Recession is a reality. So are low commodity prices and less-than-robust oil and gas stock valuations. In such an environment, and with already shored-up balance sheets from the energy-market boom of 1999 and early-2001, producers and service companies aren't likely to have much of an appetite for public equity financing in 2002-at least not right away. That's the consensus among Wall Street marketmakers and intermediaries of private capital for the industry. The bulge-bracket bankers point out that-amid record-low interest rates and the likelihood of more consolidation and asset divestitures within the sector this year-public debt financing is an extraordinarily attractive financing route for energy issuers. And the buyside is hungry for such paper. Says one top Street maven, "If I had to bet, I'd say we'll see more public debt than equity deals in 2002." Meanwhile, private-capital intermediaries stress that for smaller-cap E&P and service companies, whose cash flows and valuations have been pared during the past year, private-equity and debt financing may be the only sensible-and available-path to growth and to ultimate capital markets access. Says one industry observer, "Operators with market caps below $500 million will have difficulty raising public equity this year. The fact is, mutual funds, which are getting bigger and bigger, need to invest money in chunks, which can't be done with smaller, less-liquid energy companies." Recent visits by Oil and Gas Investor with some of the leading U.S. investment-banking firms and arrangers of private capital reflect these outlooks. Goldman, Sachs & Co. Chansoo Joung, managing director and head of the natural resources group for Goldman, Sachs & Co. in New York, says that, with the recent oversupply of 5.5 million barrels per day of crude-the largest imbalance in world oil markets in modern history-his commodity-price people are forecasting $18 oil for 2002-with lows significantly under that-and $3 gas. Certainly, that's not a crowd-pleaser for Wall Street. "However, sometime in first-quarter 2002, as investors begin to perceive improvement in the overall economy and a likely bottom in commodity prices, the equity markets will become a lot more liquid." But will the industry want, or need, capital-markets access in 2002? "Producers and service companies are going to continue to spend carefully and focus on returns, so I see very selective demand for equity issuance in first-half 2002. It's only after these companies become confident that economic activity and commodity prices are rebounding that they'll seek equity to fund the growth in capital spending they're not now anticipating." Currently, the public debt markets are not only available, but attractive, for energy issuers. "Portfolio and fixed-income managers are looking to diversify risk across sectors, and energy is generally perceived to be very creditworthy because of its high cash flows." Also, in recent years, there has been a dirth of public debt supply from that sector and investors are hungry for it. In the BBB, investment-grade market, Joung notes that although spreads are 200 to 250 basis points above relevant Treasuries-versus historical spreads of 100 to 125-those higher spreads are nonetheless attractive for energy issuers, given the absolute low level of Treasury interest rates. What will drive energy financing in 2002? "Initially, further consolidation, particularly as buyers scramble to acquire-out of what is now a smaller universe of targets-entities they feel will make them more competitive going forward." Most recently, Goldman Sachs advised Phillips Petroleum on its proposed $15.2-billion merger with Conoco; Gulf Canada, on its $6.5-billion sale to Conoco; Mitchell Energy, on its $3.5-billion sale to Devon Energy; Amerada Hess, on its $3.2-billion acquisition of Triton Energy; and Barrett Resources, in its takeover defense against Shell and its ultimate $2.8-billion sale to The Williams Cos. "BP Amoco kicked off a wave of consolidation that has now worked its way into the middle of the industry, and will continue down through the rest of it." Another driver of energy-deal activity in 2002, this time on the equity side, may well be a new financing structure that Goldman Sachs engineered in May for Kinder Morgan, the prominent midstream natural gas master limited partnership (MLP). "Historically, the MLP market has been limited to small, $100- to $150-million offerings aimed at retail investors; institutions had difficulty owning these issues because of tax problems, including filing and reporting issues. After many years, we finally cracked the code and came up with a new security-the "I" share-which allows institutions to access the MLP market, without having to be bothered with tax problems. In Kinder Morgan's case, this enabled us to complete a much larger than usual, $1-billion financing." Unlike an MLP unit, which an institution can't own, the I share represents a common stock interest in a corporation. "The security mimics the underlying economics of the MLP unit, except that instead of paying a cash distribution, it provides a 'distribution' in the form of additional shares of common stock-something institutions can own." JPMorgan Securities Because of the current recession, many industry observers are predicting lower oil and gas demand in 2002 and lower commodity prices, notes Todd Maclin, group executive for JPMorgan Securities' global oil and gas group in New York. "In that kind of environment, cash flows shrink and there's greater need to finance capex programs with outside capital," he says. "Thus, one would expect this year to see an increase in debt financing to meet the shortfall between cash flow and capex requirements. However, one must also remember that when there's less than a robust outlook for oil and gas prices, operators tend to reign in capex budgets. So it's hard to predict energy-lending and capital-markets activity for 2002 without knowing the demand part of the equation." Maclin, who is also the senior executive for JPMorgan Chase's banking activity in