The year 2011 was marked by volatile public markets and continued scrutiny of banking practices. Governments around the world reacted to ongoing fallout from the 2008 financial crisis, which continues to haunt banking systems. Meanwhile, oil prices had periods of relative strength and weakness, while domestic natural gas prices languished.

For energy lenders, 2011 was generally quiet. But many have a positive outlook for 2012, even as Europe festers, U.S. banking regulations tighten, and natural gas prices sink.

Ask Bryan Chapman, Houston-based executive vice president and energy lending manager for Iberiabank, how 2011 went, and you will not get a mixed signal. Coming into last year, the bank had under $100 million in energy loans, but it closed the calendar year near the $400-million mark.

Launched in the fall of 2009, the bank runs energy lending from the Houston office, while Iberia Capital Partners, the energy-focused investment-banking arm, is headquartered in New Orleans. The bank’s deal flow largely consists of smaller sole-bank loans or club deals (with two to three banks) with private companies, E&P and midstream companies backed by major energy-focused private-equity sponsors, and small- and mid-cap publicly traded E&Ps.

Bryan Chapman, Houston-based executive vice president and energy lending manager for Iberiabank, notes it had less than $100 million in energy loans coming into 2011, but closed the year near the $400-million mark.

“We can bank companies in a variety of operating environments,” says Chapman. Shrewd operators with modest leverage, low operating costs and attractive finding and development costs can be found in both conventional and unconventional plays, he notes.

In 2011, the bank also had success in the midstream space, again with PE-sponsored companies. The significant up-front capital required, combined with long times to flowing first hydrocarbons, make the midstream an interesting funding opportunity.

“Our midstream customers represent roughly 15% of our total commitments, and they are focused primarily on resource plays—two in the Eagle Ford, one in the Woodford and one in the Marcellus,” Chapman says.

Three of the four customers are involved in major greenfield projects to build pipeline or processing assets for independents that have signed fee-based contracts backed by significant acreage dedications and the financial wherewithal to drill in wet-gas areas. The fourth deal was related to an acquisition.

“Some of these emerging shale plays with inadequate midstream infrastructure require major expenditures to build a processing plant or main pipelines to reach drilling pads, ahead of cash flow,” says Chapman. Companies can easily spend $100- to $200 million in equity before flowing a single molecule of gas.

Banks are not, by and large, making project-finance loans to fund capex costs for greenfield midstream projects, he says. Typically, credit facilities are established as the project comes online, construction risk is diminished, well performance can be assessed, and the project starts to generate positive cash flow.

Chapman thinks the bank’s wise management before the financial crisis positioned it to take advantage of opportunities afterwards.

“If you run your business prudently by avoiding problem areas like subprime loans, and if you had the discipline to not make acquisitions at premium prices in overheated markets, while conservatively underwriting credit, when you go into a financial crisis, you are in position to go on the offense,” he notes.

Iberiabank raised capital in December 2008 and in both 2009 and 2010 to fund acquisitions and pursue organic growth opportunities, not to “plug holes in the balance sheet.” It has grown from $5 billion to nearly $12 billion in assets in the past five years through various avenues: acquiring failed banks (in Arkansas, Alabama and Florida) with loss-share protection from the FDIC; buying live banks; expanding into new markets like Houston, Mobile and Memphis; and starting new business lines like energy lending, energy investment banking, wealth management and trusts.

Uncertainties

Operators and their bankers are closely watching the ongoing European banking conundrum. Chapman sees the situation as both a cause for concern and, possibly, an opportunity.

During second-half 2011, concerns about Europe colored the global economic outlook and negatively impacted crude prices, Chapman says. The European banking crisis has also affected the U.S. stock markets and European banks active in U.S. energy lending.

“Will funding costs normalize such that Eu- ropean banks can profitably continue lending at current market rates, or will they stop issuing new commitments—or sell overseas operations (such as in the U.S.) to focus on their home market in Europe?” he asks.

A large-scale exodus of major European banks from the U.S. would reduce energy-lending capacity, which could in turn significantly increase margins for energy credit in 2012.

Several new banks have entered the energy-lending market, but since they tend to be smaller regional banks, they cannot make as large a commitment as the average European bank. But given the continued outlook for long-term low interest rates, even with higher margins, bank loans will remain attractive.

