On the first anniversary of September 11, the mournful sound of bagpipes at Ground Zero reverberated through the canyons of the Wall Street district in lower Manhattan. Then at precisely 8:46 A.M. came the first of several moments of silence that morning as everyone paused to remember. Along nearby Broadway, men with hard hats and those wearing pinstripe suits, secretaries and mothers with strollers, clustered together and simply stared reflectively at 16 acres of emptiness that was once the bustling World Trade Center complex. Then came the solemn reading of the names of all those who perished on that site a year earlier-and finally the descent of their families into "The Pit" of Ground Zero, where tributes trailed off into dusk. Looking at The Pit-now a remarkably cleaned-up, five-story-deep excavation site-one cannot help but see it as a metaphor for the rebuilding needed in this nation's economy and financial markets. For the country is also grappling with toppled stock indices as investor confidence itself has collapsed in the wake of so many corporate scandals. And, the prospect of war with Iraq looms larger, alongside further turmoil in the Middle East. Not surprisingly, jitters about war and instability in the oil-rich Middle East have spurred commodity prices to new highs. But ironically, those price spikes haven't been reflected in energy stock prices throughout 2002. This has prompted most producers and service companies to eschew the equity markets and raise capital instead in the uniquely attractive debt markets, now benefiting from rock-bottom interest rates. Says one market-maker, "Looking at the history of Treasury rates during the past 25 years, they've only been at their current level or lower less than 3.5% of the time." Is debt-issuance the wave of the future for the oil and gas industry? With interest rates not likely to climb dramatically any time soon, this is a likely scenario. But that doesn't mean the equity markets won't be open for the industry in 2003. On the contrary, investors are likely to be relatively receptive to a sector that has outperformed the S&P 500 this year. Yet, producers and service companies may not want to sell equity amid strong cash flows and balance sheets, lackluster stock prices, volatile markets and access to cheaper-cost paper. That said, investor sentiment can turn on a dime. The gap between commodity prices and stock values could close dramatically, making equity issuance more attractive next year. In fact, most analysts and bankers are eyeing relatively healthy oil and gas prices for 2003-albeit not nearly as high as they've recently been. Fadel Gheit, senior energy analyst for Fahnestock & Co. in New York, says that, because of the speculation about war with Iraq and its potentially adverse impact on world oil supply, commodity prices are artificially high. He thinks prices will likely moderate next year to the mid-$20s for oil and $3-plus for gas. "Right now, most natural gas producers aren't drilling that much, in part because they think current high gas prices are unsustainable; in part, because they don't have enough good prospects to give them production at a reasonable cost, such that in the event of weaker gas prices, their investments would still have good returns." In many respects, U.S. operators have learned from OPEC that increasing supply in a market already saturated with a commodity breaks the price structure. The major oils appear bound by a similar caution. ExxonMobil, BP and ConocoPhillips have some 30 trillion cubic feet of stranded Alaskan natural gas reserves-much more than we could ever find in the Gulf of Mexico or Lower 48-yet they haven't invested in a pipeline that would bring that gas to the Lower 48, says Gheit. "That's because there's no guarantee that, if they did, gas prices would remain in the $3 to $3.50 range-or whatever the minimum price is that would give them a high return on their capital." This sort of caution, by majors and independents alike, has been largely reflected in their approach to the capital markets in 2002, particularly the stock market, where skittish and skeptical investors after the Enron debacle made equity access at times akin to a crap shoot. Goldman Sachs Chansoo Joung, managing director and head of the natural resources group for Goldman Sachs & Co. in New York, observes that the oil and gas industry's access to public equity and debt this year has been like A Tale of Two Cities. "Portfolio and fixed-income managers are interested in creditworthy, high cash-flow-generating, easy-to-understand businesses with low disclosure and other event risks," he says. "The oil and gas industry-not a big issuer of public debt in recent years-fits that profile. So the debt markets in 2002 have been wide open for energy paper." Fortunately, terms being offered in the debt markets have been pretty compelling. Recently, Goldman Sachs led a $2-billion bond issue for ChevronTexaco, priced at 3.85%-just 60 basis points above comparable five-year Treasuries. Says Joung, "For energy credits rated BBB or better, the debt markets are very liquid, with typical spreads for five-year paper around 150 to 175 basis points above comparable Treasuries, and spreads for 10-year paper about 100 basis points higher than that. And even for credits below a triple-B rating, the pricing still remains attractive." The industry's access to the public equity markets this year, however, has been another matter. "We've been surprised at the equity market's selectivity, the continuing effects of the crisis in investor confidence in corporations, and the volatility of the markets." Despite this environment, the Wall Street firm this summer led a $330-million offering of "I" shares for Kinder Morgan, a midstream master limited partnership (MLP), and later, a $130-million I-share offering for Plains All American Pipeline, another MLP. At press time, it had in registration I-share offerings for El Paso Energy Partners and Enbridge Energy Partners-two more midstream MLPs. The