Two years before Christopher Kalnin made the first of a string of Marcellus Shale deals totaling $520 million, he took a road trip. Kalnin toured the U.S. with executives from Banpu Pcl, Thailand’s largest coal company, his prospective backer. In part, he wanted to set the stage for unconventional gas investment, which was on the outs among Asian investors.

The trip took them to NGL facilities in Ohio, the Sabine Pass LNG-export facility underway in Louisiana and fracking sites in the Permian Basin.

At the end of 2017, Kalnin, managing director and co-founder of Kalnin Ventures LLC, was the odd man out among Asian-based shale ventures.

During a span that included one of the worst downturns in oil and gas history, Kalnin said he built a position of about 60,000 net acres in Appalachia through about eight transactions. Meanwhile, other Asia-based investors looked askance at U.S. shale gas, already burned by previous investments, including some in tight oil.

Post-downturn, Asian funds are either haltingly feeling out Lower 48 prospects or bypassing the U.S. for Africa and South America, several experts said. But some investors have taken a new approach to the onshore U.S.: buy good assets along with greater influence and control on how their money is spent.

Kalnin said large overseas companies tend to want certainty in the deals they enter. “In oil and gas, that’s about the worst thing you can want because it’s a probabilistic business.”

The model he saw while working at Thailand’s PTT Exploration and Production Pcl was an effort to overcome any doubts. Risk aversion was so engrained in the culture that decision makers were “trying to understand everything they don’t understand.”

During the past decade, Adrian Goodisman, a managing director at Moelis & Co., has led about a dozen foreign cross-border transactions, many involving Asian companies. As oil prices have recovered, Asian investors are again returning to onshore U.S.

Moelis most recently was involved in two onshore U.S. transactions involving Japanese and South Korean companies.

After a learning curve in which some early investors were “crushed for a variety of reasons,” companies such as South Korean conglomerate SK Innovation Co. Ltd. have found their footing in North America—in part by bucking a long history of Asian companies investing in nonoperated interests.

“SK is a classic case. They are a sophisticated company,” Goodisman said. Subsidiary SK E&P American Inc. purchased operated assets in the Stack play in Oklahoma in March via membership interest in Longfellow Nemaha LLC. As part of buying into 60,500 net acres in Kingfisher and Garfield counties, SK Innovation reported it would invest about $450 million in the Lower 48. SK E&P already owns interests in the Midcontinent, through SK Plymouth, and the Permian Basin.

Taewon Kim, president of SK E&P America Inc., told Investor the company is comfortable with investing in U.S. resource plays because it has a clear and focused strategy and “accumulated operating capabilities and excellent technical people within our organization.”

Its newly purchased assets will “leverage synergies with the existing SK Plymouth operations for geographical vicinity, geological similarities and operational and regulatory commonalities,” he said.

In terms of commodity strategy, he said, “unconventional oil and gas is driving global supply growth necessary to meet the demands of the expanding world economy. As another competitive edge, we are mobilizing optimization techniques in our development and production operations, proven to be extremely effective in our downstream operations.”

With a track record in the U.S., the company intends to continue growing production and reserves through organic operations and strategic acquisitions, he added. “SK Innovation and SK E&P are actively expanding across the globe, and the U.S. represents a core region to this growth plan.”

Other, less comfortable Asia-based investors are proceeding more cautiously, according to Bill Marko, a managing director at Jefferies LLC. Beginning in 2008, the firm has led U.S. unconventional-resource sales to Mitsubishi Corp., Mitsui & Co. Ltd., Korea National Oil Corp. (KNOC), CNOOC Ltd. and China Petroleum & Chemical Corp. (Sinopec) among other Asia-based firms. He said that, in the past 18 months, Asian interest has slowly picked up. However, most want to do deals of “a few hundred million dollars at a time” rather than the multibillion-dollar investments that were made earlier in the past decade.

Potential buyers generally “want to stick their toe in the water” and test the temperature before deciding what to do next.

“There’s the odd successful deal and then there’s a bunch of people looking,” Marko said.

Silk Road detours

When Marko welcomes Asian investors into his office in downtown Houston, he often asks them to look out his window. In every building they see, he said, “there’s somebody thinking about buying oil and gas properties. So you have hundreds of competitors here.”

