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Energy Bet Is Long-Term, Lenders Say

Despite the current softening of natural gas prices, gas is still priced higher than it would be were it not for $70-plus oil. There are a lot of fundamental reasons why oil is as high as it is, but Warburg Pincus Managing Director Peter Kagan wonders if something else is afoot.

"Isn't it a little bit odd that at the very same time that we have this new [price] plateau for oil and gas, we're also at a brand new plateau for copper, for gold, for corn, for orange juice, for sugar, for coffee... Basically, every single commodity out there has reached an all-time high."

Kagan told attendees at KPMG's 2006 Global Energy Conference last week in Houston that given the uniqueness of energy commodities and their rise with other commodities, "I do worry a little bit that there is a bit of a commodity bubble."

Commodities generally move counter to equities, and lately Wall Street has given investors more ways to gain exposure to commodities and the hedge they provide against a downturn in stocks, so that may be why members of the commodity asset class are enjoying such popularity. Regardless, Kagan said he isn't too worried about energy. "This is a business that isn't going away. It absorbs and uses tons of capital all the time. It's a business that has new technologies involved in it. Hydrocarbons are going to be critical to the future of the world for a long period of time and you can make a lot of money at prices a lot lower than today's.

"Even if it is a bubble and every commodity has reached its exact same supply-demand inflection point at the same time, I still think this is a fundamentally sound business and good place to be for a long period of time."

Indeed, others would seem to think so as well as the energy lending business is on a tear, according to Kagan and his KPMG co-panelist, Dan Condley, Banc of America Securities natural resources group managing director. The number of private equity funds targeting energy has grown from about five years ago to about 20 today. This year alone will see about $12 billion in private equity raised compared to less than $100 million five or six years ago. If one were to gather all the energy financing deals that Warburg Pincus has turned down over the last five years, "you could create an incredible fund just on the deals we've said 'no' to," Kagan said.

Both Kagan and Condley agreed that times are good for lenders in the oil patch. The most recently formed Warburg Pincus energy fund totals $8 billion, Kagan said, and in the last two years the firm has paid $150 million in fees to Wall Street firms, so its calls usually get returned, he quipped. Nearly every one of its energy funds has been a top-quartile performer. The firm has $2 billion spread across 25 companies, Kagan said.

Condley said that in the next few weeks Banc of America will announce another $400 million raised for a private energy firm. "Senior debt is what we do, day in and day out."

Generally speaking, today's deals are predicated on oil at $35 to $45/bbl and natural gas prices of $5 to $6/Mcf. Prices in that neighborhood can scare up a lot of previously uneconomic resources that have yet to come on line. Canadian oil sands, deepwater Gulf of Mexico as well as shale and tight sands gas plays all are looking good.

Kagan said Warburg likes technology plays and is looking to help fund the next technology evolution in energy and the producers who will use that technology to develop Canadian oil sands, as well as tight gas and coalbed methane.

"We're willing to take exploration risk," he said. "We were one of the first people in our business to recognize that an exploration program, managed systematically, can provide programmatic rates of return, not just idiosyncratic risk. We're looking for volume growth, not prices. We're not looking to make bets on the commodity. We're looking at fundamental businesses with good teams that can grow over time.

"We're patient; we tend to hold our investments for five to seven years. And in energy we've often held our positions for nine or 10 years."

On the technology front, Kagan said Warburg's belief in 3-D seismic in the late 1990s paid off handsomely in the Gulf of Mexico with companies such as Spinnaker Exploration. "As we saw technology developing and improving around the 2000 time frame, we really developed a focus on the application of new drilling technologies, horizontal drilling, under balanced drilling, and where that could create economic reserves. That led to a wave of investments, including Bill Barrett Corp."

Condley said his bank generally doesn't require that a producer hedge its production in order to get financing. Normally, about 30% of their production is hedged. However, now that figure is down to 5 to 10%, but acquisitions currently almost always require hedging to get the financing through.

Much has been said about energy industry capital moving overseas to avoid the rigors of Sarbanes-Oxley requirements in the United States. But Kagan said he sees a more robust market back home in the States where there are some real competitive advantages to be had, he said.

Bankers didn't always take to energy like flies to sherbert. In the days before the dot-com bust, energy capital markets were largely ignored, the speakers said. The collapse of the dot-com sector changed that.

With hurricane season fast approaching, producers and their bankers are thinking about the cost to insure offshore rigs and business continuity: it's up from a year ago. Condley said Banc of America now considers insurance a separate line item in company budgets. "It's a significant part of cash flow." Another tough hurricane season this year could wipe out more than just offshore platforms, it could take out the availability of hurricane insurance as well, Kagan said.

With times so good, those who were in the industry in the 1980s have to wonder if another bust is coming. Kagan noted that at the same time that energy commodity prices have set a new plateau, so has "basically every single commodity out there." If there is an energy bubble it's part of a larger commodity bubble, he asserted. "Even if it is a bubble, I still think that this is a fundamentally sound and good business to be in."

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