Oil and Gas Investor: A&D in the Age of Realism

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[Editor's note: A version of this story appears in the July 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

In July 2016, Deutsche Bank analysts reported almost as a footnote that private equity firm KKR & Co. Inc. had $2 billion available and ready to spend on energy investments. The somewhat hackneyed term for this largess is dry powder.

The next year, Jefferies estimated that energy-focused funds had about $100 billion ready to deploy. These were the powder keg years, with private equity chasing after sparks in Texas, the Rockies and the Northeast.

Whether those days fizzled or dazzled for private equity firms, there’s a growing sense that the keg is running empty—and with it an acknowledgment that money won’t be raised quite the same way again. That also means potential pressure on sellers who want a good price but may see their off ramps running low on cash.

Recent deals by private equity firms show a maturation in dealmaking from the buy-drillflip days of shale glory to a more measured approach that considers a company’s geography—possible merger partners, access to infrastructure—as much as its geology.

Brad Morse, founder and president of Fulcrum Energy Capital Funds, said that private equity firms are starting to see a little of the writing on the wall.

Fulcrum Energy, which raised about $200 million for acquisitions, has seen the industry downshift into a less capital intensive, development-oriented environment.

Private equity firms’ model of raising funds to spend on later projects is being challenged by a variety of factors, including more sophisticated investors and the need for co-investors for larger acquisitions.

Private equity isn’t necessarily built to access large amounts of capital as quickly as partnering with larger investor classes. Investors may be more reluctant now to participate in direct investment or in limited partnerships that only vaguely outline objectives and potential acquisition targets.

“Now it’s different,” Morse said. “It’s been a challenge for us to raise large blind pool funds from institutional investors. However, we have had success raising funds for specific pre-identified investments.”

Larger funds such as EnCap Investments LP are more flexible and fortunate, said partner Brad A. Thielemann.

EnCap retains more than $4 billion of dry powder in Fund XI—a $7 billion fund raised in 2017 that is largely earmarked for upstream investment.

Thielemann said raising new upstream funds will likely be more challenging going forward.

“Given the volatility in commodity prices over last year, and frankly, poorer returns that certain funds have had, there’s some reluctance from some investors to commit to blind pool funds,” he said.

Investors may wonder if the private equity model for blind pools is worth an investment. EnCap’s investors continued to give the firm strong support and in first-quarter 2021, EnCap distributed nearly $1 billion back to them while also making significant acquisitions.

“We’re optimistic, and we think there’s a lot of opportunity right now in the market, particularly for those funds and companies that have access to capital,” he said.

Nevertheless, Thielemann said that there will be fewer upstream funds going forward.

“If we just look at the big picture, the number of private equity funds that are going to be exclusively focused on upstream are likely to shrink compared to the past five years,” he said.

With capital harder to raise, funds are likely to be more concentrated.

For sellers, that may mean more supply in the market relative to money chasing deals.

“We’ve been actively bidding this year on a lot of deals. There weren’t a lot of willing sellers and assets on the market last year outside of some distressed deals, but we are starting to see more quality assets hitting the market.”

But assets will have to “check all the boxes.” In particular, assets need to generate significant free cash flow and have quality inventory in order to attract strategic buyers.

EnCap, like much of the industry, did some of its own consolidation last year across its portfolio.

Cameron Brown, co-founder and managing partner of Pontem Energy Capital Management LLC, said investors may stay away as the shale A&D environment shifts.

“I think that all of the major private equity firms are very skeptical of their ability to go out and raise additional blindfold capital for the strategies that they targeted historically in this business,” he said. “Because the returns have been so bad.”

A more methodical approach to remaining funding capacity is likely, especially as EnCap, Pontem and Fulcrum enter the year with new acquisitions.

However, at some point private equity could see its ability to deploy capital strategically dwindle.

“I think they’re going to run out the dry powder,” Brown said. “I think they know that. I think everybody knows that. And the big question is, at what point do we actually start to see the effects of that?”

Pontem Energy was formed immediately following the May 2020 sale of Felix Energy LLC to WPX Energy Inc. for $2.5 billion. The COVID-19 pandemic had started to disrupt life around the world, and Pontem fashioned itself as an alternative capital provider for upstream oil and gas companies.

The firm considered investments that ranged from “passive public equity all the way up to buying RBL at a discount, and everything in between,” Brown said.

However, as time passed, it became clear to the Pontem team that its core Felix veterans were better suited to actively evaluate opportunities rather than just finance them.

As the distressed asset market refocused on A&D, Pontem evaluated more than a dozen potential operated acquisitions before landing on Ovintiv’s Eagle Ford Shale assets.

