As oil prices flirt with $100 and maybe more, there are those who believe there's a huge fear premium built into such pricing, driven by speculators in the market.

Simply put, many analysts believe global supply and demand fundamentals don't come close to supporting such pricing hysteria.

Says one Wall Streeter, "There's a $30 'fear premium' imbedded in global oil prices [which] in 2008 should probably trade in an average range of $65 to $75 while the price of natural gas-a more geographically isolated and weather-dependent commodity-hovers in a trading range of $6 to $8."

Even if this prediction proves true, the market and the industry are still looking at historically high commodity prices, and therefore investment bankers and private-equity providers alike expect the doors to all forms of capital to be wide open to the energy industry.

This includes the high-yield market, which was temporarily shut down this summer after the credit crunch caused by the real-estate debacle and subprime issues.

The consensus on The Street is that the prime driver behind the industry's need for access to the capital markets in 2008 will be acquisition financing-particularly by existing and new upstream MLPs (master limited partnerships) that will be heavily tapping the IPO and secondary equity markets. Meanwhile, acquisition-minded corporate E&P companies will likely access the cheaper debt markets-both investment-grade and high-yield-in today's remarkably low interest-rate environment.

In addition, with an expected increase in corporate M&A activity-not just asset acquisitions, the supply of which is dwindling-a lot more talented management will be looking for upstream projects to apply their skillsets.

And when they do, that's going to draw even more attention from the increasing ranks of private-equity providers looking for seasoned E&P teams.

The bottom line: Even if commodity prices tumble out of bed next year, they won't be falling far. And the capital markets will be more than ready to lend a financial hand to help energy companies bounce back.



MLP backlog

Amid ongoing historically high commodity prices, 2007 continued to be a relatively robust year for financing oil and gas companies.

According to available capital-markets data through the end of summer, there was, within the energy sector, $40 billion in investment-grade bond issuances, $17 billion in high-yield bond offerings and about $10 billion of equity issuances.

The driver of all this activity? "Acquisition financings were prevalent across the entire debt and equity spectrum," says Carlos Fierro, managing director and global head of the natural resources group for Lehman Brothers in New York.

"Another trend on the equity side-something we didn't see much of in 2006-was a lot of MLP IPO issuance, particularly with the rise of E&P MLPs as a new class in that space."

Within the past year, Lehman Brothers was book-runner on the $115-million Encore Energy Partners IPO. But more notably, the investment-banking firm in 2007 was the placement agent on seven PIPE (private investment in public equity) transactions in the E&P and midstream MLP space totaling $3 billion.

This included three PIPEs for E&P MLP Linn Energy worth an aggregate $2.1 billion and a $450-million PIPE for BreitBurn Energy Partners, another upstream MLP.

Separately, in public-equity issuance, the firm was book-runner this year on another $2.1 billion of offerings, including a $1-billion offering for XTO Energy in connection with that producer's acquisition of assets from Dominion Resources.

Why the sudden popularity of upstream MLPs? "Unlike their counterparts of the 1980s, which didn't work well in a low commodity-price environment when they couldn't make their distributions, today's E&P MLPs have the ability to employ hedging strategies not available then-so an investor can see the sustainability of their distributions," says Fierro.

"Yield-oriented and tax-advantaged structures like these are going to be of interest to both retail and institutional investors."

The banker notes that Lehman Brothers has a significant IPO backlog in both the E&P and midstream MLP space, "so we expect to see a lot of acquisition financings in that area, as well as more IPOs."

Fierro also expects to see in 2008 even more robust M&A activity in the natural-resources sector. This year, through August, Lehman advised E&P and oil-service companies on $59 billion worth of such deals. This included advising Dominion Resources on its aggregate $13-billion divestiture of assets to ENI, Loews, XTO and Linn Energy; advising GlobalSantaFe on its pending $18-billion merger with Transocean; and advising Plains Exploration & Production on its $5-billion acquisition of Pogo Producing.

"About the only thing that could disrupt energy M&A activity next year is nationalization or protectionism in the various countries where companies are being acquired," he says. "We've seen some of that in Canada, with the government talking about restricting foreign-government-owned entities from acquiring Canadian resource companies, and we've seen some nationalism of oil and gas assets in Venezuela."

This aside, Fierro believes that the current energy supply/demand imbalance-and the growing demand for oil from emerging economies such as China and India-will drive continued high commodity prices which, in turn, will drive further capital-formation activity in the coming year.

