Sheffield: E&Ps’ Capital Starvation Not All Bad, But M&A Needs Work

DALLAS—A lack of capital in the oil and gas industry has led to struggles for companies such as Formentera Partners, particularly as institutional investors have backed off from E&Ps, said Bryan Sheffield, the company’s managing partner.

Private equity has similarly gone from the swinging days of shale, with $100 billion in dry powder, to the current $15 billion in capital, said Sheffield, the founder and former CEO of Parsley Energy.

But even as E&Ps are squeezed financially, in some respects that’s not necessarily a bad thing, he said.

Sheffield, speaking at Hart Energy’s Energy Capital Conference on Oct. 3, said the industry has learned as an investor community. During the shale rush, deals that would raise eyebrows — “why in the world would they do that? They overpaid for that or the spacing on those wells are not working” —are no longer executed, he said.

“I've not seen any of that and it's probably because [private equity firms] NGP, EnCap, they're all being really stingy,” he said. “They're picking just a few management teams, and I think they really do go through the process of understanding what they're buying into.”

Gone are the days when 40 management teams were rapid-fire signing deals.

“I would say we're in the sweet spot of any kind of deal that you're getting into,” Sheffield said. “You should end up getting your money back with some sort of return.”

That said, Sheffield said that in a couple of years, he might have a different view. “Right now with the capital I've mentioned, right around $15 billion that's in the system, it seems like that's just enough to help.”

Formentera was largely built through M&A, Sheffield said. The company holds 630,000 net acres across the Permian Basin, Bakken, Eagle Ford and other Lower 48 plays. In Australia, Formentera has sunk its teeth into 1.6 million net acres in the Marcellus Shale-like Beetaloo Basin.

Sheffield also evolved on operations, including his once firm belief that 3-mile laterals were foolhardy.

And he gave a nuanced view of capital that goes beyond ESG and what he called the “anti-fossil fuel” movement.

‘Victim of our own success’

When Sheffield started Formentera, he reached out to a list of contacts he had accumulated at Parsley. They once invited him to reach out if he were to “ever start over.”

“It was a struggle,” he said.

Sheffield called contacts at the University of North Carolina, Duke University, Princeton and Yale. Around the time of the $7 billion sale of Parsley to Pioneer Natural Resources, he started pitching his own company.

He would call. The “energy guys” at an endowment would get excited.

Then, inevitably, they would all call back with a similar message: “we can’t invest in energy.”

“So it kind of gives you a sense of how hard it was,” he said.

Sheffield used his own money to backstop Formentera, including G&A, and recruited people he knew at Parsley and elsewhere.

Then Sheffield went to family offices and one pension fund thus growing the Formentera brand.

The problem, he said, was that after establishing a track record as a founder of a company in shale’s growth era, creating a new model focused on returns and dividends required “proof of concept.”

Once Sheffield was convinced of the model himself, he went from a $50 million stake to $75 million in future funds.

“So from the proof of concept, ‘Hey, I like these dividends. I'm seeing like 15% dividends with 17% to 18% returns, with low leverage,” he said. “So it's not easy. You got to hustle.”

There are two forces at work draining confidence and capital from the oil and gas sector, Sheffield said. One is fossil fuel opponents. The other is the industry itself.

But, he said, some investors may have a long memory.

“We were a victim of our own success. We drilled too much in the Midland Basin, in the Delaware and the Bakken and in the Eagle Ford,” he said. “We drilled so much, we pissed off OPEC and Russia,” resulting in a price war.

“We went to zero oil—negative $37 or something like that [during COVID]. I have it framed in my office to always remember that it can happen in this business.”

M&A therapists needed

Sheffield started Formentera at a time when banks were used to E&Ps based on a growth model.

“It took some time for the banks to get used to the dividend-paying model,” he said.

Sheffield said the company has continued to grow, but only through acquisitions. Over time, those transactions have proven to be more and more tricky.

Sheffield added, “we're not growing through the drill bit.”

Sheffield acknowledged that the company does do some drilling, but it’s largely been rolling up proved developed producing (PDP) assets while “inheriting PUDs with the PDP.”

“We call ourselves a PDP plus fund or a company. I kind of look at Formentera as a company because we are the operator,” he said. “We don't have multiple CEOs underneath us. We're kind of that operating model where we do fundraise, over time acquiring deals.”

The company’s commodity mix is 80% oil, although the heavy oil content “just kind of naturally happened,” he said.

“I'd rather be 50% on both sides on our portfolio, but we keep losing gas deals because of the contango curve, and I think there's a lot of private equity out there that want to bet on gas and have this view on gas,” he said.

And deals—gas in particular—continue to be hard to negotiate.

Sheffield, who has previously spoken out about the need for sellers to receive bid/ask “therapy,” said M&A still tilts toward a buyer’s market.

Formentera worked on a deal for APA Corp. that “we probably shouldn’t have worked on because there’s rigs everywhere there.” APA Corp. agreed to sell its non-core Permian Basin assets for $950 million. Sheffield said it's widely believed that Hilcorp was the buyer.

“So the bid-ask spread has gone for the seller's market. It has definitely gone its way in the core of Permian, in the core of the Eagle Ford,” he said. “It feels like you can still pick up acreage at a PV-15, maybe underwrite a few handfuls of wells to get maybe up to a PV-16 or -17” on a discounted cash flow basis.

“So the market's moved somewhat, but I hate it when the banks don't really educate the sellers [on] what they're really worth,” he said. “I have seen more failed process deals that you can ever imagine. Our number one competition is sellers’ reservation price. We end up winning the deal 20% to 30% of the time and they just can’t transact.”

Instead, they look at Formentera’s model and decided to hold it.

“They’re going to blow it down between the cash flow themselves,” he said. “That’s what we’re fighting against. So the market’s kind of locked in on its own religion between buyer and seller.”

Growth mode redux?

Sheffield said he’s always trying to think forward, to imagine what’s next. He says that’s happening now.

He concedes he thought the industry went “crazy” when it began attempting 2- and 3-mile laterals.

Sheffield was always concerned that longer laterals would result in having to “fish that drill bit” after it had been drilled 2.5 miles.

Now, “it seems like the industry and the technology, it's a piece of cake,” he said.

Permian and Bakken laterals are routinely 4-milers.

“So the growth model could come back over a few years,” Sheffield said. “If we continue drilling three- to four-mile laterals, we have accelerated drilling. That's downspacing.”

Downspacing is a bad word on Wall Street, he said. “You would never say downspacing to them, to investors, that you're going to down space your PUDs.”

He said downspacing typically leads to a 25% cut on the previously drilled wells at a wider spacing.

But Sheffield has lately been talking to his business development team about PUDs and asking about well spacing.

The conversation between Sheffield and his team goes something like this:

“Can you downspace?”

“Yes, but it's uneconomic.”

“Okay, if oil is at $120, can you downspace?”

“Yes, that would be very economic and it's something to kind of look out for…”

Operational efficiencies and downspacing have already produced results that justify the Scarlett D practice of reducing space between wells— with the tradeoff resulting in well interference.

In the Bakken, for example, “they're drilling 3- to 4-mile laterals even on Tier 2 acreage,” he said.

Wellhead returns have moved from 30% to 40% to north of 50% to 60%, he said. Similar results have been seen in Oklahoma.

“So there's a lot of things happening in these plays and the technology around us,” he said. “There's a lot of low hanging fruit left behind because we were more focused on big shale, Midland Basin, Delaware.

“But all these other smaller fields have so much serendipity.”