Oil prices have resuscitated the oil industry, but many Asian investments were marred by the downturn—first by the gas-price downturn and then by the oil-price downturn—raising the question of when, if ever, Asian companies will return with the same aggressiveness.

Among the lost billions, Japan’s Itochu Corp. stands out. The company invested just more than $1 billion to buy a 25% stake in Samson Resources Corp. In June 2015, after writing off most of the value of its investment, Itochu sold back all of its shares to Samson for just $1.

Meanwhile, Goodisman said some Asian companies that had seemingly written off the Gulf of Mexico have expressed new interest. “Time heals a lot of things,” he said.

Before the shale rush, many Asian investments in U.S. E&P assets centered on the Gulf. In 2009, for instance, China’s CNOOC agreed to a joint venture with Statoil ASA in a deal in which was Goodisman represented Statoil when he worked for a previous firm.

“Initially, Asian companies entered the U.S. largely as nonoperating partners in the Gulf, due in part to either their inability to operate or unfamiliarity with U.S. regulatory requirements,” Goodisman said. “In the ideal scenario, they would have liked to have had as their partner a well-known, household name company.”

Interest in the Gulf ultimately gave way to a rush for shale play positions from buyers from across the globe that saw the value of unconventional deals.

“What happened is you saw this unconventional wave take off and a lot of people started to focus on the onshore as well,” he said. “You saw a wave of transactions.”

Foreign funding began to pour into the hot plays —the Barnett, Marcellus, Eagle Ford and more.

In a two-year binge, companies based in India, China, South Korea and Japan invested $12.6 billion in U.S. joint ventures, comprising about 68% of all major foreign JVs from 2010 to 2012, according to data from the U.S. Energy Information Administration.

By 2013, Asian companies had partnered with Chesapeake Energy Corp., Devon Energy Corp., Marathon Oil Corp., Anadarko Petroleum Corp. and others. Total investments reached $20 billion.

Many investments capsized. Japan’s Sumitomo Corp., which partnered with Devon, wrote off about $1.6 billion in value tied to tight oil and gas development in Texas in late 2014.

By the time the Permian Basin’s land grab was flourishing in 2016, most Asian companies were sitting out.

China’s Sinochem Group was among the exceptions, getting in under the wire with a 2013 deal with Pioneer Natural Resources Co. Sinochem purchased a 40% interest in about 210,000 net Wolfcamp acres for $500 million. Compared to later prices, it was a bargain at about $6,000 per acre. Sinochem also agreed to fund 75% of Pioneer’s drilling and completion costs for $1.2 billion.

By early 2017, some analysts thought Asian companies might explore a return to the Lower 48, particularly if they wanted to diversify and grow production. While Asian NOCs have started to pick up their business development, they’ve focused on following major oil companies into deepwater exploration hotspots in Latin America or producing-resource opportunities in the Middle East, said Andrew Harwood, Asia Pacific research director for Wood Mackenzie.

“Many may have made the decision that onshore U.S. is a highly competitive sector, that perhaps doesn’t match the skillsets possessed by many Asian investors,” Harwood said.

China’s NOCs have also steadily developed experience they are using for their own domestic shale resources, where they also enjoy advantages from the government they wouldn’t get elsewhere. In the U.S., geopolitics and changes in U.S. laws are also proving to be a barrier.

Harwood said the recent U.S. reduction in corporate tax rates makes it easier for domestic players to focus on investment at home.

“M&A activity in the U.S. shale sector has cooled as the buzz around the Permian has subsided,” he said. “But the focus on capital discipline and generating a returns could lead to a new period of consolidation in regions such as the Permian, as operators look to develop scale and realize synergies in supply chain costs and acreage positions.”

Overall, Marko sees a landscape of once-bitten-twice-shy investors and others that are more comfortable on their “home court.”

“To a great extent, most of them did deals in 2009 to 2012,” he said. “Many of the deals turned out badly due to falling commodity price or poor reservoir quality or misalignment of strategies. So a lot of them are spooked about doing bad deals again.”

Yet a few of the Pacific Rim companies that suffered heavy losses have shown signs that they remain determined to make U.S. shale investments work.

