Private Capital For 2009

"You are going to see a tremendous environment in which to work and partner with high-class management teams to create value," says John Moon, managing director of Morgan Stanley Private Equity in New York.

T?he world financial markets were clunking to a close at the end of this quarter. Three months ago, market sentiment showed something had seriously broken and, for many, this was capitalism itself.

With that, some money began to think investment in oil and gas was doomed. Where would management teams find capital? Where would investors feel safe? It’s not so bad, though. Few energy investors have left the game, and many see this as the reduced-price asset-buying opportunity they’ve been waiting for—at least those funded with private capital.

This other path has emerged. Despite, and probably even because of real pain and panic in the markets, private-equity investors are exploring ways to further their business using hedging strategies coupled with strong and long-term investments in the fundamentals of energy assets, technology and equipment.

Private-equity players say these stand to gain from long-term strategy and the expectation that a little bit of chaos always produces some reward somewhere. As hedge funds found they had paid too much for the superficial picture, patient private-equity players sat back and took careful measure.

One upstream private-equity veteran says, “The bloom has come off the rose with hedge funds and commodity traders.” Upstream plays are beginning to be seen as a more solid investment decision that will play into greater need for both oil and gas in the near- and mid-term, long after the recession plays out.

Private capital will continue to stick to the hot U.S. shale plays that defined 2008, but they are also looking in unexpected places, such as infrastructure.

John Moon, managing director of Morgan Stanley Private Equity in New York, says he will not panic about the financial chaos.

“You are going to see a tremendous environment in which to work and partner with high-class management teams to create value,” says Moon. Consider the bigger picture: creative destruction. There is a group of investors throughout the world that see total collapse and failure as a window of opportunity.

Innovation has improved the U.S. E&P industry, for example. Horizontal drilling and multi-stage fracture stimulation have made shale plays—such as the Barnett, Fayetteville and Marcellus—economical and transformed the overall U.S. gas-production picture from one of decline to one of year-over-year production growth.

Optimistic thinking is taking a front-row seat. “I’m not of the doom-and-gloom camp,” says Moon. “At some point, we’ll all come to realize that the world is not coming to an end and that the energy industry is alive and well. I couldn’t be more excited about the opportunities in today’s market.”

Moon re-joined Morgan Stanley recently, having been with Morgan Stanley Capital Partners in 1998 and rolling that business into Metalmark Capital LLC, an independent energy private-equity firm. He left for Riverstone Holdings LLC, overseeing an E&P and other energy private-equity portfolio for a few years, and returned to Morgan Stanley this year. Moon’s energy-portfolio companies have included Canterra Resources, Concert Capital Resources, Triana Energy/Columbia Natural Resources and Union Drilling.

As public and many private oil and gas producers began to trim their capex plans and shore up cash in this quarter, great opportunities for private-equity plays have been created.

“I think that, in the near term, there may be continued malaise in the North American energy market...but also continued drilling in all sorts of basins and plays. Management teams that were planning for never-ending demand growth and perpetual escalation of commodity prices are really going to struggle,” Moon says.

Craig Jarchow, managing director of New York-based Pine Brook Road Partners LLC, says that the easing of oil demand due primarily to economic weakness in the developed world is the big mitigating factor that has driven down oil prices drastically and will continue to do so.

Meanwhile, in U.S. E&P, shale-gas plays will continue to be of interest. “Although a lot has been learned about these plays, the industry still is in the early days of determining how, why and where certain shales work,” he says.

Pine Brook Road Partners invests private equity in the energy and financial-services industries in the U.S. and abroad. It was founded in 2006 by Howard Newman, who led Warburg Pincus’ energy private-equity portfolio. Prior to joining the firm, Jarchow was a director at international energy private-equity firm First Reserve Corp. and director of international exploration and business development for Houston-based E&P Apache Corp.

Pine Brook will continue to be enthusiastic about backing proven management teams that have the geologic and engineering insight to diagnose shale potential ahead of the competition, Jarchow says of the current investment climate. The firm will also make sure portfolio companies have the landman expertise to capture large acreage tracts, and the operations expertise to maximize production and margins.

