ROUNDTABLE: The Merger Imperative in Key Energy Sectors: Dealmaking punctuates redevelopment of a critical industry.

A long-running M&A wave continues to sweep across the global energy industry, restructuring oil and gas, utilities, and every other space. The economic and strategic drivers ranging from high oil prices to pressures to gain scale were detailed by a group of industry pros at a Roundtable conducted by M&A magazine in early September. Excerpts of the discussion follow. Sikora: Are skyrocketing oil prices accelerating M&A in the oil and gas area, and just how are oil prices impacting energy areas outside of oil and gas? Schaefer: Higher oil and natural gas prices have brought more attraction and higher valuations to the entire energy field. There is more money available, more equity, and more debt capital looking at all of the opportunities across energy more broadly. Dillavou: We’re seeing an increased level of interest and activity in upstream areas, as well as the whole energy industry. The higher prices haven’t seemed to have kept anyone away. The ability to go to the market and hedge I think has helped facilitate some deals. Voccola: We’re more on the power side, and I can comment on that. The higher prices have made some assets that weren’t as attractive a year or six months ago more attractive now. Conversely, the less efficient assets are not looking as attractive as they were before. Overall, higher valuations have drawn more of a spotlight on the industry. There’s a lot more money in the sector. There seems to be a lot more new money and big-dollars money coming in, at least into the power space. That money wasn’t there 12 months to two years ago. Kostiner: My background was in power and I moved into oil and gas over the last five years because we felt that there’s basically a paradigm shift resulting from the gap between the reserves and the forward prices. We’re seeing that the gap has substantially widened between the implied reserve price of the companies and the market. For instance, about five or six years ago, it used to be that an oil and gas company would go for $5 a barrel in that implied reserve price. Last year, it was up to $11 to $15. Now we’re seeing $15 to $20. Although that seems like a great increase in the reserve valuation of companies, the gap from the $70 price per barrel in the market is enormous. That gap between the price valuation of companies and what’s in the market has widened. So we think that’s brought radically different players into the market, basically more financially oriented folks who are using hedge financing strategies to make acquisitions. We see private equity shops focusing on using new financing vehicles to close deals. In the current high-price environment, people with a lot of expertise in operations aren’t necessarily going to be able to justify their model. When you see such high prices, if they’re not hedging, they can’t necessarily justify a position. So we’re seeing new players coming in to capture hedge financing opportunities. Lewis: The tempo has been pretty robust and I think part of the mindset changed from 18 months to two years ago when prices started to go up. You used to have difficulty matching sellers’ expectations with buyers’ expectations. But now people are becoming accustomed to price levels that have pretty much stabilized at fairly high levels and they’re not really worried about prices going down to $25 to $30 a barrel any time in the near future. I think it makes it easier to do deals, because buyers are willing to pay more to match the very high prices that sellers are reading about. Dillavou: I think people realize that we’re not going to see the low prices that we’ve experienced in the past. That’s helping a lot, along with the ability to go out into the markets and hedge. Sikora: How are the current levels and trends in the stock market impacting energy M&A valuations, and how are they affecting both strategic and financial buyers? Stokes: We’re seeing two things. One is that the generally high prices in the publicly traded market make it difficult for a lot of take-private deals. They’re so highly priced to start with that it’s difficult to see where the valuations would go after that. On the other hand, we’re not seeing much competition from publicly traded strategics because everyone is so sensitive about quarterly earnings and no one is willing to take much of a risk. I think there are a lot of public companies looking to go private, but the valuations make it a challenge. But they’re not big competitors for acquisitions. I think a lot of companies are looking to the private equity market to relieve them of public scrutiny and give them a better chance to grow their business. Sikora: With so many bidders in the market now, how do buyers distinguish themselves to give themselves an edge or beat out the competition? Kostiner: We’re seeing a kind of bifurcation between strategic and financial buyers. If you have a standard company that has, say, a 20 PE, that buys a business that’s a 10 PE, at the end of the day the deal is going to be accretive to earnings. We look at commodity companies kind of non-strategically. If you’re a company that’s valued at $15 a barrel and you make an acquisition at $5 a barrel, that’s probably a good acquisition. When you see a company like Anadarko, which is basically at $10 a barrel, buy Kerr-McGee