I share-a security pioneered by Goldman Sachs-represents a common-stock interest in a corporation, allowing institutional investors to access the MLP market. Rather than paying a cash distribution, as traditional MLP units do, the I share's distribution is in the form of additional shares of common stock. Joung, who sees $3.50 gas and $23 oil for 2003, expects an increased level of equity offerings by the oil and gas industry next year, simply because that activity has been so sluggish recently. As for the industry's ability to issue debt, "the demand for paper is great; the absolute level of Treasury interest rates, low; and the spreads above Treasuries, reasonable." Although the slide in commodity prices near year-end 2001 cooled the M&A market considerably, look for a rebound in that activity in 2003. "The major oils will continue to address what they see as strategic deficiencies in their portfolios; that's more likely to happen in either a low commodity-price environment or in one where the valuations of independent producers are weak," says Joung. "Also, we should see more combinations among independents as they seek critical mass, lower operating costs and opportunities to invest in regions that offer more attractive returns." Analyst Gheit shares Joung's take on the major oils. He predicts that integrateds like Royal Dutch/Shell, BP and ExxonMobil may target large U.S. independents for stepped-up growth. "Anadarko Petroleum would make a very nice fit for any of those companies," he says. "ExxonMobil, for instance, could borrow $20 billion while maintaining its triple-A credit rating, acquire Anadarko and increase its U.S. natural gas reserves and production by double digits-an unheard of growth rate for a company that size. And even if ExxonMobil were to pay a 30% premium, the acquisition cost of Anadarko's reserves would still be cheaper than if that integrated bought back its own stock." Two other independents that could wind up in the crosshairs of the integrateds are Unocal and Burlington Resources, mainly because of their North American natural gas assets, says the analyst. Both are pure E&P companies, so there would be no fuss with the Federal Trade Commission-no downstream assets to be divested. Also, Unocal has prominent oil and gas assets in the Far East while Burlington has oil exposure in Algeria, as does Anadarko. So their international holdings would be an attractive bonus. Stresses Gheit, "All of these potential target companies are selling at very low reserve valuations, which means that any of the major integrateds will find it more attractive to buy those reserves, instead of going through the agony of gambling and drilling for them." Credit Suisse First Boston Rome Arnold, managing director, global energy group, for Credit Suisse First Boston in New York, is just as sanguine as Joung about the industry's access to the public debt markets near-term. "Looking at the history of Treasury rates during the past 25 years, they've only been at their current level or lower less than 3.5% of the time. And recent spreads, while not the tightest, are still 115 to just north of 200 basis points above comparable Treasuries for investment-grade energy issuers." Many producers are taking advantage of this environment to replace short-term commercial paper with longer-maturity debt, he says. With 10-year Treasuries recently below 4% and average spreads 125 to 150 basis above that, they're locking in rates in the low- to mid-5% range. This September, CSFB was comanager on a $300-million, 10-year note offering for Anadarko Petroleum that carried a 5% coupon. The same month, it comanaged a $400-million, 10-year debt offering for Unocal that carried a 5.05% coupon. Earlier, the firm was joint bookrunner on a $650-million, five-year debt deal for Anadarko that carried a 5.375% coupon. "I expect we'll see a string of debt issuance in the near term by independents, driven by the need to extend maturities and to move forward with drilling programs," says Arnold. This will occur partly because interest rates are so low, and partly because the equity market hasn't yet recognized how sound the industry's fundamentals are. Right now, there's a significant disconnect between the strong commodity prices that the forward market is suggesting and the relatively depressed equity values of upstream companies, he notes. "So there's no compelling reason for an E&P company to issue stock, even though the equity markets are open." There are, however, one or two larger-cap producers that have approached the market-maker about underwriting $100- to $500-million equity offerings. But these deals may never materialize, not simply because these operators' stocks are undervalued relative to industry fundamentals, but because the market is so volatile. "Unless you do a bought deal, you have exposure to the market between the time an offering is announced and when it's priced," says Arnold. "That creates serious price risk, which may have absolutely nothing to do with the fundamentals of your story. In short, you're in a choppy lake, and while everything may be fine in your boat, a big wave could come along-and up and down you go." This aside, he believes that if the equity markets begin to recognize the disconnect between forward commodity prices and upstream share values-and if there's a normal to cold winter-equity values should move up smartly and E&P companies will begin issuing stock to reload their balance sheets. "We think this gap will close, with the likely case being that commodity prices will come down a little while energy stocks move up, as investors finally recognize that oil and gas prices have reached a sustainable level." JP Morgan Securities Todd Maclin, senior group executive, global oil and gas group, for JP Morgan Securities in New York, says that even if the economy remains weak, the capital markets-both equity and debt-will be open for oil and gas companies in 2003. "The fact is, oil and gas stocks have outperformed the S&P 500 during the