The oil and gas business has not escaped all of the volatility in the overall market recently, but it has been active in spite of some headwinds. The ever-adaptive industry has made changes to soldier on, and capital providers are following suit. Two well-known energy finance executives discuss their moves in the context of the current oil and gas environment and capital requirements and availability as 2012 unfolds.

…as key is to lock

Key Bank is a fiscally conservative institution that likes the oil and gas business and wanted to significantly expand its size in all businesses: lending, derivatives, advisory, equity and high yield. That’s why the bank’s leadership concluded it needed to grow its investment-banking practice in Texas and establish a Houston office, where it has added a six-person investment-banking team.

When Sylvia Barnes left Madison Williams in October 2011 to come to Key Bank, people considerations were a primary motivation. Management at Key was willing to support moving an entire team into the group, and grow its Texas presence to 14 people. Barnes was impressed with the bank’s commitment to growth.

“It’s a bold move for a conservative institution,” says Barnes, “I believe Randy Paine (head of corporate and investment banking) is personally committed to seeing our new expanded team be successful.” The addition of Barnes and her group more than doubled Key’s investment banking presence in oil and gas.

When Key Bank came calling, Barnes had no idea it covered 514 companies in equity research, or that there were 500 people in investment banking and 15,000 across the whole organization. Key is the 11th largest bank domestically, with $90 billion in assets. Still, Barnes says, for clients, the bank’s size is ideal.

“Key Bank sort of reminds me of the Goldilocks story: it’s not too big, and it’s not too small. It is large enough to have a full suite of equity capital markets, but not so big that it is overburdened with unusual regulatory or international distractions.”

The engineer-turned-investment-banker says Key Bank’s size allows it to command a full line-up of derivatives and commodities hedging, combined with superior execution on capital markets. Key Bank also offers research, sales and advisory services, and has a billion dollars in debt commitments in the upstream sector. While not a primary focus for the bank, this is a valuable tool with which to support clients as upstream oil and gas is voracious in its capital needs, and always has to spend money to make money.

Taking stock of the market

The transition for Barnes comes at an interesting time for the markets, which she describes as very active, but a mixed story.

“High-yield investors really like oil and gas exposure right now. It’s almost a defensive play, with real molecules supporting the investment,” she says. Key Bank has seen a lot of action in the oil and gas sector, and Barnes continues to think it’s a hot market. Equity markets, however, are more complex.

Barnes can rattle off recent examples. U.S. Silica recently generated demand greater than 10 times deal size at the midpoint of its equity-offering range. However, despite strong institutional investor interest, U.S. Silica declined 6% in its first session of trading. The Dynamic Offshore Resources LLC IPO was not consummated, and instead the firm was unexpectedly sold in an M&A deal to SandRidge Energy Inc.

“Key Bank sort of reminds me of the Goldilocks story: it’s not too big, and it’s not too small,” says Sylvia Barnes, who joined the bank this past fall as managing director and head of oil and gas corporate and investment banking.

The market is more receptive to liquids and oily offerings, though a mixed portfolio is not an impossible story to sell. The company and leadership making the offering are factors. A prime example is Laredo Petroleum Inc.

“Of recent IPOs, the most successful is Laredo. It was a much larger transaction, fea- turing a seasoned management team of known money-makers who have done well for investors before, led by Randy Foutch,” she says.

Barnes believes the European debt crisis and subsequent reserves requirement modification is a chance for Key to jump in and help.

“It is a real opportunity. We can be supportive on lending and derivatives as CFOs look for capacity on borrowing-base loans. You want to work with people who, if the going gets tough, will have some patience and ability to roll with the punches.”

Another pressing issue for clients is natural gas prices. Barnes says Key has been active with producers who still need to lay off risk, and hedging prices might surprise some people.

“In late January we did a 10-year gas swap with a $4.50-plus average for a good-sized producing company.” Companies that are still gas-weighted and don’t have the ability or desire to make the liquids switch may be able to do this type of deal.

“It’s a calculated position, but if it’s done for the right reasons, it could be very helpful,” says Barnes, who has been working on activity around the liquids shift for the better part of 18 months. Some public companies were encouraged to transition by investors, while some private companies could be slower to make the transition because they lacked public pressure.

Barnes says that companies in gas-oriented plays like the Haynesville and Marcellus that have secured joint-venture partners are sighing in relief because cash demands for working interest are being eased, so they can pursue liquids plays like the Eagle Ford.

“I really think gas dropping below $3 an Mcf has shocked the market,” says Barnes, who notes that at least one household-name bank dropped its gas-price forecast for 2012 to $2.50, for 2013 to $3 and in 2014 to $3.50.

