Oil slick

The mood was somber at the Independent Petroleum Association of America's Private Capital Conference at the Houstonian Hotel in Houston in mid-January, where oil and gas executives gathered to discuss the state of the industry. There was a lot of talk of opportunity but not a lot of talk of available financing to expand companies, much less do deals.

"It's not like anything I've ever seen in my career," said Charles Hall, a managing director in the energy section of ING Capital LLC. "Last summer there was too much capital and too little opportunity. But ultimately there was a day of reckoning, and that's what we're going through right now."

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Oil slick
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Second wind
Who will buy the bargains?

The energy industry, like the rest of the economy, is suffering from the double whammy of lower commodity prices and sapped credit. Oil prices have fallen 70% from a record high of $147 per barrel in July to a four-year low of less than $33 per barrel in January. Natural gas prices have performed even worse, plummeting from a high of more than $13 per thousand cubic feet equivalent this past July to less than $5. By the end of January, rig counts in the U.S. had declined by 25% since their peak in September, to 1,515. At the same time, credit has disappeared from ailing and gun-shy banks, forcing oil and gas companies to cut capital budgets and lay off staff.

Last month, Houston oil services giant Schlumberger Ltd. announced it would let go 5,000 employees, or 6% of its workforce around the world. ConocoPhillips followed suit, saying Jan. 16 it would cut its capital budget by 18%, to $12.5 billion, and lay off 4% of its workforce, or 1,350 people. It recently reported a $31.8 billion loss in the fourth quarter of last year.

Smaller oil and natural gas companies are also struggling. The debt markets have slammed shut for many of them, and analysts are concerned that several companies will trip their loan covenants this year, including Forest Oil Corp., Chaparral Energy Inc., Berry Petroleum Co., Energy Partners Ltd., Petro Resources Corp., ATP Oil & Gas Corp., Crimson Exploration Inc. and Parallel Petroleum Corp. "It really feels like the 1980s," an investor relations chief at a large exploration and production company said recently.

If oil and gas prices continue to stay low and credit remains tight, oil and gas companies may find themselves so strapped for cash that they'll start filing for bankruptcy. Indeed, bankruptcy attorneys say they began getting calls in November from creditors worried about getting paid by potential debtors. They say the calls haven't stopped.

"When you have a lack of credit and cash flow goes way down, you need to have bridge borrowing, and it's not there," says Rhett Campbell, a bankruptcy attorney at Thompson & Knight LLP in Houston. "How long can you last?"

The current situation is certainly not without precedent. Oil pioneers such as Clint Murchison Jr., T. Cullen Davis and the Hunt Brothers were all forced to file bankruptcy in the 1980s, when they found themselves overextended during the worst recession in 50 years.

As Bryan Burrough documents in his new book, "Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes" (Penguin Press), conservation, a deteriorating economy and competition from other fuels such as coal and nuclear power cut deeply into oil demand in the '80s, causing drill bits in Texas to "whir to a halt." Wildcatters across the state who had borrowed heavily to drill expensive, deep wells saw the value of their collateral fall. Loans were called in, and companies either limped into shotgun weddings (as was the case with George W. Bush's company, Bush Exploration Co.) or filed for bankruptcy. "How do you get a Texan oilman out of a tree? Cut the rope," was the joke floating around Dallas at the time.

The oil industry is obviously not yet at that dire point. But a few companies have already succumbed to Chapter 11. Tulsa oil purchaser and transporter Semgroup LP led the bunch last summer, buckling under margin calls against losses of $2.4 billion in the company's trading accounts on the New York Mercantile Exchange. (Harvey Miller and Michael Kessler at Weil, Gotshal & Manges LLP are debtor counsel.)

Privately held natural gas exploration and production company CDX Gas -- owned in part by TCW Group Inc. -- filed for bankruptcy Dec. 12 to restructure its debt with lenders and resolve liquidity issues after Credit Suisse Securities (USA) LLC and Jefferies Randall & Dewey failed to find a buyer for the company. (It's represented by Harry Allen Perrin of Vinson & Elkins LLP.)

Then came Flying J Inc. The privately held Ogden, Utah, exploration, refining and marketing company filed Dec. 22, blaming a liquidity crisis brought on by plunging oil prices and margin calls by lenders. (It's represented by Paul Basta of Kirkland & Ellis LLP in New York.)

It's just the start, many bankruptcy attorneys say. "As energy prices have declined and access to capital continues to be constrained, we are seeing the beginning of a softening in the energy sector," says Sylvia Mayer, a bankruptcy partner at Weil Gotshal in Houston. "This is particularly true for those companies that have near-term debt maturity or interest payments and/or looming covenant defaults due to the drop in prices or decreased demand. Barring a surge in energy prices that is sustainable, I expect the restructuring demands in this sector to increase."

Plunging oil prices have certainly been the culprit in those cases, and demand predictions don't promise a better future for commodity prices.

Cambridge Energy Research Associates Inc., or CERA, expects global oil demand to fall by 300,000 barrels per day this year, while the International Energy Agency predicts a fall of 500,000 barrels per day -- which harks back to the 1980s. That's a big switch from the beginning of 2008, when analysts projected that demand would grow by 2.1 million barrels per day this year.

