Energy Capital: Volatile But Range Bound

[Editor's note: A version of this story appears in the March 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

In the final quarter of 2018, what for several months had seemed like an improving, albeit uncertain, environment for capital raises came crashing down. Another year of commodity volatility seems likely for 2019, with its attendant impact on capital markets.

When the price for West Texas Intermediate crude fell by year-end 40% from its Oct. 3 peak, a near shutdown of capital markets was almost inevitable. Concerns about a number of factors—weakening economic growth, U.S.-Sino trade friction, unexpectedly large waivers granted to buyers of Iranian oil, plus various wildcard issues—combined to create a severely negative market sentiment.

Equity issuance in the energy sector, already on a downward spiral early in the fourth quarter, evaporated in December. Likewise, issuance of debt followed a downward path, with energy high yield—accounting for about 16% of the high-yield market—particularly affected. By December, no high yield paper, from energy or other issuers, had come to market.

According to data from Drillinginfo Inc., the last three months of 2018 were the worst quarter for upstream equity issuance since 2010. Only two upstream issuers came to market, raising $67.5 million. This was down as much as 94% from the third quarter of 2018 and down 97% from the roughly $2.2 billion raised via 16 offerings in the final quarter of 2017.

RELATED: Energy Capital Markets Endure Worst Quarter This Decade

In fixed income issuance, the fourth quarter of 2018 saw three upstream offerings that raised a total $1.47 billion, down 79% from the approximate $7 billion completed in the same quarter a year earlier. By contrast, upstream credit facilities launched or amended by banks moved sharply higher, totaling some $32.7 billion, up from $5.9 billion a year earlier.

Turning Point

Fundraising in private equity (PE) last year seemed to reach a turning point, setting the stage for a performance akin to the Charles Dickens saying, “It was the best of times, it was the worst of times.”

Preqin, a consultant covering the alternative asset industry, described energy funds as having had a “banner year” in 2018. Preqin data showed natural resources funds raised $93 billion, with $89 billion coming from some 77 “energy-focused” funds last year. However, energy’s dominance of natural resources “may be an impediment to the asset class’s long-term success,” observed Preqin.

Drillinginfo was more emphatic in describing the clouds it sees gathering on the horizon for PE players.

PE sponsors in 2018 “have decelerated backing new upstream portfolio companies as exit strategies have been challenged throughout the year,” according to Drillinginfo. Sponsors “tapped the brakes on backing new teams, as the IPO option vanished, and fourth-quarter upstream M&A activity ground to a halt.”

At $82 billion, the Drillinginfo estimate for energy-related fundraises in 2018 was not far from Preqin’s $89 billion. However, there are differences between the two proprietary datasets.

The $82 billion was related primarily to North America funds. However, only 10% of the fund charters were dedicated specifically to the upstream sector, Drillinginfo noted, while nearly 50% had a multifaceted mandate that allowed greater latitude in investment decisions. Drillinginfo identified 54 new equity commitments to the upstream sector in 2018.

The narrow scope of funding for the upstream sector vs. that for multifaceted energy funds is reflected in the breakdown of Drillinginfo data. Capital raised by multifaceted funds, at $38.2 billion, made up by far the largest category. Upstream funding came in at just $7.8 billion, lower than both midstream, at $13.9 billion, and oilfield services, at $16.2 billion.

Preqin’s $89 billion raised by energy funds included $58 billion raised by 51 North American-focused funds and $28 billion raised by 25 European-focused funds. Preqin noted a trend of greater amounts of capital being raised by a fewer number of funds. The largest fundraise was by KKR Global Infrastructure Investors III, which closed with $7.4 billion in commitments.

Record-high Dry Powder

As of June of 2018, Preqin estimated that natural resource funds’ dry powder stood at “a record high of $238 billion.” This followed fundraising milestones in 2018 when as many as 57% of funds exceeded their initial target size, while another 18% hit their targets. Looking forward, it said, some 305 natural resources funds had their sights set on raising $188 billion.

“Of these, 213 are energy-focused funds seeking to raise a total of $162 billion,” according to Preqin.

