You Can't Spell Permian Without 'PE'

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Laureled with many epithets, the Permian Basin may have been most aptly described as the gift that keeps on giving. And for private equity sponsors and their portfolio companies, that has been particularly true where their influence keeps on growing.

In recent months, drilling has boomed in the Permian, and in the last two years, the number of rigs almost tripled since the COVID downturn. Meanwhile, the Gulf Coast and Midcontinent saw increases of 550% or more, as well as the Rockies with a 376% increase, a recent report by Stephens showed. But the Permian’s lower volatility is a sign of its strength.

Through the last major oil price downturn during COVID, all other oil-weighted basins saw rig counts drop into the single digits, but the Permian managed to hold on to moderate levels of activity, noted Brad Thielemann, partner, EnCap Investments LP.

As of mid-September, the Permian accounted for 48% of all Lower 48 horizontal rigs, the Stephens report showed. Such numbers demonstrate the strong confidence upstream operators and their private equity sponsors have in the basin. 

Currently EnCap portfolio companies are running close to 20 rigs across the Midland and Delaware basins, Thielemann said. 

The fact of the matter is that the Permian has been, and remains, a “focal point” of activity for its quality and depth of inventory, he said. Characteristics weighing in its favor include the Permian’s large size and extent, stacked pays, prolific and predictable well recoveries; robust economics weighted to oil but with exposure to associated gas and NGL; and good access to midstream infrastructure.

The Permian’s already abundant attributes are amplified by Texas’ more predictable regulatory environment, said Austin Elam, a partner with Haynes & Boone LLP. There are fewer regulatory concerns compared to many other basins in the Lower 48, contributing to a sense that deals can be done more quickly, he said.

“The Permian’s already abundant attributes are amplified by Texas’ more predictable regulatory environment.”

—Austin Elam, Haynes & Boone LLP

In fact, the Permian accounted for the largest share of upstream deal activity (30%) between September 2021 and September 2022, according to the Stephens report. 

Private equity was an active seller during this time as a backlog of portfolio companies developed because of challenging market conditions in 2018 and 2019, said Elam. Many private equity-backed management teams took advantage of positive commodity prices and capital availability for buyers in order to achieve an exit, he noted. 

The trend has been developing since at least 2019, agreed Anthony Speier, partner, Kirkland & Ellis.

“Even before the pandemic, companies were understanding that investors want scale, and they want cash flow. The publics needed to be bigger, and the private companies wanted to get bigger to be attractive to the publics,” Speier said.

During the challenging times of 2020 and early 2021, much of the activity was private equity creating so-called “smashcos” to combine various portfolio companies together, Speier noted.

Smashcos were driven by a need to rationalize balance sheets and facilitate a means to get capital back to investors when there were no exits in sight, said Elam. 

In second-half 2020, corporate upstream M&A blossomed thanks to Permian-centric deals like ConocoPhillips Co.’s $13.3 billion takeout of Concho Resources and Chevron Corp.’s $13 billion purchase of Noble Energy, but A&D remained muted, the Stephens report showed. As 2021 wore on, however, asset transactions quickly picked up, particularly for private equity-backed companies. 

Shifting strategies

During 2021, several factors were at work in bridging the gap between seller and buyer, helping deals to get done. One was the availability of public debt capital markets that buyers were able to tap for financing, said Elam. Another was an enthusiasm by private equity sponsors to accept public equity as consideration in transactions.

Known for its preference for cash in earlier times, private equity was “willing and happy to take equity to ride the upside,” said Speier. “There was a pretty strong feeling that equities would perform better” because they could see the pressure on commodity prices building up from underinvestment.

As a result, private equity has aggressively entered the public markets in recent years, and Permian assets have been the currency used to buy their way in.

Since 2021, seven different private equity sponsors have sold nine Permian-focused portfolio companies totaling $3.94 billion. Notable exits include EnCap’s sale of Sabalo Energy for $717.6 million, NGP’s sale of Titus Oil & Gas for $617 million and Warburg Pincus’ sale of Chisholm Energy for $604 million. Stock consideration played an important role in many of those deals.

“Even before the pandemic, companies were understanding that investors want scale, and they want cash flow.”

—Anthony Speier, Kirkland & Ellis

Multiple upstream companies now register private equity firms as their largest shareholders. Earthstone Energy Inc., Permian Resources LLC and Ring Energy Inc. are three notable E&P examples. 

Since 2014, EnCap has been involved with Earthstone Energy when it took over the company through the sale of Eagle Ford-focused Oak Valley Resources. In 2016, Earthstone acquired Bold Energy III, an EnCap portfolio company in the Midland Basin. In the past two years, Earthstone has been on an acquisition tear adding to its position in the Permian. 

In early 2022, Earthstone acquired Midland-focused Bighorn Permian Resources for $860 million. Bighorn Permian began as Aubrey McClendon’s American Energy Partners-Permian and then became Sable Permian after a bankruptcy that saw ownership pass over to J.P. Morgan. In June, Earthstone announced the Delaware-focused acquisition of Titus Oil & Production and Titus Oil & Production II, backed by NGP Energy Capital, for $627 million. In 2021, the company acquired Warburg Pincus-backed Chisholm Energy for $504 million and Independence Resources Management for $182 million; EnCap-backed Tracker Resource Development III for $126.5 million; and Foreland Investments and BCC-Foreland for $73.2 million. 

Earthstone’s current ownership includes EnCap, which holds 37.9%, and Warburg Pincus, with 24.5%, according to securities filings. 

Permian Resources, the name of the recently merged Centennial Resource Development and Colgate Energy Partners III, also brings together multiple big name private equity sponsors. Prior to the merger, Riverstone held 25.5% of Centennial, according to securities filings. Meanwhile, Colgate Energy was formed by Pearl Energy and NGP and bulked up by acquiring NGP-backed Luxe Energy in mid-2021. When it merged with Centennial, Colgate Energy was valued at $3.9 billion in the transaction.

