THE CAPITAL PUSH

High commodity prices and record returns on investments have turned the oil and gas sector into a powerful capital magnet. The financial side of the business has become even more crowded with traditional investment banks, private-equity providers, venture-capital firms and institutional investors, each vying for opportunities to place capital with winning management teams.

While this "capital push" has allowed many E&P companies to grow, it has also pushed acquisition prices up, made oilfield services harder to snag and launched a whole new crop of competitors into the oil and gas space. Here's how some producers are reacting.

Capital juggernaut

For several private E&P companies, securing funding in the private-equity market, triggers a stream of offers from other capital sources that want to put money on a sure thing.

In 1998, Chuck Perrin, now chief executive of Tulsa, Oklahoma-based Rockford Energy Partners II, decided he wanted to leave his role as general manager of business development of Apache Corp. in Houston and strike out on his own. He joined Bob Anderson and Kyle Travis to form Sapient Energy Corp. with $15 million of private-equity capital from Natural Gas Partners and later sold Sapient to Chesapeake Energy Corp. for a cool $135 million.

For his next venture, Rockford I, he raised $15 million in private equity from Quantum Energy Partners, and sold the company to Newfield Exploration Co. and others in 2004 for $56.8 million.

"During the next four to six months, I had several energy financiers make a run at me," Perrin says. "I had never heard of two or three of them. It made me leery, and some of them had schemes that seemed too good to be true. I've been in this business for 27 years, so not having heard of these capital firms raised an eyebrow."

Perrin, who again obtained private equity from Quantum for Rockford II, says capital pitches surface in phone calls, and at cocktail parties and golf outings where the phrase "if you do it again, talk to us before you commit to anyone" has become standard.

"At the end of the day, there are only a handful of capital providers I would consider getting into bed with," he says. "They've been around for awhile, and have a track record, do their homework and know what their doing. In the oil business, every time you think things are going to be great, that's when they aren't. And it's the guys that have been through the cycles who aren't going to panic, point fingers and make you sell prematurely."

Perrin is in no rush to spend his funds. "We're taking a prudent operational, engineering, geological and financial-based analytical look at our investments. I'm competing with people who are wildly overpaying for properties." In the past 14 months, Rockford II has offered some $1.4 billion for properties and had signed its first purchase agreement just at press time.

"If you have a good track record, raising the money is the easiest part; spending it wisely will make you weary. The deals that people are paying $200 million for today would have sold for $100 million three years ago. I hope that years from now when I look back at these past 14 months, I can say that the best deal I did was no deal."

A fair price

Rob Jacobs, president of Fort Worth, Texas-based Classic Hydrocarbons Inc., is also under pressure from the capital markets-to build the company's portfolio. He formed Classic in June with management funding and a $30-million equity commitment from Natural Gas Partners VIII LP. Along with partners Don Gann, chief operating officer, and Mark Doering, chairman, Jacobs hopes to build assets in East Texas and North Louisiana. He and Gann are founding partners of Fort Worth, Texas-based Encore Acquisition Co. Meanwhile, Doering had NGP backing since 1998 through the start-ups and sales of Classic Resources Inc., Classic Petroleum Inc. and Classic Petroleum Resources Inc.

"There is a huge market of buyers that want companies like ours," Jacobs says. "As a start-up with no assets, I'm feeling a lot of pressure from buyers who are saying, 'Come up with some assets so we can buy them from you.'

"I'm not running out and buying something with the hopes that I can flip it quickly. That may end up costing me, but I'll sleep better at night knowing I didn't buy something stupid just for the sake of having assets."

Once a company gets funding, private-equity firms may move on to the next management team, but the banks are still trying to place capital, Jacobs says. "When the news about our funding was released, investment banks came out of the woodwork to get a piece of the pie. Private-equity providers have plenty of capital beyond your original funding, but those other funding alternatives remain, and always want your business."

Jacobs decided on private equity because it seemed like good timing to start his own venture. His experience with Encore gave him the background in oil and gas and NGP allowed him to build an experienced team where everyone brings complementary skills.

