Oil and Gas Investor’s Capital Formation: PE’s New Game

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[Editor's note: A version of this story appears in Capital Formation 2021, a supplement to the May 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

With a timeline for a global economic recovery yet unclear, the E&P sector’s road to recovery remains challenged. Even before the global pandemic caused a historic disruption, shale gas players were in trouble—capex reductions had already been implemented to survive the last downturn, breakeven margins were dangerously thin and, ultimately, the buy-and-flip model found itself redundant in an unpredictable global pandemic.

If that wasn’t enough, an increasing environmental, social and governance (ESG) focus and global carbon emissions concerns have limited traditional and institutional sources of capital.

But despite the challenging environment, private equity investors are focusing on new models and finding untapped opportunities in a new ESG-focused environment.

Changing investment models

“The build-and-flip model is done,” said Paul Lee, entrepreneur-in-residence at Tailwater Capital, at Hart Energy’s virtual A&D Strategies and Opportunities Conference. “The model has run its course and was incredibly successful through the shale revolution for over a decade—that really worked well and created a lot of value for a lot of folks,” Lee said, adding that a lot of companies are “inventory-rich” and don’t require any additional inventory because the pace of their drilling activity has slowed down significantly.

“From a private equity perspective, you can’t go in and try to go lease some land, drill a few wells and sell,” he said.

So what does the new investment model look like?

According to Lee, one alternative is to acquire long duration cash-flow PDP assets.

“That’s what we did in this industry in the 1990s and the early 2000s. And you would kind of do that and block-and-tackle repeatedly. You do bolt-ons; you either acquire these types of assets, and that’s where we’re heading as private equity,” he said.

Lee also noted that there are tailwinds in both oil and gas pricing, which creates an opportunity to acquire long duration assets even though drilling new wells is not a priority.

“Drilling is not really high on our list right now. We would love to go convert PUDs to PDP at the appropriate commodity price. Things are starting to get interesting now that we see a five handle in front of oil prices. That’s turning on a lot of inventory at a lot of locations,” Lee said.

But will it generate higher rate of returns? “We believe you can if you buy it right. And so that’s why we’re all sitting here very excited about this backdrop, the macro backdrop of our business,” Lee said.

“This novel concept called return capital to shareholders has been in the industry for a long time,” he laughed. “That’s the new model. And I think there’s a role for private equity.”

Investments will return

Mark Teshoian, managing partner at Kayne Anderson Capital Advisors LP, noted that private equity firms have distinctly pulled back on some commitments, which he said was “kind of necessary” for the capital-starved market.

“I think when we look back on how the environment felt in the 2015 to 2017 timeframe, it felt fairly overheated, just in terms of the amount of capital flowing through the sector,” recalled Teshoian.“I think we all felt the pressure as we were looking at opportunities that people were chasing deals. I’ve argued for a while that there needed to be a flight of capital from the sector for returns to come up.”

Teshoian expressed optimism about new capital flow, once the industry gets back to its recovery path.

“My hope and expectation is that if we, as an industry, can perform and deliver, investors will gravitate back,” he said, adding that investors have given a cold shoulder to oil and gas thanks to poor returns and the aggressive climate change.

“I think it has been very easy for people to want to abandon oil and gas, and from the investing community side, mainly because returns have been poor. And then the overarching theme of ESG and climate change makes it pretty easy for them to walk away. But I think once we start making money again and we start comparing favorably relative to other industries, I think we will start to see money come back,” Teshoian said.

Echoing similar sentiment, Vignesh Proddaturi, managing partner at Glendale Energy Capital, said investors will come back once the returns start flowing in.

“There’s a lot of focus on ESG, which is great, but we do really need to see those returns back, and I think investors will only come back once we see those returns. There’s definitely a big lack of capital, which definitely creates a big opportunity,” he said.

“As we all know, there’s a big scarcity for private capital in the oil and gas space today,” said Mark Burroughs Jr., managing director at EnCap Investments LP. “I think from a GP perspective, we’ve seen private equity firms pull back on some of the commitments … we’ve seen private equity firms pull completely out of the space,” he said.

Burroughs continued, “For those that are really focused on E&P and midstream and have capital and teams out there, we’re excited about the opportunity to go capture assets.”

From the limited partners (LP) perspective, however, he said energy is “less important,” adding that LPs have been focused on ESG climate initiatives with declining demand for oil and gas.

‘Cost of capital is key’

Glendale’s Vignesh explained that there is no one-size-fits-all approach that works in the private equity market. Rather, he said the cost of capital and buying right are keys to higher returns.

