Like a merry-go-round in an amusement park, the energy sector in the past quarter-century has watched its fortunes rise and fall in cyclical fashion to the tune of commodity prices bobbing up and down. All the while, investors have been hopping on and off their favorite oil-patch ponies, ever reaching for the brass ring. Today, this merry-go-round has come full circle to those heady days of 1981, and investors are again riding high-this time to the tune of $70 oil and $6 gas. Indeed, energy has become one of the most popular rides on the Big Board at the corner of Wall and Broad streets. And pacing the momentum of this ride is a capital carousel filled with more sources and types of financing than the industry has ever seen. Unlike 1981, there are huge "universal" banks around today, involved simultaneously in lending and investment banking, that are able to take higher risks and provide energy clients-even the smallest ones-greater and faster access to capital. Private-equity-fund sponsors-backed by growing pools of institutional capital that include mutual funds and hedge funds-are popping up from behind every pumpjack and drilling rig. Also, energy lenders are stretching their credit and derivative-products capabilities to make profitable upstream asset acquisitions occur, even at record purchase prices. To get a fast-track understanding of the changes that have occurred in energy financing during the past 25 years-and the capital trends that are likely to emerge in coming years-Oil and Gas Investor recently visited with six captains of oil and gas capital who have seen all the ups and downs in the energy sector. The consensus: the capital carousel for oil and gas has more than a few turns left. Grant A. Porter - Vice chairman and head of the natural resources group, Lehman Brothers, New York Product multiplicity Energy issuers have far more capital-raising choices today than 25 years ago. This ranges from midstream or upstream master limited partnerships (MLPs), volumetric production payments, the capacity in the high-yield market to do leveraged recapitalizations, or the growth of hybrid securities that have high equity content for the purpose of rating-agency treatment but are debt equivalents in terms of the cost of capital. Coming full circle In the mid-1980s, the first upstream MLPs that came to market had the wrong type of asset base. Specifically, most had short-lived, offshore reserves with 7- to 10-year reserve/production (R/P) ratios. Now the MLP market has found its way back to the upstream in the form of limited liability company (LLC) structures with long-lived onshore assets that have 15- to 20-year R/P ratios. We think these types of investment vehicles will be a big part of equity issuance in the E&P space. Booming IPO market At the end of first-quarter 2006, Lehman Brothers had the mandate to lead more than 20 energy equity transactions during the next three to four months, about 60% of which were IPOs-for producers, service companies, MLPs and the general partners of MLPs. Overall, we have a backlog of more than $5 billion worth of energy equity offerings pending in the U.S. and Europe. To provide some insight into the liquidity in the current market and investor enthusiasm for sophisticated financial product, our firm during the first three months of 2006 alone raised $2.4 billion of MLP equity. When I first got involved with MLP issuance at Lehman in 1986, it was a pretty good year if we raised $500- to $600 million of that kind of equity. M&A perspectives During the past 25 years, the big driver of energy capital-markets activity has been consolidation. In particular, the creation of the supermajor oils and their divestitures as they rebalanced their asset portfolios have, in turn, fed the growth of smaller producers which have now become super-independents themselves, such as Occidental, Apache, XTO and Chesapeake Energy. We expect to be involved in further industry consolidation, such as advising Chevron last year on its $19-billion buy of Unocal, as well as leading the IPOs of smaller upstream players like Linn Energy. Bullish outlook We're seeing the beginning stages of an extended bullish cycle for the oil and gas industry that will be driven by robust oil prices in the $50 to $70 range. Very simply, there isn't enough productive capacity to meet global energy demand. For investors to have an equity portfolio that will beat the market, they're going to have to be disproportionately weighted to energy versus historical averages. M. Scott Van Bergh - Managing director, upstream group, Banc of America Securities, New York Universal banks In the past 25 years-particularly in the past 10 years-we've seen the emergence of universal banks, that is, financial institutions involved in both lending and investment banking. That has been very helpful to the energy industry. For independents looking to do acquisitions, such banks provide loan origination and take-out financing all at the same time. In addition, the greater size and capital capacity of these universal banks allow them to take higher risk in terms of block deals or block trades, while giving the energy client greater and faster access to capital. No borders Universal banks have also become much more international in their capital-raising and M&A activities, to the point where there are now almost no borders. This, to a large extent, is a reflection of how energy-banking clients have themselves changed. In 1981, most independents were predominantly domestic players. Now U.S. producers, especially the larger ones like Marathon Oil, are becoming more interested in international opportunities-investing in the North Sea, West and North Africa, the Middle East, Asia, Russia and South America. High-yield explosion High-yield debt, a market once dominated by Drexel Burnham Lambert and used primarily for takeovers, has now become a standard financing technique in the oil and gas sector. Today, non-investment-grade issuers like Chesapeake Energy are making tremendous use of this still relatively low-cost, capital-raising tool to accelerate their growth through acquisitions. This