As the energy industry closes out the year, many challenges remain. The commodities and financial markets continue to contain far more uncertainty than certainty, and the road to economic recovery is far from smooth. Many financial providers are reluctant to make generalizations, but they seem cautiously optimistic.

And no wonder. In the past 18 months, the industry saw unprecedented volatility in oil and gas prices, which rose and fell to record-breaking levels. Oil dropped from US$100.64 per barrel in third-quarter 2008 to $70.61 in third-quarter 2009. Gas prices tumbled from $7.44 per million Btu to $4.84 during the same period. As a result, fears of further volatility touched every sector of the energy industry.

In a break from the past, traditionally predictable semi-annual borrowing-base redeterminations, based on reserve valuations, were serious cause for concern for producers this year. Some small producers couldn’t hang on and were forced to file bankruptcy.

On the other side of the table, lenders saw their clients turn away from commercial debt in favor of issuing bonds into the more costly public high-yield market.

On a positive note, however, from a standing start of virtually no deals closing in the beginning of 2009, the market opened up to equity, debt, acquisitions and joint ventures.

Price forecasts

As for commodity prices, at press time there was still no end to wildly fluctuating price predictions, despite a fairly steady forward strip and widely used hedges.

In October, research firm Sanford C. Bernstein Co. Inc. published its opinion that “there is an upside to gas beyond the strip” and forecast a surprising $9 per thousand cubic feet (Mcf) price target for 2010, a mark some 54% above other analysts’ consensus.

Credit Suisse Securities (USA) LLC calls for $4.70 gas in 2010, citing stabilizing production and further demand contraction next year. Tudor Pickering Holt & Co. LLC’s (TPH) prediction is somewhere in the middle, at $7.50.

Based in Houston, TPH is an integrated energy investment bank and merchant banking boutique, while the company’s broker-dealer, Tudor Pickering Holt & Co. Securities Inc., offers securities and investment-banking services to the energy community. The firm’s TPH Partners LLC makes private investments in the upstream, midstream and services sectors.

“On the gas side, we have had a supply problem and a demand problem,” said Bobby Tudor, chairman and chief executive. “The million-dollar question is, how long does that take to shake out?” An analysis of TPH’s recent 500-page study foreshadows a fairly dramatic gas-price recovery in 2010.

“We are suggesting that gas prices will average $7.50 per Mcf next year,” Tudor said. “That is up off a current strip price of just more than $6. When we first made the call for $7.50 for 2010, the spot price was about $3. Our corporate clients called to ask what we were smoking.”

TPH studied 32 North American producing areas. Based on its models of each producing well and assumptions of future wells, particularly in the shales, there is “ample gas supply for any demand scenario,” he said.

However, TPH predicts a billion cubic feet per day of net demand growth based on U.S. gross-domestic-production growth. That demand will intersect with another event: a rig count maintained at its current level, causing production to fall by 10%. Such a scenario will tighten gas supply even without significant demand recovery, prompting rapid price recovery, explains Tudor.

The firm is also bullish on oil. “We use a $90 long-term oil price, based on a normalized demand scenario where the price of oil will be set by the cost of the marginal barrel of oil,” said Tudor, bucking ExxonMobil Corp.’s estimate of $70.

TPH’s marginal-barrel estimate is based on Canadian oil-sand plays, which it contends require $90 per barrel to earn a low double-digit return for its producers.

Oil price closely tracks the broader market, so there is a “short-the-dollar, go-long-commodities” trade that “has worked beautifully for every hedge fund in the world,” said Tudor. “We expect that as long as the dollar is weak, commodities will be relatively strong.”

Yet, given the high level of oil inventory at present, oil is “somewhat overbought,” he said. Current oil inventory does not support current price, so dollar-commodity trading strategies may be unduly inflating the oil price for now.

Redeterminations

Fortunately, E&Ps’ semi-annual borrowing-base redeterminations by lenders were milder than expected. Although many borrowing bases were reduced, others were raised and some were left unchanged.

In October, Exco Resources Inc.’s borrowing base was reduced by $450 million to $1.3 billion, after the company sold off assets in Appalachia and the Midcontinent. GMX Resources Inc.’s borrowing base was lowered to $175 million, motivating it to offer 6.95 million equity shares at $15 each and $75 million in debt via 4.5% convertible senior notes.

Also, NGP Capital Resources Co. reported that three of its four lenders had reduced their commitments to its investment facility (priced at Libor plus 425 to 575 points) to $67.5 million, down from $87.5 million. NGP provides senior and subordinated debt, convertible debt, preferred equity and project equity to small- and mid-cap energy companies.

At least two upstream master limited partnerships – BreitBurn Energy Partners LP and Legacy Reserves LP – saw their borrowing bases reaffirmed at $732 million and $340 million, respectively.

Elsewhere, Forest Oil Corp.’s bankers held the producer’s base steady at $1.62 billion with no change in terms. Ram Energy Resources Inc.’s base, collateralized by its 60%-proved-developed-producing reserve base, continues at $175 million. Two Marcellus drillers, Range Resources Corp. ($1.5 billion) and Rex Energy Corp. ($480 million), had no change.

On the upside, Vanguard Natural Resources LLC saw its base increase to $175 million, from $154 million. Vanguard credits the increase to its August acquisition of properties from Lewis Energy Group LP. Most of the assets, including 27 billion cubic feet equivalent of estimated proved reserves, are hedged at $8.18 per million Btu and $86.55 per barrel through 2011.

Vanguard’s lender group also increased the company’s borrowing costs to Libor plus 2.25% to 3%, from plus 1.5% to 2.125%, and tightened the E&P’s debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) to 3.5x, down from 4x.

In addition to lower bases, tightened debt markets drove asset sales during the year. Even large caps such as El Paso Corp., Chesapeake Energy Corp. and ConocoPhillips decided to sell off properties to pay down debt.

El Paso announced plans to “further improve the company’s financial flexibility to fund its core businesses” by selling up to $500 million in assets during 2010 and will reduce its quarterly dividend from $.05 to $.01 per share. The dividend reduction will result in approximately $112 million of annual cash savings.

Chesapeake found itself a bit overleveraged, according to Fitch Ratings, which reported concerns about the E&P’s cash flow and liquidity.

“High levels of capex in the current low-price environment are expected to result in minimal to negative free-cash-flow levels,” wrote Fitch analyst Eric Tutterow.

“Chesapeake continues to rely on asset sales, including proceeds from volumetric production payments, to finance drilling requirements. While Chesapeake has no scheduled debt maturities until 2012, borrowing-base redeterminations associated with the company’s credit facility ($2.8 billion outstanding at June 30, 2009) could create the potential for earlier debt reductions.”

Meanwhile, ConocoPhillips announced plans to improve its financial position by selling off a whopping $10 billion in upstream and downstream assets during the next two years. (Note: this article will continue in next week’s issue of Gas Processors Report)– Jeannie Stell, from Hart’s Oil and Gas Investor