Where will oil industry financing come from?

NOIA panel outlines options available

Previous NOIA white papers have shown the Gulf of Mexico to be the "backbone" of domestic oil and natural gas supply. Frontier areas in the Gulf, deep water and subsalt, hold great promise for significant new oil and gas reserves. At the same time, increased levels of activity in the Gulf and in offshore areas around the world have taxed the ability of the offshore industry to meet the demand for drilling rigs, offshore service vessels and other tools and skills needed for offshore projects. The resultant rising costs, if not carefully managed, could threaten the viability of some offshore projects. Given the increased demand for rigs, vessels and the whole range of tools used offshore, coupled with the need to replace some of the assets in an aging fleet, potential sources of investment capital are important. This white paper, the fifth in a series that summarize industry panel discussions held at recent National Ocean Industries Association meetings, addresses what those capital needs might be and what sources of capital might be used by the industry during a period of growth.

The first discussion occurred in the fall of 1995 in San Antonio and focused on the question of how long the Gulf of Mexico might remain the "backbone" of U.S. natural gas deliverability. One of the conclusions reached was that the "traditional shelf," out to the 200-meter water depth line, was continuing to deliver 4-5 tcf of natural gas per year based on a phenomenon called "just in time drilling." Advanced seismic and imaging technologies, coupled with readily available pipeline infrastructure, are capitalizing on increasingly small deposits of natural gas. It is this "just in time drilling" that is sustaining natural gas deliverability from the Gulf of Mexico, but its future is probably measured in years, not decades.

With that background, at the 1996 NOIA annual meeting in April in Washington, we turned to an examination of the "Frontiers of the Gulf of Mexico" and what contribution to domestic energy supply might be expected from the deep water frontier and from the subsalt frontier. There is no question that new technologies and further refinements of existing technologies have made it possible to proceed with projects that only a few years ago would have been dismissed as pipe dreams. It is also clear that some very large and productive fields have been discovered.

What is less clear is when the "traditional shelf" will start to go into significant production declines and whether new production from these Gulf of Mexico frontier areas will have reached market in sufficient volumes to fully offset those declines. The panel recognized that the full potential of the frontiers of the Gulf of Mexico could be lost if costs get out of control for lack of careful management.

The third discussion was held in the fall of 1996 at the NOIA meeting in Sea Island, Ga. The topic was "Getting the Job Done in the Gulf of Mexico: the Impact of Increased Activity." Higher prices for crude oil and natural gas, exploration and development successes in the frontier areas of the Gulf of Mexico, enactment of the Deep Water Royalty Relief Act of 1995, and recent record breaking lease sales have led to activity levels in the Gulf that are unequaled in recent years. Both the offshore drilling business and the marine service business are operating at full capacity.

Day rates have increased in both areas but not to the point of justifying much new construction. Long-term commitments from operators will probably be needed to spur new construction to both supplement and replace aging fleets. All these segments of the offshore industry, including the oil field service industry, are experiencing shortages in skilled personnel and are intensifying their in-house training programs.

The fourth panel discussion, "Preserving the Backbone of Our Domestic Oil and Natural Gas Supply" undertook to examine what had been learned from the previous discussions and then to look at where the industry might be going in the future. While current conditions in the Gulf have improved significantly and the future looks bright, there are some obstacles to overcome. Aging fleets of drilling rigs, marine service vessels and other assets needed to replace reserves are fully utilized and the need to add to those assets seems clear.

Dramatically higher day rates are still not high enough to justify much new construction. At the same time, there is a question as to how much higher the cost of working in the Gulf can go before projects are deferred or put on the shelf. Shortages of skilled personnel presents another problem that must be dealt with if the full potential of the Gulf is to be realized. If the offshore energy industry can avoid the speculative excesses of the early 1980s, achieve new gains in productivity and efficiency and find new and innovative approaches to intra-industry cooperation, the future of the Gulf of Mexico as the backbone of U.S. energy production should be secure.

