As the energy industry closes out the year, many challenges remain. The commodities and financial markets continue to contain far more uncertainty than certainty, and the road to economic recovery is far from smooth. Many financial providers are reluctant to make generalizations, but they seem cautiously optimistic.

And no wonder. In the past 18 months, the industry saw unprecedented volatility in oil and gas prices, which rose and fell to record-breaking levels. Oil dropped from $100.64 per barrel in third-quarter 2008 to $70.61 in third-quarter 2009. Gas prices tumbled from $7.44 per million Btu to $4.84 during the same period. As a result, fears of further volatility touched every sector of the energy industry.

In a break from the past, traditionally predictable semi-annual borrowing-base redeterminations, based on reserve valuations, were serious cause for concern for producers this year. Some small producers couldn’t hang on and were forced to file bankruptcy.

On the other side of the table, lenders saw their clients turn away from commercial debt in favor of issuing bonds into the more costly public high-yield market.

On a positive note, however, from a standing start of virtually no deals closing in the beginning of 2009, the market opened up to equity, debt, acquisitions and joint ventures.

Price forecasts

As for commodity prices, at press time there was still no end to wildly fluctuating price predictions, despite a fairly steady forward strip and widely used hedges.

In October, research firm Sanford C. Bernstein Co. Inc. published its opinion that “there is an upside to gas beyond the strip” and forecast a surprising $9 per thousand cubic feet (Mcf) price target for 2010, a mark some 54% above other analysts’ consensus.

Credit Suisse Securities (USA) LLC calls for $4.70 gas in 2010, citing stabilizing production and further demand contraction next year. Tudor Pickering Holt & Co. LLC’s prediction is somewhere in the middle, at $7.50.

Based in Houston, TPH is an integrated energy investment bank and merchant banking boutique, while the company’s broker-dealer, Tudor Pickering Holt & Co. Securities Inc., offers securities and investment-banking services to the energy community. The firm’s TPH Partners LLC makes private investments in the upstream, midstream and services sectors.

“On the gas side, we have had a supply problem and a demand problem,” says Bobby Tudor, chairman and chief executive. “The million-dollar question is, how long does that take to shake out?” An analysis of TPH’s recent 500-page study foreshadows a fairly dramatic gas-price recovery in 2010.

“We are suggesting that gas prices will average $7.50 per Mcf next year,” Tudor says. “That is up off a current strip price of just more than $6. When we first made the call for $7.50 for 2010, the spot price was about $3. Our corporate clients called to ask what we were smoking.”

TPH studied 32 North American producing areas. Based on its models of each producing well and assumptions of future wells, particularly in the shales, there is “ample gas supply for any demand scenario,” he says.

However, TPH predicts a billion cubic feet per day of net demand growth based on U.S. gross-domestic-production growth. That demand will intersect with another event: a rig count maintained at its current level, causing production to fall by 10%. Such a scenario will tighten gas supply even without significant demand recovery, prompting rapid price recovery, explains Tudor.

The firm is also bullish on oil. “We use a $90 long-term oil price, based on a normalized demand scenario where the price of oil will be set by the cost of the marginal barrel of oil,” says Tudor, bucking ExxonMobil Corp.’s estimate of $70.

TPH’s marginal-barrel estimate is based on Canadian oil-sand plays, which it contends require $90 per barrel to earn a low double-digit return for its producers.

Oil price closely tracks the broader market, so there is a “short-the-dollar, go-long-commodities” trade that “has worked beautifully for every hedge fund in the world,” says Tudor. “We expect that as long as the dollar is weak, commodities will be relatively strong.”

Yet, given the high level of oil inventory at present, oil is “somewhat overbought,” he says. Current oil inventory does not support current price, so dollar-commodity trading strategies may be unduly inflating the oil price for now.

Redeterminations

Fortunately, E&Ps’ semi-annual borrowing-base redeterminations by lenders were milder than expected. Although many borrowing bases were reduced, others were raised and some were left unchanged.

In October, Exco Resources Inc.’s borrowing base was reduced by $450 million to $1.3 billion, after the company sold off assets in Appalachia and the Midcontinent. GMX Resources Inc.’s borrowing base was lowered to $175 million, motivating it to offer 6.95 million equity shares at $15 each and $75 million in debt via 4.5% convertible senior notes.

