This year had to be one of the strangest in the energy-financing arena. Wall Street threw a party, but not many oil and gas companies showed up. On one hand, the public equity, convert, high-yield and investment-grade-debt markets were wide open for oil and gas issuers. On the other hand, with the exception of the equity and high-yield markets, the pace of energy-sector deal flow dampened noticeably. Through third-quarter 2003, overall energy-related equity and debt offerings totaled $40.3 billion-well off the $55.6-billion pace for full-year 2002. This market sluggishness was most evident in the value of investment-grade-debt deals completed in the upstream-$8 billion worth compared with $23.7 billion for all of last year. Such a skid was predictable, however. Last year, the major oils and larger independents took full advantage of very low interest rates to term out bank debt for longer-maturity, lower-cost financing. As such, they had little need this year to access the investment-grade-debt market. Also, the consensus on The Street is that the dollar value of 2003 energy-related M&A transactions-the driver of most public equity and debt offerings-won't come close to matching last year's $103-billion pace. Nevertheless, there were enough acquisition opportunities in the upstream this year to prompt midsize E&P companies like Tom Brown Inc. and Forest Oil Corp. to tap the public equity and attractively priced high-yield markets. In fact, by the end of September, the value of energy-related equity and high-yield offerings already totaled $9.8 billion and $12.6 billion, respectively, compared with corresponding levels of $7.8 billion and $9.5 billion for full-year 2002. That, too, wasn't surprising, particularly in the high-yield area. Says one market-maker, "We've done E&P high-yield deals this year for BB, non-investment-grade credits that carried yields below 7%-making 'high yield' almost a misnomer." While the outlook for raising capital on Wall Street in 2004 is extraordinarily positive for the energy sector, the nagging question remains: will that sector want to feed at the capital-markets trough? That depends on the flow of asset divestitures from the major oils, and the need for producers to fund attendant acquisitions in the equity and debt markets. But it also depends on whether independents can source the right opportunities to deploy capital. Many market seers believe the conundrum facing producers and service companies today is that they're opportunity-constrained, not capital-constrained. Purse strings will loosen Though energy deal flow this year was slack through the first three quarters, Lehman Brothers completed $1.97 billion worth of energy-related common-stock offerings, $2.8 billion of high-yield transactions and $2.5 billion of investment-grade debt deals-all the while increasing market share. "Put in perspective, while the available fee pool [from energy transactions] in the overall investment-banking market was probably down 20% to 25% compared with the like 2002 period, the fees we generated from energy-sector deals were down less than 10%," says Grant A. Porter, vice chairman and head of Lehman's natural resources group in New York. The reason: "During a period of immense turmoil in the investment-banking business, we haven't gone through the wholesale restructuring a lot of other market-makers have; instead, we've been able to focus solely on business," says Porter. Within the M&A arena, Lehman recently has been very active in sellside mandates, advising Cordillera Energy Partners LLC on its $244-million sale to Patina Oil & Gas, Contour Energy on its $146-million sale to Samson Investment Co. and Matador Petroleum Corp. on its $373-million sale to Tom Brown. "While some potential upstream buyers may be concerned about where oil and gas prices are headed, the corollary is there are other operators that also understand today's high commodity prices won't be around forever-and that this may be the best time to sell out for cash," explains the banker. The service sector is another matter-no significant M&A deals this year. Although commodity prices are high, the major oils and large independents still haven't ramped up their capital budgets, creating even more uncertainty for service companies. There's a huge emphasis right now by the bigger oil companies on capital discipline and improving return on capital employed, notes Porter. "However, I think it's only a matter of time before these companies loosen their purse strings. There are a lot of prospects that are economic at today's commodity prices. The only issue is whether prices will remain robust. Our view is that they will, at least through 2004, with $20 to $25 oil and $4 to $4.50 gas the most likely price range." Once the industry's view of forward pricing aligns with this outlook, the net effect will be increased drilling budgets, more activity for the oil-service sector, more confidence within the industry in general and a greater level of M&A activity. Observes Porter, "At some point, there's only so much stock oil companies can buy back and only so much debt they can repay. Ultimately, they have to get back to building their companies, spending on growth through the drillbit and augmenting that growth with stepped-up M&A spending." Strong MLP market Andrew Safran, managing director and co-head of Citigroup's global