In the wake of the recent slide in commodity prices, look for a surge in energy M&A deals in 2007 and a pullback in IPOs and other public-equity issuances.



It's hard to believe but looking back at much of 2006, the public stock-market valuations of many E&P companies actually exceeded the market valuations those companies would have received had they been sold in private-market M&A transactions.

But along came late summer and the Nymex floor saw a 2006 energy-sector version of Katrina. As speculation about an ease in tensions in the Middle East and word of high gas-storage inventories spread among traders, the wind gradually came out of the sails of stratospherically high commodity prices. Between August and late October, the futures market watched oil prices topple from $78-plus to $56; gas prices, from $9-plus to around $4.50.

Amid this reversal of fortune, a lot of speculators found themselves on the wrong side of commodity-price bets. Notably, Amaranth Advisors, a $9.2-billion hedge fund, lost about $6.4 billion in a matter of weeks on the heels of one of its traders making the wrong call on the direction of natural gas prices.

Today, speculation has begun yielding to reality and a focus on supply/demand fundamentals. And investment bankers, analysts and private-equity players are now beginning to reach consensus on where the price floor-the point of price equilibrium-is for oil and gas.

Could we see $30 oil or lower? "While OPEC might be unofficially comfortable with $45 oil, I don't think most OPEC countries could survive an oil-price drop to $30 or lower, given the need to keep their social-spending programs in place [to control their populations and avoid riots and regime changes]," surmises one Street analyst. "Put another way, if OPEC lets oil hit $30 or below, there won't be heads of state; there'll be heads on plates."

Fortunately, Wall Street is cautiously expecting a somewhat higher trading range for oil, in a band of $50 to $60 next year based on fundamentals. In the case of natural gas, 2007 forecasts vary from $4.50 if there isn't a cold winter to $7.50 if there is a high call on gas.

Given the history of commodity prices during the past 25 years, that's still a relatively healthy outlook. Yet, already-battered energy stocks aren't reflecting even that quiet optimism. As a result, many market-makers believe there will be fewer IPOs and less equity issuances in 2007 versus this year. Simply, with the recent plummet in oil and gas stock prices, and valuations now again higher in the private market, nobody wants to sell equity at an inopportune time.

Rather, because of this discontinuity in the public-equity markets, the Street looks for a stepped-up level of M&A activity in the upstream and service sectors next year, involving either asset sales or the private sale of companies as ways for managements and their sponsors to monetize their investments. Also, there's the possibility of some public E&P firms "going private" through LBO transactions.

With so many fallen angels this year among E&P stocks, a lot of acquiring-minded producers like Occidental, whose stock soared 20% in the first nine months of 2006, might well target operators like Pioneer Natural Resources, whose market value fell 24% in the like period.



'Going private' transactions

For the first nine months of 2006, there was strong energy-equity issuance in the U.S., both follow-on offerings and IPOs. In fact, Lehman Brothers anticipates that all natural-resources equity deal flow in the Americas this year may well hit a peak, on the order of $23 billion-some $9 billion of that involving IPOs.

But with the recent precipitous decline in commodity prices, and the attendant negative impact on oil and gas stock valuations-the Oil Service Index was recently off 20% while E&P stocks were down 10% to 15%-a more bearish sentiment for energy-equity issuance appears likely for next year.

"We have a number of pending transactions, both follow-on equity issues and IPOs, that are probably going to get postponed until people figure out where oil and gas prices are headed," says Grant A. Porter, New York-based vice chairman and head of Lehman Brothers' natural resources group. "So in 2007, I think you'll see less energy-equity issuance and probably more M&A activity as buyers and sellers come to a consensus that a point of equilibrium has been reached in commodity prices. At that point, you'll have a better two-way market than we saw when prices peaked this summer."

Porter, whose firm was one of the co-advisors to Anadarko Petroleum on its $19-billion buy of Kerr-McGee Corp., believes one way that E&P and service companies may choose to reposition themselves amid declining commodity prices and sagging market valuations is "going private" through LBO transactions.

The most prominent example of this strategy so far in the energy space has taken place in the midstream, with the decision by Kinder Morgan's management team to take NYSE-traded KMI private through a nearly $20-billion LBO.