Although not planned from the outset, clubbing up was a practical move by private equity sponsors to consolidate the Permian and facilitate return of money to investors, said Elam. 

Positive indicators

As private equity has rationalized its holdings in the Permian, the string of exits creates opportunities for new upstream enterprises.

The exiting management teams are not looking to sell out and go home but rather take advantage of an opportunistic exit so they can go out and build a new company, particularly those focused on drilling inventory, said Elam. 

“Many of the management teams we work with are planning to re-up and get back in,” said Speier. 

Although high commodity prices can give management teams a pause, the longer commodity prices stay high, the more confident people are at investing in a higher price environment, he said.

Positive signals are coming from both the supply and demand side. Not only are public upstream companies remaining disciplined in their drilling, but recent world events have rocked widely held assumptions on energy transition and are shaking up opinions.

One standout sign of new perspectives on energy security took place in early July when the European Parliament voted to label investments in natural gas as climate-friendly. It looks likely to pass into law despite opposition. 

Although the long-term impact is unclear, Elam described the European move as an “injection of pragmatism into the energy conversation that has been long overdue.”

Pragmatism is not only driving the natural gas markets. The domestic political implications of high gas prices create many a strange bedfellow—and a push for greater crude production.

“Longer term, we expect to see an increased premium placed on inventory,” said EnCap’s Thielemann. 

“This is evident in the valuations of public companies with a depth of core inventory of greater than 10 years who trade at a meaningful premium to companies with a perceived lack of core economic inventory. Many public companies will be forced to acquire inventory through asset purchases or consolidation, ultimately placing a premium on undrilled locations.”

Both Elam and Speier are seeing buyers giving value to undeveloped acreage in transactions. 

“Publics are willing to maintain their drilling programs,” said Speier. “We’re not back to the days where it’s all about inventory...but we’re definitely seeing a lot more deals where it’s 50:50 PDP to undeveloped, whereas a year ago it was probably 75:25.” 

“Many public companies will be forced to acquire inventory through asset purchases or consolidation, ultimately placing a premium on undrilled locations.”

—Brad Thielemann, EnCap Investments LP

Pearl Energy partner Stewart Coleman agreed but had a tempered outlook on its impact. 

“Core areas of the best basins are receiving undeveloped acreage value in transactions today,” said Coleman. “That said, we do not expect anywhere near a return to the ‘heyday’ of private equity acquisition activity, both from a $/acre and transaction velocity perspective.” 

Buyers are underwriting more realistic spacing and development pace assumptions, higher discount rates and expect more balanced PDP versus undeveloped value, with the assets able to self-fund development via cash flow compared to requiring new debt or equity capital, he explained. Furthermore, limitations on the availability of private equity capital to finance undeveloped acreage development will lead to more subdued activity levels overall.

Capital constraints

Funding access will be a key factor for management teams looking to enter or re-enter the Permian. 

“It’s a tale of the haves and have nots,” said Elam. Ability to source capital to pursue development and drilling will be a key differentiator, he said.

“While there will absolutely be teams returning for second and third iterations, the pace of new portfolio company creation will remain subdued given continued lack of capital formation in energy private equity more broadly,” said Coleman. 

Coleman’s expectation is that unlike boisterous periods, like 2015 to 2017, when individual private equity firms may have had five or more $100 million-plus equity commitments to portfolio companies in the Permian, new commitments are likely to be more limited to one or two substantial platform portfolio companies.

“The amount of private equity dry powder for upstream has dropped substantially over the last four years,” said Thielemann.

Scarcity of funding can be traced back to a vacuum left by large sponsors, such as Blackstone or Warburg Pincus, opting to not raise new funds focused on hydrocarbons, said Speier. That pullback creates gaps in the marketplace that is being served by direct investment by institutional investors, such as endowments or family offices, he said.

“Core areas of the best basins are receiving undeveloped acreage value in transactions today.”

—Stewart Coleman, Pearl Energy

Going direct requires a very good pedigree, Speier acknowledged. “You have to have gotten a 4.0x to 5.0x return a couple times and then you can cut out the double carry because investors will come directly to you."

Meanwhile, private equity sponsors with available capital see significant opportunity.

“There are a limited number of large-scale cash buyers in the space, and we see far less capital available for transactions than there are sellers,” said Thielemann. 

Public companies have remained highly selective on deals, while opting to focus on allocating available cash to shareholder returns. And private equity capital is in limited supply. “We believe this puts firms like EnCap, with significant dry powder, in a unique position to capture attractive opportunities.” 

EnCap disclosed a big bet on the Permian in June when it teamed with Apollo, Magnetar and other partners to back Double Eagle Energy Holdings IV and Tumbleweed Royalty IV with $1.7 billion in committed equity. Led by Cody Campbell and John Sellers, Double Eagle IV will follow a similar strategy as its predecessor Double Eagle III Midco 2, which sold to Pioneer Natural Resources Co. for $6.4 billion in April 2021.

Another team with plenty of Permian experience and lots of capital is FourPass Energy. In late 2020, the company helmed by former Felix Energy executives received a $900 million equity pledge from Oaktree Capital. 

Other private equity-backed companies with a Permian bent include KKR-backed Spur Energy Partners, which acquired Concho Resources’ New Mexico Shelf assets for $925 million; Carnelian Energy-backed Percussion Petroleum II, which paid $481 million for Oasis Petroleum’s entire Permian position in June 2021; and Acon Investments-backed Sequitur Energy Resources, which paid $264.6 million for Callon Petroleum’s properties in Reagan and Upton counties, Texas.

Private Equity-Related Permian Deal Activity