Energy: The calm after the storm

The rebound in crude oil prices from the January low of $27 is a welcome boost for limited partners, many of whom have seen their exposure to the energy sector battered over the last two years.

With the higher oil price has come higher portfolio valuations.

“Recovery in prices has been helpful, with markups [in our portfolio valuation] in 31 March compared to 31 December,” Karl Polen, chief investment officer of the $36 billion Arizona State Retirement System, tells Private Equity International.

By June, Brent crude had recovered to above $50 – levels similar to those seen in the latter half of 2015 – in what optimists hope could be a signal that the worst of the cycle is behind us.

For LPs, it is another indication of the long-term nature of private equity investing, and the need to look into the future for any sure signs of recovery, rather than to try to time the markets during a fund’s lifecycle.

“The one thing that we know enough is that we don’t know. These are minute movements over the course of the multi-decade relationships with our members,” says Jon Grabel, chief investment officer at the $14 billion Public Employees Retirement Association of New Mexico.

Indeed many institutional investors were still committing capital to energy-focused funds over the last few quarters, even as oil prices were falling. The Teachers’ Retirement System of the State of Illinois and New Hampshire Retirement System each committed $50 million, and Dallas Police and Fire Pension System $10 million, to Riverstone Capital Partners, according to PEI Research & Analytics.

Meanwhile, the Louisiana State Employees’ Retirement System committed $50 million in September to Bernhard Capital Partners’ inaugural, energy-focused fund that closed in May on its $750 million target.

The specific interests within the broader sector haven’t changed much, either. Brian Gildea, managing director of the global co-investment team at Hamilton Lane, a $252 billion independent alternative investment management firm, says the upstream energy areas are still interesting to LPs.

In recent years, private equity funds have been shifting their focus to core assets where they can make operational improvements – an investment approach that LPs support, he says.

Jay Yoder, partner and head of real assets at institutional investor advisor Altius Associates, which manages and advises about $30 billion, says many of his clients remain committed to the energy sector.

“In general, investors’ allocations to real assets have been increasing for 20 years and will continue to grow as investors become more comfortable with the asset class,” he says, adding that 2016 will likely be a great vintage year for energy funds. “We do think this year could be a particularly good time to put capital to work.”

But what of those investors who have taken a shorter term approach, and have tried to raise distressed funds to take advantage of the bearish environment? Blackstone, for example, in February launched Clarion Offshore Partners, backed by its private equity funds, which will invest in assets in the offshore oil and gas drilling and services sector. It will provide growth capital to fund market expansion and consolidation opportunities, with a specific focus on financing special situations to help balance sheet restructuring among struggling oil producers.

“Balance sheets are under severe pressure, existing operators are challenged to deploy assets, and related parties throughout the value chain are also facing financial pressures,” Clarion co-founder and chairman Louis Raspino said at the time of the launch. “This is an opportune time in the industry for a well-capitalised and experienced team to provide creative financing and operational solutions.”

It is an approach that relies on finding investment opportunities among energy companies defaulting on their debt.

Altius’s Yoder has noted an increase in distressed funds in the energy sector, but says the approach requires technical expertise that some distressed-debt funds lack.

“We were concerned that much of the money raised [in this space] was by firms experienced in distressed but not much in energy,” Yoder says. “The energy space is a very technical sector; one where you really need specialised expertise.”

Grabel agrees, saying market timing doesn’t work in private equity.

But others remain convinced that distressed deals offer big opportunities. In its first-quarter earnings call, Apollo Global Management co-founder and senior managing director Josh Harris told investors the firm had done some recent distressed deals, including one with Warrior Met Coal, which is owned by the first lien creditors of Walter Energy. He added at the time that there were $60 billion in distressed debt assets, 80 percent of which were in natural resources and energy.

At Blackstone’s first-quarter earnings call, chief financial officer and senior managing director Michael Chae said the private equity giant had $14 billion in dry powder, including “nearly all of” its distressed energy funds.

Many think there are still plenty of opportunities for distressed funds to deploy capital, because, even at current oil prices, a lot of struggling businesses will find it hard to keep operating.

“Some companies were hit really hard and not many of them have bounced back yet,” says Hamilton Lane’s Gildea.

“It still feels like the early stages of seeing some shakeouts, which will go on for some time because there are a lot of struggling businesses out there. They’re likely to face further pain from declining activity or unsustainable capital structures.”

The rebound in the oil price since the start of the year has brought a sense of optimism that the worst may be over for struggling producers.

The international benchmark Brent crude has recovered since hitting a near 13-year low of $27 in January, reaching $53 in June. Investment banks including JP Morgan and Citigroup have raised their forecasts for the year. Citi analysts say we could be looking at $65 by the end of 2017, but remain cautious, saying stability in the oil market remains “elusive”. “The brave new world of petroleum promises to be volatile,” they said in a report, conceding they only have a “65 percent or so” confidence in the $65 prediction.

Positive factors for the oil price include stronger demand from the big emerging economies, notably China and India, and supply restrictions in Nigeria.

But naysayers remain, notably BP’s chief economist Spencer Dale who says excess supply from Saudia Arabia and Iraq will ensure a global glut that will hold down prices until 2018. US shale producers are also expected to pump out more as prices rally, and increased supply from Iran could also dampen price rises. No wonder the analysts at Citi are hedging their bets.