CAPITAL CAROUSEL

Were he alive and asked to comment on the U.S. energy industry and its capital markets activity in 2000, Charles Dickens might be tempted to observe, "It was the best of times; it was the looniest of times." Indeed, even Gordon Gekko, the savvy slice-em-and-dice-em corporate raider and ruthless, take-no-prisoners trader in Wall Street, would have been blindsided by the puzzling antics last year of energy issuers and investors. Amid West Texas Intermediate crude prices that spiked to $37-plus and Nymex gas prices that briefly blew past the $9 mark, E&P companies acted like they were living in a world of $10 oil and $1.50 gas-eschewing for the most part any issuance of equity. Meanwhile, institutional investors, not yet fully disengaged from their torrid courtship of earningsless dot-bomb and telecom issues, shied away from the high-flying energy sector. In their considered judgment, lofty oil and gas prices had about as much life expectancy as some sports observers now ascribe to the newly formed XFL Football League. But with the arrival of 2001, oil-patch players and the buysiders that follow them have begun reassessing their positions. Producers, who prudently spent much of 2000 reloading their balance sheets and buying back stock, now realize they may be at the beginning of a new up-cycle in the industry and will likely need equity and debt capital to grow not only their asset bases but also their stock-market values. At the same time, investors have begun sobering up to the energy sector's solid cash flows, ability to pay down debt and strong fundamentals. They're also looking over their shoulders at the deteriorating earnings outlook for other industries that are susceptible to any slow-down in the economy-and are beginning to see energy as a potential safe harbor for their investment dollars. Against this new-millennium market backdrop, which energy trends and financing needs will surface most prominently in 2001? Moreover, how open will the capital markets be to would-be energy issuers? Chansoo Joung, managing director and co-head of the global energy and power group for Goldman, Sachs & Co. in New York, sees two major trends this year: consolidation and a uniquely strong commodity-price environment. "Investor-owned oil and gas companies around the world currently total about $1.1 trillion in market cap," he says. "And after the Chevron-Texaco merger, about $900 billion of that will be in the hands of just five companies: Exxon Mobil , $300 billion; Royal Dutch/Shel l, $200 billion; BP , $200 billion; and TotalElfFina and ChevronTexaco , $100 billion each. "Now when you look at the continuing consolidation that's going to be taking place in the rest of the industry during the next three to five years, it's going to be all about response and reaction to what's happening at the top." Joung points out that because the typical noncore asset package divested by a supermajor has gone from $500 million to $1 billion in size, independents like Apache Corp. and Devon Energy also need to get bigger, to compete for those packages. The same holds true for the service companies that supply their drilling needs. The result should be further consolidation through every industry segment. Another incentive for consolidation: the market today is rewarding bigger companies with premium multiples versus the rest of the industry. "The supermajors today are trading around 20 to 22 times earnings and 10 to 12 times cash flow; meanwhile, the secondary integrateds like Marathon , Occidental , Phillips , Conoco and Amerada Hess are all trading at eight to 10 times earnings and three to four times cash flow," Joung says. "When you're trading at such a steep discount like that in an industry that's so capital intensive, you're at an enormous disadvantage, in terms of the buy cost of your capital. So we think we'll see further M&A activity, not only at this level, but throughout the rest of the industry." The industry now represents only 5% of the S&P 500 (with the supermajors representing 70% of that 5%). So, Joung stresses that E&P companies must articulate to the market a compelling reason why investors should buy their stock and not an Exxon Mobil. "There's an enormous opportunity for the non-supermajors to make up a great deal of ground in their stock prices if they move ahead well on a strategy. That may mean corporate or property combinations to improve their cost base, or avoiding lower-return parts of the business, thereby adding [value] through subtraction." The leader in worldwide M&A advisories, Goldman Sachs represented Mobil in its merger with Exxon, Repsol in its purchase of YPF, Elf Aquitaine in its pairing with Total, Arco in its combination with BP, Phillips in its acquisition of Arco's Alaska assets, North Central Oil in its sale to Pogo Producing , and Basin Exploration in its merger with Stone Energy . Joung notes that the discipline in spending exhibited by the industry last year may lead to a stronger up-cycle than many observers expect. "During the past 15 to 20 years, the demand for oil and oil products worldwide has grown 1.5% to 2% annually while storage capacity has steadily shrunk. This has led to oil-price volatility, which is continuing