"Companies that need resources to replace production will continue to be acquisitive, and those exploring for resources will also need to access the capital markets."

Any storm clouds on the horizon? Because of the recent crunch in the U.S. credit markets, which began this past August, there could be less activity in the high-yield market. "So we might see in 2008 fewer and smaller LBOs (leveraged buyouts) in the natural-resources space."

Robust M&A outlook

What's been noticeable for Citi this year, in terms of energy financing, has been the stepped-up pace of MLP financings, particularly in the upstream space, both in terms of IPOs and PIPE transactions.

Within the E&P MLP space alone during the past year, Citi was involved as lead book-runner on the $109-million IPO for BreitBurn Energy Partners and the $111-million IPO for Constellation Energy Partners. It also was lead placement agent in 2007 in secondary PIPE offerings for BreitBurn, Linn Energy and Constellation.

That's not all. Within the midstream MLP space, it was even more active in 2007, leading the $316-million IPO for Semgroup Energy Partners, the $253-million one for Spectra Energy Partners, the $326-million IPO for Cheniere Energy Partners and the $406-million IPO for Targa Resource Partners.

"The MLP market has become quite broad, with more than $100 billion of publicly traded equities in the marketplace," says Andrew Safran, vice chairman and co-head of Citi's global energy and power group in New York.

Notable in particular, however, has been the emergence of E&P MLPs as a way for oil and gas companies to monetize their upstream assets at higher valuations than might otherwise be available in corporate form. In effect, he says, they have become an alternative source of funding for the energy industry.

"Currently, we have a number of E&P MLP transactions in the pipeline that we'll be leading to market in the near future," Safran points out. "So it's a trend with staying power, assuming these vehicles are appropriately structured with the right, long-lived assets and hedging programs. We expect them to become voracious acquirers of assets in 2008, which will likely drive up prices for other upstream acquirers."

The outlook isn't all that different for the midstream MLP market, notes the banker. "We're seeing continued midstream sponsorship of additional MLP entities and expect to bring a number of them to market this year and next." The reason: the yield and the fundamental soundness of their underlying business.

"Remember, although there has been some volatility in commodity prices lately, the bulk of non-E&P MLPs really don't have direct commodity-price exposure; rather, they're fee-based businesses."

Safran is no less sanguine about a very robust upstream M&A market in 2008. Why? "Although commodity prices are high, costs on the oil-service side are outpacing oil prices, thus E&P companies are actually getting squeezed on their profit margins.

"There's just more pressure on upstream earnings, and as a result, it's going to be harder for producers to show the kind of earnings and reserve growth needed to achieve higher valuations in the market," he explains. "Therefore, operators will be on the prowl to acquire more assets and/or other companies."

This year, on the M&A front, Citi represented Todco in its $2.3-billion merger into Hercules Offshore; Tenaris SA on its $2.1-billion acquisition of Hydril; and Anadarko Petroleum on its $1.8-billion sale of certain midstream assets to MLP Atlas Pipeline.

If there's any caveat going into 2008, it's the availability of the high-yield and leveraged-loan markets, the latter involving Term B loans held by hedge funds and insurance companies. Says Safran, "These markets are currently challenged, given the dislocation of the credit markets post-August 2007."

He explains these markets have been temporarily closed. "Buyers (of high-yield paper) are just on strike until they see what the floor of the market is-that is, just how low various debt instruments could trade. Until they do, they're not going to jump back in."



High-yield returning

Up until the credit crisis this summer, energy companies had unprecedented access to virtually every form of financing the capital markets offer, says M. Scott Van Bergh, managing director, upstream energy group, for Banc of America Securities in New York.

"Where we saw the most financing during the early part of 2007 was certainly in the high-yield market and the equity markets, as well as in the private-equity world," he notes.

"Issuers were attracted to the high-yield market because credit spreads-that is, the interest-rate differential between those debt securities and 10-year Treasuries-were at historic lows. This resulted in very attractive financings; for single B, non-investment-grade credits, spreads probably got as low as 250 basis points."

The most notable E&P-related high-yield transaction that B of A completed in 2007 was a $1-billion offering at the end of March for Oklahoma City's SandRidge Energy (formerly Riata Energy) to pay off an $850-million bridge financing that B of A also led late last year in connection with SandRidge's acquisition of National Energy Group.

"This was an unusual transaction because SandRidge was still private at the time," says the banker. "This fall, we launched on behalf of this company-which has made use of a whole range of financings in the private market-a $645-million IPO, the proceeds of which will fund a very aggressive drilling program in West Texas."