Also, NGP Capital Resources Co. reported that three of its four lenders had reduced their commitments to its investment facility (priced at Libor plus 425 to 575 points) to $67.5 million, down from $87.5 million. NGP provides senior and subordinated debt, convertible debt, preferred equity and project equity to small- and mid-cap energy companies.

At least two upstream master limited partnerships—BreitBurn Energy Partners LP and Legacy Reserves LP—saw their borrowing bases reaffirmed at $732 million and $340 million, respectively.

Elsewhere, Forest Oil Corp.’s bankers held the producer’s base steady at $1.62 billion with no change in terms. Ram Energy Resources Inc.’s base, collateralized by its 60%-proved-developed-producing reserve base, continues at $175 million. Two Marcellus drillers, Range Resources Corp. ($1.5 billion) and Rex Energy Corp. ($480 million), had no change.

On the upside, Vanguard Natural Resources LLC saw its base increase to $175 million, from $154 million. Vanguard credits the increase to its August acquisition of properties from Lewis Energy Group LP. Most of the assets, including 27 billion cubic feet equivalent of estimated proved reserves, are hedged at $8.18 per million Btu and $86.55 per barrel through 2011.

Vanguard’s lender group also increased the company’s borrowing costs to Libor plus 2.25% to 3%, from plus 1.5% to 2.125%, and tightened the E&P’s debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) to 3.5x, down from 4x.

In addition to lower bases, tightened debt markets drove asset sales during the year. Even large caps such as El Paso Corp., Chesapeake Energy Corp. and ConocoPhillips decided to sell off properties to pay down debt.

El Paso announced plans to “further improve the company’s financial flexibility to fund its core businesses” by selling up to $500 million in assets during 2010 and will reduce its quarterly dividend from $.05 to $.01 per share. The dividend reduction will result in approximately $112 million of annual cash savings.

Chesapeake found itself a bit overleveraged, according to Fitch Ratings, which reported concerns about the E&P’s cash flow and liquidity.

“High levels of capex in the current low-price environment are expected to result in minimal to negative free-cash-flow levels,” wrote Fitch analyst Eric Tutterow.

“Chesapeake continues to rely on asset sales, including proceeds from volumetric production payments, to finance drilling requirements. While Chesapeake has no scheduled debt maturities until 2012, borrowing-base redeterminations associated with the company’s credit facility ($2.8 billion outstanding at June 30, 2009) could create the potential for earlier debt reductions.”

Meanwhile, ConocoPhillips announced plans to improve its financial position by selling off a whopping $10 billion in upstream and downstream assets during the next two years.

Double exposure

Despite challenges, by the end of 2009 a significant number of E&Ps had paid down their credit facilities. As a result, commercial banks such as Wells Fargo lost a portion of income previously derived from interest rates.

Yet, says Kyle Hranicky, executive vice president and manager of Wells Fargo Energy Group, “We gained income from fees. We were the No. 2 high-yield book-runner for the energy sector through third-quarter 2009.”

Wells Fargo is actively seeking to put capital to work, even in the tough midstream market. The bank was involved in the recent transaction by Southcross Energy LLC, a Dallas-based gas transportation and processing company, to purchase Mississippi, Alabama and South Texas assets from Crosstex Energy LP for $220 million. Crosstex used the net proceeds to pay down $212 million of its debt facility. Wells Fargo was involved as book-runner and administrative agent.

The recent merger with Wachovia Bank has given Wells Fargo significant exposure to some names in the upstream sector. At press time, the bank had $18 billion (about 40% drawn, on average) in oil and gas commitments, of which $7 billion was acquired via the merger.

“Including Wells Fargo and Wachovia, we were lenders to about 60 energy companies that overlapped,” Hranicky says. “We looked at those to determine where we want to be with them in the long term.”

In most instances, Wells Fargo kept the combined exposure, except when the deal was up for renegotiation. “In some of those cases, we decided to right-size the exposure relative to other institutions.

“We’ve completed about 23 high-yield book-running transactions for oil and gas companies this year,” he says. “The bank-debt activity has been down, as expected. But at the beginning of the year, no one would have predicted the public-debt market would be this active. That’s the real story.”

Red hot

“The high-yield bond market has been red hot,” says Hranicky. While companies plan to use more than 90% of the proceeds for general corporate purposes, to repay upcoming maturities and term out outstandings under credit facilities, about 6% will go to working capital. The last 1% will target acquisitions.

