Energy: Why upstream and midstream yield attractive opportunities

Investing in energy isn’t for the fainthearted. The cyclical nature of the industry means there will inevitably be the sort of downturns seen when the West Texas Intermediate crude oil spot price plummeted from three digits in late 2014 to $26.68 per barrel in January 2016.

To manage volatility risk, investors have developed a safety-oriented approach towards energy. LPs, such as the $11 billion Los Angeles Water and Power Employees Retirement System, limit the downside by targeting the upstream or midstream.

“The plan has found value creation in direct upstream growth equity energy funds,” says Jeremy Wolfson, the chief investment officer of WPERP. “We’ve seen opportunities in upstream deals with low leverage, board control and staging in capital when the firm meets certain milestones to help mitigate risk across the portfolios and economic cycles.”

WPERP allocated 3.2 percent of its total assets to private equity as of 31 January, with private equity accounting for about 15 percent.

The New Mexico State Investment Council, a $22 billion sovereign wealth fund based in Santa Fe, has focused its energy private market investments on a broad range of risk, geography and sub-sectors.

“Relative to oil and gas exploration and production, our general partners are primarily in the business of acquiring control of acreage and then proving up reserves with the goal of selling to a large-scale producer. We’ll take that risk with proven managers who have shown capability to acquire acreage and execute a timely sale through public or private markets,” says Paul Chapman, NMSIC’s director of real estate and real return.

“We’re also comfortable in midstream, primarily in contracted assets, where we know we’ll get good cashflow. It’s a relatively low-risk investment because it is cashflow-oriented.”

For example, most of NMSIC’s revenue from power generation investments is contracted, not merchant-priced. This means they tend to be lower risk because they have less commodity price exposure.

NMSIC categorises energy as part of its real assets portfolio, rather than private equity. Overall 5 percent of its net assets are allocated to real assets, which includes energy, infrastructure, timber and agriculture. Energy investments accounted for 25.8 percent of the real assets portfolio as of December 2016.

Thinking along similar lines, private markets firm Adams Street Partners eschews strategies with direct price exposures. “We are opportunistic with adding exposure to energy services as the cycle recovers, and avoid strategies that are reliant on leverage or commodity price gains to generate private equity returns,” says James Korczak, a partner on the primary investments team.

While it is keen to diversify across the energy sector, most of its funds of funds are focused on exploration and production and on midstream investments.

Track record is key, with many LPs cautious about new managers. The New Mexico fund, which currently has six different relationships through 10 different energy funds, prefers general partners that it has worked with previously.

Asked about the difficulty of getting access to quality managers, Chapman says: “We don’t really have a problem getting into the funds we want to, especially where we have an existing relationship with the GP.” He adds NMSIC doesn’t have a bias in terms of size, but smaller managers tend to get disqualified in the selection process because it takes a tremendous amount of resources and work to build relationships, access unique deals and demonstrate strong returns.

This is echoed by Adams Street’s Korczak, who says his firm backs experienced managers with success across business and commodity cycles.

But Hamilton Lane takes a slight different approach, actively targeting new and emerging managers. “Track record, organisation, operational practices etc, are the focus of our diligence and we do a lot of work to figure that out. Everyone’s always looking to find the up-and-coming managers. Our overall approach is a mix of some of the larger and some smaller managers,” says Brian Gildea, managing director of co-investments at the asset manager.

Sector diversification is crucial, he says. “It’s important to find the manager that’s going to select the right deal, as opposed to being all in this one area. And being diversified by segment within energy, whether it’s upstream, midstream, power or services, has been hugely important because those segments can perform differently across market cycles.”

Investors also want exposure across different vintages to guard again cyclical downturns. Wolfson of WPERP says the pension plan takes a long-term approach, with its energy exposure across vintage years at different parts of the cycle: “The typical investment period is across various years which can minimise the impact of market disruptions while allowing the funds to execute on opportunities that present themselves.”

Thanks to this strategy, WPERP’s energy exposure hasn’t changed in a material way, even throughout the most recent market downturn in the sector, Wolfson says.