INDUSTRY FINANCING NEEDS ON A 10-YEAR HORIZON

In order to get a grip on the potential financing needs of the offshore industry, several threshold questions need to be answered. Among these questions are:

How much additional oil and gas production will be needed?
How much will be oil and how much will be gas?
How much will be offshore production, versus onshore?
What will be supplied by publicly held E&P companies versus national oil companies?
How much will it cost to maintain the current production base and how much to increase production over and above that base?
How much does it cost to expand the capacity of the oil service industry?

Actual capital expenditure data collected from 1992 through 1996 shows that publicly traded oil companies spent $279 billion on exploration and production and increased their production by 3.2 million b/d. Estimates of national oil company spending suggest that they spent $500 billion to increase their production by 5.1 million b/d. As much as 80% of those expenditures were required to sustain existing production levels and the remainder resulted in incremental production.

With projected increases in demand over the next decade at 42 million barrels of oil and natural gas (on a BOE basis) per day, if the split between private and public companies remains the same, and if cost relationships don't change, it will take a staggering two and a half trillion dollars to sustain current production and add that incremental 42 million b/d. That magnitude of expenditure, coupled with the fact that the oil service industry has no excess capacity, future expansion appears to be inevitable.

In order to generate the additional drilling rigs that are estimated to be needed to meet future demand over the next 10 years, an investment of $123 billion would be required. An additional $14 billion would be required to build the new offshore service vessels that would be needed to supply and service those new drilling rigs. An additional estimated $12 billion would be needed to furnish the drilling equipment required by the additional offshore and land rigs needed to meet future energy demand.

Clearly the industry is going to need enormous amounts of money in order to meet future needs. Higher prices will increase internal cash flows. In addition, both debt and equity will be required to satisfy the demand. The companies that will succeed in the "new world" will be those that choose the correct mix of capital sources.

SYNDICATED LOAN MARKET

The syndicated loan market (SLM) represents the universe of structured bank loans originated by major institutions, such as Bankers Trust Company and Chase Manhattan Bank, and purchased by a variety of banks and other financial institutions around the world. It is a very large, diverse and increasingly liquid market. There are approximately 200 originators of these loans and more than 500 buyers overall. Most of the buyers are banks. However, there is a growing universe of investment companies, mutual funds and insurance companies that are investing in this market. In addition, there is a large and active secondary market for SLM paper that gives it bond-like characteristics.

The oil field service industry has made comparatively little use of the syndicated loan market. Syndicated loans to service companies represent only a fraction of 1% of the total market. Similarly, the numbers of active lenders to this sector is a small fraction of the total market.

Syndicated loans represent an attractive source of intermediate term (5-7 years) capital for the oil field service industry. They generally provide more flexibility than public or private note or bond issues and are significantly cheaper than bond or equity issues. The preferred structure for oil field service companies is the five-year revolving credit which permits unlimited borrowing, repayment, and reborrowing and repayment to facilitate cash account management.

Given the extensive appetite for service company paper in the syndicated loan market, this market can satisfy a considerable portion of the industry's capital needs.

PUBLIC DEBT MARKET

The public debt market has provided $12.8 billion to the oil field service industry over the past 25 years, two-thirds of that total having been provided in the last seven years. Consolidation in the oil service industry has created larger, stronger companies that can utilize public markets where the minimum issue size is $75 million. Also, today's lower interest rates have made it advantageous to lock in those rates.

As the public debt market has grown, contract drillers and large diversified oil service firms have been the predominant issuers in the market. Public debt is an attractive vehicle for raising capital because:

Long tenors are available
Rates are fixed low
Investor demand for oil service issues is high.

Investor interest in oil service issues is grounded on improved credit fundamentals in the industry, improved ratings of oil service debt by the rating agencies and the recognition by portfolio managers that they have under invested in oil service paper.

Growth of public debt as a source of money for the oil service industry is expected to continue.There is a strong appetite in the market for all grades of oil service public debt. Regardless of where a company may stand on the credit quality spectrum, the market will be very receptive to its paper.

