Energy capital abundant in the US; lenders increasingly aggressive

Capital is more abundant in the energy business now than it has been in over 20 years. Private equity coffers are bulging, the bond market has been red hot, master limited partnerships (MLPs) trade at lofty multiples, and even the long-moribund market for new issues of energy equities is heating up. And why not? With energy companies continuing to post stellar earnings and the outlook for strong oil and natural gas prices becoming more widely accepted, we would expect these trends to continue.

Oil and gas executives have long memories, however, and are generally maintaining a disciplined approach to capital spending and financial posture. Even companies with outstanding development opportunities are having trouble reinvesting all of their cash flows. Not surprisingly, most energy banks are getting paid back faster than we can book new loans. So how does this affect the market for oil and gas bank loans?

Current trends

Relative to its conditions of the recent past, the market for oil and gas capital now has:

• More money. Price-deck increases alone have almost doubled property values since 1997. Higher advance rates (60-70% of value) and more-aggressive reliance on nonproducing categories (25-40%) are contributing to higher conventional borrowing bases. Banks are more willing to provide "B" loans, which are generally junior in payment but pricier than their higher-grade counterparts. Repayment of these can come from asset divestiture, property development, or capital-market events.
• More bank competition. Even with some of the recent bank mergers, new banking entrants into the market are providing companies more choices. Also, many banks are now willing to commit to higher hold positions than in the recent past.
• Looser structure. Terms are extending slightly, with 4-year maturities on revolvers becoming more prevalent for stronger companies. Companies can negotiate more latitude in their covenants, such as permitted hedging percentages.
• Lower interest spreads. Pricing grids have come down slightly for some companies as they are renewing credit facilities. As most pricing grids are based on various credit-risk measures such as borrowing-base utilization, debt to EBITDA (earnings before interest, taxes, depreciation, and amortization), or debt ratings, most have moved to lower tiers as their balance sheets and cash flows have improved.

Expanding product lines

Energy companies and banks are capitalizing on the currently high commodity prices in a number of ways. Many companies are choosing to take chips off the table by selling outright. Others are hedging aggressively to lock in rates of return on acquisitions and development economics. Banks, of course, are eager to help. Here's how:

• Hedging. Banks are adding to or beefing up their commodity-hedging capabilities to take advantage of the current demand. After the credit crunch suffered by the traditional industry providers of hedging products, companies are looking more and more to their commercial banks to provide these products. Since banks typically have priority rights to the oil and gas production, they don't require margin accounts for hedges. This is a distinct advantage given the high volatility of commodity prices.
• Volumetric production payments (VPPs). Banks and other financial institutions have again been promoting VPPs as a means to raise capital. This capital can be used for development, acquisition, or distributions to owners in lieu of an outright sale. Due to favorable long-term price expectations and relatively low interest rates, these instruments can provide significant capital through locked- in economics.
• Leveraged recaps. Popular for a while outside the energy business, leveraged recaps are gaining momentum primarily with private companies seeking a payout to investors without having to sell the company or commit to a long-term VPP. Although these can take many forms, the basic idea is that the company borrows the maximum it is comfortable with (probably enhanced with hedging) and distributes the funds to investors. In the case of companies that have accessed private equity, this accelerates returns to management and the equity sponsor while allowing the company to keep its staff in place and fully harvest its asset potential.

Interest outside E&P

Banks are not aggressive just for exploration and production companies. We see increasing bank competition in the midstream and energy services sectors as well.

Adjustments to contracts have been important to midstream businesses. Although margins on keep-whole processing contracts have suffered in recent years with high natural gas prices, most processors have been increasingly able to shift their income streams to less volatile fee-based, percent-of-proceeds contracts. More-predictable margins coupled with robust gas field infrastructure development create relatively stable cash-flow streams that banks and investors seek.

Banks shied away from service companies for years after the mid-1980s drilling collapse. Although still somewhat cyclical, this segment has become more attractive due to conservative financial management, consolidation, and the currently favorable drilling outlook.

We see a number of banks and other financial institutions moving aggressively back to energy services, particularly for strong management teams or companies with equity backers.

Capital is clearly abundant throughout the energy business. Banks and investors like hard assets that produce cash flow with attractive expected returns. However, while banks are willing to lend more money on more-liberal terms than we've seen in some time, we haven't really witnessed any of the "irrational exuberance" of the early 1980s. Fortunately, most energy companies and capital providers have been through difficult cycles before and are using leverage prudently. To paraphrase a popular 1980s bumper sticker, we've been blessed with one more boom, and we're not going to throw it away.

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