Expect plenty of capital, plenty of volatility, plenty of shifts in investor strategies—and plenty of unfolding stories to track as the new year progresses. (Sources: Shutterstock, Hart Energy, Bloomberg screen shot)
A nimble oil and gas industry rolls into 2019 focused on its strengths, driven by investors who know what they want and wary of a host of uncertainties.
So Much Capital
What is not uncertain is capital—there is plenty of it but a lot is sitting on the sidelines.
“Private equity investors are trying to think beyond the standard playbook,” Cliff Vrielink, co-managing partner of Sidley Austin LLP’s Houston office and co-leader of the law firm’s global energy practice, told Hart Energy. “We continue to have a lot of money that wants to be put to work and the ‘easy deals’ aren’t out there so we’re still trying to figure out where the opportunities lie and how to capture those.”
That corresponds to a new level of introspection within the industry.
“I think 2018 saw an acceleration of where folks realized, ‘hey, there’s so much money in this industry. There’s so much value in this industry. There’s so much competition in this industry. We need to figure out who we are, and we need to do that, not every couple years, every five years, every 10 years. We need to figure that out every three months,” Tim Chandler, Houston-based partner with Sidley, told Hart Energy. “’We need to say to ourselves, do these five basins we’re in still make sense, or should we narrow that?’”
But what should a company do with assets in underperforming basins? The question becomes more complex because advances in technologies have made those assets profitable, even if they burden the balance sheet and squeeze dividends. Old paradigm: hold on because size is important. New paradigm: say good-bye.
“We see a lot of companies now looking at their portfolios and saying, ‘we only have limited capacity either in terms of capital, in terms of bandwidth or in terms of leverage we can put on our operations, so let’s really focus on our “A” assets,’” Vrielink said. “‘Our “B” and “C” assets, which we still like, maybe we can sell to somebody else and we can redeploy that cash.’”
The Investors Have Spoken
And that, Vrielink and Chandler said, goes to the heart of the paradigm shift: knowledgeable investors who know exactly what they want.
“It’s amazing to see how each investor has very specific targets for their money, very specific return profiles they’re trying to achieve, return percentages, very specific industry goals, very specific basins,” Chandler said. In other words, a fund might say, give us a 12% return by focusing on the Permian—no, don’t work this part of the Permian, work that part of the Permian—and you’ll get your money for your buildout.
Historically, Vrielink said, private equity saw its purpose as building and then selling, either to public companies or larger oil and gas independents. That is still happening, he said, but now private equities are developing creative strategies. They are also looking to provide capital to big companies, examine their pools of assets and figure out a structure like a joint venture to ensure that the assets can be developed without becoming a drag on that company.
“We’ve seen some situations where the CFO and the financial team think, ‘I don’t want to get public equity because it’s too dilutive, I’m limited on how much leverage I have but I don’t want to sell this asset and maybe there’s a way to partner with one of these strategic investors,” Vrielink said. “That’s something that we’ve seen quite a bit and we’ll continue to see a lot.”
Deals Or No Deals
“I would definitely say that one of the trends of 2018 is busted options,” Vrielink said. “It may be that buyers just think they should be able to get some discount to valuation because of all the volatility and uncertainty. Sellers are thinking, ‘no, I’m not ready to give that discount.’”
The industry has moved away from a period in which rising commodity prices encouraged players to pursue deals with options, he said. Higher oil and gas prices forced prices to be bid up more and investors new to the industry might overpay or pay more than seasoned investors.
“What we saw in 2018 was where people were bidding and putting numbers on the table but they didn’t have all their equity financing secured,” he said. “I think what the market will eventually do, and what it’s started to do, is be a little more thoughtful about whether everything should, in fact, go to an option.”
Vrielink sees these deals as reverting to the norm, with auction processes involving logical prospective owners. “I think that’s another trend that we’ll likely see more of in 2019,” he said.
“I think there will be consolidations but I think it’s a different type of consolidation,” said Chandler, referring to big-company-getting-bigger moves. “I think the consolidation we’re seeing and the ones we will see are different than that in the sense that it’s consolidation around specific profile-type assets.”
So, a company with a certain asset in the Eagle Ford might form a JV with another company with a nearby asset in the Eagle Ford. Now a company exists with a more potent focus on this particular play. “If the price of oil stays low, you will see some of the smaller players perhaps joint venturing with others or getting eaten up by others so that you have more larger producers in particular basins,” he said.
That approach makes sense, Vrielink added, when several companies are jostling within a play. When this happens, there is intense competition to improve positions and negotiate with a midstream provider; recently, acquisitions have been unlikely and the IPO market has been down.
“But if several of these players do come together, maybe some of them can build an entity that not only improves the costs and improves their market position,” he said, “but also sets them up in a few years for something that’s big enough that it might actually have a public exit.”
Another driver of consolidation among producers is credit quality, or lack thereof.
Investors will demand that midstream operators demonstrate that their upstream partners have solid credit quality, Chandler said. Any risk that a producer could go under and impair or eliminate a gathering agreement will either convince a fund to retreat or at least impact the terms of the deal.
“To the extent that you’ve got multiple companies consolidating, depending on how they consolidate, they may be improving their credit quality or at least improving their overall profile through multiple sponsors and multiple investors involved, additional money coming in, and that really gives the upstream producers a bit more of a leg to negotiate better gathering agreements with the midstream providers,” Chandler said.
And here is where it gets a little more complicated. The credit quality of the producers may be fine, but will it stay that way? Another ongoing trend: diligence.
In the past, an investor looking to back a midstream operator would have been satisfied if the producer partner was backed by a big-name private equity fund. Now that midstream backer wants to know the private equity’s intentions.
“In some cases, you might start asking some more questions about it,” said Vrielink. “How does that fund feel about this asset? Are they going to be there? Because the midstream is dependent on the production and the production is dependent on additional development so where is that capital going to come from?”
During a boom, people didn’t worry that much about long-term plans. Now, things have changed, Vrielink said. “When you’re past that feverish phase, people are much more thoughtful.”
Oil, Gas Stay Home
The oil and gas industry retains its global focus, but much of the capital involved is what Chandler termed “U.S.-friendly money.”
“They say to themselves, ‘if I can go out and put that money to work in the U.S., then why am I bothering with places where there is a little more uncertainty, where the economic outlook is worse or corruption is higher, where there might be U.S. actions against those countries?” he said.
The shale boom has made it easy for the industry to concentrate more on U.S. operations for some time, but the last year in particular—trade tensions with China, meltdown in Venezuela—has diminished thoughts of looking elsewhere.
Tariffs, Vrielink and Chandler said, have not had much of a direct impact on the industry yet. Most of the major pipeline projects have already secured steel, though some future projects may be in doubt if trade issues are not resolved.
The condition of the overall global economy, however, is something to keep an eye on.
“I think everybody thinks that it’s been a long bull market and the tide will turn,” Vrielink said. “Of course, nobody knows when.”
In the short term, the impact of volatile commodity prices is manageable, he said, because many in the industry are convinced that $50 per barrel of oil is workable.
“But in the longer term,” Vrielink said, “the volatility creates uncertainty and it forces people to think about putting in place hedges, which means they are giving up some upside and it affects investors’ long-term strategic view.”
It also affects the thinking of those controlling the sources of capital that flow into private equity funds and pension funds and other investors in the oil and gas space.
“What are their long-term views of the energy markets?” he asked. “A lot of volatility shocks don’t encourage capital to come.”