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Banking on high oil prices

High oil prices have been a boon for banks, as well as for energy firms. There has been a resurgence in mergers and acquisitions (M&A) activity, global project finance volumes are at their highest level since 2000 and energy trading is back in vogue, writes NJ Watson

The rise in oil prices, from around $10 a barrel in 1998 to almost $60/b in April, has left oil companies of all sizes cash-rich. While many energy firms, including ExxonMobil, BP and Royal Dutch Shell, have chosen to return cash to shareholders through share buy-backs and special dividends, others have gone on the acquisition trail.

In April, Chevron fended off competition from Italy's Eni and China National Offshore Oil Corporation (CNOOC) to acquire Unocal for $18bn, generating substantial fees for its advisers – Morgan Stanley and Lehman Brothers. That deal helped push those two banks to the top of the M&A adviser rankings for deals carried out between May 2004 and April 2005, with 29% and 26% of the total, respectively.

Chevron's acquisition of Unocal is expected by some analysts to herald the start of another round of industry consolidation. Under pressure to replace reserves and with limited prospects for organic growth, many firms – especially the largest – have little choice but to expand through acquisition, even if that means paying a high price. In addition, national oil companies (NOCs), which have traditionally focused on domestic operations, are increasingly expanding abroad as they restructure into more commercially driven entities. Some international oil companies (IOCs) believe scale will help them fend off that competitive threat.

Industry consolidation has been particularly noticeable in the US over the past year. The Chevron-Unocal merger is comfortably the largest, but there have been several other substantial deals, upstream and downstream.

Noble Energy, for example, increased the life of its US oil and gas reserves by more than 50%, to 9.1 years, by acquiring Patina Oil & Gas. The cash and shares deal, arranged by Petrie Parkman and JP Morgan Chase, valued Patina at $3.4bn, including debt.

Downstream, Morgan Stanley, Lehman Brothers and UBS arranged the $8.7bn cash and shares merger between refiners Valero Energy and Premcor, transforming Valero into the US' second-largest refiner (from 14th) and significantly increasing its presence on the US east coast and in the Midwest at a time when refining margins remain robust.

There has also been consolidation among US oilfield-services companies. National Oilwell and Varco International say the greater scale that will result from their $4.4bn merger – on which Citigroup and Goldman Sachs are acting as advisers – will help them fend off mounting competition in their home market from foreign companies.

Bankers also expect a pick-up in M&A in Europe this year. With NOCs growing in dominance in oil activities, IOCS are busily strengthening their gas portfolios – an industry segment where they are likely to remain dominant because of the high capital costs, special technology and market access large-scale gas projects require. That makes the UK's BG, with its highly rated spread of gas assets, an attractive target.

Following OMV's $1.85bn acquisition of Romania's SNP Petrom, on which Deutsche Bank acted as adviser, central and eastern European energy firms are expected to continue to tighten links to protect themselves from Western or Russian majors.

NOCs have also become more acquisitive – a trend that is expected to grow. Although CNOOC's bid for Unocal never materialised, it was successful the same month in buying a 17% stake in Canada's Meg Energy, which owns northeast Alberta's Christina Lake oil-sands project.

Two of the largest deals between May 2004 and April 2005 involved Russian oil firms. Yet a closer look shows that opportunities for banks in Russian energy transactions carry a high level of risk.

The second-largest oil and gas deal in the year to end-April, arranged by Dresdner Kleinwort Wasserstein (DKW), was the $9.3bn acquisition by Baikal Finance Group – an obscure front company – of Yukos' main producing subsidiary, Yuganskneftegaz. This transaction is widely considered to have been the result of a political campaign against Yukos by the Kremlin and auctions of other Yukos assets are likely. However, deals founded on politics rather than economics are inevitably more prone to upset. The year's fourth-largest deal was between Gazprom and Rosneft – arranged by Morgan Stanley and DKW – but it was shelved in May.

Total's Russian plans are also suffering from political machinations – its seven-month-old application to the competition authorities to buy a blocking stake in independent gas producer Novatek remains in limbo.

The year's largest merger in the power sector was the $26bn acquisition by Exelon of Public Service Enterprise Group – a deal arranged by Morgan Stanley, JP Morgan Securities and Lehman Brothers – to create the largest utility in the US.