“No matter how good your technical team or everything is, the cost of capital is the key and buying it right is the key. So you’re focused on acquiring things at a lower basis, cost aggregating it and hopefully selling it to someone within a lower cost of capital or a public company.”

He continued, “I think it’s very important to stay disciplined, like do smaller deals and just not run for capital commitment and try to create a safety job net, but start everything with an exit. That would be my goal going forward.”

Explaining the reason behind higher asset valuations, Teshoian said they are representative of the risk of cash flows.

“It’s important to understand why assets are trading at PDP PV20,” he said. “It’s not because we’re trying to rip people, it’s because when prices drop, margins are compressed. And so when margins are thinner, the volatility of those cash flows increase for a given change of the commodity,” he said.

“You can’t price a deal at $2.50 gas the way you price a deal at $4.50 gas, because the margin or your room for air is thinner. And so when you look at the volatility that cash flows, that is what pushes unlevered returns higher. It’s a measure of risk that we’re all kind of taking to buy that asset,” Teshoian said.

He noted the other reason for higher valuations is G&A. “As prices get lower, margins get thinner and G&A as a portion of the overall cash flow increases, that percentage goes higher, which also pressures valuations.”

Lesser teams, more opportunity

Burroughs sees opportunity in the large number of private equity firms that are pulling back because of the distress in the market.

“There are fewer private equity firms who really want to just give an equity line of credit and pay a bunch of G&A until a team has a deal. So the overall effect of that is you’ve got fewer teams out there, but again, for all of us up here, I think that’s the opportunity. We’re backing teams who are fired up to go get assets, and we’re starting to see things move. The bid-ask has narrowed, and hopefully 2021 will be an active year,” he said.

Teshoian agreed that five years from now, the landscape of oil and gas, particularly on the private equity side, will be “drastically different,” and there will be half as many private equity backed portfolio companies, if not less, which will create the “next super cycle” for oil and gas.

“You have to have capital leave the sector, which we’re seeing right now. And you have to have fewer people in the sector, so that when prices do start moving back up, the industry overall, can’t spool up production as quickly as it has in the past,” he said.

He noted that an increase in consolidation will result in more capital discipline.

“The more you can concentrate down into fewer companies, the more disciplined you can be around how you spend your cash flow and how you ramp up production over time. We’re seeing both of those effects taking place right now, but it’s a terrible situation because there are a lot of people out there who have jobs who won’t have jobs in five years. And it’s just a function of where we are as an industry.

ESG and the private equity future

Panelists agreed that ESG is a megatrend that is significantly impacting oil and gas investments.

Tailwater’s Lee said ESG shouldn’t be ignored since it will be a huge attractor of capital for the oil and gas industry.

“If you’re ignoring ESG and saying, ‘I’m going to be old school; I’m not going to care about it and just go produce oil and gas irrespective of any kind of ESG,’ then your head is in the sand, and you’re completely missing it. ESG is not going away. It is going to be a huge attractor of capital,” he said.

Lee added that even though private equity investors will not shift to renewables, they will reap the benefit of ESG during the next five years because of the large amount of investments being made in the area.

“From an ESG perspective, from a renewable perspective, I don’t think you’ll see us go stand up a wind farm or a solar development for the virtue of it and go make a 4% or 5% rate of return. I mean, that doesn’t work from a private equity type viewpoint. But I mean there’s tangential businesses related to that … we’re looking at all sorts of different opportunities in that space. So, we’re excited about it.”

He continued, “I think you have to embrace it, and I think our business is going to be great in five years from now because of the investment we’re making now in ESG.”

Reflecting similar sentiment, Teshoian said, “ESG is huge. If you’re not thinking about it, not talking about it, then you’re kind of missing the boat. It’s a huge focus for our funds when we talk to our LPs; it’s the very first sheet we talk about. They don’t even care about everything else and want to talk about ESG first,” he said.

Teshoian explained that he holds annual meetings with his portfolio companies to collaborate and share best practices on how portfolio companies can run their businesses in an environment-friendly manner, how to have good relationships with their communities and promote diversity and inclusion within the organization.

He added, however, that the shift away from fossil fuels toward renewables is challenging for him.

“I won’t lie that for someone who has been so geared toward fossil fuels and oil and gas for my entire career—retooling my thinking toward renewables is very challenging. It’s like learning a new language, and it’s difficult,” Teshoian said.

But private equity companies have historically performed well on ESG metrics, way before the industry began talking about it, said Burroughs.

“I think private equity—or at least our companies—have done a pretty good job with ESG way before it was as talked about as it is right now. But think about it, not only is it the right thing to do, but when we’re trying to build a company that’s ultimately going to be sold to a larger company, you want a silver platter, you want it to be squeaky clean and that’s value back to you,” he said.