Land of the morning qualm

In April 2013, Tokyo Gas Co. Ltd. bet $485 million in a JV for 25% interest in Quicksilver Resources Inc.’s Barnett shale assets. Two years later, Quicksilver entered bankruptcy and Tokyo Gas wrote off millions in impairment charges.

Yet in May 2017, Tokyo Gas was back in the U.S., to make another deal in U.S. shale.

This time around, Pacific Rim-based investors want more than a piece of the pie. They want more control, their own local decision makers or outright operatorship.

SK Innovation purchased operated assets, moved decision makers to its headquarters in Houston and strengthened ties with the community, including making a $50-million donation to Rice University. After dissatisfaction with its initial nonop investments, Kalnin shifted to direct control by buying operated assets from Carrizo Oil & Gas Inc. in November.

Tokyo Gas’ latest investment adds a new layer of control it’s lacked in previous transactions. It agreed to by a 30% stake in a subsidiary of Castleton Commodities International LLC (CCI) that operates 160,000 Haynesville and Cotton Valley net acres. CCI purchased the assets in 2016 from Anadarko Petroleum Corp. for $1 billion.

However, Tokyo Gas won’t participate in a JV; instead, it is an equity partner—the first such Asian oil and gas equity investment—Goodisman said.

Moelis engineered the deal for Tokyo Gas.

“If you follow the history of Tokyo Gas as it relates to their investments in the U.S. oil and gas, over time they have gotten smarter as have many other Asian companies,” Goodisman said.

Tokyo Gas has reported that it will continue to expand its upstream business as it builds a global LNG value chain.

How far that horizon stretches for other investors is uncertain.

Each country and company varies in how it conducts business to meet specific energy needs, Marko and others said.

China’s NOCs are viewed as less likely to make new investments in U.S. assets. China’s own shale development, trade tensions with the U.S. and dust-offs with the Committee on Foreign Investment in the United States (CFIUS) have complicated investment, Marko and others said. Chinese companies have more recently gone to Africa, and to some extent South America, to compete, in part due to more lax environmental and safety regulations and the lack of a CFIUS equivalent.

Others have told Marko they’re interested in equal-part exposure to spot gas prices, long-term contracts and physical ownership of gas producing assets.

Among Japanese firms, some want to a nonoperated, liquids-rich deal with an established operator; others are considering operating their own assets in the U.S. “We keep chasing the theory that the off-takers that are responsible for their gas supply should want to own some physical gas, so they should want to own some upstream assets,” he said.

Mitsubishi has indicates it is thinking about how to execute on the idea. Marko said it’s unlikely it would pursue “100% physical ownership.”

Marko said Mitsubishi and others are solving for whether they should “hire a team person-by-person with [their] home country leadership here? Do I buy assets that come with a team and take them on for a year or two?”

Other logical buyers have been quiet, he said. India’s Gail Ltd. and Reliance Industries Ltd. are slow to make decisions despite obvious energy needs. Reliance, as well, has exited several upstream and midstream JVs since 2015, collecting its share of $4.7 billion in gross proceeds.

Kalnin said there are other fundamental barriers for investors to overcome. “There’s a permeating belief that unconventional assets don’t make money.”

When he tells other investors he’s making good profits now—at current gas prices with his current assets—“they sort of look at us and laugh with glazed eyes.”

Also, in his experience, Asian investments tend to go with the flow. “It tends to be follower money, not leader money,” he said.

That has led to Asian companies entering JVs with U.S. operators in which the it “wants to come in and ride on the coattails.” But buying into a JV with an established, successful operator means paying premium prices.

Kalnin doesn’t like the JV structure in general because the effects of a low-commodity-price environment “can get you misaligned very quickly” on drilling priorities.

Kalnin’s initial deals to buy into partnerships and work to optimize drilling also fell flat. “What we’ve found was operators did not respect a purely nonop company,” he said. “You really don’t have the influence you think you could.”

Several producers weren’t operating “what I would call rationally,” he said, noting that he sees volatility as a constant challenge the industry must meet. “They were drilling and spending capital that was outspending cash flow and really did not set them up to be sustainable.”

Kalnin Ventures has worked to maintain maximum flexibility and to constantly challenge the fundamental assumptions behind its strategy.

When nonoperated interests were no longer proving viable, Kalnin decided to pivot and essentially move into operatorship “to prove our concept,” he said.

