Scaling Up

At first, the comment that 2013 augurs “more of the same” for oil and gas investment appears deprecating, a bit like the phrase “same old, same old.” But this time around, even if the bill of fare looks familiar to energy investment bankers, the upside is the magnitude or scale of the opportunity-a welcome surprise, were it to materialize, against a backdrop of ongoing Euroean travails, postelection politics, the uncertainty of tax reform in the U.S., the so-called fiscal cliff, and more.

In the oil and gas epicenter of Houston, capital providers see a major ramp-up in opportunity for 2013.

Jefferies & Co. vice chairman Ralph Eads III notes that while the pace of activity in the new year may not vary much, up or down, versus 2012, and transaction types may not stray far from te joint ventures, asset sales and M&A work performed in 2012, the size of the U.S. energy opportunity is scaling up.

If one compares energy to other industry investment categories—say real estate, steel manufacturing or pharmaceuticals—“it would be hard to find an industry with the kind of return potential, at scale, that we have in the U.S,” he says. “North American oil and gas is probably the highest-return large-scale investment opportunity on the planet.”

Similarly, in transactions coming to the commercal-banking and high-yield markets for financing, there is evidence that deal size has moved upward-and sometimes dramatically.

“A significant development over the past 12 months has been the emergence of what I would call the ‘mega deal,’” says J.P. Morgan managing director Paschall Tosch.

He cites as examples KKR’s purchase of Samson Resources; Apollo’s and Riverstone’s acquisition of El Paso’s upstream assets; and the purchase by Plains Exploration of deepwater assets from BP Plc and, in smaller part, Royal Dutch Shell Plc.

“A significant development over the past 12 months has been the emergence of what I would call the ‘mega deal,’” says J.P. Morgan managing director Paschall Tosch.

“We have seen large M&A and acquisition financing transactions by both private equity and C-Corps over the past year,” says Tosch. “All of those were of almost unprecedented size in high-yield land.”

Not surprisingly, given this trend, the high-yield market is poised to set a new issuance record in 2012. Likewise, master limited partnerships (MLPs)—largely acting as a bond substitute in a market hungry for yield—are also handily outpacing equity issuance in prior years, with Wells Fargo forecasting the sector is likely to raise $21.7 billion by year-end. This would exceed the prior record of $18.4 billion in 2011 by almost 18%.

Where do we go from here? With commercial banks being accommodating, and record levels being attained in both high-yield and MLP issuance, few want to dim the lights while the party is going strong. At the same time, it’s all too easy to draw up a laundry list of uncertainties that could tighten the capital-markets spigot.

“The capital markets have really been wide open for the energy sector since the latter part of 2009,” says Jim McBride, head of investment banking with Capital One Southcoast in Houston. “Certainly, the banks have been wide open for business. We’ve seen tremendous growth in the ability of companies to access the high-yield market, and from time to time the equity markets have been there for corporate issuers.

“However, what I am really concerned about is the period when we start to deal with the fiscal cliff. Between now and year-end we have to encourage our politicians to focus on how to remove the uncertainty around the fiscal cliff, because the last thing the capital markets like is uncertainty. The longer it goes unaddressed, the potential for the uncertainty to at least temporarily close the window on the capital markets becomes a concern.”

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For some, the combination of uncertainty and easy availability of capital is reminiscent of conditions prevailing in 2007. At the Oil Council North America Assembly, held in Houston in October of this year, parallels to 2007 were drawn by Phil Cook, chief financial officer of Samson Resources, based in Tulsa, and a recent active participant in the high-yield market, as well as by Tom Chambers, his counterpart at Houston-based Apache Corp., which is an A- rated company.

“It does feel like 2007,” Chambers says. “This time I think they are being a little more judicious. But there is a lot of money chasing the E&P space.”

In terms of domestic drilling, the danger is that “cheap capital can be a little bit addicting,” particularly if companies trying to hold acreage pursue growth for growth’s sake rather than being focused on returns, Chambers says.

“It’s a crazy market, and unless you are disciplined, you can get carried away, especially if you have to drill to maintain acreage,” Chambers says. “To give you an example of how crazy it is, I got an e-mail the other day about 30-year money for Apache under 4%.” With concerns about the fiscal cliff, “I could see lending for five years. But why would someone want to lend to Apache 30-year money under 4%?”

