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Independents Profiting, But Financiers Wary
Flush with profit from surging natural gas prices and a stock rise across the board this year of about 85%, North American independents still appear to be in no rush to secure financing for more exploration and production activities. And unless you've got equity or a strong balance sheet, lenders still may be wary before jumping into any financing deals.
Instead, the independents --- especially the smaller ones --- are rebuilding the bloody balance sheets devastated in the bust two years ago, and cautiously looking for ways to secure shareholder value and regain investors' confidence. Despite the hesitation, it is falling more and more to the smaller independents to exploit the natural gas reserves in North America, as the majors turn more attention toward exploration in the deep Gulf of Mexico and overseas. Soon, say analysts, some independents may announce significant investments in North American E&P.
"For the blue chip companies, like the Apaches, investment opportunities have already opened up and actually never stopped," said David Khani, senior energy analyst with Friedman, Billings Ramsey & Co. "The smaller guys are just starting to look for investments. I think later this month and into October, we'll see five to 10 offerings by some of the smaller independents."
Because about 70% of most independents' portfolios is in natural gas, "if the independents can't find financing now, they'll never find it," said Fahnestock & Co.'s Fadel Gheit, an energy analyst and research director who covers a lot of independents. "It's now or never."
Still, Khani pointed out that investors have to be confident that the high natural gas price cycle will last. "It's starting to settle in that gas prices will remain high," he said. "The lenders are starting to gain confidence."
Investments will be easiest to come by for those companies with equity, said Khani. "Equity is the first way to obtain financing. The next is when the high-yield market opens up, and finally, the commercial banks start to increase their lending. Equity financing is just opening up now. But it's just starting."
For an independent looking for financing, it has to have had some drilling success, a focused strategy and a balance sheet repaired from the last bust two years ago.
"No one wants to lend to companies with damaged balance sheets," Khani said. "They want to see a good, clear view of drilling inventory."
Drilling inventory, though, is certainly not the most important thing anymore, said Gheit.
"We're not seeing a rush to glory like we did a few years ago," said Gheit. "We're not seeing a rush to spend money. The independents got wise. They are looking for shareholder value and a return on the capital employed."
Gheit, who covers Mitchell Energy and Development Co. among other independents, said companies no longer are rewarded for drilling holes, but for "drilling holes that produce." Before the last bust, independents would book all of the drilling rigs they could and when they went to the bank, the lenders would look at the drilling program and make the loans based on that information.
"Amazing," he said. "It's not that way anymore." He even knows of companies that until two years ago, would drill in areas they knew would not produce. "My view, and we can joke about it now, but those companies could have been sued by shareholders. At the time, the exploration programs were geared toward a big noise and not necessarily a result. Nobody cared." Two companies that participated in dry hole drilling, which he would not name, are near bankruptcy today.
"In the last bust, a lot of companies lost their credibility, and their investors dropped out and are not coming back," said Gheit. "Making promises and not keeping them...that's a killer."
Irene Haas of Sanders, Morris Mundy said it's still "tough for the small guys." She said the market is "warmish," but the independents have to have one of three things to gain financial backing these days: a good balance sheet going in, a healthy company with excess cash flow or minor problems with the balance sheet that are in the process of being fixed. "Those with even minor problems are still having difficulties obtaining loans," she said.
Another problem is with the lending institution itself. Since the last bust two years ago, many of the commercial banks have been restructured and many no longer service loans for less than $100 million, she said. "The need for financing comes from the equity side in those cases."
Analysts said that some of the smaller companies that are setting an example for other independents to follow include Comstock Resources, based in Frisco, TX, Spinnaker, based in Houston, and Nobel Affiliates.
"Comstock Resources is very small and very focused," said Gheit. "It has 97% of its holdings in natural gas, and there's no hedging. This is the kind of company that's in a dream position today."
Haas said that Houston-based Spinnaker recently completed some successful financing because it improved its balance sheet and focused its attention on specific properties in the shallow water Gulf of Mexico.
And Khani pointed to Nobel Affiliates, which had been down to 1/3 of what it is today after the last downturn. "Now they've turned the corner after waiting and cutting back on production. A lot of investors had given up on Nobel, but this is the kind of independent that took its time."
Other areas where analysts expect to see independents shine in North American exploration, specifically the United States, will be in East and South Texas and the Powder River Basin in Wyoming.
Khani said it may be surprising, but many of the best priced stocks today are the highly leveraged independents, who were "so beaten up in the last downtown and now the stock prices are performing." He said that with the commodity prices up, the cash flow is helping even highly leveraged companies with their balance sheets.
To improve domestic natural gas production, expect to see more of the smaller independents merge. "The best ones will be the prospect-rich company combining with the cash-rich company," said Khani. "The small guys have a second shot at life because commodity prices are strong. We've seen companies on the brink of going under, already in Chapter 11 and then come out. Those are the ones who go out and make the deals."
Carolyn Davis, Houston
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