In March, Pontem-backed Validus Energy agreed to purchase Ovintiv’s Eagle Ford Shale assets for $880 million. Ovintiv, formerly known as Encana Corp., purchased the assets in 2014 for $3.1 billion.

Pontem’s initial interest in the distressed A&D environment shifted last year as buyers reconsidered the way they evaluated operated assets.

“The valuation that we saw [with Ovintiv] was certainly very different than how I would think it would be valued historically,” he said. “It wasn’t distress as we all think about it but more as a right-sizing to the new environment.” Chiefly, that concerned the price at which sellers were willing to move on deals.

Large companies in general may be grappling with how to balance their remaining assets against the opportunity the assets have to create value.

“If we just look at the big picture, the number of private equity funds that are going to be exclusively focused on upstream are likely to shrink compared to the past five years.”
—Brad A. Thielemann, EnCap Investments LP

“I think everybody’s being pretty selective,” Brown said. “For the same reasons we bought Ovintiv, you’re still seeing valuations that are at pretty low historical levels.”

The market has benefitted from stability in commodity prices, with businesses feeling more comfortable with their line of sight as they weigh the risk of making larger acquisitions. And, private equity firms still have some funding remaining.

Pontem’s purchase of Ovintiv’s Eagle Ford assets allows the firm to step into the shows of a large company that has invested a large amount of money and time into the asset. A private equity-backed entity, in contrast, is often geared to sell and can potentially shortchange sellers the state of the assets.

Pontem’s next steps will be to continue to look for transactions that complement its Eagle Ford deals or venture out into other areas with the potential for high returns.

“We’re open for business; we will look at all opportunities,” he said. “We’re just trying to make money and that doesn’t need to be in operated asset acquisitions. We’re still evaluating and working on plenty of financing opportunities outside of traditional upstream.”

The market opens

At the end of a slow and disastrous summer for the oil and gas industry, EnCap Investments through its portfolio company Grayson Mill Energy reached out to Equinor ASA with a request for data to evaluate its assets in the Bakken Shale.

By January, EnCap had been working on a handful of deals during the past year with private and public companies. But the Equinor deal remained top of mind, Thielemann said.

EnCap’s primary advantage, even after Equinor began a sales process, was the certainty it offered.

“They wanted a large cash number that could take them out,” he said. “And ideally, they wanted to find a good home for their employees.”

EnCap had the dry powder and a willingness to retain a significant portion of Equinor’s workforce, Thielemann said. “We moved early on the deal and were able to get it over the finish line,” he said.

In April, Grayson Mill Energy purchased Equinor’s Bakken interests and midstream assets for about $900 million.

The deal was struck before commodity prices started their recovery earlier this year. Had the deal stretched out it would have likely created more competition.

“It’s hard to know exactly how it would’ve played out, but we tried to be transparent with them, and give them all of these assumptions that we were using to come up with our number,” he said. “They did the same with us. It was a very good process.”

Since February, the WTI price per barrel consistently stayed in the high $50s to $60s and in early June rose to $70, the highest spot price since 2018.

The commodity price recovery—and general stability—has helped thaw out the deal market. EnCap sees more deals churning the second half of 2021.

“That momentum has helped a lot relative to deal flow,” Thielemann said. “The A&D market was completely frozen in 2020. From an asset deal standpoint, there just wasn’t anything happening.”

Higher, stable equity prices have also given private equity firms and companies emerging from survival mode the ability to avoid settling for bottom-market prices. The narrowing of the bid-ask spread has created a shift from 2020, when most quality assets sat on the shelf.

EnCap’s own deal with Equinor represents the renewed license from well-capitalized operators to rationalize their portfolios or consolidate noncore assets.

“You have some pent up supply from companies with sale-ready assets,” he said.

If 2020’s market was stuck largely because no one wanted to sell assets unless absolutely necessary, deal flow has now swung in the opposition direction with a “natural window to where people feel OK about selling assets,” Thielemann said.

For buyers, upside pricing also looks far more attractive in a $55/bbl or $60/bbl environment— compared with $40 oil prices last year.

“You’ve come back into a state of equilibrium where we’re starting to see more deals get done,” he said. “I think we’re going to continue to see that this year barring some sort of big shift in the macro backdrop. But there is a finite amount of capital chasing these deals.”

EnCap has an optimistic view for constructive demand growth while operators have continued to remain focused on capital discipline and free cash flow.

“Discipline continues to be the overarching theme,” he said.

Since December, the rig count has also improved by about 35%, to 456 rigs, according to Baker Hughes data in June.

“It does feel like we’re setting up for a pretty constructive backdrop as demand recovers,” he said.

However, the firm won’t look at underwriting deals based on continued improvement but on where prices are today and the potential ups and downs.

“We run sensitivities both ways, but we’re certainly a lot more optimistic. It feels a lot better than it did nine months ago.”

