Lending in a boom market

Energy executives brim with optimism in CIT/Forbes survey

Mike Lorusso, CIT Corporate Finance, Energy, New York, NY

The new wave of US energy investment unleashed by hydraulic fracturing has made the oil and gas industry the hottest prospect in an otherwise mixed economy. Oil and gas projects – from drilling operations to pipelines – are attracting record amounts of capital from both lenders and private equity firms, many of which have had little involvement in the industry before.

The reason is pretty straightforward: they see outstanding growth opportunities ahead.

CIT, in association with Forbes Insights, recently surveyed US middle-market energy industry executives. The full study is available at cit.com/energyoutlook. We found their short- and long-term outlooks for both pricing and profitability to be unabashedly upbeat. Eighty-one percent of executives describe the past year as profitable, and 82% anticipate a profitable 2014. They're even more optimistic over the medium term – 91% of respondents anticipate they will be profitable over the next three to five years.

In fact, the executives we surveyed see US energy independence within reach. Of course, determining what constitutes energy independence is a complicated calculus and subject to a variety of interpretations. However, nearly 50% of the respondents to our survey say energy independence is likely in the foreseeable future, while 40% expect this milestone to be achieved in the next six to 10 years. Respondents believe that expanded natural gas production, domestic energy discoveries, and infrastructure projects will all play a role in helping the US become self-sufficient in energy production.

Domestic US oil and gas production already is increasing at a rapid pace. US crude output averaged 7.4 million barrels a day last year, 49% more than in 2008, and natural gas reached a record 2.1 billion cubic feet a day in March, a 20% increase in five years. The rise in production correlated to a 40% increase in energy-related jobs from 2007 to the end of 2012.

The surge in production is driving the industry's need for additional sources of capital to finance both infrastructure and operations. The midstream sector, for example, requires billions in new investment to expand pipeline capacity into new shale fields. Faced with a dearth of pipeline capacity, producers are working to find alternatives. Oil shipments by rail, for example, jumped by 96% during the first three quarters of 2013.

In addition, advances in technology, such as rigs with greater horsepower and "walking" rigs that can easily move from one well site to another, are also driving production growth – and further increasing demand for financing.

A prudent eye on the long term

Amid the rush to invest, seasoned industry lenders are continuing to lend prudently in an active market. Lessons learned from past boom-bust cycles in the oil and gas industry, and even from price spikes as recently as five years ago, have reinforced the need to carefully balance risk and reward.

Some are wary that the industry may be nearing the top of the cycle. Indeed, the US Energy Information Administration predicts that domestic crude production is likely to level off and begin a slight decline after 2020.

It's a reminder that in many ways, the widespread use of hydraulic fracturing remains in its infancy. With most horizontal wells drilled in the past five years or so, we still have much to learn about the unique nature of production curves from these fracked wells. As is always the case with oil and gas exploration, the easiest and thus least costly wells get drilled first. As fracking continues to evolve, drilling programs are likely to become more efficient, and these efficiencies, combined with technological advances, should help offset some of the challenges of drilling in the more difficult formations. This will help maintain profitability and prolong the expansion of the industry.

Of course, while the cost of production is an important factor, the price of oil and gas in the market is crucial for determining the level of investment in the industry. Experienced energy industry lenders know the industry remains susceptible to commodity price swings. It only takes one event, such as geopolitical upheaval somewhere in the world, to send prices soaring.

Indeed, the executives we polled see rising prices ahead – 66% of respondents see rising oil prices and 68% see rising natural gas prices over the next three to five years.

While rising oil and gas costs can seem to be a fact of life, there's reason to question the view that the prices of these commodities will continue to rise in the long term. Global oil demand is likely to remain flat as China's growth slows and countries with large consumer markets, like the US, become more conservation-focused. At the same time, production is rising not only from the US, but from Iraq, Libya, and emerging producers in Africa. Oil prices could be heading downward – closer to $80 a barrel – rather than upward.

A decline in prices, of course, puts additional pressure on financing, making it more difficult for companies to cover borrowing costs. On the other hand, if the survey results are correct and prices rise in the coming years, the industry will need even more capital to finance additional growth.

Two political debates

Commodity prices aside, the political environment in the US remains uncertain as well. Two out of three executives surveyed said that current energy policies are hampering US energy development – more than one third of these saying "severely." Sixty-four percent agree that energy policies that discourage and inhibit energy development also hamper US job creation.

Consider two issues that serve as a metaphor for the challenges that face the continued growth of the US energy industry: approval of the Keystone XL pipeline and exports of oil and natural gas. The pipeline remains mired in a political battle between industry leaders and lawmakers who support it and environmental groups that oppose it. As a result, US State Department approval, needed for the pipeline to cross the US-Canada border, has been languishing for years and shows little sign of moving forward anytime soon.

Meanwhile, exports remain a divisive issue. While the abundance of natural gas has paved the way for seven permit approvals for liquefied natural gas exports, the first shipments won't begin until at least the end of 2015. If all the export terminals currently approved get built, export capacity will account for about 10% of US natural gas production.

With more than two dozen additional permits pending, how far should export capacity be allowed to grow and what impact will exports have on domestic prices? Rising gas prices at home could blunt manufacturing growth, putting a damper on one of the key economic benefits of our energy renaissance.

Oil exports are even trickier. Much of the crude being produced in shale fields can't be processed in US refineries. Should we export this light, sweet crude even as we continue to import heavier grades? Will that drive up prices for refined products and inhibit the progress toward energy independence?

The need to stay nimble

All of these issues speak to the changing landscape of the US energy market and present unique challenges and opportunities for lenders and investors. The need for capital for new drilling and midstream infrastructure is significant. Fifty percent of the executives we surveyed said they will be considering structured financing in the coming year. Among the top expected uses for that financing were capital spending and infrastructure, working capital, and production expansion.