"The oil price was driven to its oxygen-short heights last summer by the 'demand shock' that came from five years of strong economic growth and was fueled further by geopolitics, oil field costs, financial markets and trading, and psychology," wrote Daniel Yergin, the head of CERA and author of the Pulitzer Prize-winning book "The Prize: the Epic Quest for Oil, Money & Power," in a recent report (the book was recently reissued in paperback with a new epilogue). "The oil market is being shaken mightily by a recession shock -- and not just a recession shock for oil, but for all energy markets and industries, both conventional and alternatives and renewables."

Companies can sell assets to boost liquidity, like Oklahoma City oil explorer Chesapeake Energy Corp. has done by selling rights to various packages of oil and gas properties to British oil giant BP plc, Norway's StatoilHydro ASA and Tulsa, Okla., billionaire George Kaiser for almost $10 billion.

But right now, analysts and dealmakers say companies can't get anywhere near what their properties are worth and potential buyers can't get the financing to buy them, so many are having to wait until commodity prices increase or the credit markets loosen up.

There's still not much credit out there, either, especially now that some investment banks have become banks with tougher lending restrictions. "We're doing some plain-vanilla deals, but we're more careful now that we've been approved to become a bank," said one such banker on the sidelines of the IPAA conference. The debt markets for energy companies appeared to thaw, however, with Chesapeake's announcement Jan. 28 that it plans to issue $500 million in long-term debt to pay off some of its bank debt, which is secured by the value of its undrilled gas reserves. That value has plummeted along with natural gas prices, which may lead its banks to cut their credit lines when they come up for renewal.

Executives don't expect it to improve anytime soon. Nearly three-quarters of oil and gas CFOs polled in a recent survey by accounting firm BDO Seidman LLP said they expect the U.S. economic crisis to affect their ability to borrow money or extend bank debt in 2009. In addition, well over half the 100 executives surveyed said that credit capacity restraints, including access to capital, will be their greatest challenge next year, followed by falling oil or natural gas prices. "They feel gravely concerned about raising money," says Charles Dewhurst, a partner at the firm and leader of its national energy practice in Houston.

Dewhurst says the credit drain may lead more companies to consider buyouts or bankruptcy as a solution. "With less credit and lower prices, smaller [exploration and production] companies are going to be attractive acquisition targets for larger companies, and because of debt constraints, many are going to feel compelled to sell," he says.

Companies that put together projects and borrowed money based on $150 barrel oil will be most vulnerable. "I've heard from clients and others that more conservatively managed companies used a lower price," he says. "Those companies that were aggressive in borrowing to the max are going to have constraints and will have to make substantial payments to the banks."

This spring, when banks set borrowing bases, they will be looking at their oil and gas customers' reserves and commodity prices and may start tightening their credit even further, which could hurt smaller, fast-growing explorers.

"If the banks start using lower oil and gas prices, companies could see reductions in their borrowing basis, which could result in them not having enough liquidity," says Steve Berman, a senior research analyst at Pritchard Capital Partners LLC in New York.

Berman thinks bankruptcy is a "strong possibility" for some oil and gas production companies that have covenant violations, but how widespread it is depends on how willing lenders are to work with companies.

"I don't think the banks want to own E&P assets," Berman says. "In most cases, they'll work with the companies. We've seen periods before where that's what happened."

Berman says a lot of companies across the sector are talking about "drilling within cash flow" and cutting back to reduce costs. But does he think it will be as bad as the 1980s? "I don't think so," he says. "Companies have adjusted, we've had a lot of advances in technology and they're more efficient."

Dan Pickering, research director at Tudor Pickering Holt & Co. Securities Inc. in Houston, doesn't think the sector will see widespread bankruptcy until next year, and only if commodity prices stay low.

"Following 20% cuts to 2009 [capital expenditures], none of our 29 coverage companies are outspending cash flows in 2009 with $50 per barrel, $5 per [million cubic feet of gas] commodity pricing," he wrote in a recent report. "Keep prices low for longer and sector health would deteriorate noticeably."

In the meantime, transactions have fallen apart, putting some companies' futures in serious jeopardy. For example, Houston's Edge Petroleum Corp. and Chaparral Energy of Oklahoma City announced Dec. 15 that they canceled their merger because they were unlikely to get debt and equity financing. (J.P. Morgan Chase Bank NA had committed the original financing.) The companies also canceled Chaparral's $150 million sale of preferred stock to investment firm Magnetar Capital LLC. Edge is considering other options, including a sale or a merger, asset sales and debt or equity financing, and Chaparral has had its debt downgraded by Moody's Investors Service because of concerns over liquidity and debt issues.

Moody's believes the current market turmoil may trigger a new round of M&A activity, as many of the larger integrated companies, which have experienced flat to negative production growth over the past few years, feel the pressure to deliver organic growth. Many of them also have robust balance sheets and a solid base of mature cash-generating assets as well as have access to capital markets.

"These large companies could take advantage of the financial woes currently afflicting smaller E&P players, resulting in increased M&A activity in the sector," Moody's senior vice president Tom Coleman said in a recent report. There's hope yet.