Many commentators believe more large-scale mergers will follow as the country's wholesale electricity and gas industries prepare for the next stage of growth. In addition, Congress is expected to revoke the 1935 Public Utility Holding Company Act, which imposes restrictions on utility mergers. Last month, Duke Energy said it is buying Cinergy in an all-stock deal valued at about $9bn and arranged by UBS and Merrill Lynch.

New buyers

Another development in the power sector over the last year – and one that is expected to continue – is the increasing interest from long-term, strategic investors in acquiring gas and electricity networks in various companies. Vittorio Perona, managing director of DKW's utilities group in London, says these new investors, such as Canada's Borealis Infrastructure Management or Bahrain's Arcapita, are prepared to consider investments over a longer time horizon than investors have tended to in the past and to take on more debt than traditional utilities. "These new buyers aren't private-equity players that want a 25-30% return over a five-year horizon."

DKW was adviser to a consortium of Borealis, Scottish & Southern Energy and Ontario Teachers' Pension Plan, which, last August, paid £3.2bn ($6.1bn) for two National Grid Transco (NGT) gas networks in the UK. This was part of larger deal that saw NGT auction off £5.8bn-worth of assets, around 1% of which went on advisers' fees, which also included Cazenove, Rothschild, Morgan Stanley, JP Morgan Chase and Citibank.

The top M&A advisers in oil and gas, and in power, remain dominated by bulge-bracket investment banks – Morgan Stanley, JP Morgan Chase, Lehman Brothers and Citigroup (see Table 2) – which benefited from arranging the mergers of Chevron-Unocal and Exelon-Public Service Enterprise Group.

However, second-tier banks are finding mandates in new growth areas, such as M&A of renewable-energy assets. In April, DKW, which is beefing up its energy team in Europe and the US, arranged the Euro272m ($351m) sale of Dersa, a renewable-energy company, to Spain's largest gas supplier, Gas Natural.

Australia's biggest investment bank, Macquarie Bank, which was also involved in the NGT deal, is another of the growing band of banks willing to take on renewables investments. In December, it set up a joint venture to own and operate renewable-energy assets, initially in the UK. "With UK [renewable] requirements set to rise from an initial 3% to 15.4% of all electricity supplied by 2015, substantial investment in the sector will be required," says Ian Kay, a division director at Macquarie.

Hedge funds arrive

A new trend in energy-market M&A that is not discernible from the league tables over the past year is the arrival of hedge funds, either providing bridge financing or forming part of bidding groups. Bankers say hedge funds are becoming more interested in M&A because they already possess the expertise in trading that allows them to hedge price risk in commodities or energy-related transactions.

Fuelling this merger boom are the high valuations of energy firms. This leads to more paper deals than those using cash because, in the view of one banker, "it's easier to pay with your own over-valued paper".

Conversely, some bankers predict high stock valuations will eventually choke off much of the M&A activity. While BG Group may present an attractive bid target in terms of its asset portfolio, its shares have risen by 25% in the past year, putting it out of the reach of most acquirers.

Bankers are also talking about an oil and gas bubble on the London Stock Exchange's Alternative Investment Market (Aim), which has proved popular for initial public offerings of small oil and gas explorers. Many in the City says the Aim boom bears an uncanny resemblance to the internet bubble of the late 1990s – valuations have soared even in cases where companies listing have no output and no guaranteed future production.

Bubble or not, the boom in the number of resource companies listing on Aim is manna from heaven for banks, which earn fat fees from underwriting such deals. In the year to March, some 52 oil, gas and mining companies joined Aim. As a result, the sector accounts for 20% of the companies listed and almost a third of the total market capitalisation of the exchange.

With oil prices high and set to remain high, at least in the near term, many banks are also returning to the project-finance market after pulling back several years ago, when excess capacity and slack demand caused energy prices to fall well below the levels used to underwrite project-financing deals.

Project finance on the rise

Global volume of project finance amounted to $170bn in 2004, the highest level since 2000 and 50% up from the previous year. A full pipeline of deals, especially in the energy sector, suggests 2005 will be another strong year, even if the year-on-year pace of growth eases.

Other recent, large project-finance deals include a $0.92bn facility for the Taweelah B independent water and power project in Abu Dhabi, led by BNP Paribas, KfW Bankengruppe and Standard Chartered; and a $0.719bn facility for Q Power, arranged by Mitsubishi Tokyo Financial Group, Calyon, Gulf International Bank, HSBC, Qatar National Bank and Royal Bank of Scotland (RBS). Q Power – owned by the state's Qatar Electricity & Water Company (55%), the UK's International Power (40%) and Japan's Chubu Electric Power Company (5%) – is developing power generation and water desalination projects and related pipelines and infrastructure in Qatar.