The implications on bank loan redeterminations have yet to be seen. Barnes thinks banks are trying to manage as best they can, avoiding reactionary responses while making gradual, incremental reductions. But some banks’ forecasts send a clear message.

Deal flow

Not everything natural gas is snake bitten. Barnes’ group has been showing oily acquisitions for a like-kind exchange to sell conventional dry gas to a private-equity-backed company with the long-gas vision. Barnes says the long-gas notion resonates with select potential buyers.

Key Bank just completed a follow-on offering for Rex Energy Corp. that encapsulates the kinds of relationships Barnes and Key Bank Capital Markets are out to replicate. Key was the sole book-runner of the $74-million offering in January, which was the latest in a long history of transactions the bank has helped Rex conduct.

“Competition in this sector continues to be very strong, because there are many quality service providers and limited barriers to entry,” says Barnes. Key was still able to act as sole book-runner in part because of the strong relationship with Rex, beginning with a bridge loan it extended to Rex for an acquisition in 2006 prior to the IPO.

Key was sole book-runner for the company’s IPO in 2007, and helped raise $112 million. In addition to book-running and agency for credit facilities, the firm has also advised on divestiture of New Albany and Permian assets.

“I think one of GSO’s reasons for hiring me was to get into development drilling, to get into smaller cap and micro-cap private businesses,” says Tim Murray, who runs Blackstone’s GSO Capital Partners’ Houston office.

“That’s the type of company we like to grow with, produce well-regarded research for, and be supportive of management,” Barnes says.

The latest offering closed February 6, selling all 8,050,000 shares, including the full over-allotment option of 1,050,000 shares, at $9.25 per share. The net proceeds to Rex will be approximately $70.6 million, which the company plans to use to pay down borrowings under its senior credit facility.

“This deal reached out to the full spectrum of investors, not just the usual dominant players,” says Barnes. She says the success of the offering reflected credible execution and the right pricing in response to market trends.

In this market, everything from high-grading assets and making acquisitions to finding strategic solutions is coming across Barnes’ desk. The Key team is currently working with some public companies to find strategic alternatives, which could involve M&A.

“Enabling clients to have the boldness to sell when they need to sell—to sell when a good opportunity arises; that’s exciting.”

Perhaps the most exciting opportunities in this market are on the ground floor, with companies that are starting anew. Privately backed entities are looking for opportunities, and helping those groups go from start to full speed are deals where Barnes feels Key can bring all of its expertise to bear.

“We can help a private-equity-backed management team at the early stage. That’s when we can support them with derivatives and advisory, and help them access debt and equity. When we can bring a company like that good ideas and work with them prudently on the credit side, while adding top-drawer advisory services, then that’s when we are firing on all cylinders.”

Private-equity partner

While at Guggenheim Partners, long-time Houston energy banker Tim Murray was part of an energy team that in six years, under his leadership, did about 50 deals worth nearly $3 billion pre-syndication. The firm’s energy practice originated deals, rarely took participation in deals it did not originate, and successfully raised an energy fund in 2008, which was not an easy time to raise a fund.

Murray left Guggenheim in late 2011, as the opportunity to run Blackstone’s GSO Capital Partners’ Houston office was too good to pass up.

Murray found particularly exciting the prospect that the firm has been an active player in the industry with both a credit focus and a related large private-equity presence.

But Murray believes part of being brought on board aligns with the nature of the capital the firm is bringing in to invest.

“I think one of GSO’s reasons for hiring me was to get into development drilling, to get into smaller cap and micro-cap private businesses,” he says. GSO had invested in the larger end of the market before, including some public companies. Murray says GSO was looking for something different this time.

“They were interested in getting into the smaller end of the market, with equity-type returns in mezzanine-type facilities,” he says. Though Murray has just recently joined, GSO has been busy with a variety of transactions. The firm took a part of Chesapeake Energy’s Utica preferred financing with a $400-million commitment.

GSO will provide straight mezzanine loans with low double-digit coupons, usually with cash pay arrangements and overrides as equity kickers; in some cases those convert to net profit interests. These are the developmental-drilling deals, characterized as mezzanine with higher returns.

Murray says GSO will look at some smaller equity checks to complement a debt deal.

“We are capital providers. We look at everything across the capital spectrum. People lay their story out, and we will engineer capital to match their needs,” says Murray.

Saratoga

As an example of how GSO can help upstream companies, Murray cites the case of Saratoga Resources Inc. Concluded before Murray joined the GSO team, the deal closed in July 2011. A combination of debt and equity investments, GSO took $75 million of $127.5 million in Saratoga’s senior secured five-year notes and $20 million in common stock.

