After a semblance of recovery in 2018 that had many private equity market participants optimistic that deal activity and fundraising in the energy market would rebound and the sector would turn a corner, oil prices declined in a meaningful way in the fourth quarter. Although they have come back to some extent since then, the volatility seems to be here to stay.
Oil and valuations volatility reign
The price of West Texas Intermediate crude oil fell to a 17-month low at the end of December at $45.88 a barrel, after hovering around $75 a few months prior.
It has since recovered but only stood at $56.59 a barrel at the end of May amid global trade war worries and supply decline.
It has resulted in weakened deal activity. As of the end of April, private equity firms invested only $9.9 billion in 37 US energy transactions, according to data from PitchBook, down from $64.8 billion across 220 deals last year, $59.8 billion in 222 deals in 2017 and $55.5 billion in 290 deals in 2016.
“It’s a fairly subdued market for oil and gas transactions,” says Brent Burnett, managing director on the real assets team at Hamilton Lane. “There isn’t a lot of market appetite for new deals. That’s brought valuations down. It’s created some opportunities on the smaller side for some of the larger groups monetising some of their non-core holdings. But those transactions have been relatively small and have not really been driving big deal activity.”
Transactions on the upstream side have been particularly impacted, while deals in midstream have fared a little better. In particular, general partners investing in energy have continued to focus on the Permian Basin in west Texas and to a lesser extent on the Haynesville-Cotton Valley in north-east Texas and north-west Louisiana for shale gas.
Secondaries supply could outstrip demand
Other LPs have opted to tap the secondaries market.
“I think the secondaries sales have really come from a couple of places,” says Burnett. “They’ve come from LPs that are a little bit discouraged that their energy portfolios haven’t performed, so they are overweighting other sectors. They’re still selling some names that are of reasonable quality. They’ve also come from institutions that have taken a step back from any kind of fossil fuel investing and have looked to completely liquidate their energy portfolios.”
GPs have also turned to the secondaries market for liquidity hoping to recap funds and return cash to investors, but few deals are being done due to a wide bid/ask spread.
“I do think we’re approaching a situation where the supply of managers looking to do a secondary transaction or fund recap as a way of providing their LPs with liquidity is far greater than the demand from secondaries buyers looking to put more money into the space,” says Jeff Eaton, a partner and the global head of origination at Eaton Partners.
“It implies the bids for these transactions are going to be significantly lower and there will be fewer transactions done because sellers are not going to want to sell at a discount and buyers are not going to want to buy anything unless at a big discount.”
David Foley, a senior managing director in the private equity group at Blackstone and chief executive of Blackstone Energy Partners, says: “When there are mergers of large companies like Occidental and Anadarko … there are always pieces that are not core and that they want to divest for cash. What Chevron or Occidental might consider a smallish, non-core asset, could be a very nice and sizeable deal for us.”
Returns are being hit by a dearth of exits
Exits have been few and far between, while publicly traded companies have also suffered from depressed valuations, preventing them from actively making strategic acquisitions, which would send cash back to investors.
The S&P 500 Energy sector index was up only 3.57 percent for the year as of 30 May, compared with 11.25 percent for the overall S&P 500.
“Crude oil prices rebounded during the first few months of this year after collapsing in late 2018,” says Foley.
“However, public equity share prices of energy companies, which fell sharply in late 2018 alongside crude oil prices, have not fully recovered and valuation multiples continue to compress for companies in the energy sector.”
That has also meant GPs have not been able to exit portfolio companies through the IPO market. With few exits, distributions and returns have gone down.
Such a dire environment has prompted LPs to rethink their exposure to energy funds. Some institutional investors are holding off and not committing more to energy funds, which has become evident when looking at fundraising figures.
Between 2016 and 2018, energy-focused funds raised on average $14.17 billion per year, nearly half of the average – $27.27 billion – raised per year for 2013-15.
Occidental highlights M&A opportunities
While the energy sector has been volatile and activity has remained subdued, it is not all negative.
There have not been many distressed portfolio companies yet, although market participants warn that if the current environment continues, private owners of smaller assets might not be able to keep funding them and distressed opportunities could arise.
The most promising glimmer of hope may come from the recent bidding war between Occidental Petroleum and Chevron for Anadarko Petroleum and the subsequent $38 billion deal won by Occidental. Occidental could divest billions of assets from Anadarko to reduce debt, which would be a boon for private equity investors and would prompt an uptick in the M&A market.
“When there are mergers of large companies like Occidental and Anadarko, or the sale last year of BHP’s onshore US business to BP, there are always pieces that are not core and that they want to divest for cash,” Foley says. “What Chevron or Occidental might consider a smallish, non-core asset, could be a very nice and sizeable deal for us.”
The rebound will take a while…
…but in the short term, the outlook for the private equity energy sector remains grim.
Volatility in the energy space is here to stay and it might take a couple of years more for the sector to rebound. “It was a very strong returning sector historically, and yet the last four or five years have been pretty challenging for institutional investors and their energy portfolios,” says Burnett.
“M&A activity has remained very low since Q4 2018,” Foley says. “You’ve had one big deal so far this year, the contest between Occidental and Chevron for Anadarko, but so far that’s a bit of an anomaly.
“Do other major companies want to acquire high-quality acreage, particularly in the Permian? Yes, but they aren’t rushing to do so right now and are trying to show their shareholders and the rating agencies that they can live within internally generated cashflow to fund organic growth rather than issuing equity or debt for acquisitions. Consolidation is definitely needed and I believe activity will accelerate over the next few years, starting with top quartile assets.”