at $20 a barrel, from our perspective, that’s difficult to understand. We’re seeing pressure from the funds on companies. Pioneer, for example, is trading at around $7 a barrel, and the general idea is that you should do what’s best for shareholder value. Basically that’s putting on debt and buying back your shares. If you’re trading at $7 a barrel, rather than buy a $15-a-barrel company, you should be buying your own company. Voccola: A lot of deals happen outside of auctions. Once you get into an auction, the banks are basically going to take the highest price, which means the lowest return for the buyer. We’re able to find deals before they get to the auction process, if you want to call that a competitive advantage. Stokes: Any time you negotiate a deal as opposed to participate in an auction, the presumption is that you have an opportunity to get a better deal. Whether that’s the reality is hard to tell. But every time you’re lined up in an auction, it’s you and 10, 20, or 30 of your closest friends and competitors looking at the same sets of assets. For most big assets it’s hard to get somebody to agree to a negotiated deal. Sikora: Utilities used to be off limits for private equity. Some people said the debt load was too high. Now we see PE funds, sometimes in consortiums, being very active, and often winning utility assets. What’s accounted for that change? Stokes: I think the biggest factor is not the debt profile but the repeal of the public utility holding company act. In the past, if you owned a regulated utility then every other business that you were involved in became subject to a bunch of restrictions. With the repeal, a lot of restrictions are disappearing, and that has two key affects: It allows existing utilities to merge with each other across state lines and it allows private equity funds to own utilities without that affecting their other businesses. I think that’s the biggest factor for us. Schaefer: I agree that the reason PE firms didn’t like doing a regulated deal wasn’t that utilities had a lot of debt but that it would take a year or two to close and they’d watch the regulators extract some of the value from the deal. With the repeal of the holding company act, the biggest benefit for PE firms is going to be that as utilities merge, there will be pieces of the businesses that no longer strategically fit, and they’ll be sold off. That’s a more likely way, at least for Riverstone, to pick up an asset than to actually buy a regulated utility. We have limited desire to participate in a regulated utility business, but we are interested in the parts that might not fit when two utilities merge or parts that regulators say must be sold off. Dillavou: I’m not certain that private equity people want the scrutiny and the difficulty of dealing with state regulators in electric utilities, even though repeal of the holding company act has made it more available to them. A few large mergers that have been announced recently have had a lot of difficulty in getting approved. That says a lot about the process. That being said, outside of the electric utility area, we’re seeing private equity move in and make acquisitions in other utility areas, such as local gas distribution. Stokes: Also, before a private equity investor would come in, there has to be a value proposition that’s something other than just a conventional utility operation. We just recently bought a water utility. Those types of companies are not subject to the holding company act, but it was an exceptional opportunity because of its growth rate. When you see these utilities merging and assets are shuffling, there are some opportunities. But to just buy and hold a static utility doesn’t generally create the kind of returns that a private equity fund looks for. So there will be more specialty situations. Schaefer: But you still have all of the state issues. It takes a long time and it costs a lot of money. Sikora: Let’s look at alternative energy. It’s still an emerging industry, but what M&A prospects do you see in that market? Schaefer: We have a renewable energy fund, and I think that you’ll find that most of the renewal energy opportunities are smaller than what would be considered main fund activities. Right now, it’s more about building a business than buying an existing one, because it’s a relatively new market. Alternative energy is much more mainstream than it was 18 or so months ago. It’s a very small part of the industry, but it’s growing very rapidly, so we expect tremendous opportunities. It’s also an industry that’s highly influenced by commodity prices and government policy and programs, whether it’s production tax credits for renewable power projects, portfolio standards for individual state utilities, or ethanol and biodiesel credits that are granted by the government. Kostiner: A lot of people jumped on the ethanol bandwagon, and that market is starting to get saturated. We’ve looked at a couple of niche opportunities because we think it’s better to cherry-pick individual deals that have a reason to fly on their own merits. A lot of people are rushing to build capacity. Tax credits are driving deals that we believe are fairly solid, but you still need to distinguish yourself by having something special in the deal because too many people are building new plants. However, something that’s scaring people right now is that there’s resistance