[Editor's note: A version of this story appears in the Capital Options 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

In mid-August, Sanchez Energy Corp. joined the still small but now-growing list of upstream independents for whom the shale boom has gone bust. With the Chapter 11 bankruptcy filing, Sanchez joins a list of 2019 E&P bankruptcies that includes Legacy Reserves LP, Vanguard Natural Resources LLC, Arsenal Energy Holdings LLC and several others.

E&P companies have been under pressure by shareholders to focus on returns instead of growth. But the volatile nature of the oil business, which has seen oil prices rise post-downturn but nowhere near pre-downturn levels, has left some companies—most of which are saddled with debt— struggling to stay afloat.

Investors, investment bankers and lenders have been down on the upstream for quite some time. In April, Hart Energy reported the somber mood at the usually convivial annual Oil & Gas Investment Symposium (OGIS) sponsored by the Independent Petroleum Association of America in New York. Investors did not seem eager to move. Of the overall conference one said, “I’m not really looking for anything in particular. I’m just trying to understand where the sector is now. I have not been paying it much attention for the past few years.” Another investor said simply, “I have not been wowed.”

Producers seeking capital do have a few options remaining, even though public markets are largely closed to them. A few deals have been getting done but only for the highest quality assets that are immediately accretive to the acquirer. The mood remains dour, though a contrarian view is starting to coalesce. That is: The sector has been down so far for so long that it does not have much further to fall. The uptick in bankruptcies is taken as confirmation that capitulation is at hand. With broader markets teetering near the end of a 10-year bull run, the relative ratio of upside to downside favors the out-of-favor upstream segment.

Michael Bodino, managing director of investment banking at Seaport Global Securities LLC, based in Dallas, suggested that energy, specifically upstream independents, could have an opportunity when the market stalls. For that to materialize, he stressed that several factors, within the sector as well as without, have to break favorably.

“Upstream has been bouncing along historic low valuations,” Bodino said. “At present, it does not seem to be getting any worse, but neither is it getting much better yet. These days, I think of energy almost as a safe haven because it has hard assets that will retain value if the broader market cracks.”

To be sure, the sector remains out of favor, and for good reason, Bodino noted. Both upstream and services equities have been down, while the midstream has done well. There has simply been massive under-performance for years. After the E&P Index outperformed the S&P 500 by about 15 percentage points in 2009 and ’10, both were about zero in 2012. E&P has underperformed the broader market in seven of the eight most recent years, by an average of 24.5 percentage points. “Institutional investors simply cannot get into energy; they would get their heads ripped off,” said Bodino.

The retreat from energy has become structural, Bodino explained. Over the past 10 years, the weighting of energy in the S&P 500 has shriveled from 13.14% to 4.99%, a decrease of almost two-thirds. Of the 10 major categories, it has lost the most shares.

Potential for free cash

“This is a relative performance game,” said Bodino. “Money has been moving out because of the long run of underperformance. What seems to have been lost in the shuffle is the fact that enterprise values have not changed for many of these companies, even though many of them have doubled their cash flow. That is staggering. The market is not paying for growth but is rewarding companies for being capital independent. If companies can execute on the plans they detail in their presentations, this sector could be on course to generate 5% free cash next year.”

If they cannot execute, things could get even worse, precisely because the sector has few other sources of capital. “Private equity has recently had tremendous fundraising problems for upstream strategies,” said Bodino. “It’s hard for them to convince investors of a valuation on paper when assets have been offered and not taken. That is a failed sale. PE is finding it necessary to keep assets longer and grow production.”

All of that is leading to an increase in combinations among stand-alone entities but also among portfolio operators. “There are three criteria to judge a combination today,” said Bodino. “Is it accretive to the acquirer, in terms of enterprise value to EBITDA; does it reduce leverage on the balance sheet; and does it add inventory that competes with other assets for capital?”

The last resort is still high-yield debt, even though the high is getting more so. “Over the past 10 years, high-yield rates have commonly had a 6 or 7 handle. Now that has moved to 9 or 10,” said Bodino. “Investors and lenders are showing these days that they don’t want growth; they want capital, equity or return. Producers that can show yield and return cash to investors or lenders will be rewarded.”

Reflecting on the crude and gas differentials and the implications they have for independent producers, David Foley, senior managing director and chief executive officer at Blackstone Energy Partners LP, suggested that much of the current chill in public markets for new equity and debt fund raising by upstream companies may be warranted.

“Once producers demonstrate that they can exercise some self-discipline, funding all of their expenses, capital expenditures necessary to at least maintain production volumes, make interest and tax payments, and oh a dividend would be nice, then generalist investors and public capital markets will reopen to the sector. But at present no one is willing to pay for more reserve booking and more drilling inventory.”

The market for publicly traded master limited partnerships (MLPs), which have been used to fund much of the midstream infrastructure in the U.S., has also been depressed, Foley noted. “With a dearth of capital inflows, private investors still find midstream a desirable area to deploy capital. There is a lot of appetite, some of it probably underestimating the risk and commodity price exposure of certain assets. High quality existing assets with revenues backed by long term-contracts probably should be valued at a more modest return target to reflect the stability of cash flow and lower risk,” said Foley.

Another relative value game

An important driver for midstream investment is the compression of returns on fixed income and cash yielding assets anywhere else. “European sovereign debt has a negative interest rate,” said Foley. “U.S. Treasuries are paying about 2%. Compared to that, a 6% or 8% cash dividend plus growth on midstream assets looks pretty good, as long as they have staying power.

“Once Blackstone Energy Partners and our management teams have borne the higher risk to develop, find long term revenue contracts and subsequently construct the pipelines, power generation facilities, etc., those assets are basically long-term investment grade bonds that can deliver reliable current cash dividends for many years into the future. Sovereign wealth funds and infrastructure funds are clamoring for assets with those characteristics.”