This summer, the investment banker also completed a $450-million high-yield offering for New Orleans-based Energy Partners Ltd. to fund a recapitalization of that producer's balance sheet, including a substantial stock buyback.

B of A was one of two book-runners on a $240-million IPO for Midland's Concho Resources. Like SandRidge, Concho is a good example of a company that has grown through a progression of different financing sources, says Van Bergh.

The company was originally formed by raising private equity from Yorktown Partners, then became an aggressive user of bank financing-first a $500-million borrowing-base facility to acquire assets from Chase Oil, a private New Mexico-based producer, then a roughly $200-million second-lien facility to reduce its borrowing-base debt-then the $240-million IPO to pay some of those bank facilities.

Although the high-yield market shut down temporarily this August, Van Bergh believes that market is beginning to come back, as suggested by the recent Range Resources Corp. high-yield deal this fall.

What the banker also sees rebounding in 2008 is the corporate M&A market. First, if one compares where upstream stocks were two years ago, a lot of them haven't gone anywhere. Second, a lot of them have depended on asset purchases-and the supply of assets is declining at the very time demand for them, particularly by E&P MLPs, is increasing.

"Thus, those E&P companies that have experienced relatively flat stock prices and have been reliant on acquiring a diminishing supply of assets to replace reserves rather than growing through the drillbit are going to run into trouble next year and could find themselves targets for acquisition or willing buyers in a sale," says Van Bergh.

The producers best positioned for 2008: all the resource-play companies like Quicksilver Resources, Ultra Petroleum, Chesapeake Energy and EOG Resources that have large inventories of undeveloped resources.

The banker's take on E&P MLPs? "These are all relatively young entities, so the jury is still out," he says. "We really don't have the ability at this point to judge how well they're going to do in terms of reserve replacement through acquisitions while distributing a substantial amount of their cash flow to their unit-holders."



$30 fear premium

In 2008, global oil supply and demand will be delicately balanced, says Fadel Gheit, managing director and senior energy research analyst for Oppenheimer & Co. in New York.

"Demand growth will likely trail its pace in 2006 and 2007 in an obvious response to sharply higher oil prices," he believes. "Also, the impact of the real-estate debacle and the recent subprime issues could cool off economic growth next year."

Meanwhile, on the supply side, there should be a modest uptick as long-delayed oil projects finally begin to come online.

The analyst notes that in the Gulf of Mexico, BP's Thunderhorse project, delayed for more than two years, could add an incremental 300,000 barrels of oil per day, while its Atlantis project, brought online this fall, should add another 200,000 daily barrels.

"Economics 101 tells us that higher commodity prices-as we're seeing today-do two things: They curtail demand growth and increase supply growth," says Gheit.

"It therefore seems to me that OPEC will put more oil on the market to take advantage of current high crude prices," he predicts. "Also, it doesn't want to keep oil supply off the market since that could lead to some very serious government actions by the OECD (Organization for Economic Co-operation and Development) countries to significantly curtail energy consumption, thus oil imports, and move toward alternative fuels, which would not be in OPEC's best interests."

Given this thesis, the analyst looks for oil prices in 2008 to probably trade in an average range between $65 and $75 while the price of natural gas-a more geographically isolated and weather-dependent commodity-hovers in a range of $6 to $8.

Gheit contends that current oil prices do not reflect market fundamentals, and have not for a long time. Speculation, he says, has completely taken over the market, causing a $30 fear premium to be imbedded in oil prices amid concerns about war in the Middle East and whether the U.S. will launch strikes against Iran.

"If we're right that there will be a correction in oil prices going forward, we're likely to see a repeat of what happened in second-half 2006-which is a flight to quality in energy stocks," forecasts the market seer. "And that will favor the large integrated oils, as well as the large E&P companies."

Investors will therefore gravitate more toward names like BP, Chevron, ConocoPhillips and ExxonMobil-a stock which through late summer was the best performer this year among the majors, up 36.5%, he points out.

Among the large-cap E&P companies, the analyst cites Apache Corp., Anadarko Petroleum, Devon Energy, EOG Resources, Occidental Petroleum, Noble Energy and XTO Energy.

"All these stocks-amid high oil prices and fairly robust natural gas prices-will do wonders; they all have strong balance sheets and strong production growth," says Gheit. Overall, he notes, his entire large-cap E&P stock universe through late summer gained, on average, 40% in market value-with Apache turning in an outsized 52% gain due to higher oil leverage, strong growth potential and low costs.