Also, spreads have narrowed dramatically in the high-yield market since last spring. The BB and B indices were at 7.87% and 9.43%, respectively, as of October 31. These levels were 13.34% and 17.91% as of March 1.

“The improvement in yields, as well as pent-up investor and issuer demand, opened the door for a robust second quarter,” Hranicky says. “Since then, the market has remained opened and is, for the most part, a complete reversal of conditions seen in the second half of 2008.”

Good for producers, but excellent for investors, as virtually all of the 2009 energy issues are trading above their at-issue price.

New energy issuance has already surpassed $15.5 billion, up 83% over 2008, with upstream oil and gas deals comprising 57% of that pool.

Hranicky points out that bank debt is still less expensive than bond issues, given differences in security, covenants and maturity. At first look, a typical borrowing-base grid looks costly, having increased to a basis-point range of 225 to 325 over Libor, up from 100 to 200 points in 2008. Yet, Libor is so low that the underlying rate is still very cheap. With Libor at 25 or 50 basis points, Libor plus 300 is still under 4%.

“There is another camp of E&Ps who, because they are private, are not big enough, or don’t have the credit profile, to access the capital markets. They must borrow at a relatively high percentage of their credit facility,” he says. “For them, there is more pressure. They are starting to break covenants and are being put on ‘reducers’ (plans to reduce base-ceilings within six months) or are being forced to amortize debt over six months to meet newly lowered borrowing bases.”

Equity markets awaken

But don’t call bankers the bad guys, says Scott Baxter, managing director and head of energy at international investment bank Houlihan Lokey in New York.

“Banks do not want to throw the upstream companies into bankruptcy or force a fire sale of assets,” he says. “But we do see commercial lenders using more conservative price decks, extending debt maturities and lowering borrowing bases more now than in the spring.”

Before joining Houlihan Lokey, Baxter was head of Americas for JP Morgan’s energy investment-banking group and managing director for Citigroup. During his 20-year career, he has been involved in energy M&A deals totaling more than $100 billion in value.

Today, Houlihan Lokey is the world’s largest privately held investment bank. It was ranked the No. 1 M&A advisor for U.S. transactions under $2 billion by Thomson Reuters and the No. 1 investment-banking restructuring advisor by The Deal in 2008. The firm has been involved in restructuring deals for Enron Corp., Lehman Brothers Holdings Inc., SemGroup LP and Flying J Inc., among other major names.

With such a weighty resume, the bank’s clients listen when Baxter judges debt markets as “still troubled.” Equity markets, on the other hand, are awakening.

“The market for follow-on financing has been more active during the past six months than it has been during the past couple of years. Some of this is because stock prices are low and look interesting to many equity investors looking to put money to work,” says Baxter.

“The forward curves look reasonable to investors who are tired of zero interest rates from Treasuries. They are beginning to move into higher-risk assets. We are seeing transactions across the board in upstream, midstream, downstream, oil services and alternative energy.”

In the upstream MLP sector, Houlihan Lokey was financial advisor to Pioneer Southwest Energy Partners LP for its West Texas Spraberry Field asset acquisition from Pioneer Natural Resources Co. for $171.2 million in cash. The deal closed in late August. The assets included 170, 40-acre drilling locations, some 1,300 barrels of oil equivalent per day (65% oil) of production and about 18.9 million barrels of oil equivalent (37% proved developed) of reserves. Pioneer Southwest funded the deal with $30 million of cash on hand and borrowings from its credit facility.

“Recently, most of the upstream MLPs (master limited partnerships) have had a difficult time getting the kind of multiples that their managers desire, but the structure is still very viable,” says Baxter.

Overall, Baxter expects deal flow to pick up in 2010. Following on the heels of upswings in the financial and stock markets are improvements in company values, enabling a significant amount of private-equity money to be put to work.

“We are seeing material increases in gas-weighted equity prices, even though we are awash in natural gas supply and storage. If we see industrial demand pick up, we will also see the gas M&A bid-ask spread narrow,” he says.

Yet, despite investor appetite and money spent on independent evaluations, not all deals get done. “We had a few mandates, early in the year, where the client chose not to pull the trigger due to market conditions. Not all deals are easy. I have a saying: ‘The only easy deal was yesterday’s deal.’”

Midstream M&A

In addition to upstream M&A, the popularity of the MLP business model has grown in recent months, says Andrew Safran, vice chairman for Citi Global Banking and head of its global energy, power and chemicals business. Safran is often credited with being one of the developers of the MLP marketplace, now comprising more than $140 billion in aggregate market capitalization. He has been involved in more than 50 transactions and 30 IPOs.