“We’ve seen a version of this movie before,” Cook says, recalling that credit was “very available to the independent space” in 2007, with little sensitivity to corporate debt ratings, only to become “very tight” at the end of 2008 and into 2009. “It feels like 2007 again to me. Our debt is single B-rated. We just did a 6%, second lien for $1 billion. That is pretty inexpensive money—certainly less expensive than equity, by a long shot.”

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Cook is quick to add that, in instances when it can take advantage of very attractive terms in the high-yield market, Samson is willing to do so only within an overall strategy focused on returns and reducing commodity risk. “The only fear I have of inexpensive money is stupid drilling, so we are very focused on returns-based drilling and on hedging to make sure we lock in those returns.” With those in place, “it seems the markets are wide open and, as the bankers say, ‘white hot.’”

So far this year, “white hot” conditions in the high-yield market have translated into $48.8 billion of issuance by the oil and gas sector, based on data through October 22, 2012, from J.P. Morgan. This already exceeds the $34.8 billion issued by the sector for full-year 2011 and $37.1 billion for 2010.

Significantly, even as high-yield issuance as a whole has grown—to $260.7 billion year-to-date in 2012, from 222.5 billion in 2011—the percentage comprised by the oil and gas sector has also risen, to 18.7% year-to-date from 15.6% in 2011.

For the MLP sector, the yield characteristics have similarly resulted in not only record levels of issuance, but also in MLPs accounting for a greater share of overall equity issuance. A measure of how dominant MLPs have become is the fact that, for the third year in row, MLPs have made up roughly half of all oil and gas equity issuance, based on figures provided by J.P. Morgan. MLP issuance has continued to hover around the 50% mark, even as overall issuance has risen from $29.1 billion in 2010 to $32.9 billion in 2011 and $34 billion year-to-date in 2012.

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“It’s the same phenomenon,” Tosch says, referring to demand for product in both the high-yield and MLP sectors. “The market is all about yield right now. That’s where so much of the focus has been.”

In the high-yield market, Tosch says, “throughout 2012 we have seen huge volumes with record low coupons at every rating level.”

The J.P. Morgan High Yield Index hit a record low yield of 6.43% yield in September, and although yields have “backed up a little bit from what were the record lows in September, we still feel really good about the market for the rest of the year.”

What does his crystal ball foretell for the high-yield sector in 2013? “Beyond the looming macro economic clouds, we believe conditions should remain robust. A lot of the issuance that has been done this year has been refinancing, with old supply being removed as new supply has been coming on. Investors are clipping interest payments every quarter that need to be reinvested. Every time the market seems to soften a little, the market has been able to regain its footing and is back to being very strong.”

With regards to the recent emergence of “mega deals,” Tosch notes that the greater deal sizes have prompted J.P. Morgan to tap into additional capital tranches to arrange financing on favorable terms. For the deepwater asset acquisition by Plains, J.P. Morgan served as M&A advisor and lead underwriter of a $7-billion financing package. Of the total, a recent “high-water mark” of $3 billion was targeted for the commercial bank market.

“Between now and year-end we have to encourage our politicians to focus on how to remove the uncertainty around the fiscal cliff,” says Jim McBride, head of investment banking, Capital One Southcoast.

However, with Plains having as much as $5 billion of senior debt capacity, J.P. Morgan turned to both the institutional and the bank term-loan markets for a further $2 billion of first-lien financing. A $3-billion senior note offering, the largest high-yield offering ever by an E&P company, was later completed to retire a $2-billion bridge loan.

On the equity side of the ledger, Tosch notes that whereas traditional C-Corps have experienced somewhat “more erratic” levels of issuance, MLPs have enjoyed “a relatively steady, wide-open market throughout most of 2012.” In the MLP sector, “there has been such a demand for yield, combined with valuations that have been very attractive for issuers, and the confluence of those two events has resulted in a lot of activity.”

Signs of a slowdown? Far from it, Tosch indicates, noting that as of October there were a dozen or so MLPs—representing a broad base of issuers in the upstream, midstream and downstream subsectors—queued in the IPO pipeline.

By contrast, traditional C-Corp equity issuance—roughly the other half of oil and gas equity issuance—has been more event driven. There have been several “chunky” transactions by Cobalt International, Kinder Morgan Inc. and Williams Cos., and a handful of smaller deals, typically done by follow-on issuers in the upstream and service sectors that are levered to crude and liquids. For these, “timing has been important in terms of market conditions and commodity prices,” Tosch says.