By early 2019, however, the lift in crude prices off year-end lows had far from buoyed prospects for a more vibrant capital market for energy. As investors awaited year-end results and forward guidance on 2019 capex and production, their mantra remained one of urging producers to spend within cash flow and prioritize investor returns (dividends, stock buybacks, etc.) over growth.

The latter investor sentiment—prevailing amidst a shortage of cash buyers and a history of E&Ps seeing their stocks punished for issuing equity—has severely soured the A&D market.

“It’s just horrible. It’s terrible out there,” commented Chuck Yates, managing partner at Kayne Anderson Capital Advisors LP, referring at a late-January Private Capital Conference in Houston to the lack of activity in the A&D market. “How many versions of crap can we come up with to talk about the A&D market?”

The Kayne Anderson presentation included a slide showing how energy’s share of the S&P 500 index has materially contracted over the last decade. Energy made up 13.8% of the S&P at year-end 2008, but its weighting in the S&P had fallen to 5.3% by the end of last year.

Fund Distributions

A more focused survey of prospective capital formation in 2019 was conducted by Parkman Whaling, a Houston-based provider of advice and capital to the energy industry.

“U.S. private equity may have as little as $10- to $15 billion of capital available for new upstream deals in 2019, according to our recent poll of more than 40 of the most active private-equity firms in energy,” said the Parkman Whaling note. “And fundraising remains challenged due to negative sector sentiment and lack of fund distributions available to be recycled by investors.”

The Parkman Whaling note estimated uncommitted capital from existing PE funds at about $30 billion. In addition, it said fundraising efforts in 2019 are targeting an additional $15 billion, although it was skeptical the latter goal would be reached. With opportunities to invest described as “ample,” this would lead to “more stringent underwriting criteria and a higher cost of capital.”

Of course, in looking back over all of 2018—and not just the fourth quarter—year-over-year comparisons still show significant, but less steep, percentage changes in public equity market issuance.

Equity financing in the upstream sector in 2018 came to $16.5 billion, down 55% vs. 2017, according to Drillinginfo. Midstream financing, at $5.7 billion, was down 67%. Oilfield services were actually higher, up 31% at $7.2 billion, helped by six IPOs in the early part of the year. (A late-year Baker Hughes stock helped optically but simply involved existing equity being transacted between parties.)

In fixed income financing, the upstream sector issued $22.8 billion in bonds in 2018, down 35% from a year earlier, according to Drillinginfo. Bond issuance in the midstream sector totaled $39.8 billion, up 5%, while issuance by oilfield service companies came to $12 billion, up 41%. As sensitivity grew as to issuer quality, investment grade bonds rose to account for 85% of issuance in the fourth quarter.

While issuance in the energy sector as a whole slowed in the fourth quarter, 21 bond issues were completed for a total of $16.2 billion. Most-active issuers were the midstream sector, with eight issues totaling $7.3 billion, and the downstream sector, with six issues totaling $6 billion. The upstream and oilfield service sectors each issued $1.5 billion in bonds.

Maturing Energy Bonds

Drillinginfo said it expected to see $96 billion of energy bonds to mature in the next 12 months, with 38% of those bonds coming due in the first quarter.

In December of last year, Moody’s Investor Service published a report identifying key credit themes for energy in 2019. It currently has a “positive” outlook for both the E&P and midstream sectors.

Within a framework of “volatile but range-bound” commodity prices, and oil trading in a $50- to $70-per-barrel range, the E&P sector’s improved capital efficiency and moderate prices “will support better cash flow through 2019,” the report said. “As cash flow and asset values increase, companies will increase borrowing bases or access capital markets more easily.”

In addition, according to the Moody’s report, “midstream credit quality will finally improve.”

But having easier access to capital markets may also be measured by a more stringent test: access to equity markets without punitive consequences to E&Ps, and even a re-opening of the IPO market.

Early in 2018, the oilfield service sector tapped the IPO market, with six offerings raising roughly $2 billion, according to Drillinginfo. Meanwhile, the upstream sector has launched three IPOs, but has done so using a SPAC (special purpose acquisition company) rather than a traditional IPO.

The last traditional IPO was completed more than two years ago, in January 2017, by Jagged Peak Energy Inc.

How long will it take until the next such IPO?

Chris Sheehan can be reached at csheehan@hartenergy.com.