The rationale? In any 'going private' transaction, there's usually a discontinuity between what management thinks its company is worth and what the public markets are saying it's worth, explains Porter. So if management believes it can create more value going forward as a private entity versus the valuation the market is assigning the company, then an LBO would make sense.

"While no such large transactions have been announced yet in the upstream, we believe there are a lot of private-equity houses-with long-term bullish views on both oil and gas prices-that view the recent rollover in commodity prices as an opportunity to back 'going private' transactions in that sector," he says.

Although used to date only by such midstream players as Southern Union, Dominion Resources and Enterprise Products Partners LP, hybrid securities like Lehman's Enhanced Capital-Advantaged Preferred Securities (ECAPS) might become attractive to E&P companies that have been aggressive acquirers through equity issuance but have balance sheets that now need support, notes the market-maker.

Effectively, these securities are long-term, subordinated debt instruments that are tax-advantaged to the issuer; however, they're treated by rating agencies as though 50% of their issuance is equity since the issuer can defer interest payments on those securities under certain circumstances, which is supportive of a company's senior capital structure, he explains. "Compared to issuing equity, these hybrid securities are far less dilutive to shareholders and represent a lower cost of capital."

Another 2007 trend to keep an eye on: more upstream MLPs. "In a healthy interest-rate environment, you're going to continue to see these yield-oriented vehicles in the market because they're perceived as a defensive security with less volatility in valuation than that of pure C-corporations," contends Porter.

"Take Linn Energy, an IPO we co-led last January. While commodity prices have declined, the price of that security hasn't because the company has managed to maintain its yield, increase its potential for future dividend increases, and hold its IPO value while the values of traditional E&P stocks have declined."



Fewer 144A deals

Around the start of 2006, M. Scott Van Bergh, managing director, upstream group, for Banc of America Securities in New York, noticed an anomalous situation taking place within the oil and gas sector.

"For the first time in a very long while, the public stock-market valuations for many E&P companies, particularly resource-play independents, actually exceeded private-market valuations, that is, the values those companies would have typically received if they had been sold in a private M&A transaction," he says.

Given this sea change on Wall Street, the market has since seen about a half-dozen upstream companies make their public debut, predominantly through fast-track 144A transactions, including the $800-million one for Rosetta Resources, and the $130-million one for Geomet Inc. Banc of America Securities was sole book-running manager on the latter transaction.

"However, with the recent decline in commodity prices and stock-market values in the upstream, we've reversed direction to where private-market valuations are once again higher than those in the public market," observes Van Bergh. "So from a trend perspective, my expectation is that we won't see next year as many E&P companies going public through traditional IPOs or, in particular, through 144A transactions where the discount in share values that investors may demand could be as great as 30%-plus."

Rather, due to the recent reversal in upstream valuations in the public markets, the investment banker foresees a pickup in M&A activity in 2007, involving either asset sales or the private sale of companies as ways for managements and their sponsors to monetize their investments-rather than dilute their business by issuing equity at an inopportune time.

This doesn't suggest Van Bergh isn't upbeat in his market outlook for the E&P sector. He points out that investors still believe in the longer-term fundamentals of the gas story.

"They recognize that gas reserves are becoming harder to find economically and harder to replace, that the economy is growing, that gas demand will continue to grow right along with it, and that future gas prices will be more robust than we've seen this fall."

However, he cautions, "We need to work off this gas-storage bubble. And this time around, that means we need cold weather going into the heating season, not just in January."

Also good news for independents: there are more financing alternatives today than ever before, Van Bergh says. He cites robust interest in the upstream from traditional private-equity sponsors like First Reserve, Yorktown Partners, Warburg Pincus, Natural Gas Partners and EnCap Investments, as well as from the growing ranks of hedge-fund investors.

"Meanwhile, on the debt-financing side, the larger banks such as ourselves, JPMorgan Chase and Citigroup are now lending down into the smaller-cap E&P universe," he says. "Also, the high-yield market continues to be strong, with institutional investors-mutual funds, insurance companies and money-market funds-showing a willingness to look at different sorts of financing structures."

