If you want an illustration of how the 2015-16 oil price crash hit the energy industry, take a look at the bankruptcy data. In January 2015 there was one chapter 11 bankruptcy filing by a US oil exploration and production company. By March 2018 144 companies had filed for bankruptcy, according to Haynes and Boone, a US law firm.
In the interim, oil prices had crashed from over $100 a barrel in mid-2015 to near $20 by mid-2016, caused in part by new techniques and more sophisticated machinery able to extract previously unprofitable ‘tight’ oil and gas by fracking. At these prices, explorers and producers were knocked out as fast as they had piled in.
Experiences of the last few years have led to what one investor describes as a “reassessment” of the oil and gas opportunity – and falling returns. “The last five to seven years have been extraordinary in how the industry has transformed,” says Mike Brand of Cambridge Associates. “Since unconventional techniques have taken hold [in the US] it’s really changed how new investments are made in the space particularly as it relates to private equity.”
Fracking turned the page in terms of what the investment opportunity is and private equity was all over that opportunity. Early in the onset of fracking, the main play was to buy land and grab as much as you could in the most economic basins, hold it, drill a well or two to prove there was enough there and then flip it upmarket.
“It was a surefire way to make a nice multiple on relatively smaller dollars invested in a short period of time. The IRRs were fantastic,” says Brand.
The numbers bear this out. The average IRR in 2013 for an oil and gas fund was nearly 14.5 percent. This couldn’t last. The rush to claim a slice of the fracking pie led to an overhang of capital as funds jumped in.
To illustrate the growth, Brand says that in the mid-2000s there were “probably 35-40 managers in Cambridge Associates’ universe of private equity energy managers. Fast forward 10 years and numbers had ballooned to over 150 active managers and it was growing.”
All of this led to a stalled exit market, with some companies having nowhere to go apart from Chapter 11.
“We’ve come to a point where North America-focused strategies are pretty saturated and capital rich so we’ve had to reassess what constitutes a GPs’ competitive advantage and also assess how to react to moderating returns in private equity energy over the last five to seven years,” Brand says.
“Moderated” returns mean sometimes much lower returns, compared with both historical averages and generalist LBO funds. By 2015 oil and gas fund IRRs had crashed to -12.44 percent and over a five-year view to 2017 have recorded a multiple of 1.28x. This compares with a 1.54 average multiple for LBO funds of the same vintages.
No more quick flips
Declining returns have forced a re-thinking of the opportunity that LPs say will require a shift in how value is created at underlying companies. “Private equity-backed companies could previously build a position, drill a handful of wells to prove out production and then sell to a larger acquirer or go public,” says James Korczak, partner on the primary investments team at Adams Street Partners. “Today, these same companies will likely need to invest more capital developing their properties and actually have meaningful production to be attractive for exit.”
Focusing on development rather than a quick asset flip will be the key to generating returns in the future, agrees Brand. “The industry has evolved from the opportunity being the land-grab to where you have to actually develop the asset. It means funds need to invest more into the portfolio companies, they need to buy the land and invest multiple millions to do the capex and hold these things longer.”
Korczak says that as capital built up Adams Street has had to adapt to the new realities. “We have shifted our focus onto smaller funds that are investing in smaller projects either in exploitation strategies or proving out smaller acreage positions in the core counties that will be attractive to larger exploration and production companies already operating large scale projects nearby.”
But the fundamentals have changed. “We’re at an inflection point in the industry and it is harder today to achieve returns comparable to those in the past,” says Brand. One reason is because, in 2018, oil and gas is just one part of the energy investment opportunity. Policy support to shift the world’s energy infrastructure onto a cleaner footing has resulted in a sector that is a challenge to fossil fuel dominance.
“We’re at a tipping point in the market. Close to 50 percent of infrastructure investment in each of the last two years was into renewables – this is likely to continue,” says Simon Eaves, head of Capital Dynamics’ European clean energy infra team. “Cost and efficiency improvements over the last few years means renewables are, on many levels, as competitive as fossil fuel energy.”
But like the fossil sector, the renewables industry is at its own inflection point. Subsidies are being withdrawn and “renewables are competing against other sources of energy, and investors and LPs have to think differently about how to invest in renewables”, says Eaves. “No longer can developers look to develop a renewable asset and get a supported route to market with 20-year subsidies.”
Even with this supported route to market, renewable investors have not always fared well. “If you look at the first generation of European renewable infrastructure funds, the vintages between 2008 and 2013, they got significantly hit in their returns from their investments in wind and solar PV parks,” says Martin Vogt, managing director at energy investment firm MPC Renewable Energies. “The investments either suffered from regulatory changes or too optimistic energy projections to the point of a zero percent return or even negative returns. In addition, the high leverage of those assets wiped out projected dividends.”
And now, in the absence of 20-year subsidies, Eaves says investors “may have to take a little more risk for additional return, such as taking more late development risk, or constructing these assets rather than just purchasing operating assets”.