capital services at Los Angeles-based Union Bank. “It is obviously a very attractive sector in view of what has happened in the commodity prices. People view it as kind of a hot sector right now, and relatively safe sector from an economic point of view.”

Most of the financial people interviewed for this article agreed that the current environment is a good one for borrowers. With loads of capital chasing after energy patch deals with credit-solid companies, financing terms are bound to be very attractive, Ahearn says. More stability in commodity prices will tend to reinforce this even more, he says.

The consensus view from the dozen financiers, bankers, lawyers, and academics interviewed is that new sources of capital are readily available, large players are self-sustaining, smaller ones have no problem getting debt or equity financing, rising global commodity costs are a manageable problem, and the hurricanes’ aftermath is equally manageable.

In fact, the Gulf natural disasters may prove to be a good thing in the long run in terms of stimulating more onshore production, sparking more diversification away from over-reliance on the Gulf as the nation’s energy hub, and more robust growth in the oil field service sector.

Union Bank, which has been an active player in the energy industry for 25 years (power sector, as well as oil and gas) and maintains offices in Dallas and Calgary, is bullish about the broader sector’s future for the next four to five years, says Ahearn, adding his bank had $5 billion committed to the energy space at the start of 2006.

He calls the demand for energy in the United States “insatiable and growing at a steady pace,” spelling out many opportunities for various companies to take advantage of the demand.

Two areas that everyone in the energy financial space agrees deserve close scrutiny in the next two years are: (1) cash piling up in the major exploration/production companies and many super-independents, and (2) how much asset acquisition and stock buy-backs this stimulates.

Some early indicators might be ConocoPhillips’ $35 billion move to acquire Burlington Resources’ vast North American natural gas interests at year-end, and Chevron’s recently announced 35% increase in its 2006 capital expenditures - just shy of $15 billion, more than half in international upstream plays, but still $4.3 billion in US upstream and downstream activity.

“This is a very resourceful, resilient industry,” says Arthur “Buzz” Gralla, one of the principals at Guaranty Bank in Texas, where he established the bank’s oil and gas unit in 2001 with an emphasis on financing small energy projects.

“To operate in the Gulf, you need to have a different set of skills and strengths to operate in all kinds of weather,” says Gralla. “You have to know how to fix things and respond quickly to damage. I was very impressed with our clients. None of them retreated (in the aftermath of the 2005 and 2006 hurricanes).

“The small energy projects have lots of lenders and lots of investors chasing after them,” said Gralla. “There is tremendous capital out there in the marketplace today - bank, equity and mezzanine financing.”

In lending to the smaller players, Gralla emphasizes “the quality of their management team” is what makes a bigger difference than the assets themselves being financed.

Investment banks and the equity funds now provide an interesting set of options for energy companies looking for new and creative ways to finance projects. The increasing competition among a growing variety of financial providers is good for the industry generally and will continue in the New Year, according to John McNabb, founder and partner in Growth Capital Partners LP in Houston.

McNabb, a US Air Force combat veteran pilot during the Vietnam War and a long-time oil and gas financial professional with Prudential-Bache Securities and Bankers Trust Company of New York, believes the investment banks have a clearer grasp of movements in the capital market.

“I think the investment banks do have a role to play and see them as trying to be more creative,” he says. “They should generate new ideas and new products for the business. Between the hedge funds and the investment banks, I see all their competition as positive. The industry is going to continue to need capital, and those are two places where there is huge capital access.”

One of the creative results of this competition is the increased use of “PIPE,” private investment into public equity, which has been used for unregistered securities for a long time, but is taking on more prominence in today’s bullish oil and gas financing market, McNabb and several other people said.

PIPEs are unregistered securities that eventually get registered after a few months with the buyers getting a discount as a result. They have provided a method of finance for a number of oil service companies in the past year. PIPE typically involves between $10 million and $30 million of equity for a company.

“It is a quick form of financing for a company that doesn’t have a shelf registration with the SEC. The buyer is purchasing a security that is un-liquid, with the hope that the company has a set period of time - usually 90 days - to get the securities registered,” says Tommy Pritchard, the principal in Pritchard Capital Partners, New Orleans. “After they do the filing, you’re at the mercy of the SEC.”

“PIPEs have been a good means of capital raising in the marketplace recently, particularly among the smaller companies in E&P and oil field service. Other options have become quite cumbersome, getting the documentation to the SEC and keeping it in place. This enables companies to do just-in-time financings,” he says, noting two of his firm’s PIPE deals in 2005 were deployed for an oil field service company and a global energy engineering firm.

In addition to the influx of new private equity, a second trend is the use by E&P sector players, particularly the large ones, of production payments as sort of a throwback to the 1980s and ‘90s, according to David Asmus, one of the senior energy attorneys at Baker Botts LLP, Houston, and a veteran of the upstream market for financing.

“We see more and more use of the production payments to hive off the short-term production of pre-developed reserves by selling them to funds or investment banks or other third parties at a fairly high current price, allowing the buyers to buy the remaining E&P plays at a little lower price (per-barrel or mcf),” says Asmus, a Harvard-educated lawyer. “Those trends have been ramping up over the past year to year-and-a-half, and if anything, I expect to see them get stronger.”

Asmus’s Baker Botts colleague following project finance, Stephen Krebs, also operating out of Houston, says with the building flood of cash and the inevitable spike in capital expenditures, project financing will follow in the coming years.

“What we saw in the ‘90s is that the number of drilling contracts was the cash flow for the development of new rigs,” Krebs says. “And that market, of course, is very cyclical. It swings in favor of the drilling contractors every once in awhile. I haven’t seen the kind that developed six or seven years ago. So far there is not enough to galvanize a lot of new financing around,” he says.

Alan Blackburn, managing director for Growth Capital Partners in Houston, says he sees “more and more private equity firms that haven’t been in energy before looking to see how they can play in the space.” PIPEs offer one vehicle, and Blackburn sees the hedge fund influx has been a “positive influence,” lowering the cost of financing while increasing the total dollars available.

Everyone acknowledges that rising costs generally, the Gulf of Mexico recovery, and the shortages of equipment and labor in the E&P service sector are all unknowns that could impact upcoming financing. No one wanted to say they were going to have a dampening effect, however. Not in the next year or two, at least, the financiers maintain.

For senior banking people specializing in the service sector, such as Amegy Bank’s Carmen Jordan, the general health of the E&P space and continued high commodity prices will provide enough of a cushion against the rising costs.

“On the drilling contractor side, we can see price increases on a weekly or monthly basis. Their average daily rates are constantly going up because they have had cost increases, but they are getting higher margins from the E&P companies,” Jordan says. “Service companies have to attract a labor pool from a good portion of people who left the industry and now are retired. Whatever the reasons, there is a very short supply of labor to meet the demands. That’s part of what also is driving up the price.”

Energy consultant and hedge fund expert Gary Vasey does think the high costs could eventually begin to impact financing in the industry.

“Potentially, the big surprise over the next year or so is going to be the cost-side of the equation and the availability of resources to get the job done,” says the Ph.D. geologist and native of the United Kingdom.

Higher costs mean that all through the oil field services side, there are going to be what Vasey called “constraints on being able to get rigs, equipment, etc., to follow through on the plans of some of the oil companies.” For Vasey this all “carries over to the cost side; simple supply/demand dynamics are at work.” $

The author

Richard Nemec is OGFJ’s West Coast correspondent, based in Los Angeles. He can be reached at [email protected].