One E&P financing structure Van Bergh is a little cautious about, however, is the publicly traded upstream MLP. "Personally, I view this as a very bullish, peak-market structure," he says. "The idea that such MLPs will generate enough cash flow to fund maintenance capital expenditures on assets and also fund a healthy distribution to investors works very well at $7 or $8 gas prices. But it may not work very well at $4 gas. So the jury is still out on these MLPs until we see how they perform should we get into a weaker commodity-price environment."



Upstream picks

A market seer with a relatively upbeat outlook for commodity prices, Ellen K. Hannan, managing director and senior E&P analyst for Bear Stearns & Co. in New York, sees gas prices averaging $7.50 for 2007 and beyond.

"Much below that, it becomes uneconomic to drill for gas in the Lower 48, given the industry's current cost structure," she contends. "Also, this forecast is tied to our belief that oil prices will remain in the low $60s."

Hannan predicts that during this heating season, the call on North American natural gas is going to be 500- to 600 billion cubic feet (Bcf) greater than last winter-simply because the corresponding 2005-06 period wasn't much of a winter, with gas consumption well below the historic trend line. "So despite the fact we currently have very full inventories of gas, just a normal winter will cause a better draw-down than last year."

In addition, the analyst expects the recent slump in gas prices-to around the $5 level-may cause a slowdown in drilling activity. "That's the only fix for low prices." She says the best indicator of a slowdown would be if the U.S. rig count-which hit a record high of 1,450 this September-declines by about 200 rigs.

Notably, of those 1,450 rigs operating earlier this fall, all but 80 or 90 were working onshore-the bulk of them in the Barnett Shale in East Texas, the Fayetteville Shale in Arkansas, the Woodford Shale in Oklahoma and other unconventional-resource plays in the Rockies.

She offers yet another catalyst for sagging natural gas prices. "If some industrial demand for gas returns at the very time production is falling, that could easily correct the cycle."

Given her commodity-price outlook, Hannan believes several growth and value stocks in her E&P coverage universe are poised to benefit. Among large-cap independents, she cites her top pick Devon Energy; among midcaps, Newfield Exploration; and among small-caps, Goodrich Petroleum.

The knock on Devon, whose production is 60% gas, has always been that it would just acquire and exploit and hadn't the expertise to explore, she says. But four or five years ago, the company, following its acquisition of Ocean Energy, decided to focus more capex on offshore exploration. "Today, that in-house strategy has resulted in six announced oil discoveries in the Gulf of Mexico's lucrative Lower Tertiary Trend."

Although output from these discoveries won't come online until 2009 or 2010, Hannan stresses the finds will greatly enhance Devon's production and reserve base. Recently, the stock was trading at 3.8 times estimated 2007 cash flow versus a peer-group average of 4.4.

While Newfield Exploration is still perceived as a shallow-water Gulf of Mexico play with short-lived reserves, the company has become more dominant as an onshore U.S. player-its biggest production and reserve-growth prospects being the Woodford Shale and Wyoming's Monument Butte Field, the analyst says.

Undervalued, the stock is trading at only 3.0 times estimated 2007 cash flow and at 64% of appraised net asset value (NAV); comparatively, its peer group trades at an average cash-flow multiple of 4.0 and 82% of NAV.

Although small, with only 25 million shares outstanding, Goodrich Petroleum is in the process of developing a substantial 80,000-acre lease position in the Cotton Valley Trend in East Texas, Hannan says. "This play has the potential to provide Goodrich an awful lot of production and reserve growth, on the order of 20%-plus annually during the next five years.

"Right now, its Cotton Valley lease acreage is worth about 1 trillion cubic feet of gas reserves, net to Goodrich, when fully developed. By contrast, at year-end 2005 it had only about 120 Bcf equivalent of reserves on its books."



Flight to quality

Not a market maven to mince words, Fadel Gheit, senior vice president and senior energy analyst for Oppenheimer & Co. in New York, offers a sobering outlook for the oil and gas sector-one not for the faint of heart.