to grow." Meanwhile, there's a strong fundamental demand outlook for natural gas, based upon the increasing need for gas-fired electricity plants. "Some studies are calling for an annual 30- to 32-trillion-cubic-foot (Tcf) North American gas market in five years versus a 24-Tcf market today," he says. "That's an enormous increase relative to historical growth, and it's not at all clear from where that [additional] gas will come." Against this backdrop-and an assumption of $24 oil and $3.25 gas for 2001-Joung believes the equity, high-yield and convert markets will be generally open for the energy industry. The only question is what will trigger the need for financings. One catalyst could be the elimination of pooling-of-interests accounting; another could be nontraditional structured financings. (See sidebar.) The ideal candidate for accessing the capital markets this year: a company that has a good use for ongoing cash flow. Joung points to Anadarko Petroleum , which is ramping up drilling in its Bossier play in East Texas and in Algeria. "The market is willing to pay a premium for such a stock because it knows that a significant amount of the free cash flow the company generates is going into high-return projects." Michael J. Dickman, managing director in Morgan Stanley Dean Witter 's energy group in New York, exhibits much the same mindset as Joung. "The energy financing market-whether equity, high-yield or straight debt-has always been tied very closely with what's going on in the acquisitions market, and in 2001, we see more M&A activity than last year, at least in terms of the number of deals." A potential impediment to such mergers, however, is that during periods of high commodity prices as now, energy companies are often reluctant to make acquisitions because they think they'll have to pay up a little more. "But with increasing liquidity in the commodity markets, where buyers can hedge some of the price risk they might experience in this type of environment, they can take advantage of the arbitrage between where the commodity markets currently are and where relatively lower oil and gas stock prices are trading." Explains Dickman, "In several cases right now, you could buy a public E&P company at a premium to where its stock is trading, hedge the first two to 2.5 years of its production at the current commodity-price strip, and still lock in an attractive return on your [invested] capital during that time frame." This could be accomplished, he says, either through a straight acquisition with hedging or through a structured financing that uses risk management to achieve a higher-rated, more cost-attractive source of capital for the acquiring client. Like Joung, Dickman believes consolidation continues to make sense operationally and strategically. "There are obvious economies of scale, but more importantly, when companies combine, they're better able to spend capital on higher-return projects and focus on strategic areas where they can better utilize their skill sets and management talent." Mergers also bring with them another silver lining. "The market tends to reward companies with larger size and liquidity, by assigning to them more competitive valuations than it does to smaller-cap operators in their peer group." A dominant leader in the M&A arena, Morgan Stanley advised Texaco on its pending merger with Chevron, Amoco on its merger with BP, the latter on its acquisition of Arco, Elf on its pairing with Total, Burlington Resources on its purchase of Poco Petroleums , Devon Energy on its buys of Santa Fe Snyder and PennzEnergy , and R&B Falcon on its combination with Transocean Sedco Forex . In February, the firm advised Phillips Petroleum on its $9-billion acquisition of refiner Tosco Corp. and Schlumberger on its $4.9-billion pending purchase of Sema , a French IT company. Dickman sees M&A deals driving the majority of energy financings this year, but he also sees an uptick in equity transactions. "This will occur once there's conviction among investors about where commodity prices will settle." For its part, Morgan Stanley is eyeing $4.75 gas and $27 oil for 2001. "Combine this with continued strong performance by the energy sector as other industry sectors continue to disappoint, and you'll see more allocation of capital to producers and service companies." Morgan Stanley, which last fall led the $150-million initial public offering of W-H Energy and the $3.9-billion IPO of China's Sinopec , expects to be involved this year in several more IPOs and equity financings for both E&P and service companies, as well as other privatizations of state-owned oil and gas companies. Recently, it completed a $700-million, zero-coupon convert for Nabors Industries. Still, what if energy companies, particularly smaller caps, continue to trade at low cash flow multiples despite high commodity prices? Says Dickman, "Then you could see additional M&A activity, and private equity may come back into the energy sector more aggressively than it has in the past." M. Scott Van Bergh, managing director and co-head of Salomon Smith Barney 's energy finance group in New York, serves up a similar view. "The industry's issuance of equity and fixed-income securities this