the southwestern U.S., does allow, however, that when commodity and stock prices are down, many operators like to take advantage of low valuations by spending on acquisitions rather than drilling projects. "Even after the recently announced merger of Phillips and Conoco-where we were one of the M&A advisers to Phillips-there's still room for further industry consolidation, notably within the upstream sector. It's possible we'll see another major oil acquiring a large E&P company this year, or two large E&P companies combining-particularly if valuations remain flat or down. That would positively affect the loan and bond markets." This past fall, JPMorgan Securities co-led a US $2-billion, multitranche, multicurrency bond offering for Schlumberger, on the heels of the service company's purchase of Sema, a French technology company. Concurrently, it co-led a $4.5-billion bond offering for Conoco, following that company's acquisition of Gulf Canada, wherein JPMorgan acted as M&A adviser to Conoco. Also this fall, it was manager on a $3-billion bond offering for Devon Energy, after that independent's buyout of Mitchell Energy and Anderson Exploration, wherein JPMorgan acted as adviser to Mitchell's shareholders. "In each of these cases, the buyer financed its purchase with a loan that was later taken out in the bond market," says Maclin. According to Thomson Financial, JPMorgan Chase through the first nine months of 2001 was the leading arranger of syndicated U.S. oil and gas loans-$19 billion, or 43% of the market. Most recently, JPMorgan Chase, a substantial lender to Enron Corp., attempted to arrange hundreds of millions of dollars in financing to shore up Dynegy's proposed, but later withdrawn, bid for the failed energy-trading giant. The outlook for energy-equity deals in 2002? Not all that great, says Maclin. "Amid low stock valuations, operators are reluctant to issue equity; with relatively strong balance sheets, they're inclined to finance projects or acquisitions with debt." Salomon Smith Barney To understand the outlook for energy capital in 2002, one must first understand what happened in 2001, says M. Scott Van Bergh, managing director and co-head of the energy finance group for Salomon Smith Barney in New York. "Robust commodity prices and extremely strong cash flows dramatically reduced the need for producers to go to the capital markets this past year," he explains. "Also, with the major oils generating large cash flows from their properties and facing pressure to show growth in production, there wasn't very much divestiture or asset acquisition activity in 2001. That further reduced the need for financing, in both the equity and high-yield markets." He notes that through the first 10 months of 2001, the industry raised $2.6 billion through high-yield debt transactions, with $800 million in one deal (Chesapeake Energy). Meanwhile, on the equity side, the industry raised $1.4 billion-$600 million of that in a zero-coupon convert (Anadarko Petroleum). The investment-grade debt market, however, was another story. Through some 25 issues during the same period, almost $12.3 billion was raised-substantially more than in prior years. About $9 billion was tied to corporate M&A-related financing; the balance, to debt-portfolio optimization. Will this financing profile repeat in 2002? The industry still looks strongly capitalized, so very little financing has to happen to improve balance sheets, says Van Bergh. "However, based on the current level of gas storage, and assuming a normal winter, a relatively weak economy near-term, and flat to slightly down production volumes, our equity-research people are projecting average $2.25 gas prices for 2002, with crude prices in the $18 to $20 range. If that forecast turns out to be correct, there's going to be greater demand for capital by producers to fund operations this year. "Also, given the level of corporate M&A activity that took place in 2001, there's going to be a lot more asset dispositions in 2002, and that should also prompt the increased demand for capital within the upstream sector." But will investors be receptive to this demand? On both the investment-grade and high-yield debt side, investors will continue to be very interested in energy because it's viewed as a defensive sector, given where the economy is right now, says Van Bergh. "On the equity side, they'll selectively buy into large- to midcap E&P equity issues on the expectation that, with a turnaround in the economy, gas prices will move beyond the $3 mark through 2002 and 2003." Warburg Pincus LLC Jeffrey A. Harris, senior managing director at Warburg Pincus LLC in New York, sees higher industry demand for private-equity capital in 2002. "The futures market suggests lower oil and gas prices this year than in 2001, which means less cash flow from internal operations and more properties available for sale. To the extent that E&P and oilfield-service companies can't or don't wish to access the public-equity markets to fund growth opportunities, they'll need outside financing from private sources like ourselves." During 2001, Warburg Pincus invested some $35 million in the oil and gas sector. This included an initial $10-million funding for Carneros Energy Inc., a private Bakersfield, California-based company focused on the San Joaquin Basin. "We're impressed with their seasoned management, their focus area and their use of 3-D seismic technology to develop prospects in an underexplored part of the basin," says Harris. Within existing investments, the firm raised its funding of Gryphon Exploration Co., a private Houston operator focused in the shallow-water Gulf of Mexico, from an initial backing of $20 million to $40 million. "Gryphon is very much like one of our earlier private-equity investments, Spinnaker Exploration, which is now a highly successful public E&P company," says Harris. Gryphon's management has acquired the exclusive rights to prestacked, time-migrated, 3-D seismic data covering waters offshore Texas, has made several discoveries, has a solid inventory of prospects and