explosion in high-yield offerings, and the growing investor appetite for such issues, is one of the most important changes that has occurred in energy financing during the past 10 years. New funding sources Today, mutual funds and hedge funds have emerged as very large pools of energy capital. In addition, we're witnessing an increasing number of private-equity sponsors entering the energy space. This changing dynamic is allowing smaller independents to gain much more rapid access to greater levels of capital than ever before. Recently, for instance, we did a pair of 144A transactions-the private placement of equity with institutional investors-for Riata Energy and Geomet Inc. In each case, there were numerous hedge funds involved. So today, the issue for independents isn't access to capital-it's finding opportunities to spend that capital. Cameron O. Smith - Senior managing director, COSCO Capital Management LLC, New York Filling a vacuum With the enactment of the Tax Reform Act of 1986 and the collapse in crude prices around the same time, institutional investors and tax-driven investments in energy disappeared from the market. But between 1986 and the early 1990s, we saw this capital vacuum begin to be filled by professionally managed, closed-end, energy-focused, private-equity funds-the likes of First Reserve, Yorktown Partners and Natural Gas Partners. Indeed, it's fair to say that during this period, private equity became the only source of outside capital for the oil and gas industry. Exponential growth In 1987, only two such private-equity funds existed; by 1992, there were four; and by 2002, that number nearly quadrupled to 15. Meanwhile, the capital available to the oil and gas industry from these funds mushroomed from less than $1 billion in 1987 to $11 billion by 2004, with the average fund size about $750 million. Today, with the migration of open-end hedge funds and mutual funds into the energy space, we're now tracking some 250 private-capital providers to the industry. Driven by returns During the 1990s, we saw the tech boom and bust in the public markets. For institutional investors seeking strong performance, private-equity funds generally, and those focused on energy specifically, were generating annual returns way above 5% while the returns for every other type of investment were either below 5% or negative. So energy was the bull's eye-and the demand push by institutions into energy caused private-equity funds focused on that space to grow. If one looks at 2005, funds like Quantum Energy Partners, Lime Rock Partners and Natural Gas Partners were generating internal rates of return greater than 50%-as one would expect when earlier energy investments were made at $25 per barrel, then sold at $65 per barrel through IPOs or asset sales. Riding the tide COSCO is an investment bank that intermediates energy private-equity transactions, a merchant bank that invests its own capital in every equity financing we manage, and a broker-dealer through our Private Energy Securities Inc. affiliate. Five years ago, we handled two energy deals totaling $50 million. Last year, we intermediated 10 private-equity transactions worth $430 million. During that time, we've invested in 26 companies and gotten back nine times our invested capital on seven of the investments we've monetized. This year, we're on track to intermediating upwards of 12 private-equity deals worth $400- to $600 million. Sustainability The resolve of open-end funds that have come into the energy space has yet to be tested by any meaningful downturn in commodity prices. However, closed-end private-equity funds should be around 10 years from now because they raise money on the basis of a 10-plus-year life. Jeffrey Harris - Managing director, Warburg Pincus, New York Trickle to flood If one looks back to 1981, the amount of capital controlled by private-equity firms in the U.S. at that time was probably around $10 billion across all sectors. Today, those firms, both in the U.S. and internationally, control hundreds of billions of dollars of capital-and that's private equity complemented by debt. The reason for this expansion: investors have concluded that the risk/reward ratio and the underlying growth in all asset classes are better in the private markets than in the public markets. Drawing a crowd A lot of capital is coming into this space, not just from private-equity and venture-capital firms, but also from hedge funds which now have amassed assets of more than $1.1 trillion. So the scale of available capital from financial groups to invest in energy is unprecedented. That said, most people invest by looking in their rear-view mirror. If they were successful in energy in 2005, they'll invest in that sector again this year. But if oil prices come back down, a lot of that money will go away. Impact of hedging Another big change in the industry, mostly in the past decade, is that independents making acquisitions are using hedging a lot more to lock in long-term prices on their production in order to avoid commodity-price volatility. This changes the risk/reward ratio, such that banks now feel more comfortable making bigger acquisition-related loans. That, in turn, benefits private-equity sponsors and buyout firms seeking to leverage their investments and take on less risk. Shifting focus In the past, we've been in on the ground floor of the private funding of such domestic producers as Newfield Exploration, Spinnaker Exploration, Encore Acquisition and Bill Barrett Corp. But today, we've become much more internationally focused and our energy investments reflect that. At year-end 2005, we led an equity-financing commitment totaling several hundred million dollars to Fairfield Energy, a privately held U.K.