year is largely going to be event driven, that is, it's going to be linked to the acquisitions market as opposed to cleaning up the balance sheet. And right now, the capital markets are available, whether that's equity, investment-grade debt or high-yield debt." Van Bergh contends that if the gap between high commodity prices and low oil and gas stock valuations continues, many operators-looking for the best use of their cash flow windfalls of the past year-will focus not merely on property acquisitions, as they have historically, but on corporate acquisitions, which right now make more economic sense. "You could buy a corporate oil and gas entity today for around the equivalent of $3.25 gas and $20 to $22 oil prices," he says. "Comparatively, if you were doing a property acquisition, you'd have to use much higher price decks-closer to the $4.25 gas-price and $24 oil-price assumptions that we're using for 2001-to get the transaction done. So for the first time in a long while, we're back to the idea that it's cheaper to buy reserves on Wall Street." Certainly the capital for would-be buyers is there. "Energy is viewed as one of the few safe harbors for investors today, because of the industry's high commodity prices, strong cash flows and its ability to pay down debt," says Van Bergh. "In fact, energy has actually shown strengthening credit while the rest of the market has experienced deteriorating credit due to recession fears and corporate disruptions." As a result, weak investment-grade energy issuers can probably issue debt at tighter spreads above comparable Treasuries than some blue-chip names like AT&T, he says. "For example, we recently did a major multibillion-dollar bond offering for a telecom giant that priced 300 basis points over the comparable 30-year Treasury. A weak triple-B investment-grade energy credit could currently do a similar debt financing at around 250 basis points above comparable Treasuries." On the high-yield side, he notes that a few years ago, Salomon Smith Barney was able to do subordinated debt financings for single-B, non-investment-grade energy issuers-small-cap producers with reserves on the order of 50- to 200 million barrels-in the 8.5% to 9% range. Today, the coupon for a new single-B high-yield issuer is closer to 10%. But relative to other industry sectors, that's still a very tight spread. The typical energy M&A deal going forward: last summer, AEC Oil and Gas , a subsidiary of Alberta Energy , acquired Wyoming producer McMurray Oil for $618 million in cash, which it funded through its banks. Then it came back to the capital markets and termed out the debt in a $500-million investment-grade bond deal. "That's the sort of transaction we'll see more of this year," says Van Bergh. "In fact, we've got several similar fixed-income, M&A-related deals we'll be leading in the first half of 2001, and that's just on the E&P side." As for the service sector, that has been a much more robust market for equity and debt financing during the past year, and he anticipates that continuing. "Service companies have a lot more capital spending going on because they need to bring on new equipment to address the new technologies and the new environments-like deep water-that they face." Returning to the E&P sector, Van Bergh concludes, "The biggest question facing producers today isn't how to finance. It's what to do with all the capital that's coming in the door every day." Gregory P. Pipkin, managing director and head of Lehman Brothers ' worldwide E&P vertical group in Houston, shares a positive outlook. "In 2001, the majority of capital-raising by the industry will be tied to M&A activity, with companies using cash to make acquisitions, then turning to the capital markets to finance those transactions long-term, either through equity and/or debt. And to the extent that we experience lower volatility in oil and gas prices, M&A activity should increase in velocity." Lehman Brothers knows a lot about such transactions. Last year, it advised Chevron on its pending $35-billion paring with Texaco; Shell on the sale of its interest in Altura Energy to Occidental Petroleum ; Forcenergy on its merger into Forest Oil ; and IRI International on its marriage with National Oil Well . In the energy convergence arena, it also represented Dominion Resources on its $8.4-billion merger with Consolidated Natural Gas , and Dynegy on its $3.9-billion acquisition of Illinova Corp. This year, cash M&A deals are becoming the norm in the E&P sector. Lehman has thus far advised Anadarko on its recently announced $1-billion acquisition of Calgary producer Berkley Petroleum , Pennaco on its $500-million sale to Marathon Oil , and Tom Brown on its $100-million purchase of Stellarton Energy, another Calgary operator. "Also, we provided financial advice to UTI Energy Corp. this February on its $1.4-billion sale to Patterson Energy, which signals further consolidation within the U.S. land drilling business," says Pipkin. With the fundamentals of the industry steadily improving, Lehman also expects better access to the capital markets for producers and service providers. "With an average price of $25 for oil and $5 for gas in 2001, energy companies should provide