“We found the right deal in the Carrizo deal and inherited a field operating team and very rapidly built a complete operating team around them,” he said.

Other Asian investors will likely have to become as nimble as their U.S. counterparts—which could be difficult when decisions require meticulous proofs, Kalnin said.

“It’s a fine line,” he said, “between flip-flopping and not doing things that are not fundamental and being flexible enough to respond to what the market is actually telling you.”

SIDE BAR STORY

THE CFIUS FACTOR

Outwardly, U.S. shale seems a tough sell to Chinese national oil companies (NOCs) these days, but the reluctance may have more to do with the scrutiny brought on itself for years.

Chinese companies are blamed by the U.S. government for attacks on government institutions and corporate espionage, accusations that China’s leaders deny. China’s NOCs also engage in acquisitions and joint ventures (JVs) in which it may get more out of a deal—particularly technology—than meets the eye, according to federal and U.S. military reports.

China’s NOCs have found it increasingly difficult to invest, including earlier this year when President Trump blocked Singapore’s Broadcom Ltd. from acquiring Qualcomm Inc. for $117 billion. Trump and his predecessor, President Barack Obama, both blocked Chinese acquisitions.

Review by the Committee on Foreign Investment in the United States (CFIUS) can unravel deals.

At press time, an $800-million deal by a Hong Kong firm to buy Dallas-based Alerian, developer of the Alerian MLP Index, has been delayed while still in CFIUS review. A $665-million deal by China’s Goldleaf Jewelry Co. to buy U.S. operator ERG Resources LLC was scuttled in 2014 because the assets were deemed too close to U.S. military facilities.

In a bipartisan effort, Congress is working to further tighten control of foreign investment in the U.S. and eliminate what legislators see as loopholes by revamping CFIUS. CFIUS makes recommendations to the president, who has the authority to block certain transactions in the interest of national security.

In recent months, Congress had held at least eight hearings on foreign investment, according to law firm Latham & Watkins LLP. Hearings have centered on efforts by the Chinese government to acquire technology.

A March 2018 Congressional Research Service (CRS) report noted that CFIUS has zero oversight of foreign companies that purchase U.S. refineries. Companies such as Saudi Aramco, China’s Sinopec and Russia’s Rosneft are buying refineries in the U.S. and around the world, according to the report’s author James K. Jackson, a specialist in international trade and finance.

Blu Hulsey, senior vice president of government and regulatory affairs for Continental Resources Inc., said at Hart Energy’s DUG Rockies conference that the company is keeping tabs on the CFIUS debate in Congress.

“Those type of situations we’re concerned about from a large-scale production standpoint,” Hulsey said. “What happens to refiners if they’re easily transferred to large state producers? It’s a question we need to look at and be cognizant of as independent producers.”

He noted concerns over Russia-controlled Rosneft Oil Co.’s ability to control U.S. refineries operated by Citgo Petroleum Corp. should its parent company, Petróleos de Venezuela SA (PDVSA), default on a Rosneft loan.

From 2013 to 2015, China led all nations in investments reviewed by CFIUS, according to a report by the committee. China has also been a leader in the acquisition of “critical technology,” such as in the information, aerospace and defense sectors.

While recent trade disputes between the U.S. and China have ratcheted up tension, U.S. officials also cite a long history of government and corporate cyber espionage reportedly originating from Chinese servers.

Hackers have targeted energy and petrochemical companies, and were able to access executive accounts and highly sensitive documents, according to 2013 testimony by Larry M. Wortzel, a commissioner on the U.S.-China Economic and Security Review Commission.

In other cases, cyber criminals in 2012 targeted 23 gas pipeline companies, stealing information that could be used for sabotage. Forensic data suggested the intrusions originated from China, according to a January 2018 report by the Defense Innovation Unit Experimental, which reports to the U.S. Department of Defense.

A bill introduced by Sen. John Cornyn (Texas) would sharpen CFIUS’ authority when looking at transactions to include identifying countries of “special concern” that involve critical technologies or materials. CFIUS’ authority would expand to include a reviewing:

  • Other investment structures, including joint ventures and equity interests;
  • Side agreements relating to transfer of intellectual property;
  • Financial or passive investments and real estate purchase near U.S. defense facilities; and
  • Reexamine previously approved transactions.

A companion bill has been filed in the House.

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