As for oilfield services, Pine Brook is looking to back teams that have well-defined intellectual property that applies to large, growing markets. These might be unconventional plays or oil and gas provinces controlled by national oil companies.

In its energy portfolio, Pine Brook is currently invested in Washington State-focused E&P Comet Ridge Resources LLC, Houston-based producers Common Resources LLC, Phoenix Exploration Co. LP and Stonegate Production Co. LLC, and Southeast Asia-based Asia Pacific Exploration Consolidated LP.

Jarchow thinks it is helpful to look at the development of shale-gas plays in North America. It took more than 15 years for Mitchell Energy & Development Corp. and, subsequently, Devon Energy Corp. to crack the code on the Barnett shale. With time and improved drilling and completions, the gas has been bursting onto the U.S. scene. The lessons learned have resulted in development of gas production from shales across the U.S.

Jarchow takes some fundamental lessons from this. For instance, development of shale-gas production is a two-stage process: cracking the code, or “de-risking” shale in a particular region, and then the manufacturing process.

Success requires persistence, a fundamental geologic understanding of the rock, a technological edge, particularly in drilling and completions, and careful attention to capital allocation. It’s important to “de-risk” shale by spending the money efficiently. It also requires a razor-sharp land function so acreage acquisition is closely aligned with the de-risking.

The manufacturing process has different capital needs and different risk-reward trade-offs than the discovery process. “Pine Brook will focus on the initial stage because the rewards are high. Large ‘strategics’ are particularly suited for the second stage,” says Jarchow.

Strategic plays
One would think the sensitive price environment and global panic would have swept all deals off the table, as investors waited to see what would develop in the next few quarters. Actually, investors are keen now to make strategic plays. While there is sensitivity to the global harm done to holdings and portfolios, there is still optimism and long-time players in the market see this as cyclical, to some degree.

Investors seem to agree that the economic woes of 2009 will push strategies into the upstream portion of oil and gas. Moon is less certain as to whether shale would be his go-to play at this time, saying he prefers to keep a balanced and open view of opportunities.

“What I feel strongly about is that anything we do, we do with strong world-class executives as our partners,” he says. He mentions shale plays are possible but so are conventional opportunities as long as the management teams have experience in that specific play.

Frank Pottow, managing director for New York-based energy private-equity investor Greenhill Capital Partners LLC, says, “When it blows out like this, it never stays that way for more than a year.” He forecasts a production response. There is just too much supply in the system for an economy heading into a recession.

Pottow joined Greenhill in 2002, leading the firm’s energy portfolio, including investments in BreitBurn Energy Co., Knight Energy, United States Exploration, Hercules Offshore, Energy Transfer Equity, Everlast Energy and Triana Energy. Previously, he was a founding partner of Societe Generale Capital Partners, a managing director of Thayer Capital Partners and a principal of Odyssey Partners.

Pottow looks to the firm’s $305-million co-acquisition of Calgary-based Provident Energy Trust’s 96% stake in private E&P management company BreitBurn Energy Co. LP in August, with BreitBurn directors and Metalmark Capital Partners. Los Angeles-based BreitBurn’s assets consist primarily of producing and nonproducing reserves in the Santa Maria and Los Angeles basins in California.

Greenhill hedges up to 80% of its portfolio companies’ production. Prior to oil prices plummeting in September, Pottow expected very attractive opportunities, using prices locked in by hedging. Since the deal, “the extensive hedges BreitBurn put on at the time of the deal are now well in the money due to the subsequent decline in oil prices,” Pottow says.

He remains bullish on some unconventional-resource plays. “We think the low-cost operators are going to do fine in the long run. The key is to manage debt and land costs and have per-well economics that remain attractive in a lower price environment,” he says.

Greenhill uses hedging in both high and low commodity-price environments. “Our strategy is not to bet on commodity prices,” says Pottow. “We have been able to make money in a wide range of commodity environments because we hedge and back good operators.”

Generally, the current E&P investment market is promising, he concludes. “When prices are low, you want to buy more existing assets, as you are buying off a lower base. When the price is high, you want to buy properties that have more drilling opportunities; that offer attractive economics on the new drills.”