energy investment-banking group in New York, says of the reduced capital raised by the energy sector this year: "The primary cause was the retrenchment in upstream investment-grade debt deal flow-a function of high commodity prices and cash flows and hence, less need by larger oils to access the capital markets." Counterbalancing this somewhat was an uptick in 2003 equity issuance within the oilfield-service sector. Through September, offerings totaled nearly $4 billion versus just $2.5 billion for all of 2002. Citigroup was strong in that sector, leading convertible debt deals for Schlumberger and Halliburton-each in excess of $1 billion-and a $700-million convert for Nabors. "These companies, which haven't been as positively affected by high commodity prices as E&P companies, were effectively taking advantage of low interest rates and related low convert coupons-essentially issuing cheap debt even though the financing was structured as an equity-linked security," the banker explains. Meanwhile, the firm played to its strength in the midstream master limited partnership (MLP) market, completing $100- to $200-million unit offerings for the likes of Teppco Partners LP, Plains All American Pipeline LP and Enterprise Products Partners LP. Says Safran, "The average pipeline MLP is throwing off better than a 7% yield, which is very attractive to retail investors." In the high-yield end of the debt market, the market-maker has also seen a surge in deal flow this year, including a $1.2-billion transaction for El Paso Production Co. "While much of the high-yield issuance in the energy sector is tied to continuing low interest rates, a lot of it reflects the activity of fallen angels from the investment-grade ranks that now need to access the non-investment-grade debt market." Looking to 2004, Safran anticipates a moderating of commodity prices, which will require upstream companies to access the capital markets more frequently since they'll have less cash flow. The banker also expects to see more consolidation within the upstream sector. "Producers need to build out a stable, accreting production profile, and acquisition is one way to further that," he says. "At the same time, some independents will realize that they've grown their companies as much as they can, and that they're better off selling and starting over." Safran's outlook for asset divestitures in the midstream is another matter. "Most energy merchants have regained some degree of financial health, so the need to sell assets won't be as apparent." Despite some expected creep in interest rates next year, he believes the convert market will remain an opportunistic source of financing for the energy sector because it can be accessed virtually overnight. "That's something for which we're seeing an increasing appetite." Big equity push While other market-makers might lament the sluggishness of energy M&A activity and related capital-markets deal flow this year, JPMorgan Securities doesn't, at least not in the equity-issuance arena. Through September, the firm led more than $1 billion worth of common-stock offerings in the sector, including an aggregate $347 million worth of issues for Forest Oil, a $281-million offering for Tom Brown and an $88-million deal for Houston Exploration. Meanwhile, in the service sector, it jointly led a $1.2-billion convertible note offering for Halliburton. JPMorgan Securities' push into the energy-equities arena was deftly timed. "Institutional investors, flush with sidelined cash, have been noting the defensive nature of the oil and gas sector relative to other investment classes, plus they view the multiples in the sector as attractive," says Douglas B. Petno, managing director and head of the firm's oil and gas investment-banking group. "As a result, they've been seeking meaningful positions in energy-which is what large equity offerings allow-without affecting the market. We expect this investor sentiment to continue into 2004." While there has been a spate of secondary equity offerings in the E&P sector this year linked to the sale of major shareholder interests, much of the balance of upstream common-stock offerings has been tied to financing-on a very receptive basis-opportunistic acquisitions, says Petno. He cites Forest Oil's recent purchase of Unocal's Gulf of Mexico properties and Tom Brown's acquisition of Matador. "When they did their related stock offerings, these asset buyers were rewarded by the market, in terms of share-price appreciation and an expanded shareholder base," says Petno. "Also, issuers like these are driven by the desire to keep their balance sheets conservative; they prudently don't want excessive leverage." Energy companies, not wanting to sell too much equity, have also turned to the wide-open, attractively priced, high-yield and convert markets, he says. "We've done E&P high-yield deals this year for BB, non-investment-grade credits that carried yields below 7%-making 'high-yield' almost a misnomer." In the case of the convert the firm jointly led for investment-grade Halliburton, the coupon was only 3.125%. Aggressive not just in the public equity arena, JPMorgan Securities this year provided a panoply of energy-financing products to assist Tom Brown in its buy of Matador. "We were brought in by Tom Brown very early on and worked alongside management, looking at Matador's reserves in