Going into this fall, he reduced his rating on the energy sector from a blanket Buy to a blanket Neutral. "Current oil prices aren't sustainable based on industry fundamentals," he says. "There's no shortage of crude oil, and there hasn't been for the past four years. So unless annual demand rises much higher than 2% or we have major supply disruptions, $60 oil isn't sustainable. Rather, we believe crude prices will gravitate lower, to a range of $50 to $60."

As for gas, the analyst sees prices retreating to a more sustainable range of $5 to $6. However, he warns that "unless we have a cold winter, we could see significantly lower gas prices in the first half of 2007-as low as $4.50."

Stresses Gheit, "We're therefore advising investors in oil and gas stocks to take profits on spikes and buy back near-term on dips. But be ready to trade. The easy money has been made. Now people have to earn it."

The analyst notes that one of the sure signs the oil and gas sector is nearing, or is already at, the end of a commodity-price cycle is when investors start dumping the stocks of independent E&P companies like Pioneer Natural Resources-down 24% in value during the first nine months of this year-and begin moving their money to higher ground, to major integrated oil stocks that are less volatile.

"Small wonder why ExxonMobil's stock rose 27% during the first three quarters of 2006," says Gheit. "It wasn't because investors thought the company's earnings will be higher next year. That would be impossible with oil and gas prices on a downward bias."

Rather, it's a flight to quality, not only to ExxonMobil, but also to names like Chevron, Royal Dutch Shell and eventually BP, he says. "Most of those companies are going to be profitable even at $45 oil and will be the top gainers in the energy sector. And, unless oil prices collapse, these stocks are also likely to outperform the S&P 500."

Can any money be made at all in the E&P sector? Yes, but it would have to be based on M&A activity because commodity prices aren't likely to bail out the group, says the researcher. "In that case, those independents with the least depreciation in their stock-a favored currency in M&A deals-will have the upper hand."

Gheit cites as potential acquirers Apache Corp., whose stock this year slipped only 8% through the end of September; Devon Energy, down only 1% during the same period; XTO Energy, off 5%; and Occidental Petroleum, whose market value soared 20%.

The potential targets? Not surprisingly, he cites Pioneer Natural Resources, given its 24% fall from market grace through September, along with Cabot Oil & Gas, an Appalachian gas producer whose stock value remained relatively stable during the same time, but whose access to major Northeast gas markets would be attractive to the likes of Chesapeake Energy, which is looking to expand in that region.

Still, one nagging question remains: could world oil prices retreat to $30 or lower? "If it weren't for the all-time-high social spending by OPEC countries to keep their populations under control, there could be riots and regime changes," says Gheit. "So while they might be unofficially comfortable with $45 oil, I don't think most OPEC countries could survive an oil-price drop to $30 or lower, given their social-spending programs.

"Put another way, if OPEC lets oil hit $30 or below, there won't be heads of state; there'll be heads on plates."



Expanded presence

Headquartered in Irving, Texas, Natural Gas Partners-which since 1988 has invested $3 billion-plus of private-equity in more than 100 E&P, midstream and oil-service companies-also has a presence in Stamford, Connecticut.

The firm's Irving-based parent, NGP Energy Capital Management, additionally oversees Washington-based NGP Technology Partners, a $148-million fund investing in companies providing technology-related solutions for oil and gas, power and alternative-energy firms; and NGP Capital Resources, a Nasdaq-traded Houston firm with $250 million for mezzanine and structured-finance loans to North American energy companies.

The parent will also soon oversee NGP Energy Infrastructure and Resources Partners-a fund now being marketed-that will target $1.5 billion of investments in the midstream sector as well as coal, mining and minerals operations.

This fall, the expanding energy-financing firm announced that Barclays Capital, the investment-banking arm of Barclays Plc, had purchased a 40% stake in the company.

Explaining this alignment, Ken Hersh, NGP Energy Capital Management's chief executive officer, says that energy increasingly is becoming influenced by economic and political events worldwide, and that the investment by Barclays Capital "now gives us access to all of the world's leading economies" and key investment relationships spanning the globe.