is expanding its exploration team, he says. Other Gulf of Mexico operators that have received a private-equity boost from Warburg Pincus include Newfield Exploration and EEX Corp. The firm has also backed Encore Acquisition Co. "What all these operators have in common are experienced management, a focused strategy and the potential for significant growth." In 2002, Warburg Pincus is going to be very focused on Canada, as well as the U.S. "With all the divestitures arising from the consolidation of the North American oil and gas industry, we see a lot of experienced management becoming available," says Harris. "We'd like to back those people-with investments ranging from $25- to more than $100 million-as they begin building new companies." Carl H. Pforzheimer & Co. Frank Reinhardt, a partner at Carl H. Pforzheimer & Co. in New York, also believes there will be a greater need for private equity by the industry in 2002, particularly on the part of smaller-cap E&P companies. "During the past year, we've witnessed a major decline in commodity prices, especially for natural gas. That, in turn, has depressed the share prices of a great many gas producers that already have projects they want to move forward. Faced now with valuations that, in many cases, are half of what they were a year ago, these operators can't or don't want to access the public capital markets. For them, private equity will be essential." Reinhardt reasons that if producers can get their drilling or acquisition programs up and running today with private capital, they'll be able to grow their assets and share prices incrementally to the point where the public markets eventually become a viable option. An intermediary for private equity, Carl H. Pforzheimer was recently visited by a publicly traded Northeast-based operator with production in California and onshore the Gulf Coast. The company, which has seen its stock price pared during the past year, wants to grow production through acquisitions to better supply its downstream holdings, says Reinhardt. "For them, it makes sense right now to raise $25 million in private equity and gradually grow their upstream and downstream asset base and share price. Then, a year from now, the company will be in a much stronger position to attract an even higher level of capital in the public markets." Pforzheimer is also in the process of sourcing $5 million for a privately held Louisiana-based producer, which would allow that operator to take control of a publicly traded Gulf Coast E&P company, and thereby go public through that entity. "The operator is profitable, but its onshore and offshore wells in the area have fast production-decline rates. This acquisition would allow the company to expand its regional production platform, with associated cost benefits and improved profitability." Early in 2002, Pforzheimer may also be sourcing private equity for a Rocky Mountain producer that's trying to contend not only with rapid production decline rates, but also with gas prices that are well below Nymex. "To arrest its decline curve and begin growing again, this company is going to need to drill at least 50 wells a year, and perhaps expand its basin focus. We've already been approached by two investment banking firms that would like to provide private equity to this operator. Meanwhile, we've introduced the producer to the Louisiana company we're helping, with a view to creating a joint venture that would give both producers an exposure to more than one basin." Tovey & Co. Joe Tovey, managing partner for Tovey & Co., an energy-focused merchant bank in New York, believes public and private capital may be scarcer this year than in 2001. "With the disturbance to the U.S. economy and financial markets arising from the recent acts of terrorism and the dislocations that may be caused by further political uncertainties, we're looking at a recession that's not going to be over for a year or more. So the total amount of money available to the petroleum industry is probably going to decline. At the same time, in a recession the industry's need for capital will also decline." Tovey points out that many institutions that normally make private-equity investments in the energy sector are likely this year to turn their attention to publicly traded oil and gas issues. "Many of them feel that buying and selling the stock of an ExxonMobil will provide a rate of return substantially equal to what they might achieve through a direct investment in a privately held entity that doesn't have the same liquidity or market visibility." A former Mobil Oil tax planner and Wall Street petroleum analyst, Tovey adds that the outlook for commodity prices in 2002 isn't very encouraging-and that's not just because of the recession. "To the extent that the U.S. government will exert political pressure on OPEC, it will be to increase supply, because lower energy prices mean other sectors of the domestic economy will do better. Also, in these uncertain times, the U.S. and the western European countries are going to want to increase their emergency petroleum supplies-and obtain them in the open market at a lower, rather than a higher, price." Given all this, Tovey & Co., an intermediary of private equity and debt financing for the energy sector in both the U.S. and Canada, foresees a less than robust-but still active-deal pace in 2002. Currently, the firm is lining up about $25 million of private-institution equity and debt financing for a Midcontinent oil and gas producer, which would allow that operator to acquire another regional E&P company. The typical rates of return sought by Tovey's investors: if the investment is a pure loan, something on the order of 50 to 75 basis points over what the rate would be for an A-rated, investment-grade credit; if it's a mezzanine transaction-debt with an equity kicker-a return in the 14% to 22% range; if it's equity for wildcatting, but the operator has a good track record, a return closer to 35%. Says Tovey, "In all cases, we and our investors look for three things-management, management and management."