EnCap Investment has recovered from the COVID doldrums, when the firm scaled its operations from about 20 operated rigs across its portfolio to none last summer. Now the firm’s portfolio companies have restarted and, in May, were running 13 rigs because of favorable drilling economics.

“Everybody’s focused on capital discipline and generating free cash flow,” Thielemann said. “We’re seeing some good opportunities to put capital back to work in the drill bit as well as looking for acquisitions.”

The Equinor deal returns EnCap to the Bakken, where it’s in familiar territory.

Now at a more mature point in the basin’s lifespan, EnCap saw the play in terms of how much potential remained and at a good entry price to generate cash on the proved developed producing (PDP) assets that it purchased.

“We believed there was an opportunity to lower operating costs significantly over time,” he said, adding that Equinor also had a number of DUCs and a solid inventory of drilling locations.

“We felt like there was a good mix of an asset that had upside but could generate a significant amount of free cash flow,” he said. “We still have drilling inventory to go execute on and utilize that cash flow to hit our target rates of return.”

Together, those factors made for a good risk-adjusted return profile, and the basin is likely to see continued consolidation.

“Strategically, we thought if we got the right footprint, we could position ourselves to be active … ultimately doing more deals or being part of a larger consolidation down the road after we’ve operated the asset for a while.”

Equinor’s position also came with a lot of midstream infrastructure that the company had built out, which helped to enhance its margins and economics. With lowered costs and a focused drilling plan, the assets have the potential to generate strong returns.

“We look at the upside on a risk adjusted location basis—what we call low-risk inventory that feels really solid from a technical standpoint and in areas in which we have a really good sense of what the results and costs are going to be,” he said.

Elephant hunting

Fulcrum Energy has largely specialized in distressed lower middle market deals. Roughly half of its transactions have been through bankruptcy stalking horse bids. In July 2018, for instance, Fulcrum purchased Nighthawk Energy Plc and its subsidiaries through a 363-bankruptcy sale.

In December, Fulcrum-backed Gondola Resources LLC purchased SandRidge Energy Inc.’s North Park Basin asset in Colorado for $47 million in cash. The transaction closed in the first quarter this year.

In general, Fulcrum’s design the past five years has been acquiring assets that yield cash flow, with the upside development opportunity a secondary concern.

Fulcrum’s SandRidge transaction was in step with other deals the firm has made—part of the market Morse described as an opportunistic carve-out. Such carve-outs apply to companies with small teams divided among two or more basins that do not have the interest or capacity in continuing in multiple regions.

“I think this deal for [SandRidge] probably made a lot of sense because they don’t really have a core presence in Colorado,” Morse said.

The market appears to be working out the kinks of consolidation, whether it’s Ovintiv selling in the Eagle Ford Shale or SandRidge selling its North Park Basin assets.

“I think that that’s kind of the angle that private equity has taken, and public companies are willing to let go of those assets a little bit more because of this push for core and synergies,” Morse said. “I think it’s positioning them in a lot of ways to be able to merge with another pure play in that basin and claim cost reduction, synergies and scale.”

Morse said he’s also noticed a shift in investor mentality—a sophistication among people who don’t want to invest in a fund but actually work on a deal.

“They can touch and feel and see the historical cash flow and see where the assets are,” he said. “Whenever we’ve had a deal, we’ve raised whatever capital is required to get it done, because it’s a good deal—whereas I think a fund is a harder sell today. One quote that resonates with us is that good deals always find capital, which generally summarizes our experience in raising capital.”

The SandRidge acquisition was partly funded through its own fund as well as through co-investments. The deal was like a hanging breaking ball in the strike zone, with cash flow, cash on cash returns, PDP, 93,000 net acres of upside and 50 wells. Prior owners of the assets had already invested hundreds of millions of risk capital dollars into the leasehold, as well.

“There was more capital than we even needed for that transaction, and we had to turn investors down because I think people just saw the timing and the opportunity,” he said. “When they could see an asset specifically in the historical cash flow and the well results, it got our investors much more excited.”

A deal with a sense of urgency that needs to close in four months, for instance, requires a different type of investment.

“That has kind of been an interesting development that we’ve noticed in general and even talking to real estate managers and people in other sectors as they’ve said the same thing of always doing so much better with co-investments and deal by deal investment structures,” he said.

In the fund world, huge asset managers with seven funds may be hunting a multitude of deals, while Fulcrum and similar firms are finding good deals and capital through focus.

That and, “raising huge funds eventually requires institutional capital and institutional capital kind of unjustly hates our industry right now, for lack of a better word. The lack of capital, in Fulcrum’s view, will likely result in undersupply of oil and gas relative to demand, and create an extended period of higher commodity prices in the medium term.”