Back to the world of private equity, John Foster, managing director for Natural Gas Partners in Stamford, says institutional investors are now coming to the realization that energy isn't just a commodity-price game-that it has a permanent place in everybody's private-equity portfolio, assuming those investments are analyzed and structured properly.

"We have data on full-cycle returns during the past 10 years-which includes periods of large commodity-price increases followed by periods of large price declines-that demonstrates that seasoned private-equity funds like Natural Gas Partners have been able to make money in all cycles," says Foster.

Hersh notes that, amid high commodity prices and huge liquidity in the capital markets in 2006, the firm exited nine prior private-equity investments-eight of them in private E&P companies-for which it received more than $500 million. This included its exit from Rising Star Energy, a Dallas-based producer; CH4, a Fort Worth-based operator; Trifecta Resources, a Calgary independent; and Crow Creek Energy, a Tulsa-based producer.

Meanwhile, the fund invested some $200 million-although its commitments are much larger than that-in 11 energy companies. Six are upstream-focused; the balance, midstream players, a Texas utility and a biodiesel company in the alternative-energy space.

What's ahead for 2007? "We're going to begin a period where the oil and gas industry recognizes that more moderate prices are here to stay for a while, and that excess liquidity in the market has dried up," predicts Hersh. "So we see next year being dominated by us making more private-equity investments in the energy space rather than exiting existing investments."

He also envisions oil trading in the range of $45 to $75 and gas prices moving in a band between $3 and $6-with an awful lot of volatility in both 2007 and 2008. But that doesn't perturb Hersh. "If you're backing good managements that know how to make money in all cycles, there's no such thing as an up- or down-market in private equity."



Service-side M&A

Since its inception in 1992, Growth Capital Partners-a boutique investment-banking firm with headquarters in Houston and offices in Dallas, Austin and Greenwich-has closed $1.3 billion worth of energy-related M&A transactions-84% of that value representing the private sale of oil-service companies to strategic buyers or to private-equity firms, many seeking base companies around which to build and targeting returns in the 20% to 25% range.

Spearheading this advisory effort in Houston have been John T. McNabb, the company's founder and chairman, and Edward J. DiPaolo, a senior managing director. McNabb previously had 22 years of energy-financing experience at Prudential Capital and BT Southwest; DiPaolo, 30 years with Halliburton Co.

"During the past five years, particularly the last two, we've seen a tremendous pickup in service-sector M&A activity on the selling side, and it's likely to continue at the same pace or even grow going into 2007," says George A. Khouri, managing director for Growth Capital Partners in Greenwich.

"For one thing, due to high oil prices and increased drilling activity, there's a greater need for the products of service companies," he points out. "As a consequence, their revenues and resulting EBITDA (earnings before interest, taxes, depreciation and amortization) have increased dramatically. Layer onto this the higher EBITDA multiples that are being paid for these entities by both strategic buyers and private-equity firms and it's not hard to understand why many service-company managements believe the time is ripe to sell."

Khouri notes that, in some cases, service companies wanting to continue to grow may see the need for outside capital and seek a private-equity investor that can help take their business to the next level.

During the past 12 months, Growth Capital Partners has closed on six M&A advisories for selling service companies totaling about $250 million in value. The average EBITDA multiple paid for these companies was 7.0-one or two multiples higher than historical averages.

One such advisory involved the sale of a private Texas service company that provides coiled-tubing and pressure-pumping services to producers in South Texas. The company was purchased by a Midwestern private-equity firm with little or no experience in the energy sector. Nonetheless, it was attracted by the growth prospects of the service provider and its management.

Another advisory involved the sale of a private Louisiana service company that provides well-monitoring, chemical-injection systems and multi-line services for deepwater and subsea oil and gas wells. The purchaser was a Houston-based service provider seeking to fill a hole in its array of product offerings but, more importantly, looking for a strategic competitive advantage through consolidation.

While the aggregate enterprise value of these two companies was north of just $100 million, Growth Capital is currently working on six more M&A advisories for selling oil-service companies whose combined enterprise value is in excess of $500 million.

Says Khouri, "The financial performance of service companies and the availability of capital at all levels-and at reduced prices-is extremely positive and is fueling the higher prices now being paid for these companies."

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