earnings momentum and returns on equity superior to those for telecom and technology companies." So far in 2001, Lehman Brothers has lead-managed the $84-million IPO of ATP Oil & Gas Corp. , a producer focused on the Gulf of Mexico and the U.K., and the roughly $86-milllion IPO of Williams Energy , a master limited partnership engaged in the storage, transportation and distribution of refined petroleum products. But count on the underwriter to be engaged in many more such deals this year. "When you add up all the equity and debt transactions we completed last year in the energy sector, we raised well in excess of $2 billion of capital for our clients," says Pipkin. With respect to further mergers within the Wall Street financial community, Pipkin sees the pace of such consolidation dramatically slackening in 2001 versus last year. "There are, after all, only three major independent investment banking houses left-ourselves, Goldman Sachs and Bear Stearns." As reported in "Street Squeeze" in the December 2000 issue of Oil and Gas Investor, there is considerable speculation that Lehman Brothers may combine with another major marketmaker. Says Fadel Gheit, senior energy analyst for Fahnestock & Co. in New York, "A Merrill Lynch-Lehman Brothers match-up would be interesting." What's already interesting is the biggest banking merger of 2000-that of Chase Manhattan Corp. and J.P. Morgan & Co. -and that combined entity's take on energy trends this year. "In the U.S., in particular, the No. 1 trend in the oil and gas industry right now is the real squeeze on natural gas," says Todd Maclin, group executive for J.P. Morgan Chase & Co. 's global oil and gas investment banking group in New York. "Supplies aren't as healthy as demand for that commodity. As a result, there will likely be a lot of focus in 2001 on drilling up domestic gas reserves and, in the case of Alaska, finding a way to deliver that state's tremendous gas supplies to the markets that need them. So we see a bigger need for capital-raising by the industry this year than last, both in terms of equity and debt." The good news for producers and service companies is that the capital markets will look favorably on the energy sector-and that assumes just an average Nymex oil price of $27 and gas of $4.50, says Maclin. "The fact is, the investment alternatives in the new economy haven't fared as well as many institutions would have liked and there's now a back-to-basics trend under way. In oil and gas, investors see strong fundamentals and companies that represent Buy opportunities at current stock-price levels." The new J.P. Morgan Chase & Co.-with assets in excess of $705 billion-is poised to tackle the capital-raising needs of the industry. Last year, Chase by itself was the top U.S. oil and gas lender, with 64 transactions that totaled $33.8 billion; J.P. Morgan ranked fourth in that category, with some $10 billion in transactions. But the acquisition of J.P. Morgan gave Chase another new dimension. "While Chase had equity underwriting powers, it hadn't built-outside of technology and media-any substantive equity-issuance platform; by contrast, J.P. Morgan was already among the top six or seven global equity underwriters," explains Maclin. "Now we, the new J.P. Morgan, have the ability to offer Chase's previous oil and gas clients strong equity research, underwriting, sales and trading capabilities. That's huge." What's also huge is the M&A talent pool the banking combination creates. Premerger, J.P. Morgan represented Exxon in its paring with Mobil and just recently, ENI, the Italian state-owned oil, in its acquisition of Lasmo . Meanwhile, Chase last year represented Santa Fe Snyder when it was acquired by Devon Energy, and El Paso Energy in its purchase of PG&E Gas Transmission . Says Maclin, "As the new J.P. Morgan, we expect to advise on more energy mergers than last year. These mergers will be driven by many of the same fundamentals that have prompted recent consolidations on Wall Street-greater scale, services and efficiencies." Through J.P. Morgan Partner s, formerly Chase Capital Partners, the new banking giant also expects to be involved in more private equity investments for those early-stage energy companies that might not be big enough to access the capital markets. Last year, Chase Capital Partners bought out the Beacon Group , one of the largest U.S. private equity investors in E&P, oil-service and power companies. In which energy financing area will J.P. Morgan be strongest this year? "We're client-focused, not product-focused," says Maclin. "We know that advising a company on whether or not to issue equity or debt or take out a bank loan can vary from week to week, depending on where the capital markets are and what the best execution strategy is for that company. So we'll be looking at a variety of capital-raising options for each oil and gas client and present them with the ones that make the most sense at the time." Maclin has one concern about the financial markets this year, however. "There's evidence that the economy is slowing down, so the markets could get a little choppy from time to time." Rome G. Arnold, managing director of the global energy group for Credit Suisse First Boston in