Capital Markets Outlook: The Road Ahead

While many commercial banks are looking to fund energy deals again, the market’s mood is still cautiously optimistic.

Just as the financial markets began to regain some balance following the 2008 financial crisis and subsequent recession, the energy industry was dealt another blow from the Deepwater Horizon blowout and the massive oil leak in the Gulf of Mexico that followed. While Wall Street responded by sending several Gulf-focused company stocks plummeting, many traditional commercial banking sources opted to stand firm, openly announcing their intent to stay in oil and gas investments.

Three such firms were represented at Oil and Gas Investor’s Energy Capital Conference in June. Though the speakers on the commercial banking panel agreed that the oil and gas industry has some tough sledding ahead, there is capital available for quality companies, the IPO window is opening and the M&A market is gaining traction again.

No, gas prices haven’t completely rebounded. And yes, some of the legislation initiatives on deck on Capitol Hill do not bode well for traditional E&P. But—all things considered—the state of oil and gas financial markets is much better than it was a year ago, the speakers said.

While some industry watchers have openly questioned the growing amount of debt the U.S. has taken on, the panelists were optimistic that the nation would not see another financial meltdown during the next 24 to 36 months. While they said “anything is possible,” the increased public scrutiny toward banks and the financial markets in general make the scenario much less likely going forward.

"Banks may not need to reinvent themselves but they do need to find other sources of revenues beyond traditional M&A," says Marc Cuenod, managing director of Wells Fargo's Energy Division.

“A year ago, the banking market was in disarray,” said Marc Cuenod, managing director of Wells Fargo’s Energy Division. His firm has made investments in the energy sector for the past 35 years using a lending approach that is “disciplined but flexible.” This lets Wells Fargo remain active through the tougher parts of the energy industry’s cycles, he said.

“The financial crisis, combined with low commodity prices, made borrowing redeterminations very tough last year. Many first-lien lenders could not or would not extend credit to new clients. While some lenders, including Wells Fargo, continued lending through the cycle, it was extremely difficult to put together a syndicate of any significant size for strong clients and good transactions. For the few deals that did get done, prices increased and terms tightened.”

One year later, the banking markets are back and hungry for good, funded assets, he said. This trend was encouraged by a strong high-yield market earlier this year, which gave companies the opportunity to reduce their bank borrowings and extend their maturities. Now the market’s hunger for new loans has resulted in oversubscriptions on many deals.

“Deal pricing has remained relatively firm, and we’re seeing good opportunities for drilling deals, especially in the shales.”

Capital One has also been focused on growing its energy-banking business during the past 24 months, and has grown from $1 billion in energy-lending commitments to about $2 billion during that time. The firm owns Capital One Southcoast Inc., a New Orleans-based energy-focused investment banking group. Today, Capital One has grown to become the eighth-largest bank in the U.S., with roughly $180 billion in total assets.

"The tried-and-true energy lenders understand how to manage risk, so there is definitely capital available to the energy sector today," says James McBride, executive vice president and managing director of Capital One's energy banking group.

James R. McBride, executive vice president and managing director of Capital One’s energy banking group, said while the industry watched oil prices tumble from heyday highs to $32 per barrel a year ago, many banks didn’t take losses on their E&P portfolio. In 2009 Capital One was involved in 40 capital-markets transactions and 35 of these were in the energy sector. Twelve were equity deals while the balance was debt transactions. So far in 2010, the firm has been involved in 19 capital transactions and 12 of these have been in energy.

“The tried-and-true energy lenders understand how to manage risk, so there is definitely capital available to the energy sector today. Now it’s not as cheap as it was, but the most important thing is that it’s still there.”

It’s not all roses in the capital markets, however. As an example, the panelists noted the current financial crisis in Europe is something to keep an eye on, as those banks are critical to financing activities in the U.S. Of the six or seven deals recently syndicated in the banking markets, eight of the top 20 banks involved in those transactions were European banks, said David Dodd, managing director, BNP Paribas.

BNP Paribas doesn't typically require hedging for its reserve-based lending deals, "though typically when you hedge you get a bump in the borrowing base and you can hedge above the bank price deck," says David Dodd, managing director.

“If we were thinking that the activities in the European banking sector won’t impact the financial landscape here in the U.S., we should think again,” Dodd warned.