lock step with the company," says Petno. "To support Tom Brown's bid, we arranged a $155-million bridge financing and a $425-million permanent bank facility. Following that, we were sole bookrunner on a $281-million bridge-takeout financing in the public equity market while jointly leading a $225-million high-yield offering for the company." Says Petno, "We expect to see more independents go to the acquisition market next year to augment their asset portfolios, and as that happens, that's going to play to our 'one-phone-call' financing strengths." Looking internationally Through the end of the third quarter, Morgan Stanley led or co-led $4.4 billion of public equity-related financings for the energy sector and $10.2 billion of public debt deals; during the comparable period last year, it led $2.6 billion of equity-related offerings for the sector and $12.5 billion of debt offerings. "This has been another year of solid commodity-price performance, with producers generating tremendous amounts of free cash flow," says Michael Dickman, managing director and head of Morgan Stanley's energy M&A group in New York. "As such, most publicly traded E&P companies haven't needed to access the capital markets, except for balance-sheet repair or acquisitions." In first-half 2003, the market-maker led or co-led three major equity offerings for independents-all related to acquisitions. This included a $575-million issue for Apache Corp. tied to that operator's $1.3-billion purchase of BP's Gulf of Mexico and North Sea assets, a $416-million offering for Chesapeake Energy related to that producer's $800-million acquisition of Midcontinent gas assets from El Paso and Oneok, and a $259-million offering for XTO Energy tied to that operator's $400-million acquisition of onshore properties from Tulsa's The Williams Cos. These transactions aside, the level of M&A-related activity in the U.S. upstream in 2003 has been relatively quiet. "Producers are generating so much cash flow that they're facing the dilemma of where to redeploy that cash for future growth," says Dickman. He points out that some operators, feeling opportunity-constrained domestically, are now beginning to look internationally for their growth-whether that's participating in LNG projects in Trinidad or acquiring stakes in the Russian upstream. This past June, Morgan Stanley represented Marathon Oil in its $280-million acquisition of KMOC, a Russian producer. Earlier, it represented BP when that major oil formed a 50-50 joint venture with TNK, another Russian operator. In addition, the firm this October sponsored an investment conference in Trinidad to educate U.S. buysiders on the future role of LNG in meeting North American natural gas demand. Says Dickman, "We also see that at the $4 to $6 level, U.S. gas prices support the importation of LNG and companies become willing to invest in related projects to fill either growing gas demand or declining supply in the North American market." The banker points out that the equity, high-yield and fixed-income markets are currently very receptive to asset-acquisition companies and upstream stories in general. He notes that convertible securities, in particular, offer energy issuers a very attractive opportunity to achieve low-cost financing. This spring, Morgan Stanley led a $300-million convert issue for driller Pride International that carried a 3.25% coupon and a very high equity-conversion premium. "While the convert market fell off this summer, it's rebounded strongly. Now, there's not enough supply [issues] to meet [market] demand." The upstream conundrum Last year, Wall Street saw a lot of fixed-income transactions in the energy sector, with companies taking advantage of very low interest rates to term out bank debt for longer-term, lower-cost financing, says M. Scott Van Bergh, managing director, corporate and investment banking, Banc of America Securities, New York. "This year, however, capital-markets activity in the sector has been dominated almost entirely by event-driven financings-usually M&A-related transactions." One example is the $115-million common-stock offering Banc of America co-managed for Forest Oil when it acquired a large block of Unocal's Gulf of Mexico properties. Looking to 2004, Van Bergh, who is focused on building the firm's upstream business, sees a relatively low level of financing activity for the energy industry. "That, of course, could change if the major oils decide to accelerate the sale of some of their smaller assets, or if there were a significant drop in commodity prices that adversely affected the capital-spending plans of producers." Should either or both occur, the market is wide open for independents. "The industry has the opportunity to take advantage of an exceptionally low cost-of-capital environment," says the banker. "For instance, high-yield financings have recently been done at [interest-rate] levels of 7% while other operators have been able to access investment-grade debt at rates in the 4% to 5% range. We've never seen anything like that before and we may never again." Stresses Van Bergh, "For probably the first time in 20 years, financing isn't a problem for upstream companies. Their biggest problem is sourcing, on an economic basis, opportunities to deploy their capital." In light of this conundrum, he believes operators may have to become more creative in