New York, is also sanguine. "Even at the prices we're projecting for 2001-an average $23.50 for WTI and $4.20 for gas at the wellhead-the E&P sector makes a lot of money." Arnold notes that it's especially appropriate to be optimistic about the minimum price of natural gas going forward. "Year over year, domestic supply has increased only 1% to 2% at best; meanwhile, demand continues to increase at a much higher rate. And if there's not enough gas to go around, the flex point is price. We've already seen this phenomenon reflected in California this winter. "The problem is that we've been merrily building lots of very efficient, gas-fired power plants that don't have the ability to switch to fuel oil or some other energy source," he says. "These plants have to have gas or they shut down. And if you have to have the gas, you have to pay whatever it takes to get it. This means gas producers are going to be generating lots of cash." Oddly enough, the equity markets have recently seemed oblivious to this, with small-cap E&P stocks ranging from flat to down. Credit Suisse First Boston, however, doesn't have its eyes wide shut. It sees a fundamental buying opportunity for investors in producer and service stocks, and it has been pounding the table making that point. Insists Arnold, "No matter how well these stocks performed last year, we believe they still have tremendous upside remaining. So if overall market conditions remain sound-and the economy experiences nothing more than a soft landing-you'll see a strong equity market for energy stocks in 2001." Osmar Abib, managing director of Credit Suisse First Boston's global energy group in Houston, echoes this. "Last summer/early fall, we were lead or joint lead underwriter on the IPOs of Westport Resources , Hydril , W-H Energy and Chiles Offshore . But then, amid a market correction, we witnessed a disconnect between energy stock prices and the forward commodity price curve, and the new-issue window closed. That window, however, should reopen-particularly for service companies-in the first half of 2001." (See "At Bat: Energy IPOs," in this issue of Oil and Gas Investor.) Why? Abib points out that E&P companies are generating substantial cash flow, such that they're going to start spending aggressively on drilling projects, which is positive for the service sector. "At the same time, as business gets better, service companies-constrained by aging equipment and available manpower-are going to experience significant capital requirements, which they'll need to fund in the equity or debt markets." During February, CSFB joint-led (with Merrill Lynch) a nearly $100-million IPO for Oil States International, a diversified service company controlled by private-equity funder SCF Partners . In the second quarter, the marketmaker is planning to take public another oil-service company. On the international front, the banker was joint book runner with Merrill Lynch at press time on the relaunch of a $1.5-billion IPO for China National Offshore Oil Corp. As investors come off the sidelines into the energy sector, Arnold sees his firm's recent $12.4-billion merger with Donaldson Lufkin & Jenrette paying handsome dividends. "DLJ brings us more finely tuned experience in the high-yield market, which is generally for small- to midcap operators." Adds Abib, "It also brings us some strong skill sets in structured finance. Attractive incremental financings can be provided through special-purpose, off-balance-sheet vehicles that have [credit] ratings and tax enhancements. In addition, DLJ brings a very sizeable private equity franchise for our smaller clients who are looking for partners to pursue strategic initiatives." Kevin S. McCarthy, managing director and head of the global energy group for UBS Warburg LLC in New York, is another market maven who sees sizzle in the gas story. "With every month and quarter that goes by, institutional investors are starting to believe that sustained high prices for this commodity are here to stay. In addition, we continue to see sector rotation out of technology issues-whose volatility has only grown since last November-into energy shares." But high gas prices, which this winter spiked to nearly $10, have been something of a double-edged sword for the market. The very fact that such prices have generated lots of cash flow for the upstream has meant operators haven't needed to tap the capital markets very much. "Nonetheless, there's only so much debt you can pay down and only so much stock you can buy back," observes McCarthy. "Eventually, you've got to spend for growth. Right now, we're seeing a wave of announced E&P budget increases for 2001-probably 20% to 25% higher than last year. So there's going to be more demand for capital this year, principally equity, by producers and the drilling companies." Proof: UBS Warburg, which last year co-led the IPO of Energy Partners Ltd. and secondary stock offerings for both Evergreen Resources and Spinnaker Exploration , will be bringing to market during first-half 2001 four IPOs, including one for Norway's Statoil. What about the high-yield market? "Last November, we did a $200-million high-yield financing for Grant-Prideco ; it was a 10-year piece of paper that