to bringing in ethanol from overseas. The cost of making ethanol in Brazil is about one-third of what it costs to produce here, so if we were to liberalize trade policies with respect to ethanol, it could really put the industry in jeopardy. Once again, if you’re focusing on niche opportunities with low-cost producers, the strategy is not going to be at risk. Stokes: A big factor is the tax profile of these projects. Unless you’re an efficient user of that tax profile, it’s difficult for the economics to justify. We find that to be a challenge. Sikora: Exploration for oil and gas is getting harder and more expensive and requires investments in high technology. Does this indicate that smaller and mid-sized firms won’t be able to finance exploration and will have to sell? Are there acquisition opportunities stemming from this? Kostiner: There’s a big gap between the big players and the little ones. A lot of the bigger finds are deep-water and offshore, and a characteristic of offshore drilling is that it depletes very quickly. So even though you have massive finds, you’re on a treadmill, because in three years you’re going to have to drill again just to keep your reserves constant. On the flip side, what’s going on in mergers between bigger players is that they often sell off smaller pieces of their portfolios. So we believe there are good opportunities for the smaller players, because the big ones really want to do only the billion-dollar projects that have high risk but enormous returns. There’s an opportunity for companies in $50 million to $5 billion area to do very-low-risk projects. If you drill a well that costs $250,000 and produces 30 barrels a day, you’re going to get your money back in six months. If you have a strategy of buying rigs and rapidly drilling shallow wells, that is a very low-risk strategy that has a high return. This is something that the big guys simply don’t pursue. We’re seeing that as the bigger companies pursue bigger projects, these smaller opportunities fall through the cracks. Private equity firms are really jumping on this and doing these smaller acquisitions and roll-ups. Dillavou: A number of small companies have been successful and have demonstrated that they can make money with deals that the majors ignored. Probably the biggest risk to them is that the majors are now interested again and may be looking to buy some of the companies that have built some size and have shown some expertise in doing it. The big companies can look at what their results have been and see that, in many cases, those smaller opportunities weren’t something they should have ignored. Lewis: That’s the history of the industry. Larger companies that go for putting a lot of capital to work on higher-risk, higher-profile projects invariably get rid of some things that are of lesser interest to them. They’re going to maximize their capital, sell some things, and devote the money to something else. That offers opportunities for the smaller players to step in and, in some circumstances, actually operate at a lower cost. Kostiner: Your point about maximizing capital is key. When somebody drills a billion-dollar project offshore of Mauritius, it’s basically getting reserves at under $5 a barrel. The rationalization of Exxon or any of the other majors that are selling assets is that they’re drilling a billion-dollar project that has reserves of $1 per barrel and divesting something in the U.S. that’s mature at $15 a barrel. That kind of the rationalization is the optimal use of capital, and it’s been the story for the last 20 years, but now it’s just accelerating faster. It makes sense for them to do big-capital projects at under $5 a barrel and divest mature assets in the North Sea or North America at $15 a barrel. But that creates big opportunities for smaller companies. They’re not looking at $5 a barrel versus $15; they’re looking at $15 versus $70. Stokes: Is that an operating play, a financing play, or just a production play? Kostiner: It’s actually a combination of all three. I tend to view things financially, but you can’t neglect operations, because there’s huge synergy. If you already have rigs in place, it’s very easy to add a few more rigs to an existing operating infrastructure. It’s a financial play but you also need to have the operations infrastructure. That’s one of the reasons why private equity firms that have focused on building portfolio companies or hiring operating managers have been very successful. The Wall Street players who like pure financial plays find it very difficult to get into the business because they’re not really comfortable with owning the operation. Stokes: It sounds like the benefit is not in the operation but in buying reserves at some discount to the market. As long as the market holds, that’s really where the benefit is. But it frees up capital for the bigger players to drill the huge, but less expensive, projects. Dillavou: But the independents also have shown ability to use improved drilling technology to get more out of the reserves. Maybe a big part of their success lies in being able to go into some places and find a way to extract more oil than what people thought was there. Sikora: Why are some oil companies disengaging from chemicals? Kostiner: If you look at the different businesses within an integrated oil company, the margins are increasing in exploration and in refining, and