By LOUISE S. DURHAM
EXPLORER Correspondent

Pro$pect Enthu$iasm

Money Making Oil World Go 'Round

Pssst, buddy, can you spare a few $million?

Chances are good the answer is affirmative -- provided you have a truly viable drilling project to offer.

Welcome to the new reality, where there's a whole lotta money looking for a home in the oil patch. In fact, potential investors of varied ilk often are flashing the kind of cash that conjures up memories of the boom days -- although this time around, rather than the reckless abandon of past cycles, it's being dispensed for the most part with intelligence and forethought.

Some of the available greenbacks are even being targeted not just for development projects but also for exploration, which for so long has been shunned by low-risk-demanding investors.

"I see a lot of enthusiasm for drilling, not seen among individual investors since the late '70s when everybody wanted to be in the drilling business," said James Gibbs, chairman of Dallas-based Five States Energy. "But you don't hear cocktail talk about drilling and starting up new companies all over the landscape like then.

"People can't go in and get a reasonable ROR (rate of return) by buying existing properties, so they're forced to do drilling," Gibbs said. "They would like to do development drilling, but there's not much of that available at a reasonable price, so then they're forced to be in the exploration business."

Bang for the Bucks

So where, you ask, is this money coming from?

Depending on who's talking, the sources are rife: both domestic and international individuals and companies (small), equity funds, banks and more. Not to be ignored is the sizeable amount of internal capital available for drilling at companies who have paid down debt -- thanks to soaring commodity prices -- and now have cash on hand for the drill bit.

"We see a different source than what it used to be when it was major companies and large independents," said Dan Smith, executive vice-president of Sandalwood Oil & Gas in Houston. "Now so much of it's coming from consortia put together with money raised from private sources, mostly high-end earners around the world."

These are not the doctor and dentist investors who once proliferated in the oil patch, convinced that every well would bring instant wealth. Rather, it's a wide range of individuals seeking more bang for their bucks than the paltry returns offered through such instruments as savings and money market accounts and CDs, according to Smith.

Gibbs concurs.

"If you want to see a 10-12 percent ROR, there's not many places you can safely do that," Gibbs said. "You have higher expectation of returns in exploration drilling than that; it's hard to find a higher ROR easily.

"Another thing is when the market collapsed after the tech era, people looked around, asking where's a better place for ROR," Gibbs noted. "Financial advisers and others began saying maybe we can get it in real assets, including timberlands and some types of real estate. So a lack of anything else is driving a lot of people to the oil business right now."

A Period of Transition

Along with the new money comes a renewed interest in cooperation, a recognition that everyone has to win, according to Robert Pledger, president of Swedish-owned Benchmark Oil & Gas.

"It used to be that people were willing to drill wells with you but weren't willing to cover the cost it causes you in running your business," Pledger said. "Now more companies say, 'Yeah, we'll joint venture with you, and while we're not going to pay for everything, we'll pay a reasonable markup.'

"That's kind of the cost of doing business that people are beginning to once again understand," Pledger noted. "They're saying we know this takes a lot of time, and let's do this thing together."

Even though clearly there is some infusion of capital into exploration activity, some folks say there's work yet to do to convince investors to sink their money here rather than the more sure-fire acquisition/development arena.

"We've reduced exploration risk significantly, but not enough to satisfy the banking community and various financial organizations," Smith said. "It still seems most of the big money sources -- big banks and such -- are earmarked for acquisition, along with some drilling if it's tied to production being acquired.

"I think we're in a transition now," Smith noted, "where if prices stay high, acquisition will stay slow, and in turn provide more money for exploration."

You Can Bank on It

Given the competition of multiple investors and investment vehicles on the scene, Gibbs asserts the banks are having difficulty pushing money out the door these days.

"They have plenty of money to lend, and they're making capital available at pretty good rates," Gibbs said. "If you have projects that need financing for development drilling, this money could free up capital for exploratory drilling."

Despite having ample funds on hand, the memory of being burned in the past is still fresh in the minds of the energy lenders at the banks. Indeed, the modus operandi currently appears to be one of "aggressive caution."

"When it comes to senior debt, the banking industry is a little more aggressive," said Stephen Kennedy, senior vice-president and manager of energy lending at Southwest Bank of Texas in Houston, "but we still stick closely to the tried and true parameters used for years.

"But in terms of the way we price credit facilities (interest rates and fees charged) we're becoming more competitive, because there's a lot more competition for investing," Kennedy said. "About half of the funds we lend are for acquisition and about half are used in the exploration segment for drilling wells.

"What we loan is predicated on existing reserves," he continued. "They can use the funds to drill, but repayment and collateral for that loan and the cash flow for repayment are all tied to existing production.

"We're slightly more aggressive with our structure and terms and much more aggressive in the way we price deals," he added, "not just because of the increase in the number of banks doing energy lending, but also because of fewer acquisition transactions in the last 18 months."

Mezzanine Investing

Senior bank debt provides capital, but it is not an actual investment in a company, Kennedy noted. It takes a lower risk profile than mezzanine or equity investing, with mezzanine being somewhere between bank debt and equity in terms of risk characteristics.

Because once-high-flying power companies such as Enron, Dynegy and others had groups to provide mezzanine financing, this type of funding is more limited now. A few new players have come in, according to Kennedy, and some private equity groups have stepped in to try to fill some of that mezzanine space.

Some institutional investors and banks, such as Southwest, participate in the E&P equity arena by investing in equity providers like EnCap, which recently completed investments from a $520 million fund. Kennedy noted it has raised another fund, which stood at $825 million at that time.

"A lot of companies they are funding are acquiring properties, but with a lot of drill sites or prospects on them, so a lot of capital is used to further develop those properties," Kennedy said. "This capital is usually underpinned by existing production but not 100 percent like with bank debt."

The Southwest energy group currently has $1 billion in loan commitments in its portfolio, with only about 45 percent of that actually doled out.

"Historically, we're closer to maybe 60 percent," Kennedy said, "and I think this is reflective of the really strong cash flow in the industry right now; companies are more liquid than they have been. Still, you wonder why there isn't more money flowing into the industry -- and why there isn't more drilling going on."

Kennedy voiced the now-familiar refrain echoing throughout the industry: "Wall Street has rewarded companies through acquisition growth more than the drill bit."

But this practice has the potential to come back to bite everyone, including the market makers.

"If we keep trading reserves," Kennedy said, "at some point the consumer is going to wake up and find there's not enough to go around. But Wall Street still isn't completely convinced we're on a long-term up-trend."