"There's more money available, but it may not be the money you want. You run an incredible risk, partnering with unknown entities in the capital space."

Acquiring properties is a challenge today, he agrees with Perrin. "The challenge is to be selective in evaluating which ones allow for bidding with confidence. There is also a temptation to overlook keeping the balance sheet strong when buying. We don't want to miss a good opportunity because of a poor balance sheet."

Instead of waiting for deals to come to him, Jacobs plans to initiate them. "If the deal comes to us, that means it's already gone to plenty of other people too, unless it's some unique opportunity that's only going to fit us. There are good opportunities out there, but finding one at a fair price that someone else isn't willing to pay an unfair price for is getting tougher."

Stay competitive, he advises. "You have to play off of your advantages. Seek deals in areas where you already have rigs, for example. Also, there are companies that are in the pure acquisition game that present very stiff competition. You can't just pay attention to what you're trying to do. In this capital climate, you need to watch for who else is trying to do it too."

Tough sell

In spite of the heady capital markets, not every management team found it easy to secure financial backing. Clinton Coldren, chief executive of New Orleans-based Coldren Oil & Gas Co. LP, says several private-equity sources were wary of the company's plans to focus on the Gulf of Mexico shelf. Management started the capital-raising process in early 2005.

"There was a lot of interest and we talked to a lot of people, but at the end of the day, a lot of them had never invested in the Gulf of Mexico," says Coldren, a founder of and former executive vice president and chief operating officer of New Orleans-based, publicly held Energy Partners Ltd. "That was a big deterrent for them."

After a few months, First Reserve Corp. stepped forward with $100 million of equity for Coldren to fund a 19-well drilling program with oil-company partners.

"That funding gave us a lot of firepower to get transactions done, drill wells and get very aggressive. An opportunity for an acquisition presented itself in 2006 and First Reserve stepped up again." A subsidiary, Coldren Resources LP, was formed and, with Houston-based Superior Natural Resources, an E&P subsidiary of oilfield-services firm Superior Energy Services Inc., acquired all of Noble Energy Corp.'s shelf assets for $625 million. Credit Suisse and Bank of America arranged debt capital for Coldren to fund the purchase, and Superior gained a 40% stake in the Coldren subsidiary.

Before it secured funding, Coldren Oil & Gas' strategy was to drill its way to value. Once it partnered with First Reserve, the focus shifted to acquisitions. "We saw opportunities starting to open in the divestiture market and we seized the moment. It was a major step to go from drilling a few wells to acquiring all of Noble's shelf assets."

The shift to a more aggressive operating strategy was partly due to the increased competition from existing and other newly funded players, Coldren says.

"When you have other people's money invested in you, you have to always look at the return on investment. Considering our size and the fact that we're private, we still have to get out there and compete with ExxonMobil, Shell and others to get rigs. The execution side of organic growth has become challenging because of demand for equipment and services."

Coldren says the best reaction to today's capital boom is a conventional one. "You have to stick to the economics of the situation. It's easy to get money and spend it right now, but you have to be smart and take a conservative look at your investment decisions. When all this wonderful stuff is going on in the industry, I'm not relaxed. I've been in this business 25 years-long enough to know how ugly it can be."

The 'resource play'

When Robert Boswell, chief executive of Denver-based Laramie Energy LLC, set out to start his company three years ago, he was hoping to access enough capital to pursue an organic, drillbit strategy in a capital-intensive resource play in the Rockies.

"Back then, the notion of the 'resource play' and the ability to attract private-equity capital was somewhat limited," says Boswell, the former chairman and chief executive of Forest Oil Corp. "There were only a few firms that were very familiar with these plays. Most of the private-equity firms focused on acquisition opportunities, which were more tangible."

Boswell and his partners began the capital-raising process in 2004. They met with 10 private-equity firms, and of the group, only half were interested in the team's strategy.

"At the end of the day, we selected EnCap Investments LP and Credit Suisse/Avista Capital Partners to back us. The initial commitment was $150 million, and it's been increased to $215 million. Both firms understood the risks of our strategy, and we opened our doors in June 2004."