carried a 9.75% coupon, and it was very well received," says McCarthy. "But we don't see this market being particularly robust this year for first-time issuers. What you're likely to see instead is repeat issuance by well-established names in the industry." As for momentum in the merger market, that's another matter. "In the basic bread-and-butter E&P sector, you're always going to have M&A because for every combination, another new public company emerges through an IPO," he points out. "Some people say that of the top 50 public companies 10 years ago, only 20 of them exist today. But if you look at the current universe of producers with market caps between $200 million and $10 billion, there's probably just as many now as there were then-they're just under different names." Last November, UBS itself merged with PaineWebber in a $12.1-billion deal. "With 8,500 brokers, PaineWebber had outstanding retail equity distribution and research capabilities," explains McCarthy. "However, it didn't have the strong high-yield, balance-sheet, bridge-financing, equity-derivative and international capabilities to be a global lead manager of a large transaction. UBS brought all that to the table, plus it was very strong in crossborder M&A." The target energy clients of the new UBS Warburg are medium to large-cap U.S. E&P and service companies, and in Europe, the industry's goliaths-the likes of Royal Dutch/Shell and BP. "In the U.S., we tend to look at energy companies with a public float of more than $100 million, an established track record, and most importantly, strong management," says McCarthy. "A perfect example is Denver's Westport Resources. Don Wolf and his team used to be with General Atlantic , which they grew through focus, attention to costs and high profitability. Now they're doing the same thing at Westport. So this IPO sold very well to investors." What does not sell well to many investors, however, is hedging. But McCarthy doesn't put much stock in that conventional wisdom. "Institutions typically say they want full exposure to commodity prices, but they only say that when commodity prices go up-not when they head south. With the futures market becoming increasingly efficient, we see more producers this year locking in returns based on current commodity prices-particularly if they have on their plate large projects with significant capital costs." Daniel O. Conwill IV, executive vice president, corporate finance, for Jefferies & Co. in New Orleans, says, "The biggest event that will affect capital market access for energy companies in 2001 will be when both the industry and the financial community finally come to believe that we've entered a fundamentally stronger period of natural gas prices-and that to develop new sources of supply, spending is going to have to increase." Says Jay M. Courage, Jefferies' senior managing director, corporate finance, in New York, "With commodity prices continuing strong during this year-an average of $26 for oil and $4 for gas-energy companies are going to exceed analyst expectations, which bodes well for their stock-price trading performance and new issuance activity. So we see a better year than last on the equity-raising side and even on the high-yield-issuance side." Conwill points out that whereas inflows into high-yield mutual funds were around $12 billion in 1996, $16 billion in 1997 and $12 billion in 1998, those same inflows were flat to negative in 1999, and negative by $5.7 billion in 2000. "This year, however, with the Fed easing monetary policy, inflows into high-yield mutual funds should again be positive. And as that happens, portfolio managers are going to be looking to the energy sector as a safe harbor-away from other industry groups that are susceptible to any weakness in the economy." From January 1993 to October 2000, Jefferies lead-managed 40 high-yield transactions in the energy sector, totaling roughly $7.5 billion, he notes. On the equity-raising side, Courage sees a big bounce over 2000. "There was probably much less activity last year in energy than one would have expected, given the dramatic improvement in commodity and company-stock prices, which in many cases doubled from prior-year levels." But a lot of producers just weren't ready to pull the trigger on equity deals. Meanwhile, investors, believing that oil and gas prices were going to tumble-and stock prices along with them-took the view of "Why buy now?" "Commodity prices, however, haven't tumbled, earnings continue to surprise and now there's pent-up demand for equity-both on the part of issuers and investors," Courage observes. Jefferies, which last year comanaged respective $250-million and $87-million equity offerings for The Shaw Group and Friede- Goldman -both offshore service suppliers-recently sole-managed two other deals: a $75-million stock deal for Cabot Oil & Gas and a $27-million offering for Goodrich Petroleum, both Houston-based producers. Says Conwill, "In first-half 2001, we expect to complete two or three other equity deals, primarily for E&P companies seeking to fund expansion projects." Another area of stepped-up activity for Jefferies is M&A. "As buyers and sellers come together on their [commodity] pricing assumptions