Thomas Rajan, managing director and group head, oil and gas, KeyBanc Capital Markets, says, “Now, the market does not value the growth story. The market values the integrity and sustainability of the balance sheet.”

?Investment banking depends, in large part, on M&A deal flow. Although the first half of 2008 saw only a 2% to 5% decline in transaction activity, the second half showed a steeper decline, as much as 30%, according to findings by Ernst & Young LLP’s Energy Center. Meanwhile, current energy economics have widened the spread between buyers’ and sellers’ price-point expectations.

“We are still seeing an expectation gap between what sellers want and what buyers are willing to pay,” says Jon McCarter, transactions leader for Ernst & Young. “This gap might close over the next few months. The transactions we’re seeing now are desperation-driven.”

But while the number and dollar value of deals are down, the decline could actually be a signal that a new wave of consolidation is about to begin, according to industry insiders. Thomas Rajan, managing director and group head, oil and gas, for KeyBanc Capital Markets Inc., and Mark Ammerman, head of U.S. energy for Scotia Capital, are two financiers still doing a few deals.

KeyBanc has $1 billion committed to about 30 onshore U.S. energy clients (60% gas). In February, it was part of Denver-based Whiting Petroleum Corp.’s successful 8-million-share offering at $29 each, raising more than $222 million after expenses. Whiting used a portion of proceeds to pay debt and is deploying the balance toward its 2009 capital budget.

“This was the first equity offering that took place in our space in 2009,” says Rajan. In 2008 it was involved with a follow-on offering for Pennsylvania-based Rex Energy Corp., which raised about $112 million after expenses; and it advised Concho Resources in its $565-million acquisition of Henry Petroleum. (See “An Acquisition Before The Fall,” Oil and Gas Investor, April 2009.)

Although KeyBanc is getting deals done, “business could be better,” Rajan admits. “Everything we do in the oil and gas space is based on mergers, acquisitions or divestitures. When people get comfortable about selling at a certain price and buyers are comfortable with that price, there is a change of velocity in deal flow. But right now, there are two huge problems.”

First, sellers have not surrendered to the current price environment. “The bid-ask price has not narrowed enough so people will trade assets,” he says.

“When you look at equity valuations on a dollar-per-proved or dollar-per-production basis, most small- and midcap E&P stocks are trading at the same levels as they were five or six years ago. But during that time, there was an increasing-price environment due to a booming global economy. Now, we seem to be in a protracted lower-price environment, so there is an even higher discount on reserves prices.”

Meanwhile, although there may be some premium on producing assets that can support cash flow, very little value is attached to undeveloped acreage. Last summer, undeveloped acreage was a hot item on most producers’ acquisition wish lists. Now, not so much, except in the core areas of the Marcellus and Haynesville shales.

“Last year, public companies were pursuing resource plays where there were a lot of PUDs. The market wanted that growth story,” says Rajan. “Now, the market does not value the growth story. The market values the integrity and sustainability of the balance sheet.”

Also at play is a lingering lack of capital to leverage large, cash deals. “The capital markets have not come back as robustly as needed to get transactions done.”

At one time, a producer may have leveraged projects to increase the internal rate of return into the mid-teens; now the same project is difficult to leverage and requires at least a 20% unlevered rate of return because both equity and debt are more expensive.

By the end of 2009, supply and demand may once again be in balance, he forecasts. “There is a significant group of E&Ps laying down rigs now. They are not going to drill at these prices. Once the gas storage levels come down, prices will pick up.”

Dogs and cats

For Scotia Capital, energy sell-side deal flow was good until December 2008, averaging about $2 billion per month over 20 months in corporate and asset transactions, says Ammerman, based in Houston.

In the U.S., the firm’s I-banking practice is Scotia Waterous, which completed the most oil and gas M&A advisory deals in 2008, according to Bloomberg research.

Mark Ammerman

Mark Ammerman, head of U.S. energy for Scotia Capital, says, “Probably a quarter of the property transactions that we completed last year were dog-and-cat properties.”

“Probably a quarter of the property transactions that we completed last year were dog-and-cat properties,” he says. “They were the type of noncore assets usually found at the bottom of a package of producers’ portfolios. Sellers were taking advantage of the fact that they were getting $100 to $140 per barrel for low-end assets.”

Times—and asset quality—have changed. “We are now advising clients who are trying to quickly raise money from property sales that only high-quality properties will attract a large suite of buyers,” he says.

Denver-based Berry Petroleum Co.’s planned divestment to pay down bank debt is one example. The producer asked $154 million for its mature, noncore assets in the D-J Basin in northeastern Colorado, including reserves, midstream assets and a $14-million gas hedge.

“We are still moving transactions, even in this market,” says Ammerman. “Buyers realize there may be some once-in-a-lifetime opportunities to double up in their core area, and if they don’t buy it, someone else may. We are still seeing good bids for good properties and we expect to see more high-quality properties come to market during the rest of the year.”

Some offerings will come from noninvestment-grade operators that need to reduce debt. “We are already seeing a number of distressed deals,” says Ammerman. “Entire companies could be sold to right-size their debt to avoid bankruptcy, especially where there are other competing creditors such as second-lien notes or subordinated debt. The operator may have to sell high-quality assets to pay debt down quickly because it may not be able to issue high-yield bonds with anything less than a 15% to 20% yield.”

Meanwhile, many of Scotia Capital’s energy clients are hedged at $100-plus per barrel. In some cases, the operator may choose to sell its hedges back to the bank. For example, at $100 per barrel, borrowing-base debt could be paid down by the $60 per barrel the bank will lend against the hedge, and the operator would retain $40 per barrel to use to further reduce its revolver for additional liquidity.

“In the 1980s, we would say that access to capital is more important than the cost of the capital,” says Ammerman. “And that is still true today. There are people who cannot raise money at any price today.”

The supermajors have large cash tills. “I would not be at all surprised to see them come in sometime next year, to make acquisitions, and completely miss the window of this year, because it takes them so long to move.”

Many E&Ps’ credit facilities are being tagged with higher interest and commitment-fee rates, as they undergo redeterminations this spring of their credit worthiness. The rates are ranging from Libor plus 150 basis points to Libor plus 400.

“A bank’s client that struck a deal at nine or 10 times interest coverage of cash flow, when oil was $100 per barrel, has fallen to four or five times coverage. That credit risk has changed significantly.”

For example, Linn Energy LLC’s cost of debt recently rose from Libor plus about 175 to Libor plus 400 with high upfront fees.

In some cases, clients are approaching their banks and agreeing to 100- to 150-basis-point increases even when there is no event to reopen the deal.

“Why would they offer that if they don’t have to, you might ask,” says Ammerman. “It’s because they realize that if they tick these banks off, when their deal comes up for renewal next year or the year after, or if they do bust a covenant, the bank may take their pricing all the way to 400 or 500 (basis points above Libor) to get even. They realize that getting access to the capital is more important than the cost of the capital.”