Minerals Private Equity: Weathering the Storm

[Editor's note: A version of this story appears in the 2020 edition of Oil and Gas Investor’s Minerals Business Supplement. See more stories like this here.] 

Faced by a barrage of setbacks including crippling crude prices and shrinking storage capacity, produc­ers across shale basins continue to shut in thousands of wells. Though the complete picture is yet to be seen, private-equity firms and their mineral portfolios are brac­ing for the likelihood of distressed market conditions by exercising caution and practicing greater discipline.

However, despite the market uncertainty, private-equity firms have no plans to slow down acquisitions and are confident the crisis will create new opportunities for their mineral portfolio companies.

According to Kyle Kafka, partner with EnCap Invest­ments LP, the distressed market is likely to open doors to attractive opportunities for acquiring minerals due to improved risk-adjusted valuations.

“The minerals space has attracted a significant amount of capital from public and private investors alike over the past several years,” he said. “As a result, it became increas­ingly challenging to acquire meaningful opportunities that met our return expectations. We believe there will be less capital available on the other side of this downturn, and valuations and expectations will have to adjust to the cur­rent environment.”

Kafka also expects that the current market conditions will lead to increased consolidation.

“In the coming quarters, we also expect to see more con­solidation of minerals across the space just like we’re start­ing to see on the operator side. Increased scale provides synergies and reduces overall cost structures,” he said.

To adjust to the changing market con­ditions, EnCap Investments is working to increase efficiency by controlling costs of doing business.

“Fortunately for mineral companies, revenue translates directly to free cash flow outside of overhead and the redeployment of cash into acquisitions. Our management teams are all highly focused on keeping corporate costs to a minimum. Given the bid-ask spread in the market and the lack of transac­tion activity right now, free cash flow is being used to make distributions and/or bolster liquidity,” Kafka explained.

“Two of the biggest components of mineral acquisition underwriting are commodity prices and timing of development,” he continued. “Clearly, both inputs are being impacted in a significantly negative way in the current environment. In a $20 or $30 per barrel environment, it’s difficult to expect much, if any, drilling activity in the near term.

To adapt to the unprecedented slowdown of activity, EnCap is working on a concrete plan of action to support the distressed E&P producers on its acreage.

“Our mineral companies are in constant dialogue with operators,” Kafka said. “And in some recent instances, our teams have worked with operators to amend lease terms to allow for shut-ins or to amend/delay well commitments. Like the operators, we are incentivized to real­ize cash flow from production in a better environment.”

Even though the downturn has impacted EnCap’s un­derwriting standards, Kafka is optimistic that it will create unique prospects.

“Companies are focused on acquisition opportunities, consolidating larger packages of minerals and working with operators on lease provisions,” he said.

Continuing acquisitions

Post Oak Energy Capital is less than 30% invested with a $600 million fund, which is roughly two and a half years old.

“Our plan is to continue acquiring minerals, which has been our strategy for over 10 years, and we have no plans of changing that,” said Frost Cochran, manag­ing director and founding partner with Post Oak Energy Capital. “Our portfolio companies run with either low or no financial leverage.”

“We have not made an upstream investment, as we saw that the oil markets were oversupplied; therefore, oil prices were too high, and we anticipated a pullback in oil prices,” he continued. “We could not get comfortable with upstream valuations based on higher oil prices.”

Post Oak has two companies that are committed to mineral strategies, both of which have substantial commitments to pursue acquisitions in the low-price environ­ment, Cochran said.

“Additionally, our operating companies have been ac­quiring minerals for the past 12 years. We have rarely sold any minerals, so we have quite a bit of accumulated mineral acreage. This strategy provides regular distribu­tions to our fund investors,” he said, adding that he ex­pects distributions to decline due to slowed activity.

“Obviously in an environment of declining prices and lesser activity, we expect distributions to decline over the next 60 to 90 days,” he said.

Considering the mineral positions that Post Oak has held for a long period of time, the perpetual investors believe that “this is just a cycle,” according to Cochran.

“When we talk of operating companies, we have to think differently in terms of executing and managing per­sonnel, services and contract relationships. However, in the mineral space, it’s an embedded long-term strategy for our funds and always has been,” he said. “We will adjust valuations to reflect the reality of the market, but we will keep doing the same things in each county with an expectation that activity levels will remain slow until the middle of the next year.”

However, due to an increasing number of E&Ps shut­ting down production, Cochran said Post Oak plans to support the distressed producers on its acreage.

“What we’re seeing in the field is that shut-ins are much larger and much more extensive than what is perhaps being publicly discussed in the market,” he said. “Clearly there are going to be distressed producers on the mineral positions that we own, and we will have to think of ways in which we can be flexible partners and respond to those producers in a constructive way as they navigate the mar­ket downturn.”

Post Oak also has canceled all new drilling activity for its portfolio companies for the rest of 2020.

“When you have a good operator on your acreage as mineral owner, it is in your best interest to be helpful to the operator to avoid ownership changes to a large extent, which disrupts operations even further. As a good partner, it’s in the best interest to incentivize producers to drill on our acreage,” Cochran said.