that’s eating into the margin on chemicals. Take the low end of the chemicals business, like fertilizer. That’s a completely negative business. So most of the fertilizer business has really been shut down. The margins on chemicals aren’t there, and it may be more productive to put capital in other parts of the world where, for instance, they don’t have a developed gas infrastructure. It used to be that natural gas was very cheap and not really used, so it was the foundation of the chemicals business. Now that’s not really the case, and you can put chemicals businesses overseas. Sikora: Can we expect more blockbuster deals in the energy industry? And what has been driving them and what are some of the drawbacks of doing them? Schaefer: On the power side, it’s clear that people will continue to merge. You will see more utilities trying to merge with neighbors or even companies that are not as close. People will learn from the difficulties that FPL Group and Constellation Energy are facing, and PSEG and Exelon faced, but I think there will be more deals as utilities try to grow. The private equity people look at how the regulated businesses get bigger. They haven’t been big competitors in auctions for unregulated power-generation companies, but perhaps at some point that will change and they’ll start to get interested again. Sikora: Has the segmentation of the utility industry into three or four spaces gone as fast as you think it should? Stokes: The segments are just beginning to form. What are forming them are the economic drivers that affect them and limit them. There still is a lot of talk about investments in transmission, but a big sticking point is that it’s difficult to control the power flow through transmission. If it’s difficult to control flow, it’s difficult to control who’s getting the economic benefit from the investment. That limits people like us from getting too deep into it, since we’re not sure how we’re going to get a return on it. That tends to push it more and more into the regulated structure. Generation has had some fits and starts but if you look at where the bulk of generation is going to be built, it’s probably going to fall into two categories. One is unregulated fossil fuel, which may be more coal now than natural gas, but fossil fuel nonetheless. As for nuclear plants, it remains to be seen who does them. The risk profile is somewhat different and the question is going to be driven in the end by the regulatory agencies and whether they’ll allow a utility to accept that risk. Schaefer: It’s difficult, from a private equity perspective, to participate in the development and construction of nuclear facilities. It takes too darn long. I think the regulated utilities will get approval to build the next generation of nuclear facilities, and I think a handful have already started the process – Duke and Exelon, among others. But I agree that distribution and transmission likely will stay predominantly in utility hands, with some exceptions. There’s a good bit of generation that’s still in regulated hands. In some states, it will come out and in some states it will stay in. But a lot of it is going to get built by non-regulated opportunities, and that will be funded either by private equity or by other sources of capital. Stokes: Some of it comes back to the question of oil and gas. As oil and gas prices fluctuate, that changes the emphasis on coal. I find that to be an interesting trend. It’s not clear to me exactly where it’s going, but it does seem that if oil and gas prices remain high, the push is going to be more toward coal. However, everyone is hesitant to make an investment in a coal plant. Because it takes so long to build, everybody is waiting to see whether oil and gas prices actually remain high long enough to justify building one. So it’s an interesting dichotomy, and I think the industry is wrestling with that. Sikora: With the holding company act repealed, will utilities diversify again into oil, gas, and other energy areas? Schaefer: I don’t think so. Wall Street has everybody focusing on a back-to-basics approach. Most of the big utilities in this country are shedding non-utility assets across the board. At least in the current environment, it’s hard for me to imagine that a utility would buy a big coal company, for example. Stokes: It could be going the other way. What drove that trend in the 1980s and early 1990s was that a lot of utilities had overbuilt and their capital programs flattened out. Cash started to flow uncharacteristically, but the companies were restricted from expanding in conventional means by the holding company act. So they were stuck with a big pile of cash and not much to do with it, and they started to go afield into other areas. Now I think the opposite is happening. The existing infrastructure, whether it’s generation or transmission, demands a lot of capital, so there are plenty of places to invest. Roundtable participant: 1- Stephen Schaefer, Managing Director, Riverstone Holdings 2- Jim Dillavou, Partner, M&A Transaction Services, Deloitte & Touche 3- Gene Lewis, Partner, Fulbright & Jaworski 4- Marc Voccola, Vice President, Energy Investors Funds 5- Barry Kostiner, CEO, Platinum Energy Resources 6- John Stokes, Managing Director, AIG Highstar Capital 7- Martin Sikora, Editor, Mergers & Acquisitions (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com