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In between equity and debt instruments, of course, lies the convertible sector, which is beginning to see an uptick in activity.

“There is a tremendous untapped appetite for convert paper by investors, both debt converts and more traditional equity converts,” Tosch says. “One reason we haven’t seen a lot of debt converts in the past 12 to 24 months is simply because high-yield rates have been so low that issuers haven’t felt the need to buy down their coupon by offering up a convert option.”

Historically, if an E&P lacked critical mass to get a suitable rating from the agencies, it might consider a convertible issue carrying a meaningfully lower coupon than with high yield, he recalls. For a period, volume dried up, but for those with reason to access the market currently, “the convert market is extremely strong.”

Joe Cunningham, managing director and cohead, U.S. energy group, with RBC Capital Markets, has a similarly upbeat outlook for 2013, having come off a record year with strength across all business lines in investment banking.

“It’s been a terrific market, and we have every expectation that it’s going to be a strong environment going into 2013,” he says. In addition to record levels of issuance in both high-yield and MLP sectors, “the acquisition and divestitures (A&D) business was very strong this year. We think that total transaction value in the A&D business in North America was probably about $60 billion this year, and we expect that it will be about that level next year as well.

“What we are seeing as drivers of that business are corporate clients selling conventional assets to finance the development of their shale assets.”

In addition, Cunningham indicates that the private-equity sector, among others, has become a more motivated seller ahead of possible changes in tax legislation, notably the capital gains rate, starting in 2013. “They are trying to take profits,” he observes, “and I think it will continue to be a driver not just in A&D, but also in mergers and acquisitions as we move toward the end of the year.”

In one case, involving midstream asset owners, “at least one of their motivations is to get something done by the end of the year,” he says. Potential buyers are typically MLPs.

With MLPs being the mainstay of equity issuance in recent years, Cunningham expresses confidence in their continued attraction as yield vehicles. At the same time, he clearly has devoted time to considering the implications of possible tax reform in the event that MLPs should be at risk of losing their flow-through status (see sidebar).

Jay Boudreaux, managing director with Simmons and Co. International in Houston, expects to see a strong finish in terms of transactions in the fourth quarter of 2012.

Two points to consider: One, while MLP financing continues its upward trend, there are signs that the limits of the traditional source of financing—the retail investor—are becoming stretched. Also, in the event of tax reform, if MLPs were to become “1099-payers” instead of issuing K-1s to investors, the net effect could be some MLPs ending up with similar or sometimes higher market capitalizations—provided they continue to pursue a high-payout business model.

In the A&D sector, Jay Boudreaux, managing director with Simmons & Co. International in Houston, also expects to see a strong finish in terms of transactions in the fourth quarter, bringing the total for the oil and gas industry in 2012 to $60- to $70 billion. Boudreaux is head of the firm’s upstream investment-banking group, which has specialized in A&D advisory work focused mainly on sales of assets in emerging resource plays.

“We have built out a substantial in-house technical team that has significant experience in evaluating plays early in their life cycle and demonstrating the potential associated with those plays,” he says.

With incentives to transact before year-end—but often amid unsettled market conditions—several investment bankers have advocated a dual process in which both IPOs and outright sales can be considered. “When you have an uncertain environment like this, it is intelligent for people to look at dual tracks,” Cunningham says. “The marginal cost is not that much, and it gives you optionality on a couple of different markets to capture the best value. In some cases, it may be a trade-off between value and liquidity.”

For Boudreaux, this type of assignment is his stock in trade. “Very frequently, we are asked to evaluate all the alternatives available to a company,” he says.

“Given the capital intensity of resources plays, we have seen companies that have sizeable acreage positions, but need additional capital to develop those resources. And they are thinking through the next steps for them in their life cycle as to whether the best option for them is to sell to someone that is better capitalized or for them to do some form of refinancing.”

For Ralph Eads of Jefferies, the financing needs of resource plays in the U.S. have been the subject of much study. Put simply, with horizontal drilling and hydraulic fracturing combining to unlock unconventional resources, “a lot of the owners of assets have way more assets than they have money, and they have to fix that problem.”

According to Jefferies and Co. vice chairman Ralph Eads III, “North American oil and gas is probably the highest-return large-scale investment opportunity on the planet.”

Jefferies estimates that the oil and gas industry needs external capital—financing needs beyond the cash flow generated by owners’ existing assets—on the order of $35 billion a year for the upstream sector alone. “That will abate over time as the plays mature, but let’s say over the next decade,” Eads says. Add in another $15 billion a year for the midstream build-out, and the total for the next decade comes to $500 billion.

