Growing need, size mismatches create dual capital challenge

Scott W. Johnson
Weisser, Johnson & Co.
Houston

The oil and gas industry is currently blessed with the greatest capital availability that we have seen in many years. Both public and private capital markets for debt and equity are relatively receptive to exploration and production companies. Yet as an industry we face a dual capital challenge. We will need even more capital in the years ahead to meet growing energy demands, especially for natural gas. In addition, there is a mismatch between the capital that is available and some of the projects and companies that require outside funding.

In most mature industries, the natural progression is toward consolidation, often resulting in a few dominant companies. In oil and gas, large company consolidation has occurred, but because the trend is toward smaller fields, small producers are constantly springing up to capitalize on their niche expertise and greater operating efficiency.

In times of high commodity prices such as we are now experiencing, larger companies are well funded with internal cash flow and have little need for outside capital. Small companies, on the other hand, are always looking for equity and debt financing for their projects. The current environment is one in which much of the need for outside capital exists within small to mid-size companies.

While the current needs for outside capital are largely with smaller companies, the size of investing institutions has increased substantially. Through the 1990s, pension funds, endowments, foundations, and various funds grew dramatically, and so did the size of the investments they prefer to make. This is one reason why companies need to be larger today to consider an initial public offering than was the case 10-15 years ago.

Most decisions about private equity, mezzanine, and project investments in oil and gas are made by knowledgeable teams managing pools of investment capital—or "funds"—for pensions, endowments, foundations, and other institutions. Many of these funds focus entirely on energy investments or more narrowly on only oil and gas, only oil service and supply, or only midstream investments.

Typically, each new fund created by one of these teams of specialists is larger than its predecessors. As the size of each successive fund grows, so does the minimum size of individual investments that it will consider. Small deals thus have become more and more difficult to finance. In terms of size, the financial world is moving in the opposite direction from much of the universe of private investment opportunities in oil and gas.

Growing needs

Current trends in US natural gas demand and production point to an extended need for accelerated resource development. Last fall's National Petroleum Council study concluded that the US will need all gas available from all sources—including LNG and an Alaskan pipeline—to meet growing demand and keep prices at $3-7/Mcf. Already, gas prices are near the upper end of that price band, and doubts are growing that LNG regasification facilities can be sited, approved, and built at the anticipated rate, given terrorist and other concerns.

Last year's drop in production indicates that the current level of about 1,200 active drilling rigs in the US will not be sufficient to overcome steep production decline rates. We need more drilling, and commodity prices appear sufficient to support more drilling. This means we need more prospects and the capital to drill them. The two must come together.

Many of the larger oil and gas companies have more cash flow than they have acceptable projects to consume it. Many are paying down debt. Some are repurchasing stock. These choices reflect more financial discipline than companies practiced in the past. There is now greater willingness to forgo aggregate volume growth in favor of higher rates of return on capital employed. If any of the large companies develop a need to raise outside capital, their options are numerous, and the cost of financing is relatively low.

By contrast, start-up companies, small producers, and private companies in general face an uncertain path to meeting their capital needs. Even in this group, some companies have access to substantial funding. Private companies managed by teams with records of profitably building and selling companies have little difficulty in reloading their balance sheets with new equity from private equity funds to pursue strategies focused on acquisition and exploitation.

Companies not fitting that mold are usually not so lucky. If their needs are less than $10 million or include significant exploration risk, they face a particularly difficult challenge.

Funding possibilities

So what funding is available to smaller companies, other than industry joint ventures? Here are some possibilities:

Banks and VPPs. Despite numerous mergers, banks remain active oil and gas lenders, and some new entrants have fortified the ranks of those making loans of less than $20 million, some even less than $10 million. Because strong industry cash flows have shrunk their aggregate outstanding loans, most banks are eager to consider new credits. But, as always, lending limits are geared primarily to existing production, typically at 50-65% of the producing reserve value plus a bit extra for nonproducing proved reserves. Therefore, for most companies the unused borrowing base will provide very limited funding for development operations. A company without substantial existing production, or with an existing bank loan that is fully utilized, will usually be held to very slow development if the only source of funding is the bank.

Volumetric production payments are likewise based predominantly on producing reserve value, though the advance rates, and the cost, are higher. These usually work best on reserves with medium to long remaining life and in a situation where there is unlikely to be any near-term need to refinance or sell the underlying assets.

Although production payment structures have been adapted to fund some development drilling, they generally do not supply adequate development capital and are not sufficiently flexible to adapt to changing circumstances. Also, most providers prefer a size of at least $20 million, and some prefer deals over $50 million.

• Mezzanine and project finance. Although the formats vary, most mezzanine loans are nonrecourse to the parent company or its management but have a first lien on specific properties, a set interest rate, and an overriding royalty that is put in place upon repayment of the loan. The focus is on financing of development drilling projects and acquisitions, generally with some amount of existing production at the outset. The total return target is in the 15-25% range, depending on the risk assessment, but often hovers around 20%.

The mezzanine financing market is coming back after decimation of most providers in the financial crisis following the Enron bankruptcy, which affected integrated gas and electric companies that had marketed natural gas for producers and provided mezzanine financing together with a price hedge. These companies had been the core providers in a market that surpassed $1.3 billion/year in 2000 and 2001. By contrast, in each of the last 2 years mezzanine volume has reached only $300-400 million (Fig. 1). New participants are becoming established, and volumes are likely to rise.