With more than $50 billion of private equity capital still waiting to be deployed into the energy sector, this is a heady and challenging time for energy investors. While many have described this period as the “investing opportunity of a lifetime,” the increased volatility in commodity prices and the paradigm shift in the global supply-demand portfolio also pose unprecedented risks for those seeking to make long-term investments in the industry. While in some respects the industry has responded as one would expect in the wake of a supply shock (curtailed drilling, cost reductions, focus on efficiency improvements), the continued turmoil and uncertainty highlight that the adjustment period will hardly be short-lived. And though the increased risk may imply higher returns for the few that make the right bets, not all energy investors will escape this period unscathed.
After major oil-producing nations failed to agree to a production cut in the November 2014 OPEC meeting, oil prices fell by more than 50 percent as compared to their June 2014 highs. The market was shocked to see that Saudi Arabia was relinquishing its traditional balancing role, ostensibly in an effort to push upstart U.S. producers out of the market. This oil price decline ushered in a period of rapid and painful changes for all participants in the oil and gas industry, especially in the U.S. The resultant drop in revenues for upstream oil and gas companies necessitated a rapid rationalization of capital expenditures in an effort to preserve limited liquidity. Unprecedented growth in the era of the U.S. Shale Gas and Tight Oil Revolution, much of it financed by borrowing in the public markets, had led to large fixed charges in the form of interest expense on debt, which were becoming more and more burdensome in a time of evaporating cash flows. In addition, at lower commodity prices, the economics of most drilling opportunities had shifted dramatically; many fringier acreage positions that were economic at $100 oil had become worthless at $50 oil. As upstream companies scaled back activity, the pain trickled down to the oilfield service providers who rely on upstream spending for their own revenues. As these companies began to be squeezed for cost reductions by their upstream customers, their revenues were hit by the two-fold decline in both order volume and pricing. They were quick to shrink their workforces, as evidenced by several rounds of layoffs totaling more than 100,000 personnel over the last several months.
The oil price decline was accompanied by a rapid decline in the shares prices of energy companies, especially the upstream and oilfield services companies mentioned above (midstream companies have fared comparatively well in this debacle, largely due to the nature of their contract structure with their upstream customers). For oil-weighted upstream companies, asset values shifted by almost as much as the decline in the oil price, mitigated somewhat for companies that had extensive and robust hedge portfolios. This decline in upstream asset value hit not only equity valuations, but also market valuations of debt securities. At the outset of the price decline, publicly traded debt for some over-levered and liquidity-constrained upstream companies was valued as little as 50 or 60 cents on the dollar as investors feared that assets would not provide sufficient collateral to creditors in imminent liquidation scenarios.
This decline in valuations was initially heralded as the “buying opportunity of a lifetime” in the energy space. After all, everything had suddenly become 50% cheaper, almost overnight. Debt investors were eager to buy debt at steep discounts to par value, and equity investors, especially public investors, were piling into energy stocks in anticipation of an imminent recovery. However, value in the upstream energy space is heavily dependent on future oil and gas prices, and therefore subject to the volatility and unpredictability of the underlying commodity. The recent paradigm shift whereby OPEC is no longer serving as the “global bank of oil” (swing producer) guarantees that prediction of oil and gas prices has become harder than ever before. Even before the recent price collapse, we were never very good at price prediction, as demonstrated by the comparison of historical prices to forward curves over the past several years; the increased volatility ensures that we are about to get much worse at it. Only if you are convinced that prices are headed back up, which has been the status quo assumption for several years now, does it make sense to pile into energy stocks and debt. However, the timing of this inflection point has been at the forefront of the debate. Investors are keenly watching drilling and production data to determine when U.S. production might finally start to decline and signal an erosion of the oversupply.
However, the assumption of ever-increasing prices is being called into question more and more often. Before the price collapse, proponents of Hubbert’s peak oil theory pointed to oil as a finite resource and exponential growth in oil demand. The price was expected to creep higher and higher as demand would eventually outstrip supply. In the past few years, however, this calculus has been upended. Oil is still a finite resource, but not quite as limited as previously assumed. The U.S. Shale Gas and Tight Oil Revolution proved that technological improvements (most recently horizontal drilling and hydraulic fracturing) will continue to help unlock new supplies of oil, and the resource base is not invariant. Meanwhile demand is weakening globally as India and China mature and their economies become less energy intensive. Additionally, slowly but surely the global energy portfolio is changing to incorporate more renewables and energy efficient residential and industrial technologies. The installed capacity of renewables today may not be large in comparison to the sheer amount of fossil fuels we consume, but even incremental reductions in oil demand can dramatically upset the fragile supply-demand balance.
As we would expect, views on each of these supply and demand drivers vary widely across industry experts. After all, nobody can really predict the future. As such, the consensus view on forward commodity prices is hardly a consensus at all. To mitigate this problem of price prediction, energy investors have often tried to treat commodity prices as an “exogenous factor” in their investment theses. In other words, good investments avoid taking bets on the direction of the commodity price. If an investment requires a dramatic increase (or decrease) in oil and gas prices to generate returns, one could much more easily just buy commodity futures to generate a similar return. Instead, investors have focused on investing in companies that have differentiated operational or strategic characteristics. In the upstream space, this focus has translated to the mantra “good rocks and good operators”. The best investments are in companies with advantaged geological assets and the technology and expertise to most efficiently and effectively produce hydrocarbons from these assets. This focus has become even more important in the wake of the price decline, but the assumption of price as exogenous is no longer applicable. Having a view on the direction of future commodity prices has become critical to even the most basic of investments in the sector. This is because exogeneity is a simplifying assumption that can only hold true when price movements are small enough to not impact fundamental operating principles. But when price movements are large enough to make entire acreage positions uneconomic, to constrain liquidity, and to require whole-scale recapitalizations, price is thoroughly endogenous.
Despite the dramatic swings in commodity prices, the damage so far has been relatively muted, at least in comparison to what was expected at the outset. The U.S. Shale Gas and Tight Oil Revolution may have slowed down with the price collapse, but is at no risk of going away. Robust hedge positions have helped shore up near term cash flows. Redeterminations of reserve-based lending facilities have been lenient, helping forestall the most imminent of bankruptcies in the upstream sector. And most importantly, after an initial phase of hesitancy, the capital markets have been very receptive to issuances in the energy sector. In the first quarter of 2015, small and mid-cap energy companies took advantage of the eager inflows from equity investors to issue an unprecedented amount of equity. This round of equity issuance was followed by a similar rush of debt issuance, with some of the stronger issuers rumored to be accumulating firepower for acquisitions.
This ready availability of capital from the public debt and equity markets may have been both a blessing and a curse for private equity capital. On the one hand, more patient private equity capital has been spared the volatility of the first few innings. Many equity investors were burned by jumping in too soon in anticipation of a V-shaped recovery in oil prices and share prices. On the other hand, many of the voids that existed in the sector, in the form of undercapitalized companies, were quickly filled by the fast-moving public markets, marginalizing slower moving private capital. With the public markets so ready to jump into the energy sector, most companies would rather have relatively cheap public capital than private capital with its accompanying stipulations. Only the most desperate of the public companies (for example, upstream MLPs and over-levered, single-basin small caps) opted to take advantage of private equity capital, and that too after they discovered that the public markets were not willing to provide a lifeline. Hence, the challenge for energy-focused private equity funds will be to find opportunities that cannot be filled by other sources of capital, especially the public markets. In an era of increased volatility and jumpier markets, private equity will have to further differentiate itself as the only source of truly patient capital, available for long-term projects that require the vision to look beyond the cycle and the commitment to stay put even when the going gets tough.