If you thought 2011 was a big year for energy investments, wait until you see 2012.
Several factors that helped drive investors into funds targeting the asset class in 2011 will likely continue through next year. The outlook for oil prices should remain strong, barring some sort of global meltdown. Improved technology has created new sub-sectors in the space, including in shale investments, which will lower the risk on future investments. Third, and most importantly, energy assets create a relatively safe alternative to fixed income at a time when lower interest rates are driving down returns for the asset class.
Institutional investors’ energy investments double as a proxy for fixed income because they occur along a continuum of returns. For example, with shale investments, you have the potential for a play as an early mover when you acquire acreage. If you flip that acreage, you can make as much as 3x to 4x your cost. Next, someone will usually enter and start operating wells on the site – and that’s what delineates the potential for that specific investment. They can either hold it or sell it to someone who will buy it at a 10 or 12 percent discount rate – and since the well is producing, you’ve got a proxy for a bond that’s yielding 10 or 12 percent.
As more firms buy wells, you will also a see a spike in the number of funds that focus on operations that support the oil, gas and energy industry. It’s a classic case of remembering the lessons of the California Gold Rush. The people who went west to look for gold didn’t always come back millionaires, but the businessmen who sold them denim jeans, mining equipment and tents made a fortune.
The development of service companies that cater to the energy sector is particularly strong in the fracking industry, when companies drill for natural gas under shale rock formations. Shale plays are equipment hogs, and put a lot of stress on the equipment. Whether it’s the frack equipment or drills, everything gets chewed up. Between the number of wells being drilled and the depreciation of the equipment, there is a strong demand for companies that can provide operational support to the growing industry.
The key is going to be identifying who can produce these hydrocarbons at the lowest cost. When it comes to shale plays, one of the things that people are beginning to understand is that not all shales are created equal. There will be a learning curve on determining which shales are more economic. Over the next couple of years, you’ll see investors start to develop a better understanding of these factors, which will generate more consistent returns.
Michael McMahon is a managing director at Pine Brook Partners.