Boswell calls the capital push "a natural side-effect of the robust nature of the industry," and says he's willing to stomach the resulting competition for assets and services, since that same capital has helped broaden the range of potential projects.

"It's easier now to raise funds for riskier ventures. The challenging side to that is the increased activity in the industry has made it harder to get services in a timely fashion and according to plan. But the availability of capital lets us keep up a steady rate of operations."

Boswell doesn't feel additional funds are being forced on him. While other private-equity firms still voice a courteous expression of interest, "the veterans recognize there will be opportunities where we can work together and some where we can't."

Knowing when to seek private equity is directly related to the context of your business plan, and management needs to constantly consider which kind of capital is appropriate, the cost of that capital and what the alternative sources are, Boswell says.

"When you strike the best balance between cost and chemistry with the capital provider, then aspects of this 'capital push' go away."

Boswell says the company's most drastic adjustment has been to get more aggressive at tying up acreage in front of its drilling program.

"The two faux pas that occur with industry booms are the new entrants on the capital and the E&P side. Some of them just don't have the expertise to execute. When those two types of inexperience meet is when you hear about real problems and bad investments, which can tar the whole spectrum of oil and gas players."

Pressured to buy

The pressure to stay one step ahead of new entrants has led some privately held E&Ps to consider more acquisitions over drillbit growth. But some seasoned executives realize that many of today's asset prices are inflated compared with historical deal values-and they're opting to bow out.

William Flores, chief executive of Houston-based, Gulf-focused start-up Phoenix Exploration Co., says, "We'll offer to pay what we think is appropriate, and in many cases we'll lose, but we're backed by patient investors, proven private-equity providers-and the capital will be there. Our backers rely on us to know when to step up, and they have yet to tell us to bid higher on a deal. Also, we're a patient acquirer."

Flores adds that approaching an equity provider about paying more for assets can easily backfire. "They could start to question my commitment to our strategy. If we have a hydrocarbon-price correction, our private-equity partners should anticipate that we may accelerate our deployment of capital. But that's a change in pace, not strategy. We have our own capital in the game, so if we make a bad decision, it's going to leave a mark on each of our personal finances."

While the capital influx has been positive for asset sellers, Flores says the excess capital from providers has made some of his peers look at deals that have marginal economics.

"Some equity firms that don't have the benefit of experience are still making investments. In some cases, they're providing capital to companies that wouldn't make the first cut. It's not just private-equity and venture-capital funds providing the influx of capital-it's also happening with the public markets."

Phoenix's management team was with Gulf-focused Gryphon Exploration Co. until it was acquired by Woodside Petroleum Ltd. in 2005. In April, New York-based Carlyle/Riverstone Global Energy and Power Funds committed $250 million to Phoenix for exploration and acquisitions on the Gulf Coast and in the Gulf of Mexico. Phoenix also received $100 million from a new private-equity firm organized by a couple of long-time private-equity players: Howard Newman, formerly vice chairman of Warburg Pincus, which had funded Gryphon, and partner Michael McMahon, a former investment banker with Lehman Brothers.

"Raising our capital was difficult and time consuming, but not as hard as it would have been in the past," Flores says. "It's hard to say whether it was easier because of market conditions or because of the fact that we have an experienced management team and a solid strategy. We think it was the team and strategy."

Phoenix has received a number of additional capital pitches, primarily from financial intermediaries, and brokers have become more aggressive in pitching asset acquisition deals. Management has passed on many of them because the reserve size was too small, there was no upside or there was a lofty price expectation.

In accepting private equity, Flores says Phoenix limits its capital use to a "just in time" formula. "I don't want $350 million just sitting in our treasury and you don't want it in your pocket with the returns-expectation clock starting that same day. I would rather see it invested in a project. When one of our funded projects is up and running, if we've done our analysis and the economics are right, the value creation is much higher than the cost of the capital."

Scrubbing the deal

Dallas-based Camden Resources Inc. executives Marc Rhoades, president, and Bryant Patton, executive vice president, say they aren't opposed to making acquisitions-but competition has made it hard to find anything to buy at a value-driven price.