The other big uncertainty for 2012 is natural gas prices, notes Chapman. Although the rig count is attenuating in dry-gas areas, gas production associated with oil and liquids could prolong oversupply. With continued increases in production to record levels, similarly elevated storage levels at the beginning of the withdrawal season, and, thus far, a mild winter, he believes both the forward curve and spot price are headed south.

“We could see a spot price with a $2 handle.”

The capital shift to oil projects and drop in the gas-rig count will eventually help balance the market, but the timeline is uncertain. Some early-2012 announcements from companies suggest low gas prices are already prompting better capital discipline and a willingness to sacrifice production growth rates.

“The market has continued to go down, and most people think we are getting close to the bottom,” says Chapman. Banks have been gradually more aggressive on price decks as a percentage of the forward curve.

“A lot of the larger, stronger public companies took advantage of capital markets to issue high-yield debt at attractive interest rates to repay outstanding loans under their revolver,” says Chapman.

Larger companies are maintaining strong liquidity to survive lower gas prices as drilling to hold acreage continues. Companies that were overleveraged coming out of the recent financial crisis have had to either restructure their debt or recapitalize.

Despite producers’ bearish posturing and widespread bracing for another economic siege, Chapman is optimistic about 2012.

“It benefits no one if the European crisis gets out of hand, and it isn’t good for commodity prices, either,” he says. But there is a bright side: The exit of major European players would create an opportunity for smaller banks experienced in energy lending.

Vote of confidence

One bank trying to jump into the domestic energy-lending market is Branch Banking & Trust, or BB&T, based in Winston Salem, North Carolina. Senior vice president and corporate banking team leader Jeff Forbis brought his six-person team from Sterling Bank in February 2011 to launch the initiative, with a mandate of upstream and midstream lending. The energy group is, in effect, a start-up within the $170-billion institution.

Texas is a growth market for the 140-yearold bank. BB&T entered the state in 2009 through an acquisition and opened a Houston office. The energy team started from scratch.

“We had to write the energy-lending policy, the price deck, risk-rating methodology, and build from the ground up,” he says.

In short order, the group had committed more than $1.2 billion to upstream and midstream projects via 28 transactions. Its strategy is to take $50- to $75-million pieces of larger syndicated transactions.

BB&T specifically targets lending in the Lower 48, and is looking for independents with a reserves value of $200- to $500 million or more, because of the better credit metrics of larger deals. The bank has made several $100-million-plus commitments to quickly build a portfolio. Eventually, the portfolio will be 75% upstream and 25% midstream, though it is slightly overweighted to the upstream sector at present.

“We think there will be growth not only for existing midstream companies with revolvers, but start-up activity as well. The shale boom is coloring so many aspects of the domestic E&P business now—it’s driving a lot of drilling, and people are borrowing,” says Forbis.

Like Chapman, he thinks depressed natural gas prices will be a major theme in 2012.

“We think natural gas prices will be at or below $4 for the next couple of years, and it will impact independents’ ability to borrow,” he says, noting that price decks are starting to come down.

He has not seen pressure on bank-loan redeterminations yet, mostly because of hedging. BB&T gives producers credit in their borrowing base for hedges, but not every producer has been using these instruments.

“Those who have chosen not to hedge will get pressure, probably in the spring,” he says.

“We don’t think they (French banks) will have the capacity to step up, and in some cases, won’t be able to take their pro-rata share of borrowing-base increases,” says BB&T senior vice president and corporate banking team leader Jeff Forbis.

Up to the plate

Forbis is also tracking the European banking situation. The French banks, and perhaps others, may be in a bind, and could potentially exit the U.S. energy-lending space.

“We don’t think they (French banks) will have the capacity to step up, and in some cases, won’t be able to take their pro-rata share of borrowing-base increases. That will have an impact.”

What will happen to the deals led by European banks is a significant question.

However, Forbis sees the European banking crisis and its direct impact on domestic energy lending as a short-term problem—and perhaps an opportunity for asset-hungry do- mestic banks.

“We continue to see oversubscriptions by two to three times, and that is an opportunity for other banks to step up. I think the market is going to be uncomfortable not going with a name-brand U.S. or Canadian bank that has good footing,” says Forbis. BB&T has been invited to some deals purely on the strength of its credit rating, he adds.