One way some companies have tried to strengthen their positions is to convert themselves from partnerships to traditional C-corporations. Christopher Sighinolfi, managing director for gas, utilities, midstream and refining at Jefferies, said his analysts “don’t find any meaningful difference. There is a greater appetite for traditional C-corp structures among institutional investors and offshore funds, but the well-capitalized operators can ride out the tide of active rather than passive administration. The prudent teams will adjust their balance sheets.”

Public capital has eschewed producers, especially unconventional operators, for several years now. It might seem that midstream companies would be insulated, but Sighinolfi suggested that the situation is not clear cut. “If an operator does not have a tether to export, that will be an issue for investors. The vertically integrated networks become more viable with more market options.”

Phil Lookadoo is fully aware of these current trends. He is a partner at Haynes & Boone LP with practice in energy transactions, regulatory compliance in oil and gas, power and renewables, commodity trading and derivatives, mergers and acquisitions, as well as project finance and development.

For several years during and after the last down cycle in the upstream sector, Haynes & Boone released a quarterly synopsis and analysis of oil and gas bankruptcies. That series has continued. Reflecting on persistent high production and low returns, Lookadoo noted, “a friend in the midstream called me recently asking if we have one [a report] for this year. Renewed interest in that report may be a sign of things to come.”

That growing concern throws a harsh light on the already limited capital options for producers. “The challenge for investors is where they think the future is for the oil and gas industry,” said Lookadoo. “‘What do they think the long-term plan is for producers?’ The issues of economic and environmental sustainability and shareholder activism are important to investors, as is the lack of a coherent national energy policy. Those concerns definitely affect investor appetite for the sector.”

Inherent value in existing infrastructure

Appetite for the resource is the key unknown. “I don’t have a crystal ball,” said Lookadoo, “but I do see mobile sources of emissions—vehicles—moving to a mostly electric or at least hybrid fleet. But I do not see power generation moving to all renewables. A mostly electric vehicle fleet moves the issue of emissions control to larger stationary sources where emissions can be more effectively and economically captured. Building carbon capture into power plant development will take climate risk and uncertainty concerns out of the equation.”

However the hydrocarbon consumption sector develops, Lookadoo expects that the controlling factors will be cost and utility. It is much more likely for existing infrastructure and supply chains to evolve than for whole new assets and systems to be funded and built. “For example, using liquid organic hydrogen carriers and hydrogen fuel cells for electric cars is a more efficient use of existing fuel distribution infrastructure and would reduce many of the international (political and economic) risks of relying entirely on batteries for electric vehicle fleets.”

“If the demand side materializes in those sorts of ways, that would give the E&P sector a shot in the arm,” said Lookadoo. “If long-term viability and thus value could be made more secure, then immediate concerns about immediate profitability become less.”

In the near term, however, prices for oil and gas continue to be depressed and yet production continues to grow. “Even so, we do see real increases in demand for natural gas with a role in the global economy. As that grows, it seems reasonable to expect that pricing may become more stable.”

Political uncertainty

Oil remains even more of a question mark, however. “Sovereign wealth funds, private equity and other institutional investors don’t know where the upstream sector is going long-term,” said Lookadoo. “We see the same thing in plastics. The export market seems to be the answer for everyone. If an investor does not know what the future looks like for an industry, a company or an asset, it is difficult to determine value. Certainly there is value in the upstream sector, and in export markets, but no one seems to know what it is or what itlooks like.”

Ethan H. Bellamy, senior research analyst at Baird Equity Research stressed factors outside the immediate industry. “What is missing from the discussion on gas supply is the political and regulatory uncertainty,” Bellamy said. “That is an increased concern regarding carbon. We are already well into the campaign ahead of the 2020 elections. Many of the candidates for the Democratic Party have advocated against hydrocarbons. One has suggested an outright ban on energy exports. Others have suggested eliminating further leasing on federal lands, including the Gulf of Mexico.” Most support some type of carbon tax. In contrast, the current administration has been a strident advocate for coal, leaving gas in the middle without a champion.

“The perverse reality for gas producers and investors,” Bellamy explained, “is that the best thing to hope for would be the victory of a moderate Democrat. That would be incredibly positive for gas prices because any limitations on leasing or development would increase the value of existing assets and operations.”

The range of possible outcomes depending on what happens in November 2020 is so varied that Bellamy cautioned, “Any forecast for gas prices beyond the third quarter of 2020 has got to have at least two different lines. There is a huge swing in eventualities. Some operations and companies will benefit greatly, others will be hurt.” Almost like the old sailing charts with vast unexplored areas marked ominously, here be dragons.

In the long run, Bellamy sees the gas midstream, especially in the Permian, as an attractive place for investment. “There is no shortage of private equity capital for building the infrastructure to move that glut of Permian gas to the Gulf Coast,” he said. “Ultimately that will benefit LNG producers and buyers, LPG producers and buyers, and so forth. There are a lot of midstream opportunities.”

Keeping that larger perspective, Bellamy assessed that “we are in the midst of a massive world-wide realignment in hydrocarbons, especially gas, from demand pull to supply push.” That means both upstream and midstream operators must be aware of the shifting geopolitical sand. “You can know everything about your own industry, but if you don’t pay attention to global macro-economic issues, you can still get run over.”

Specifically, he cited the federal debt of $22 trillion, as well as “ridiculously accommodative” monetary policy. “Easy money and loose regulation always create malinvestment. Excess capital has shredded margins in this business. But if the punch bowl is taken away, that would be good for existing assets and bad for anyone subscribing to the greater fool theory.”
 

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