PUBLIC EQUITY MARKET

Investor's attitudes toward oil service and E&P stocks is reflected in the fact that in recent years, these stocks have significantly outperformed the S&P 500. Factors include:

Near capacity utilization of rigs and boats
Double digit increases in oil company capital expenditure budgets
Consolidations in both the oil service and E&P sectors
Technology advances leading to lower finding costs and enhanced reserve economics
Higher oil and natural gas prices.

Another factor is momentum investors who saw large sums going into energy stocks and went along for the ride.

In 1997, E&P stocks and oil service stocks parted company. Oil service stocks continued going strong, outperforming the S&P 500 by 23%. At the same time, E&P stocks lagged behind the market in 1997 under performing the S&P 500 by nearly 24%. Some of the reasons why the E&P stocks have performed as they have include:

Concerns about the reentry of Iraq into world oil markets
Declines in domestic production despite a 30% increase in well completions
The threat that increased drilling costs could render some smaller prospects uneconomic.

Natural resource companies must constantly replenish their inventory of reserves in order to survive and grow. Given the surge in merger and acquisition activity since 1992, it is apparent that many view the acquisition of reserves as more efficient than exploring for them. However, mergers in the oil field service industry have also been substantial, driven by the need to drive down costs, force efficiencies and make the most effective use of increasingly advanced oil field service technologies.

All of these factors have led to dramatic increases in energy common stock offerings. At the same time, the demand for both energy equity and debt is red hot and getting hotter because industry prospects look so favorable. All of which leads to the conclusion that energy stocks represent extraordinary values. Thus, their ability to raise capital in this market and going forward is very strong.

PRIVATE EQUITY MARKET

Private equity is one of the fastest growing sources of capital in the world. Investors in private equity include endowments, foundations and pension plans. These are institutions that are willing to make a commitment for up to a 10-year period. Private equity investors would expect either zero or negative returns for the first two years, but outstanding returns thereafter. Private equity is a very long-term, stable form of capital.

The objectives of a private equity firm and its investors are to effect a change and to live with uncertainty in the short term, in order to achieve longer term objectives. They possess the patience to go through the process of restructuring a company and rebuilding it in order to achieve substantial long-term returns. Expected returns would be in excess of 20% per annum internal rate of return over a 5-7 year period. These transactions will use 60% debt to capital or higher, as compared to 30% debt to capital that would be typical in a public company.

The overall strategy in private equity is to invest in a company, build that company and then make distributions that would roughly equal new investments. The impact on the investor is to make an original investment in a portfolio company, retrieve a large part of that cash investment and have the portfolio grow in value in a balanced manner.

Private equity would work well in a situation where a company wants additional liquidity, but the management wants to retain some ownership. Private equity is frequently used when a company is seeking to divest non-core business units. Finally, we will see increasing use of private equity to fund new ventures or projects.

The opportunities to take advantage of private equity are substantial. There will be tremendous growth in private equity investment in the oil field service industry in the years ahead.

Large amounts of capital will have to be invested in the petroleum industry to offset declines in worldwide oil and natural gas production. In addition, even more investment will be needed to meet the increases in demand for oil and natural gas that lie ahead. The implications of all of this investment for the oilfield service industry are that it will clearly have to expand capacity, and in order to do so, will require substantial amounts of new capital.

The following summarizes a White Paper, prepared from a presentation made before a 1997 meeting of the NOIA. The summary examines the characteristics and advantages of four potential sources of capital. The four presenters, representing various financing sectors, are Leonard H. Paton, Managing Director in the Global Oil & Gas Group of Chase Manhattan Bank; Laurence E. Simmons, President and Founder of SCF Partners; Matthew R. Simmons, Past Chairman of NOIA and President of Simmons & Company International; Robert D. Wagner, Jr., Managing Director of Energy Finance for Bankers Trust, and William H. Walker, Jr. , President of Howard, Weil, Labouisse, Friedrichs Inc.