their business strategies and consider things they haven't before, such as buying back stock, working on stronger balance sheets through debt repayment, seeking out non-conventional plays like coalbed-methane and tight-sands gas or international opportunities. The banker cites the acquisition of Ocean Energy by Devon Energy. "That's a good example of a producer gaining access to multiple new opportunities for growth, in terms of technology, the deep water and a less mature province internationally. As other operators try to change the nature of their reserve replacement away from predominantly North American natural gas, we would expect to see more transactions of that nature." RESEARCH RUMBLINGS Carl H. Pforzheimer & Co. is a New York-based institutional research boutique and brokerage firm specializing in the energy sector. Recently, Oil and Gas Investor visited with four of its top energy seers: Frank Reinhardt, partner; Albert J. Anton Jr., partner; Mary B. Safari, vice president and analyst; and George Frelinghuysen, associate and analyst. We asked about their outlook for the energy sector in 2004 and the stocks they're recommending to their institutional clients. Anton There's a consensus building that 2004 will be a rough year for oil prices, given that non-OPEC production will supply all of the anticipated increase in world demand while OPEC will have to cope with increasing volumes from Iraq. We forecast an average WTI price of $27 next year. This is the high end of the consensus, as we believe OPEC is determined to stem the price decline. Meanwhile, we expect natural gas realizations to average about $4. Our favorite stock since late last year has been Marathon Oil-a stellar performer but still cheap. The company has major new projects in Norway, Russia and Equatorial Guinea, and meaningful deepwater discoveries in Angola and the Gulf of Mexico. Downstream, the company dominates the lucrative Midwest market. We also like BP, which recently completed a joint venture with TNK, the Russian oil and gas company. This involves some political risk, but has President Putin's approval. Potential reserves are enormous. Production growth will also come from the deepwater Gulf of Mexico, Angola, Azerbaijan and Trinidad. Most of all, we like Lord Browne's disciplined management style. Reinhardt We think the trading multiples for big E&P companies in Canada are lower than those for their U.S. counterparts. EnCana is a core stock that should be in the holdings of virtually every institution, not only because of its relatively low valuation versus its peers, but because of its above-average growth profile. We also like Talisman and Nexen, both trading at low multiples of cash flow. Talisman was penalized by investors for its holdings in the Sudan, but has sold those assets and redeployed the proceeds into such areas as the Appalachian Basin, Malaysia, and the U.K. and Norwegian sectors of the North Sea. Likewise, Nexen's stock has been penalized for the company's position in Yemen; however, Yemen is steadily become less of a factor, in terms of its contribution to the company's overall earnings stream. Also, the company has become a significant player in the Gulf of Mexico. Safari In light of the shrinking prospect base in the U.S., we believe E&P companies best able to prosper in the current environment are those with long-lived assets in the Midcontinent, the Rockies and Canada, and those with unconventional sources of natural gas. In tandem with the domestic trend toward lower-margin, production-related work, oilfield-service companies in North America are seeking to redeploy assets internationally. The largest companies appear to have the advantage in this effort, given their marketing reach and their ability to bundle services. Bundled services can be particularly attractive to national oil companies, an increasing client base. Frelinghuysen Some local gas-distribution companies are interesting because they have large oil and gas subsidiaries. Keyspan Energy, for instance, owns 56% of Houston Exploration, and Questar has a large upstream subsidiary focused on the prolific, gas-prone Pinedale Anticline in Wyoming. Notably, Questar is deriving 65% of its operating profits from its nonregulated upstream business. Investment in these utilities takes advantage of the stability of their traditional business and the growth prospects from their E&P activities. POOLS OF PRIVATE CAPITAL The oil and gas industry is witnessing a confluence of events that will profoundly affect private-capital supply and demand in 2004. "There's a steady flow of seasoned management teams coming out of publicly traded E&P companies today that are looking for it," says Cameron O. Smith, senior managing director of New York-based Cosco Capital Management LLC. "Meanwhile, a whole new generation of general funds is coming into the energy sector-alongside existing, freshly reloaded, energy-mandated funds-looking for start-up opportunities to place their high-return, institutional dollars." During the past four years, Cosco Capital, with offices also in Hartford, Houston, Tulsa, Oklahoma City and Calgary, has raised as an intermediary some $350 million of private equity for upstream companies and has advised on $360 million worth of energy-related M&A transactions. In 2004, Smith sees private capital primarily pursuing managements with