Oil and gas financing outlook for 2012

Mike Lorusso, CIT Energy, New York, NY

The US energy industry is in the nascent stages of a new growth period that could soon lead us towards the elusive goal of energy independence. In CIT's recent 2012 "US Energy Sector Outlook," 70% of middle market energy executives we surveyed agreed with the statement that this independence could be achieved within the next 15 years.

There is no denying that the sector's long-term outlook has dramatically improved with the emergence of hydraulic fracturing and horizontal drilling techniques. This technological one-two punch has fundamentally shifted America's standing vis-à-vis its trading partners. In 2011, the US became a net exporter of petroleum-based refined products for the first time in 62 years.

Natural gas is undergoing an even bigger paradigm shift in the US as rock-bottom prices and environmental emission rules are prompting power generation companies to accelerate switching from coal to gas as the fuel of choice. In addition, serious consideration is being given to transitioning major liquefied natural gas import facilities for export use. And, of course, there is the prospect of natural gas being used as a transportation fuel in the near future, potentially for long-haul trucks and/or commercial fleets. Finally, there is the small but growing application of renewable energy.

Balancing these factors will be the key to leading a successful business through this period of growth and expansion. A major component of this complex calculus will be businesses' ability to work effectively with the financial community to access the capital needed to sustain growth.

Near-term uncertainty

In contrast with this promising long-term outlook, the short-term picture is murky at best, particularly for natural gas producers. The recent plunge in natural gas prices – exacerbated by our recent mild winter – has caused many natural gas exploration and production firms to scale back drilling activity in the US or switch from dry gas to wet gas or oil-based liquids due to their much more attractive market prices. Another key uncertainty resides in the possibility of new regulations imposed on hydraulic fracturing, with the Environmental Protection Agency vowing to impose new standards.

Those that supply E&P businesses, or ultimately take their fuel, are on firmer ground. Support services companies in shale hydraulic fracturing "fracking" businesses – the providers of drill bits, fracking sands, drilling rigs, etc. – are still expanding as their equipment and services are in demand regardless of what they are drilling – dry gas, wet gas, or pure oil.

One measure of supplier strength is the fact that US oil and gas drilling activity has rebounded to such an extent that nearly 2,000 total rigs are currently working, up from about 700 in mid-2009. While more of these companies are currently supporting oil drilling, they are utilizing the new technologies developed for shale gas production, and thus the expectation is that they will revert back to supporting natural gas as well once its price recovers.

On the downstream side of the business, power generators are taking advantage of the low natural gas prices by stepping up coal-fired plant retirements and investing in new gas-fired generation. The expanded availability of natural gas was cited by 42% of the respondents in the CIT study as the development that will have the greatest impact on US power generation capacity in the coming decade.

For its part, the US Department of Energy forecasts that the use of coal to generate electricity will drop 2% this year to the lowest level since 1992, while gas-fired consumption will increase 5.6%. Environmental considerations are contributing to shift, due to natural gas's lower carbon footprint and increasing scrutiny of coal waste byproducts.

The biggest wrinkle for power producers is how to manage their growing portfolios of renewable generation assets given how expensive they are becoming relative to natural gas prices. Wind and solar energy assets are extremely uneconomical to develop at present without substantial government subsidies and tax incentives, which are in the crosshairs of the Congress's budget-cutting efforts. However, many states still have legislative mandates to increase renewables' share of electricity generation in the coming years.

Financing implications

Of course, energy companies have to plan for the long haul regardless of the volatility in short-term trends. With the expectation that oil prices have reached a sustainable level and natural gas prices will ultimately follow oil's ascent, many sector participants are looking for financing to fund their plans for expansion. Eighty-five percent of our survey respondents said their companies will seek financing this year to put toward infrastructure and capital spending, to expand production, and for exploration.

The good news is the credit environment for E&P companies remains relatively healthy, even after a number of European banks bowed out of the US market in recent months. Certain US lenders have helped to pick up the slack, encouraged by drillers' long-term outlook. Companies that have shifted a good portion of their E&P operations from gas to oil are probably having little trouble securing credit from their reserves; it is simply much easier to get financial backing if a company's focus is currently on liquids.

Natural gas producers who for whatever reason have not made the shift from dry gas to wet gas or oil are in a different boat. Deals that are dependent on gas will be less likely to occur if sufficient price hedges aren't in place. Companies with low capital investment and fairly low lifting costs will be in a much better position to continue operations and ride out the trough. Smaller to mid-sized drillers that are heavily reliant on financing may need to minimize their operations in the immediate term as they wait for prices to recover.

While the industry's suppliers and service companies are currently holding their own, there is still plenty of reason for caution from a lending perspective. A significant and sustained drop in the price of oil could be trouble due to the weakness in natural gas prices. More industry players might see the risk of an upward price spike as greater over the next couple of years, but markets have surprised before and they will again.

Given this uncertainty and expected volatility, suppliers therefore shouldn't be surprised if lenders demand that some risk mitigations be put in place (such as low leverage, or certain contractual arrangements with credit-worthy counterparties) before extending any new borrowing capacity.

Environmental regulations – a perennial uncertainty – continue to hang over the industry as well. In addition to the EPA's pledge to impose new standards on hydraulic fracturing, the agency's Cross-State Air Pollution Rule (CSAPR) is currently under a court-imposed stay, which could be lifted later this year. Ironically, the passage of CSAPR would have the converse effect on gas as its stricter standards on hydraulic fracturing would likely accelerate the shutdown of coal plants and make the need for natural gas, and even renewable energy, more prevalent.

With regard to potential environmental legislation, it is important to acknowledge the role of renewable energy for power generation. Wind and solar are currently the most mature and prevalent renewable generation technologies being employed. Despite advances in efficiencies and costs they remain intermittent and often expensive alternatives to natural gas. However, state- mandated requirements for minimal renewable energy production continue to drive the expansion of the renewable sector. Furthermore, financing of renewable energy generation often requires some combination of federal government subsidies, state-issued energy credits and contracted power sale arrangements.

It is an exciting time to be supporting the US oil and gas industry. The long-term fundamentals behind the sector's growth look more favorable than they have in years, thanks to a powerful combination of American ingenuity and innovation to develop our newly realized abundant natural gas resource. This means the stakes are even greater for managing this short-term market volatility. Understanding how to work with lenders during this period may make the difference between merely surviving and positioning your company as a market leader for the bright future ahead. OGFJ

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