Patton says, "Our business is cash flowing from the success we've had, but there hasn't been a great need for capital because we haven't been able to acquire anything for value. That's a result of capital being so available to others. It's competitive and it's hard to acquire anything."

Rhoades adds, "With the influx of capital now, you have to be on the fast track to get ahead of that capital because usually somebody's trying to put money to work fast. Sometimes you don't have the opportunity to scrub the deal like you would want-do the due diligence necessary to make the right decision. There are times when you feel like you have to jump on something or be prepared to watch it slip away from you."

Camden still avoids projects that don't fit the company's original, conservative strategy, Patton says. "We will walk away from something if we know we won't get the time and effort to put it together right. That has probably slowed our growth a bit, especially since it's primarily through the drillbit."

Rhoades adds that rig dayrates continue to soar since there's more capital in the E&P space and more companies drilling no matter the cost. Meanwhile, he adds, service quality is going down-another drain on the business. "There aren't enough people in the service sector and the ones who are are being run ragged, operating equipment that's not maintained."

Camden received equity from Yorktown Partners in April 2000 to focus on the Frio, Vicksburg, Wilcox and Yegua trends from the Rio Grande to the Sabine River in South Texas. Patton says that, when the company was funded, the available amount may not have been as plentiful, but his experience in the capital sector helped him to know to whom to talk.

"It was as if there was an overabundance of money because we had a high-quality opportunity to talk about," Patton says. "We put in the effort to go out and find the right capital partners. There is adversity that has to be dealt with in our business, and how your provider handles it is important. You can't just throw money at this business and be successful."

Since it was formed, Camden initiated plans to sell the company-twice. Both times, the buyers were unable to close.

"Any time you're sponsored by private equity there is a time to sell," Patton says. "Each time, we were given the indication that the buyer could close. In the last case they couldn't perform and the other deal fell apart for purchase-and-sale-agreement issues. We were led to believe, because of the amount of capital available in the marketplace, that the second buyer could do a very creative financing and pay a premium for our company."

Staying focused

When Mark Wilson co-founded Tulsa, Oklahoma-based Coronado Resources LLC in July 2004, the management team was able to invest in smaller opportunities without outside funding. He and partner John Coates spent seven months spending their own money, acquiring leases in the Midcontinent. They also approached some wealthy individuals about project-by-project funding, with few results.

"It was during the spring of 2005, and even though we met several people with substantial amounts of money wanting to invest in our projects, they had a difficult time deciding how to participate in opportunities," says Wilson, formerly senior vice president of corporate planning and development for The Williams Cos. Once he realized his financial contacts, and the capital climate, would let him grow Coronado at a much faster pace, it seemed like the right time to seek private funding.

"Private equity made the most sense for us because we're focused on unconventional resources with a frontier exploration component of trying to turn acreage into proved reserves. Mezzanine or debt financing would have been harder to get since we didn't have proved reserves when we began our road show."

Coronado closed on $81 million of equity commitments from Lime Rock Partners and Greenhill Capital Partners in October 2005.

"We went to the capital markets saying 'We hope we get a single opportunity to be funded' and we wound up with multiple opportunities from several high-quality firms. Our business plan at the time wasn't focused on specific opportunities but on a range of opportunities that we were evaluating. We asked for the capital we thought it would take to fund a portfolio that captured both scale and balanced risk, and that's what we received."

Wilson says the increased competition for properties is "not necessarily a bad thing, but it places a premium on being very disciplined in what we look at, what opportunities we believe can create the most value, and determining the value of those investment opportunities."

Since being funded, Coronado has stuck to its original operating pace and strategy. Wilson says the biggest pressure created by today's capital markets is a potential loss of focus.

"It's not necessarily driven by capital or the expectations of the capital providers...We're not in this to simply get capital. We're in it to use the capital to be successful."

Public markets

The back-to-back announcements of initial public offerings confirm that many E&Ps are willing to hack through plenty of regulatory red tape to access funding from the public markets. While the positive shift in the capital markets has allowed many publicly held producers access to more acquisitions and drilling opportunities, it has also increased the pressure to execute such plans at a faster pace.

