Energy: Just what the doctor ordered

Fundraising may have struggled of late but there are definite signs of optimism among energy investors as oil prices recover.

General partners believe the energy investment climate is finally starting to turn, particularly in the US, with shale among the opportunities being targeted by private equity firms.

“We didn’t invest in a new company in 2015, but we are investing this year,” says Houston-based Will Honeybourne, managing director at First Reserve, a US energy private equity house. “We’re seeing a lot of dealflow, including some quality coming through. First Reserve has already made three investments in 2016, including two in US midstream companies: Plains All American and Western Gas Partners.”

Limited partners remain wary, though. Energy-focused closed-ended funds have raised only $2.1 billion between the beginning of this year and late May, according to PEI Research & Analytics. This compares with $31.4 billion for the whole of 2013 and $22.8 billion in 2015, despite tailing off later in that year.

“Energy fundraising has been pretty tough since the middle of last year,” says Jeff Eaton, Houston-based partner and head of origination at Eaton Partners, the fund placement agent. “A lot of that is to do with the uncertainty about prices.”

Ironically, “it also reflects strong energy fundraising for several years. Because they have invested a lot already, there’s no feeling among limited partners that if they don’t invest in funds today, they will miss out on investing opportunities when prices are low”.

The exceptions to this rule, says Eaton, fall into two categories: “Those managers doing something different” – investing in a particular niche, for example – and “those managers doing something better than the competition”.

As for the latter, he cites Post Oak Energy Capital, which closed its third fund in May after raising $600 million. Eaton Partners did not work on this fund.

Of course, the price environment has been highly uncertain. The benchmark front-month Brent crude oil futures contract hit $116 a barrel in June 2014, only to fall to a low of $27 in January before recovering to $53 by June.

That, in turn, has hit exits. “I don’t think you’re going to see many, if any, exits for a while other than random cases – probably not until oil goes higher than $60 or $65,” says William Sonneborn, president of the private equity firm EIG Global Energy Partners, located in Washington, DC.

OBSCENE LEVERAGE
But Sonneborn is optimistic that the investing climate is finally beginning to turn, especially in the US shale sector which was hit hard by the price falls.

Lower oil and natural gas prices – the latter pushed down by the surge in shale production – threatened the viability of North American upstream shale ventures more than any other part of the industry.

Reacting to this, many firms shifted their interest to parts of the energy sector less affected by falling commodity prices.

“We became very bearish on US shale in 2013,” says Sonneborn. By the middle of 2014, “we were telling our limited partners that never in our 32-year history had we seen US upstream so overvalued. The amount of financial leverage in the sector was enormous to the point of becoming obscene”.

He notes that some private equity-funded companies were buying undeveloped land for $50,000 an acre, compared with an historical average of $3,000-$5,000. Responding to this fever, “we spent most of our time investing in other markets around the world”.

These included various renewable transactions, such as its November 2014 investment in Greenko, an owner and operator of clean energy projects in India.

But now EIG is changing its priorities again. “We are finally starting to develop an interest in US shale,” he says. “We think valuations are becoming much more attractive, though we also see interesting opportunities in other parts of the world.”

Renewed interest in North American shale exploration and production is based on pricing – in part the rising price of crude oil, and in part the much lower price of shale assets.

Sonneborn has observed a heavy imbalance between the small number of buyers and large number of sellers, given that about 80 US energy companies have filed for bankruptcy.

Because of this dynamic, EIG is in “advanced negotiations” to make an investment in the Permian Basin for a price of around $3,000 an acre. In this case the seller is not distressed, though Sonneborn says that EIG is also interested in distressed assets. This includes US power plants hit by falling revenue – the prices they charge under long-term contracts are linked to natural gas prices – as well as upstream oil and gas assets.

The recovery in prices is also making upstream investments to drill for oil in other parts of the world more attractive. The result is a reordering of priorities among general partners. “For the last five years we’ve invested more in midstream and downstream than upstream,” says Marcel van Poeke, head of Carlyle Group’s ex-North America energy business, Carlyle International Energy Partners, in London. “But with oil prices stabilising, upstream is becoming much more attractive.”

Van Poeke also thinks upstream investments will be not just more appealing but also increasingly available. He forecasts a rise in M&A activity in the second half of this year, as oil majors return to their regular divestiture of assets to fund dividends and capital expenditure after refraining from this while oil prices were so low.

For many general partners, the mild recovery in the oil price is just what the doctor ordered. When it was below $30, few upstream assets looked viable. In North America even midstream assets looked unpromising, with pipeline operators hit by falling volumes of oil and gas throughput, though private equity houses showed interest in companies providing downstream services to refiners, since refining margins tend to rise when crude prices are low.

However, if prices return to anywhere near the 2014 peak, many high-quality assets, with good balance sheets, strong management and good production prospects, will begin to look extremely expensive because sellers will raise their prices.

Honeybourne of First Reserve summarises the situation: “We see opportunities at the quality end, for assets for which we frankly didn’t get a look in at $100 oil.”

His reference to the “quality end”, however, encapsulates an unresolved tension within the energy private equity market: how much should GPs focus on price and how much on quality?

First Reserve is concentrating on quality, while acknowledging that other assets are cheaper.

“There are some other private equity firms that are just playing the energy cycle,” he says. “In today’s down cycle … they are investing in third-tier opportunities in North America”: companies which may have weak management teams, poor balance sheets, low market share in a particular service offering, or a combination of these. “It may be a hell of a long time before any of that stuff recovers.”

But with oil and gas prices having been so low for so long, “there’s a lot of desperation in the sector. I’m sure you can buy lots of stuff real cheap if you want to”.