Far from being spooked by the vertiginous tumble in the global price of crude oil, private equity investors are seeing the down cycle as a buying opportunity.
“We are hearing from our LPs that they want us to get them as much exposure as possible right now,” says Frost Cochran, managing director of Dallas-based Post Oak Energy Capital. “Our LPs view the current situation as an opportunity to get longer in the space, and while I can’t speak for other firms, I would be surprised if they are not hearing the same things.”
West Texas Intermediate crude, the US domestic benchmark, peaked at $106 a barrel in July 2014, before tumbling to a low of $44 in January, while the international benchmark, Brent Crude, peaked at $114 in June 2014 before plunging to $45 in January. Both have staged modest recoveries since but were still trading at below half of last year’s peak in mid-February.
As a result, most producing companies have reduced capital budgets for this year, especially in the more expensive unconventional shale plays with high drilling costs. The number of drilling rigs has fallen dramatically, but development continues in most regions, albeit at a slower rate. And while production growth is slowing, there is no expectation of an actual decline in oil production until well into 2016 at the earliest.
“When we think about the upstream exploration and production business, both strategically and tactically, we recognise that there are cycles,” says David B. Krieger, managing director with Warburg Pincus. “Over long periods of time, on average, the upstream exploration and production industry has delivered a 10-12 percent return on assets.”
RATE OF RETURN IS THE REAL DRIVER
Late in October 2014, the firm closed Warburg Pincus Energy, L.P. at $4 billion, surpassing its fundraising target of $3 billion and reaching the fund cap agreed with investors. The fund was launched in November 2013 and held an oversubscribed first close in May 2014. It will focus primarily on E&P in North America, but will also be looking for opportunities elsewhere. In addition to E&P, Warburg Pincus Energy will also pursue opportunities in the midstream, oilfield services, mining, and power sectors around the world.
“What we aim to do in our energy investing is to select teams that can generate reserves, production, and cash flow at a sustainable basis throughout the cycles in the sector,” Krieger explains. “We focus on margin, and that is adjusted with the cycles. We look at what has happened recently and work with our operating teams on how to maximise margins in the current environment.”
Krieger is based in New York and has focused exclusively on energy since joining the firm in 2000. He serves as a director of Black Swan Energy, Canbriam Energy, Endurance Energy, Kosmos Energy, MEG Energy, Osum Oil Sands and Velvet Energy.
“We and our operating teams are looking at service costs as they are adjusted to the commodity price cycle,” says Krieger, “and also to maximise capital efficiency by drilling great wells and acquiring great assets. There is always a balance between drilling and acquiring wells or acres. That varies idiosyncratically by locality.”
Notably, Krieger does not dwell on either the price of oil itself, or on driving down capex or rig counts. “We are driven by rate of return. Our companies want to drill consistently within the rate of return that underwrote the investment in the first place.”
“This is very much a long-term opportunity of the kind not seen since 2008,” says Post Oak’s Cochran. “We certainly don’t want to try to call a bottom, we are getting strong green-light signals already.” Cochran says energy-focused firms like Post Oak do not run their portfolio companies with much leverage so are less likely than some other operators to be under pressure from lender redeterminations.
PRICED FOR PERFECTION
Private equity and oil-industry veterans are wise enough not to hazard a guess about the length of any leg of the commodity price cycle but they can assess the factors. Cochran points out that supply is actually running just a few million barrels ahead of demand.
“In a historical context, that is a fairly thin oversupply. Absent a deep recession or other demand factor the current market does not seem structurally set up for a very long trough.”
He also notes that “oil is priced for perfection at the moment. There is zero war premium right now in the price of oil, and that is at a time when all producing regions are on line. Traders are playing the contango and buying all the physical commodity they can and putting it into storage against some change in production.”
Downstream from the wellhead there has been a real change in the competitive landscape, according to Sam Pitts, managing director of EnCap Flatrock Midstream (EFM) and head of the San Antonio-based firm’s new Houston office.
“There has been a much greater acceptance among producers of private-equity-backed midstream operators. That is because they can be more flexible, more focused on the producers’ specific projects.”
The current downturn in oil prices and reduction in development plans by producers has underscored that, he adds. “Some producers have been disappointed by some of the bigger and public midstream firms. Our portfolio companies have had and will have opportunities to step up.”
EFM’s companies tend to be focused on a single basin, and have fewer customers than the bigger public or MLP-backed midstream operators, says Pitts.
“Where there once was reluctance by producers to work with a start-up midstream enterprise, it is now seen as a good alignment in terms of both speed and utilisation. The current situation in the sector creates a very attractive competitive dynamic for us.”
“Success in the midstream starts with success upstream,” states William R. Lemmons Jr., managing partner at EnCap Flatrock. “We feel pretty good about our positions. Our portfolio companies are managed by a very capable and highly experienced team who are staying very much plugged in to their customers and responding as producers make adjustments.
“These include slowing plans to expanding gathering and processing systems, to something as small as changing the diameter of a pipe,” says Lemmons.
“But also include optimising existing assets and looking at expansions to make certain our companies are well positioned to meet producer needs when prices come back and activity ramps up.”
But EnCap Flatrock is not all about defense. Lemmons says the firm has a lot of ‘dry powder’ to put to use and an experienced senior team that has been through previous commodity cycles.
“We have seen how important it is to be careful with leverage. Over the course of the last year we saw a lot of producers step into the high yield market.”
Pitts concurs. “There was $13 billion of upstream M&A in October. Not many people had on their radar a high probability of long-term $50 oil. The threshold of having a relatively pristine balance sheet versus being perilously levered changes fast when your cash flow gets cut in half. But this is a ruthless market and people are waking up on the wrong side of that threshold lately.”
Lemmons adds: ‘This is a challenging time for everyone, us included. Our point is that there will also be opportunities. Our companies have mostly grown organically through greenfield projects. There may be more opportunities for M&A in the near future.”