But much of the project-finance action centres on LNG, as oil firms attempt to take advantage of rapid growth in US gas demand over the next few years. The largest project-finance deal of the last 12 months was in LNG, when a group of 36 banks contributed to a $9.3bn bank facility for the Qatargas 2 project financing. That deal was co-ordinated by BNP Paribas, which was ranked fourth in project finance for oil and gas, and third for power (see Table 4).

Peter Goodall, managing director of project finance for Calyon, Crédit Agricole Group's investment bank – created last year by the transfer of Crédit Lyonnais' investment banking division to Crédit Agricole Indosuez – says the LNG market has come back very strongly since 2004, with several large developments being launched in the Mideast Gulf, Africa and Asia.

Qatar leads the way

Qatar is leading the way, but LNG projects are also being financed in Russia, Nigeria and Indonesia. Several African projects are also being developed or have been proposed, with new schemes emerging in Equatorial Guinea, Angola, Egypt and possibly Libya and Mauritania. Meanwhile, around 20 banks attended a presentation in April for Yemen LNG, a project involving Total and Hunt Oil. "In the five years to 2004, the amount of investment in LNG was $35bn-40bn, but this amount is expected to be $70bn in 2005 and 2006 alone," Goodall says.

Staffing levels suggest project finance remains a healthy area in energy financing. Hurbinder Mudan, director of energy at Royal Bank of Scotland (RBS), which was ranked third in project-finance loans arranged for the oil and gas sector, to a large extent because of its involvement in Qatargas 2, says his bank expects to generate more business in Europe and the Middle East in the next 12 months.

RBS is considered one of the main contenders to lead the project financing of the 7.5m t/y Qatargas 4 LNG project after its energy team advised on Qatargas 2. It also has high hopes for the financing of electricity projects and has positioned itself accordingly. "Our power project-finance team is as big as it's ever been and it's doing a huge number of deals in Spain, Italy and the Middle East," he says.

Although Calyon has not hired more staff to its project-finance department recently, it says this is because of post-merger restructuring and points out that it has not cut staff numbers. The project-finance division "has benefited from reallocating resources so we didn't reduce the overall numbers dedicated to energy", says Michel Anastassiades, global head of project finance. "Over the long term, the energy part of the business is pretty stable."

Calyon, whose constituent banks were both major players in the project-finance market before the merger, claimed fourth spot in Dealogic's table of mandated arrangers of power and utilities project-finance loans with deals such as a $1.1bn secured syndicated loan facility for Gazprom (see Table 4) – at that time the largest loan raised in Russia since 1997.

Even with solid balance sheets, energy firms have a powerful incentive to fund projects with debt because credit is cheap and plentiful. Meanwhile, NOCs are increasingly keen on raising debt and gaining a credit rating into the bargain (see p26). Besides, bankers say the high oil price is making so many projects commercially viable that energy companies need all the financing they can secure.

In power, the biggest project-finance deal was in the US with the $3.6bn acquisition by GC Power Acquisition of Houston-based Texas Genco. The transaction was the largest power-plant purchase by a financial buyer since deregulation of the electricity markets began in 1999 and, experts argue, suggests the power sector has finally steadied after the problems caused by the collapse of Enron and the power crisis in California.

Trading profits

Oil prices may have fallen since early April's peaks of around $60/b. But at around $50/b they are still uncomfortably high for many consumers. With major fuel users, such as airlines, forced to review their hedging policies in the face of rising costs and shrinking profits, banks are also once more diving back into energy trading.

Apart from the leading players, Goldman Sachs and Morgan Stanley, most banks reduced their energy-trading operations or exited the business altogether in the wake of Enron's bankruptcy. Yet in the last 12 months, at least 10 banks have re-established trading desks.
Some banks are re-entering the business by buying up companies wholesale, such as Merrill Lynch and its acquisition, last September, of Houston-based Entergy-Koch.

Others have taken to raiding each other's teams. ABN Amro has hired from Deutsche Bank, Bank of America and BNP Paribas, while BNP Paribas has lured traders away from Société Générale, HSBC, Sempra Trading and Shell Trading. Other banks hiring in this field include DKW, Citibank and Barclays Capital. "The banks have finally put Enron behind them," says RBS' Mudan.  

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