William S. Daugherty, chief executive of publicly held, Lexington, Kentucky-based NGAS Resources Inc., says the abundance of capital cannot be a substitute for common sense. "For the smart management teams, the capital markets have changed for the better. But it is incumbent upon us to make sure that the capital is utilized wisely.

"We have turned down 'easy money' several times. The financings we completed over the past several years have been associated with pending transactions, rather than taking money just because it is readily available. You can't know if a financing is going to be accretive if you don't know where you're going to spend the money."

The shift in capital markets has allowed NGAS to put more money in the ground and acquire more assets. The company has also bid on larger acquisitions. "There is a lot of competition among financial institutions and investment banks, and if you have a good asset that you want to drill, there's always someone who will give you the money for it-for a fee."

The capital-markets environment has given NGAS more flexibility in designing financial vehicles that work for its shareholders. "Over the past couple of years, we have raised about $60 million in private placements. About $51 million of that has been in convertibles, and the balance, equity. We had to pay interest on the converts but it gave us the ability to sell stock in the future at a definite premium."

In the past, NGAS funded most of its drilling with drilling partnerships. Now, the company keeps a larger interest in new development opportunities while having the financial flexibility to pursue acquisitions. "Increased financing options have allowed us to control a much larger area than we could in the late 1990s, when money was harder to come by.

"The biggest challenge today is in having to decide if an acquisition makes sense for the longer-term growth of the company even if the money is available. It's important to stay focused on this point regardless of where the money comes from."

Denver-based, publicly held Cimarex Energy Co. has opted to take a measured capital approach. Chief financial officer Paul Korus says the company's capital-formation process has focused on using cash flow to fund drilling, and using stock to accumulate assets. It uses traditional bank credit facilities when cash flow is tied up in drilling, and this hasn't changed during the last five years while access to capital has increased, Korus says.

"Where the capital comes from is not important-it all wants a return," Korus says. "What's important is the amount of capital that's available. Since our sector, relative to others, seems 'hot,' we're seeing a heightened flow of capital and it will continue until the returns on investment are competed down to levels no better than the rest of the economy."

Higher prices and the push of capital to the energy markets made it possible for Cimarex to be formed in 2002, when drilling company Helmerich & Payne Inc. decided to spin off its E&P assets. "That transaction wouldn't have happened in 1998 when oil was $10."

Cimarex's $2-billion merger with producer Magnum Hunter Resources in 2005 was another positive result of strong commodity markets and capital availability. "The rise in prices and equity values has definitely benefited the company along the way, despite the fact that we have not been a direct issuer of common stock or any high-yield debt."

Korus says he hasn't had many intermediaries approach the company about investing in Cimarex because its business model is well understood. "Our business model doesn't usually require external capital-public or private-on a recurring basis."

'Hear them out'

In the course of competition, producers such as publicly held, Denver-based Whiting Petroleum Corp. are taking care to not become overleveraged. It also aims to raise enough equity and debt to not get pushed into selling properties if the markets turn south.

Jim Volker, chief executive, says, "We have to be disciplined with capital and pursue projects that have high enough rates of return so they can sustain themselves, even at lower prices. From what I've seen, public and private money is pursuing things that may only give you a 3-to-1 return on your money."

Whiting went public in 2003. Since then, it has placed three subordinated debt issues and two stock issues in successively increasing amounts-$150-, $230- and $250 million-with the debt at rates of 7% to 7.25%. The stock was placed at higher prices each time, and the debt was placed at lower interest rates each time.

How Whiting finances a deal is determined by the rate at which cash flow can be extracted from the opportunity.

"All capital comes with a cost, and smart investment firms don't burn bridges," Volker adds. "Any time we're going to raise capital, we try to include firms that have been helpful to us in the past.

"We also try to make room for people in our investment- and commercial-banking groups who bring us new opportunities. It means they receive a smaller percentage, but it's a smaller percentage of a bigger company. They may not like it, but they understand it."