drillbit strategies. "Given today's high oil and gas prices, there's more downside pricing risk to acquiring proved producing reserves than there is upside," he explains. "Right now, a lot of money can be made through the drillbit because the differential between service costs and product prices is so great and because there's a plethora of low geological risk, manufacturing-type plays like coalbed methane. All this appeals to the institutional investor." Also, expect next year to see more private funding of international E&P opportunities. Both investors and private operators have regained a certain amount of confidence about putting capital to work in places like Venezuela, he says. "I've also talked to a lot of private-capital sources that are focusing on the U.K. North Sea, Europe and Australia. The fact is, fund investors are becoming very comfortable with an industry that has performed so well historically, on a return basis, and they're now much more willing to spread their wings." Jeffrey A. Harris, managing director for Warburg Pincus in New York, confirms much of this investment mindset. "For the first time, we're seeing upstream management teams focused outside the U.S.-in Canada, the North Sea and West Africa-with the sort of appropriate business plan and skill sets that we've seen in the domestic onshore or offshore E&P industry. In fact, we may soon be providing equity for a private start-up focused on exploration drilling internationally." Currently, Warburg Pincus' upstream portfolio consists of investments in eight U.S. producers, including privately held Antero Resources, Bill Barrett Corp., Carneros Energy, Gryphon Exploration and Latigo Petroleum. This year, the firm invested $125 million of private equity in these five operators. Ultimately, it expects that 10% to 15% of its latest $5.3-billion fund will be earmarked for the overall energy sector. In the case of the planned backing of the start-up operator focused abroad, the capital provider will draw upon both that fund and its $2.5-billion international fund. "Our confidence in and understanding of the upstream sector has grown, and along with it, our deal flow," says Harris. "At the same time, a reset has occurred in investors' minds. They realize that natural gas is no longer a $2 commodity and that oil is no longer an $18 commodity. As a result, they're more comfortable that there are real investment opportunities in the energy sector-and they're showing that with their dollars." Also contributing to Warburg's deal flow is the increasing availability of talented management teams coming out of recent industry consolidations, as well as asset rationalizations by larger independents and major oils. "There's more emphasis today by larger companies on return on capital employed versus growing the number of barrels they produce each year; as a result, they're divesting more noncore properties," he says. "Concurrently, new drilling and seismic technologies are creating better opportunities for smaller producers with low overheads to earn attractive rates of return." Adds an optimistic Harris, "I would be surprised if our company next year doesn't invest nine figures again in the upstream oil and gas sector." Another active player in private-equity funding for energy companies has been New York-based Greenhill Capital Partners LLC. Since October 2002, it has made nearly $70 million of commitments to that sector. This includes $10-million investments each in Everlast Energy LLC, Exco Resources and La Grange Energy LP. It has also committed $20 million to Triana Energy Holdings Inc. and $18 million to United States Exploration Inc. "The past year or so has been a great time for investors to back strong management teams buying energy assets because there have been many motivated sellers," says V. Frank Pottow, a Greenhill managing director. He cites the cases of Nisource Energy and Aquila Energy, which became overleveraged and had to sell off cash-generating assets. This presented asset-buying opportunities for Triana and LaGrange, respectively. "In the case of our other three energy investments this year, we had prior working relationships with management-Tim Goff at Everlast, Doug Miller and his management team at Exco, and Steve Durrett at United States Exploration," says Pottow. "That's an important part of our investment strategy." Also important to Greenhill, which has another $70 million available for energy investments, is capitalizing on industry trends. "In the post-Enron era of increased scrutiny of corporate governance and fewer analysts providing research coverage, some operators feel that it's becoming too expensive to run a small- or midsize public E&P company and that there's less of a public institutional market for those size companies," observes Robert H. Niehaus, chairman, Greenhill Capital. "Many believe it's easier to attract capital as a private company, so they're moving in that direction. One such operator is Exco, which we helped take private earlier this year." With the combination of continued strong commodity prices, an economy on the rebound, more credit available to support private-equity investments and asset divestitures by major oils and larger independents, Niehaus expects a higher level of private-capital activity in 2004 than this year or last.
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