“The sector is seen as a stable business model with visible and predictable cash flow, which investors prefer,” he says. “A vast percentage of the MLPs’ cash flow, other than certain upstream, gathering and processing segments, is predicated upon fee-based business without exposure to commodity prices.”

Safran notes that investors also like yield-oriented securities. MLPs have attractive total return (income plus capital appreciation) profiles, and such yield is historically prized in times of volatility. As a class, MLP indexes have typically outperformed other stock indexes. Also, the “pass-through” tax treatment characteristic of MLPs is favored by income-oriented retail investors.

But there is no guarantee for the midstream, either, in the marketplace. In September, Marcellus-shale player Atlas America Inc. announced the pending merger of Atlas Energy and its MLP, Atlas Energy Resources LLC, after a failed attempt to IPO the entity as an MLP.

Then, in October, Abraxas Petroleum was finally forced to roll back into the general partnership its 2007-proposed MLP, Abraxas Energy Partners LP, when the debt, equity and IPO markets vanished in 2008, and it ran out of time to go public in 2009. A registration-rights agreement between Abraxas and its unitholders required the partnership to go public in a timely manner or be converted back into Abraxas common shares.

Corporate consolidation

Safran predicts a new trend of corporate consolidation in the energy space. “That is something that we really haven’t witnessed much over the past several years. The combination of weaker commodity prices and more restricted access to the capital markets will challenge smaller players who want to continue to grow and execute their game plans.”

Consolidation will also hit the oilfield-service sector, driven by large caps seeking to fill out product suites and conduct bolt-on acquisitions. There will be fewer such consolidations than those likely to occur in E&P, he says.

Another trend, one that could spawn IPOs in 2010, is that of private-equity fund managers now pressured to monetize part of their portfolios. Due to the financial downturn, endowment and pension-fund managers invested in private equity may need more liquidity from the general partners of those funds.

“Endowments may need cash to cover current expenses,” says Safran. “They might have to monetize their illiquid holdings, and can put pressure on fund managers to push some of their portfolio companies to IPO.”

Conversely, other private-equity providers have made portfolio changes toward natural gas and oil. In October, Fort Worth-based Texas Pacific Group (TPG), a $45-billion (assets under management) private-equity investment firm, sold its stake in British department store Debenhams Plc, and invested $500 million in Houston-based Valerus Compression Services, a gas-processing equipment supplier to shale-gas players.

Kohlberg Kravis Roberts & Co., which recently placed $350 million with Marcellus-driller East Resources Inc., will IPO its Dollar General entity and plans six more launches. Blackstone Capital Partners, a major investor in Kosmos Energy LLC, is reportedly planning to IPO as many as eight portfolio companies.

Finance M&A

But not all of the M&A has been in upstream energy. In September, Calgary-based Macquarie Group acquired Tristone Capital Global Inc. for $108 million. Tristone’s A&D group will operate under the name Macquarie Tristone. The global combined entity has 210 corporate finance and technical professionals in 22 cities.

Overall, the M&A market has been slow, says Paul Beck, executive director in Macquarie Group’s Energy Capital office in Houston. “We are actively attempting to grow our business, but it is hard when gas prices are so low.” Beck has seen large deals, but the smaller deals, $25 million or less, are few and far between, he says.

In October, Macquarie Capital Markets Canada Ltd. was named financial advisor to Glamis Resources Ltd., Calgary, to assist in the acquisition of Saskatchewan assets from Connaught Energy Ltd., among others, for a total deal value of $244 million.

Especially hard to come by are oil deals, as “producers are holding their oil properties fairly close,” he says, but Macquarie has found a few.

The firm was financial advisor to TriStar Oil & Gas Ltd. when it was acquired by Petrobank Energy and Resources Ltd. in a $552-million-plus stock deal. The combination resulted in a new entity, PetroBakken Energy Ltd., now focused on the Williston Basin. In September, Macquarie was co-managing underwriter for Goodrich Petroleum Corp.’s $190-million offering of 5% convertible senior notes.

Deal flow

“Deal flow has definitely picked up in the latter half of 2009,” says Tommy Pritchard, managing partner of Pritchard Capital Partners LLC.

Transactions were sparse in 2008, he says, as negotiators wrestled with questionable asset valuations during the escalation of oil prices in the first half of the year and through the free fall in the latter half. Now the environment has changed, and he is in transaction mode.