-based producer focused on the North Sea. We've also committed similar amounts to Kosmos Energy, a private Dallas-based operator focused on West Africa, and to MEG Energy, a private Calgary-based independent seeking to develop Canadian oil sands. Changing dynamics We would expect to see some of the level of activity that has been going on in the Canadian royalty-trust sector to migrate to the U.S. That would create a different flow of capital into the upstream energy space such as we've seen in the case of midstream MLPs. The creation of such upstream investment vehicles-such as the recent Linn Energy limited liability company-wouldn't necessarily involve the need for private equity because the risks/rewards would be different and the investors would be different. But it's a potential trend we're following closely. Bob Stone - Senior vice president and manager of energy lending, Whitney National Bank, New Orleans Disciplined days In 1981, most E&P loans were based solely on the liquidation value of the collateral properties. Then, there was a lot of emphasis on engineered reserve values and strict adherence to policies that had collateral-coverage guidelines. Changing times Subsequently, however, bankers largely became cash-flow lenders, placing much more reliance on the ability of a producer's cash flow to service debt and grow the company. So in our credit underwritings, we began to focus on the borrowing entity as a going concern. That was a big change. In addition, capital-markets groups became imbedded within the energy-lending function and interest income became secondary to fee-derived income. Today, derivative products, advisory services and other fee-based activities are the principal drivers of bank profitability rather than the renting of the balance sheet. So what I'm seeing now is a little less structured and disciplined approach to energy lending versus 25 years ago, and the need perhaps for a little more pencil sharpening by lenders, particularly since energy clients are demanding more borrowing capacity against their collateral assets. Bankers gone wild One of the more calamitous events for the banking industry in the past quarter-century was the early 1980s rise and fall of Penn Square Bank in Oklahoma City. The bank shot from the hip, doing energy loans with just about anybody who even looked like they knew something about oil and gas, disregarding solid reserve evaluations and appropriate loan structures and terms. Soon, that little bank grew beyond its lending capacity and syndicated a lot of its questionable energy loans out to other banks. That ultimately created a mini-banking collapse. This event was probably the bellwether that made banks again become disciplined about energy lending. Other bellwethers Energy banking has clearly benefited from the continuing expansion of drilling in the western Gulf of Mexico shelf, deep shelf and deep water; the emergence of 3-D seismic technology, which is helping move banks toward a more comprehensive reserve-evaluation approach; and unconventional resource plays, which have become the largest source of U.S. onshore gas production. Even last year's major hurricanes, Katrina and Rita, taught energy bankers some very hard, but valuable, lessons. We awakened to the vulnerability of upstream and downstream facilities offshore and onshore the Gulf Coast, and I expect we'll tighten our business models accordingly. Whitney's evolution The bank was always a relationship-focused oil and gas lender. What we did in 2000 was establish a specialty group within Whitney that blended the best parts of this relationship approach with very disciplined, structured, traditional engineered, reserve-base credits. Two years later, we put together the same specialty group in our Houston office. Today, we have a Louisiana bank that has legacy clients with a lot of Gulf of Mexico orientation and Houston clients with a more onshore orientation. Charles S. Searle - Former senior vice president and head of energy industries group, US Bank, Denver Climbing credit curve At the end of 1981, some 10 years after I joined Central Bank & Trust Co. in Denver, the bank had total energy commitments just north of $100 million, with an average loan size of $100,000 and a loan yield of 17%. Today, after several banking mergers into what is now US Bank, we have more than $2 billion in energy commitments, an average loan size of $25- to $30 million and a loan spread of less than 200 basis points over cost of funds. Putting all this into context, the early 1980s was a period of very high interest rates across the board, and oil and gas prices weren't nearly as strong as they are today. Watershed events On the negative side, it would probably be the collapse of Penn Square Bank in July 1982, which brought down some pretty big names in energy lending including Continental Bank of Illinois. On the positive side, it would have to be the advent 10 or 15 years ago of commodity hedging in loan transactions. Hedging is extremely valuable in lending transactions, particularly those related to major acquisitions, because it takes the near-term volatility of commodity prices out of cash-flow forecasts-the basis upon which we lend money. As the result of using commodity hedging, operators these days can go out and acquire assets at record high prices and still achieve acceptable rates of return. Bigger is better In the old days, when we got up around $2 million on an energy-loan commitment, we had to bring in another bank on the transaction. Today, with US Bank's overall balance sheet now $200 billion, we're in a position to make commitments to our energy clients as large as $100 million-plus we have the capability to lead bank syndications involving even higher credit needs. Expanding footprint As the result of the bank becoming bigger, we've been able to expand from being essentially a lender to Rockies-based independents to a credit provider to upstream companies in the Houston, Dallas, Tulsa and Oklahoma City markets. Also, in the past couple of years, we've developed expertise and relationships in the midstream, with gas-gatherers and -processors, which has further fueled our growth in energy lending. Parting thoughts As I retired this June, after 35 years in energy banking, I foresaw more consolidation occurring in the energy sector. With domestic resource plays becoming fewer in number, the inevitable result will be more reserve purchases and more M&A activity.

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