As for more stringent U.S. bank regulation, Forbis is not concerned about compliance. There is a meaningful period of time to meet the required thresholds, and he thinks new rules will be more a distraction that a disruption. Regulation could make capital more expensive, and it could have an impact on credit-facility pricing, but it will not grind the industry to a halt.

“Certainly, compliance is an issue on the minds of executive management. For people looking to make loans and do deals, it’s not something to worry about. For those with capital adequacy questions, that is a bit trickier,” he says.

His outlook mirrors BB&T’s positive view of the Texas market. “If you look at the other economies, none of them has the upside Texas has. BB&T’s chief executive officer has stated on the record that he wants to make one or more acquisitions in Texas.”

Twenty-year-plus Union Bank N.A. veteran Carl Stutzman was encouraged by the level of activity in second-half 2011, and he hopes the momentum carries over into 2012. Dallas-based Stutzman says the European banking shake-up could be interesting for Union, especially following a slow summer that saw asset owners stand pat with quality holdings. Wholly owned by the Bank of Tokyo Mitsubishi, Union Bank is a $90-billion entity.

The upstream, reserve-based lender focuses on North American oil and gas. The bank’s exposures range from $250 million with large public operator Chesapeake Energy Corp. to $5- or $10-million deals with early-stage management teams with good track records.

“The most activity we saw last year was start-ups or restarts with management teams that had sold assets and were getting restarted with II or III,” Stutzman says.

Union lent to several of these early-stage companies, as well as participating in the $7.2-billion Samson Investment Co. transaction; it committed $100 million to the revolver, $45 million to the bridge loan and was a senior managing agent.

The bank’s opportunities to commit larger percentages of its portfolio may occur in the wake of the European crisis. “There have already been opportunities to step up and take larger pieces of transactions.”

Turnaround timeline

No one is willing to predict when gas prices might rebound. Stutzman says the near-term price outlook for domestic natural gas is weak. At current and expected short-term prices, some conventional-gas drilling isn’t economic.

“Hedging is helping, but over time, not being able to re-hedge at advantageous prices is reducing the benefit. That will be our biggest challenge in 2012,” says Stutzman. Like other active oil and gas lenders, Union Bank is 60% to 65% weighted to natural gas, reflecting North American hydrocarbon production. Stutzman’s clients are starting to adjust.

“Management teams in our portfolio are responding to the new gas-price paradigm. They are shifting to plays that provide better returns in this market.”

Still, lease-expiration issues and pressure to grow reserves have forced some companies to drill in areas with marginal economics, and liquids-focused companies are continuing to drill wells with associated gas, adding to the glut.

The shift in business strategy is ongoing, with minor rig-count declines in gas-oriented activity, Stutzman says. But weak gas prices may spark opportunity for some E&Ps.

“We are seeing some management teams take contrarian stances on natural gas. Samson (Investment Co.) was one of those, as an attractive long-term asset that provides attractive returns in the near term, and interesting as a long-term gas-price-arbitrage play,” he notes.

The banking industry itself will be tested in 2012. The Dodd-Frank Act and Basel II and III regulations—which the Federal Reserve has said it will implement, in large part—will affect all lenders.

“Regulation is going to be a bigger and more cumbersome part of life for bankers going forward,” Stutzman notes. Union, like many other banks, is still determining the ramifications of Dodd-Frank. The bank has been a consistent provider of first and second lien capital, and also does direct equity investing, which is still allowed under the act. Energy funds are off limits, and it is not clear whether in-house energy-derivative activities can be kept in-house.

Stutzman predicts increased oversight and transparency, to be expected in any industry requiring a bailout, will have little to no impact on the bank’s underwriting policies.

Stutzman does see risk in the European banking crisis. “Europe is a mixed story. On the plus side, some of the European banks are very formidable competitors that are now, at least temporarily, on the sidelines.”

But this upside is offset by the changes in syndication ability.

“A big chunk of the capital needs of North American energy is serviced by European banks. Because there is only so much of a given deal people can hold, a widespread exit from the industry by European banks would change syndication strategies, and make it tougher to underwrite in this market.”

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