Pritchard founded his firm in 2001. At the time, “energy was on the outs,” he says, and investors were turning to technology and telecom stocks. Pritchard and his partners, at the time with Jefferies & Co., wanted to continue to focus on energy, so they formed the investment bank that now employs more than 40 people in five offices.

Since then, the firm has managed about $12 billion in energy transactions, including IPOs, secondary offerings, private placement of equity and debt, mergers and acquisitions, and equity-linked securities. Pritchard is pleased to see a pick-up in deal flow over the past several months as more producers turn to investment banks for deals that historically would have gone to commercial bankers.

“It’s basically turned economic theory on its ear,” he says.

“Since the spring, people began replacing low-cost debt with high-yield debt just to get their bank covenants straight. Now we are at a point where most of the companies have worked their way through it, although gas prices are still an issue. We are still seeing people turn to their investment banks—not as a survival strategy but because they are looking for growth capital. My guess is that M&A activity will pick up too.”

Some 15 E&Ps hit the high-yield markets in October alone, offering multi-hundred-million-dollar deals with good rates, notes Pritchard. He points to Comstock Resources Inc.’s recent public offering of $300 million in 8.375% senior notes, due 2017, to pay down its credit facility. “Three months ago, they would have been looking at double-digit coupons.”

The investment-banking sector “was beginning to look like a ‘who’s who’ of commercial banks,” he says. “Now we are seeing more equity deals as the stock prices recover. People are once again beginning to raise growth capital.”

Pritchard’s latest sole-managed deal was a $105-million term loan for Houston-based Vantage Drilling Co. The driller will use the capital for construction, completion, commissioning and initial start-up costs of a rig. The loan bears 15%-per-year cash interest with a pay-in-kind interest component and matures five years from the November 2009 closing date.

The deal terms include two options to retire the loan—first, between September 1, 2011, and August 31, 2012, with accrued-and-unpaid cash interest due plus $127.5 million; or second, between September 1, 2012, and August 31, 2014, with accrued-and-unpaid plus $140 million.

Earlier in the year, Pritchard managed Houston-based BPZ Energy Inc.’s $48-million private placement of public stock, the first energy-PIPE deal completed in more than 12 months. BPZ sold 14.3 million shares ($3.05 each) to institutional and accredited investors to fund development of its Corvina and Albacora oil fields in Peru.

“From that deal, we started to get the sense that energy was back on the launch pad after a dismal start to the year,” says Pritchard. “Deal flow has picked up from there.”

Pritchard Capital was busy this fall, when the firm acted as co-manager on two offerings for ATP Oil & Gas Corp. —a convertible-preferred stock offering and a follow-on—as well as a senior-note offering by Goodrich Petroleum Corp., all in October, and a follow-on offering by Hercules Offshore Inc. in September. In addition, the firm was co-manager for Brigham Exploration Co.’s $168-million secondary offer and GMX Resources’ $104-million secondary.

Alternative energy

Although Pritchard is determined to continue its hydrocarbon focus, the partners recently diversified into alternative energy.

“We looked at solar and wind, but it seemed like a crowded space that was more geared toward technology-investment banks than energy boutiques. But we understand geothermal. It’s about drilling in hard rock with a rig similar to what you’d see in Texas or Louisiana.”

Pritchard sees interest in geothermal heating up due to 30% capital-expenditure rebates available for new projects.

To build up this sector focus, Pritchard brought in six bankers from Glitnir Capital Management, an Icelandic bank focused on underwriting M&A deals for geothermal power. During Iceland’s 2008 banking crisis, Glitnir was taken over by the Icelandic Financial Supervisory Authority. Its bankers started looking for a new home.

“We convinced these bankers to come over to our shop to ply their trade,” says Pritchard. “Since then, we advised on the $87-million IPO of Magma Energy Corp. in July.” Geothermal firm Magma has since acquired a majority stake in Icelandic HS Orka.

Pritchard expects to see more geothermal M&A deals, such as Ram Power Corp.’s acquisition of Polaris Geothermal Inc. and Western GeoPower Corp. in October. “There are some 130 geothermal power plants in Oregon, California and Nevada that are on the drawing boards. They’ll have to raise about $15 billion over the next few years.”

It just goes to show that in good times, bad times and recoveries, the financial community remains creative when it comes to banking energy ideas. M

Comments