“This is a good example where capital is the solution. We don’t necessarily want to talk about debt or equity when you walk in the door,” says Murray, who would prefer to have the whole story on the table in order to see what kinds of structures would best fit the need.

“People in the firm understand how upstream companies need to be capitalized, and will optimize a deal based on experience in the business,” he says. By GSO’s judgment, Saratoga was undervalued. It had never missed payments and had paid its creditors, but had experienced a bankruptcy that may be viewed to be caused more by the credit crisis in general.

At the time, this was simply a recapitalization for Saratoga, to repay a term-loan and a revolver with which it had exited bankruptcy. Saratoga has since been negotiating with McMoRan Exploration Co. on some deep Wilcox acreage in the shallow-water Gulf of Mexico, offshore Louisiana, where McMoRan has had success. Saratoga also has acreage in the middle of more prospective plays in deep Wilcox.

Murray thinks 2012 will be an active year in the industry and for GSO in particular. In 2011, the GSO team invested over a billion dollars in energy investments. Murray’s personal goal is that it exceeds the billion-dollar mark again this year.

Murray says people should talk to him before they engage an investment bank.

“Come see us before you engage an investment banker. Tell us the story. In many cases, we may recommend you engage an investment banker who will assemble the parts, put a ribbon around it, and approach the market with a nice package,” says Murray.

In cases where there’s a straightforward deal or the company would rather not engage a banker, Murray is happy to talk and offer an opinion. He says there have been more than a few occasions where he could have saved some people time and money if they had just come in to ask, “What do you think?” first. On the other hand, Murray lets people know if the deal is not ready.

“If you come in without an investment banker and you put a box of parts on my desk, I will tell you your deal requires more work. That’s the great service that investment bankers provide. They put a deal in a pretty box with a nice bow.” Of course, if a great team with a great track record comes in with some interesting parts, Murray says, “We will do the deal.”

Unconventional resource development is driving the industry and these plays are not ideal for debt capital without significant equity underpinning. Unconventional plays require acquisition of a large, expensive acreage position and a significant number of wells to develop, so capital requirements grow quickly.

”Trying to do all of that in an environment where service costs are elevated makes for a situation that doesn’t lend itself well to senior debt,” says Murray “Senior and mezzanine lenders will not advance capital to buy leases and drilling on top of that. Specifically, leasing and initial drilling is usually done with equity. Once a play is proven and the development strategy is well-defined, mezzanine becomes feasible. When a portfolio of successful wells is producing, an operator can approach a commercial bank for a traditional reserve-based loan.”

Not surprisingly, GSO is looking at this situation from the other side of the equation, and is fairly active in the service sector.

“We’ve seen good opportunities in pressure pumping. We like that business,” he says. GSO has an investment in a start-up pressure pumper, but the firm believes the market is changing.

“It’s not likely to be as good 24 months from now, but we like where we are today. Once new units come on the market, the prices will turn down.” Murray and his team are actively looking at the oilfield-equipment businesses and even proppant suppliers. Once the market hits true equilibrium and players start consolidating, Murray expects to be involved. He has played a few oilfield service roll-up waves over his 30 years in the business.

In the meantime, Murray thinks attrition and retirement of pressure-pumping equipment may be more than the general consensus would indicate. The old frac fleets used in conventional plays would pump modest-size fracs on a regular basis, and the equipment would last 10 years or more. In the unconventional plays, these same frac fleets are pumping massive fracs at high pressures 24-7. He thinks the rate of attrition will surprise some people, and the market might not be oversupplied as quickly as some believe. Unconventional plays have contributed to a high level of service-industry activity and margins. High service-company margins and conventional natural gas development are at odds.

“You almost have a perfect storm. Historically, when commodity prices dipped, service costs came down as well, because they were unsustainable. With the advent of the unconventional plays, the dip in natural gas prices isn’t precipitating a decline in service costs. It’s not just that service companies are staying busy, but most services remain in short supply because unconventional plays are soaking up almost all capacity,” says Murray. As an example, while the Haynesville may not be attractive with $4 gas, service firms have shifted equipment to the nearby Woodbine oil play. As long as there are unconventional liquids and oil plays, oilfield-service activity and margins will remain robust and conventional natural gas is not likely to see much action.

In fact, this could lead to a consolidation of gas-heavy, over-levered independents for patient capital providers. If gas-heavy independents are competing for services with unconventional plays, improving returns through increasing scale may be a winning strategy. Vertical integration is another possibility for independents to improve returns, particularly in unconventional plays.

“You may see companies like Chesapeake and Pioneer Natural Resources, which have their own rigs, getting into the frac business,” he says. That could be a smart play. Given the huge acreage positions these companies have in unconventional plays, locking in some enhanced economics by using company rigs and personnel could pay off.