From his perspective, the high-yield sector turned out to be an industry savior during the latter part of 2009, providing substantial capital to the oil and gas sector when it needed it most. The sector was going strong for most of 2010 up until recent months. While he’s seeing some uptick in the second-lien markets, it’s slower for deals under $100 million that are non-investment-grade, he said.

Open for Business

Many financial institutions had their hands full maintaining their existing client base during the market crash. Now, while energy lenders have the capital capacity to consider new clients, the guidelines for engagement haven’t changed.

“If you have a proven track record and a strong management team, you really shouldn’t have any trouble getting banks to work with you,” Dodd said. “It will probably be more difficult now for players that don’t have that solid track record, but banks are open for business.”

Cuenod agreed. “There is definitely capital available. There’s not as many stretch and first-lien deals but there are other avenues out there to take up the slack. As a lender, it’s important to our group to lend through the cycles and maintain the principles we had during the high times. Sometimes that makes us look conservative in a frothy market and liberal in a downturn, which isn’t a bad thing to be.”

Each of the banks is keeping an eye out for the up-and-coming management teams, the “young blood” that will keep the E&P industry moving forward as its current icons move toward retirement. Historically, teams that returned to the capital markets with success are E&P veterans, and they are securing the equity funding that’s hard to access right now.

While experience definitely matters in the oil patch, so does an entrepreneurial spirit.

“If you’re good at what you do, your age really doesn’t matter,” Cuenod said.

“Clearly, people with a track record have an advantage. But there are a lot of people who work for larger energy companies for years who decide they want to start their own business, and we look for people like that, too...Also, we look very closely at the people we’re doing business with. We would rather have a really strong management team with average assets than a reversed situation. The teams that we’ve done business with have always helped us get through the tougher energy cycles.”

Before the financial meltdown, a good portion of energy lending was for M&A activity. Historically, this activity was a sign that the buyers were active, but joint ventures are dominating the deal landscape these days, and these transactions haven’t been an automatic kick-start to lending activity, the panelists said. In addition to joint ventures, the other major M&A trend is the push of gas-weighted companies into oil plays.

“The M&A activity has slowed somewhat,” Cuenod said. “But our group has been fortunate enough to have financed a number of acquisitions since late last year, and some of our clients are looking at additional deals. The good news is, if there’s capital spending to be done, then there are opportunities for lenders to help provide that…Banks may not need to reinvent themselves but they do need to find sources of revenues beyond traditional M&A.”

Hedging Perspective

Under the recent hedging reforms proposed by the Obama administration, banks’ participation in energy trading may be negatively impacted, thus changing hedging options for oil and gas producers. Hedging is not banks’ core business, so if restrictions are put in play the impact on banks will be small. The producers that lose access to hedging through traditional financial institutions will be affected the most.

Dodd said BNP Paribas doesn’t typically require hedging for its reserve-based lending deals, “though typically when you hedge you get a bump in the borrowing base and you can hedge above the bank price deck. Bank price decks are not as low as they used to be relative to the forward strip, so you don’t get much of an increase in borrowing bases, but it’s still a plus for companies outspending cash flow.”

In spite of how the hedging landscape may change in the future, Cuenod said hedging is still an essential risk-management tool for E&P companies. “We don’t force clients to do it, but we like to be on the same page with them on how much hedging they need to do. Our hedging is solely to help clients manage risk.”

Today, there is an optimum scale for bank debt and public equity, the panelists said.

“We can do bank-debt transactions as low as $5 million up to billions of dollars,” Cuenod said. “It depends on the team, equity sponsorship, and other factors. In terms of high yield, $200 million is the low end of what you’ll see because investors want liquidity.”

McBride added, “As for the equity markets, it would be nice to have more initial public offerings the size of Cobalt’s (International Energy) but the truth is if it’s an IPO, it needs to be in the $100-million range. For the debt side, you’d be better off doing $150 million.”

So how does an average-size independent with a strong balance sheet approach financing options today? According to the panelists, a company will typically access bank debt against proven reserves, preferably proven producing. If it needs more than what this option can offer, raising equity may be an alternative. There’s also private equity, one of the quicker routes to company growth.

Cuenod said, “Banks have learned a pretty hard lesson from the financial crisis and they’re going to continue to manage their capital very carefully. Now more than ever, it’s very important for growth-oriented companies to forge a relationship with very strong banks.

“It will depend on a company’s specific drilling program and what the economics look like—but if the management team is experienced, the plan is sound and the price projections are reasonable, funding will be there.”