Prior to the market downturn, several mineral own­ers turned down acquisition deals offered by Post Oak because the owners had high expectations with respect to activity levels on their acreage, Cochran added.

“Obviously since that’s not happening now, they might have some alternative investment opportunities. Mineral owners could partially monetize some of their minerals with the hope of rolling in capital for diversification and liquidity. We are revisiting the desires of a lot of mineral owners to sell their rights in the current environment,” he said.

According to Cochran, the low-price environment is a good time to acquire, even though he believes the valuations will not deteriorate considerably.

“There might be a small amount of distressed mineral buying, but the majority of mineral owners are not distressed. It is unlikely in our view that mineral valuations would materially decouple from past trends. Minerals have great intrinsic value. The asset class is durable and will not trade at extraordinarily low valuations,” he said.

Adjusting to the new equilibrium

According to Jeffrey Scofield, managing director and COO at Lime Rock Partners, due to the severity of the industry’s downturn, Lime Rock, like many other pri­vate-equity companies, “put brakes on everything immediately,” while suspending current offers and assessing the current situation.

“The sector has been in a downturn for five years, and we were just getting to a new normal. This is hopefully the final round of structural change, which will get us to a more disciplined business on the other side,” he said.

Focused solely on the energy sector, Lime Rock’s funds have received more than $8.9 billion in total private capital commitments including over $6.5 billion made to the Lime Rock Partners strategy that invests in E&P and oilfield service companies. The firm is 22 years old there, and most of its investment activity is concentrated in U.S. onshore opportuni­ties. With the slowdown of drilling activity and falling crude prices, Lime Rock has been adapting to the new reality.

“Our strategy in the minerals space has largely been fo­cused on a very small number of counties predominantly in the Midland Basin, D-J [Denver-Julesburg] Basin and the southwestern Marcellus. Over the last eight weeks, we had to re-underwrite be­cause all the model assump­tions we had been using have changed considerably,” Scofield said.

He added that even though shale “isn’t going away,” the scale of the segment will be smaller, with a slower pace of growth and more focus in core areas.

“As the pandemic eases and demand recovers, busi­nesses will be required to have a supply response, and we will have to underwrite in that new equilibrium,” he added.

Even though the rig count recently plunged to a record low, Scofield believes certain private-equity companies are “advantaged” during the downturn.

“The benefit of minerals is obviously that it is a unique asset relative to a working interest E&P company. The na­ture of the asset that has unlimited duration at no capital cost is very unique in the downturn,” he said.

He added that while cash flow will decrease with lower commodity prices, hedges could protect some of the cash flow. Even more important, according to Sco­field, is that private-equity investors are not focused on quarterly performance.

“Every month, you’re getting liquidity. Yes, you may have to adjust the allocation of the capital from a distribution mode to debt pay down. But from a private-equity perspective, it’s a lot less painful, and there is more flexi­bility than the public context where investors tend to buy solely on cash yield.”

Changing expectations

“Clearly a few of the key assumptions that many mineral acquirers were using previously were too optimistic in hindsight,” said James Wallis, partner at NGP Energy Cap­ital Management LLC. “I think that was becoming evident prior to COVID-19 but is fairly obvious now. The entire industry is now resetting to lower expectations for future activity, capital availability and earnings growth amid a highly uncertain macro outlook.”

According to Wallis, uncertainty in the oil and gas industry would translate into lower valuations nearly everywhere.

“The value of unhedged production is down materially, and most undeveloped inventory is very difficult to under­write anywhere close to prior seller expectations,” he said.

NGP Energy Capital has responded to the market turmoil by narrowing its already-tight focus areas further and spend­ing more time on partially developed properties with a more predictable cash flow profile. The company has blended re­turn expectations that are less dependent on future develop­ment activity, and it expects to continue acquisitions.

“Overall, we’re fortunate to have great partners and a long-term capi­tal structure that allows us to be pa­tient with our existing portfolio and opportunistically acquire in times like this,” Wallis said. “We’re proud to be partnered with some of the best entrepreneurs and deal-makers in the business—all of whom are excited about the buying opportu­nities, which we expect to materi­alize over the coming quarters. I’m confident they will continue finding great new opportunities throughout the cycle, and NGP will be there to support our high performers in building great businesses.”

Wallis does not believe that the distressed market will result in significant decrease in valuations in the short term.

“I think it will still be some time before we broadly see sellers’ price expectations drop to levels low enough to incent widespread transaction activity,” he said. “Typi­cally when we have this much market volatility, there is a small spurt of deals driven primarily by liquidity issues, then largely silence while market participants wait to see where things stabilize. We’re in that period right now I think. There should be some great opportunities on the other side of that lull though—and we’ll be in the market bidding conservatively in the meantime.”

Looking forward, Wallis concluded, “There is generally more caution and less competition in the system over­all, which one would normally expect to translate into lower entry prices and decreased risk relative to just a few months ago. But increased caution is certainly warranted given the exceptionally wide range of economic recovery outcomes we may see from here.”