To date, says Eads, the industry has used three main strategies to address the problem: joint ventures; asset sales, typically of conventional assets to develop higher return resource plays; and company sales. “I think there will be a steady pace of all that going forward.”

What would prevent companies with deep pockets from pushing forward more aggressively? Eads points to the labor-intensive nature of unconventional drilling, as well as the normal business process. “The constraint is the ability of the people to actually drill the wells,” he says. “They are only going to buy things at a pace at which they can absorb them. If they buy something, they have to be able to develop the assets in a timely manner.”

Eads sees the North American transaction market at $70- to $100 billion a year, up from a $20- to $40-billion range prior to the advent of unconventional resource plays. While he sees continued steady activity at that level for next year, he has somewhat higher expectations—a pick-up in activity in 2013—for capital markets, not just on the high-yield side, but also in equities, including some IPOs.

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In part, this reflects his optimism as regards an eventual revaluation of public energy equities.

Eads uses a three-legged stool concept in explaining his optimism. In attracting capital to resource plays, the first leg of the stool was international buyers (China, Japan, Korea), while the second leg was private equity (KKR buying Samson Resources; Apollo buying El Paso’s upstream assets). A third leg would come from greater equity financing—at higher stock prices—in the wake of a revaluation of E&P equities as the plays mature.

“People are going to begin to understand that these companies are generating high rates of return,” Eads says. “These resource plays are new, relatively speaking. Most have very long-term assets, and the companies are typically only two to five years into the plays. You would expect the early development to be the least efficient, and that has been the case. But over time the companies are getting more efficient, the wells are getting better, and the returns for the industry are going to improve a lot.

“Equities are going to have a halcyon period,” he predicts, as it becomes clear that owners of good resource plays have assets that will grow and generate free cash flow at high returns.

Dennis Petito, managing director with Paris-based Credit Agricole Corporate and Investment Bank, describes the high-yield market in energy as having been “white hot” of late.

Dennis Petito, managing director with Paris-based Credit Agricole Corporate and Investment Bank, has an advantaged viewpoint on global energy through the bank’s activity in international markets as well as its U.S. operations. It ranks among the top 10 banks internationally in its overall energy business and in the top five in energy project finance. Petito came to Credit Agricole CIB when it acquired Credit Lyonnais in 2004. He is head of North American energy, in Houston, a position he also held at Credit Lyonnais.

“What we do here is really a projection of what we do on a global basis,” says Petito. As an example, he cites the bank’s relationship with client Reliance Industries, of India, which entered into a $1.15-billion joint venture in the Eagle Ford with Dallas-based Pioneer Natural Resources. “We have a large exposure on a worldwide basis to Reliance. They’re a prime client of the bank globally, and it’s very exciting that we can carry that relationship into the U.S. as well. We have committed there at top tier.”

Petito describes the high-yield market in energy as having been “white hot” of late. He notes Credit Agricole CIB has served as lead bank and active joint book-runner in high-yield offerings by Linn Energy LLC and Vanguard Natural Resources LLC, both based in Houston. For Linn Energy, investor road-shows have been arranged not just in the U.S., but also in Europe; and increasingly, Credit Agricole CIB has advocated, with some success, that high-yield deals include a European tranche.

If actions speak louder than words, Credit Agricole CIB exhibits confidence in its energy business, with growth under way in both A&D and M&A. In A&D, the firm has hired Kirk Tholen, formerly with Albrecht Associates, to head up a team based in Houston. On the M&A side, senior managers are being added in Paris and New York, with a focus on bringing non-U.S. players to the U.S. market, while actively pursuing A&D within the U.S.

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“We see A&D and M&A activity increasing quite significantly over the next couple of years,” Petito says. With the “revolutionary changes” in the U.S. energy industry, the unconventional industry is one that is “hungry for capital. And the only way that they are going to exploit that resource is if they do it on a joint-venture basis and/or through the A&D/M&A process.”

And will the joint ventures materialize? Petito has little hesitation. “When I first started in this business, you had a lot of U.S. companies investing substantially overseas. Now you are seeing the reverse flow, where you have large players overseas investing in the U.S. I think you are going to see it on a global basis.

“We’re seeing European, we’re seeing Asian, we’re seeing Latin American investment in the U.S. This is a market that most of the global energy players want to be a part of.”