past year, so the market will be receptive to new issues," notes Maclin, who is also senior executive for JPMorgan Chase's southwestern U.S. banking activity. "Moreover, on the debt side, there'll be a lot of investor demand for oil and gas paper because the industry has a quantifiable asset base and steady cash flows, with a positive outlook for commodity prices. We're estimating for 2003 an average $25.40 for oil and $3.50 for gas." Through early September, JPMorgan Securities completed nearly $3 billion worth of oil and gas investment-grade debt deals for 2002 (see chart). "E&P and oilfield service companies are recognizing, with interest rates and spreads as low as they've recently been, that if ever they're going to borrow money-either to refinance existing debt or finance future growth-now's the time to do it." But on the equity side, is there-or will there be-an appetite on the part of oil and gas companies to do stock offerings? This year, producer cash flows have been good and operators have moderated their capex budgets, so there hasn't been much need to issue equity, Maclin allows. A big part of the reason producers have trimmed upstream spending relates to their focus on return on capital employed. Thus, while the capex dollars may be there for drilling projects, the projects have to be the kind that generate profitable growth-not growth for growth's sake. "This is particularly important, in light of the fact that since 1997, all-in upstream costs have risen at a 6% compounded annual rate." Another recent drag on equity issuance: the M&A market has been pretty dead. "That's because most E&P companies see a disconnect between industry fundamentals and their stock prices; also, they're reluctant to enter into transactions that might be difficult to complete, given all the concern about accounting irregularities and investor confidence. In addition, the economy is tough." For 2003, the banker sees a soft M&A market-more so than this year or last-and only situational or opportunistic equity transactions. On the lending side, Maclin talks about the lessons learned from JP Morgan Chase's recent loan-loss exposure to Enron. "One of the things we do as bankers is assume risk, so for banks to take losses is part of the normal course of doing business. However, after the Enron event, our focus has been on redoubling our efforts to avoid any relationship that could remotely impact our reputation in a negative way." In line with this, the firm has established an Office of Policy Review, not just for loans but for all client relationships. "Headed by very senior people, that office will consider every possible outcome or alternative before we enter any transaction." Morgan Stanley "Today, the equity and fixed-income markets are open for energy companies-even for high-yield, non-investment-grade firms," echoes Michael J. Dickman, managing director, energy group, for Morgan Stanley & Co. in New York. "If you look at the funding this year for all those that bought the Devon, Burlington Resources and ConocoPhillips divestiture packages, they had ample access to debt and equity capital, from both public and private sources. That's because the fundamentals of the energy business are strong, and during the next 12 to 18 months, the markets will continue to be open for oil and gas companies with the right use of proceeds." Within the past year, Morgan Stanley advised Conoco in the $37-billion ConocoPhillips merger; Enterprise Oil, on its $6.5-billion sale to Royal Dutch/Shell; Pennzoil on its $3-billion sale to Royal Dutch; and EEX Corp. on its nearly $600-milion sale to Newfield Exploration. The market-maker also led a three-tranche, $1.8-billion offering of five-, 10- and 30-year notes for Valero Energy; a $1-billion offering of 10-year notes for Schlumberger; and a $75-million, high-yield, add-on offering of senior notes for Comstock Resources. "We don't see interest rates changing in the next few months, but even if they gradually creep up, they'll still be in an attractive range to do a public debt offering," says Dickman. "As for issuing public equity, that's going to be more opportunistic or acquisition-related. Otherwise, with commodity prices and cash flows so strong, there just isn't a lot of need for operators to do stocks deals." About the only part of the energy industry for which the capital markets may not be completely accessible is the midstream sector. The banker observes this segment has been dominated by Enron, Dynegy, El Paso, Reliant and Mirant, "but given what has happened to those companies during the past 18 months, just how much public equity can those type of entities attract today to pay down debt?" MLPs and private equity capital, however, are now entering this sector. Indeed, Kinder Morgan, a natural gas limited partnership, is reportedly looking to buy more than $1 billion of midstream assets this year-out of an estimated $10 million of assets that have been put on the block by the midstream's cash-strapped giants. And this August, Warren Buffet's Berkshire Hathaway-owned MidAmerican Energy Holdings Co. completed the nearly $1.9-billion buy of Northern Natural Gas Co. from Dynegy. (For more on the midstream asset shuffle, see Oil and Gas Investor, October 2002.) Unlike some of his Street colleagues, Dickman sees M&A activity in the oil and gas sector continuing at a very visible pace in 2003. "This is a relatively mature, slow-growth, commodity-based industry, which means that keeping an eye on costs is important-and one of the big benefits of consolidation has been lower cost structures," he explains. "So we'll see more consolidation within the E&P and oilfield service sectors-and we'll certainly see a reconfiguration of the midstream business. "Right now, we're witnessing a dismantling of that business-asset by asset-by the likes of Dynegy, Enron and The Williams Cos. The question is, Will companies like those be reaggregated into brand-new entities or will one of them merge the others and reconsolidate that industry?"