After 41 onshore domestic deals involving $112 billion in transaction value during the last five years, Ralph Eads, vice chairman for Jefferies & Co., finally took a breather in early September to share his perspective on why he thinks the energy industry is in the midst of a once-in-a-generation transformation.
“We sit today at the confluence of two of the most important economic tsunamis of the last century,” Eads told attendees at Hart Energy’s recent A&D Strategies and Opportunities Conference in Dallas.
“One of those is the world is seeing the developed economies print money on a scale that is unprecedented in world economic history. What that means, especially as Europe and U.S. deal with massive amounts of leverage, is that they are printing money and that is providing financial investors a huge amount of liquidity on a scale that is really hard to understand.”
The result, according to Eads, is that foreign investors in particular want to trade dollars for hard assets.
“Oil and gas is at the top of the list of hard assets you want to own and that is explained by the huge capital flows we’ve seen — and are likely to see going forward.”
Eads should know. Jefferies has been the advisor on 11 of the 15 largest U.S. onshore transactions since 2008. The company introduced several foreign firms into the North American energy market, including CNOOC Ltd, Korea National Oil Co, Sasol Ltd. and Gas Authority of India Ltd., among others.
Jefferies has also been involved in several private-equity-backed transactions, including the November 2011 $7.2 billion leveraged buyout between Kohlberg Kravis Roberts & Co (KKR) and Tulsa’s Samson Investment Co. But the investment banking firm also claims to have pioneered the joint venture transaction model that transformed unconventional shale development in North America after 2008.
Eads told the story of talking to the chairman of a Chinese national oil company who explained that China had $3 trillion in U.S. treasuries and planned to put 20% of that into North American resource assets.
“That is $600 billion,” Eads recalls. He compared it to one-and-a-half Exxons in value. Eads said he did a quick mental calculation and told the Chinese executive: “For one percent, I’m your man.”
The other tsunami economically, according to Eads, is the discovery of the unconventional shales in North America, which, because of the size of the prize, will continue to attract foreign capital to the U.S. and especially Canada.
These two trends are unfolding within a greater global context of stable oil prices. Eads outlined an estimate that the world is experiencing one of the lowest excess supply scenarios in a generation. Of that excess supply, which he pegged between 5% and 7% of daily consumption, the Saudis control the greatest portion, which provides pricing power.
“While we may see prices drop for some period of time — and maybe overcorrect — the Saudis at the end of the day hold a strong hand,” Eads said. “The Chinese know that, and most investors know that, so it gives people confidence in the long-term investment in oil because they know at the end of the day that the price is unlikely to collapse.”
Eads outlined the channels through which foreign investment capital flows toward U.S. energy markets. There are international companies willing to invest directly. There are sovereign wealth funds built upon a favorable balance of trade that will provide investment dollars. And finally, there is private equity.
Eads cited leveraged buyouts involving Apollo Global Management LLC and El Paso Corp., along with the KKR/Samson deals, as examples.
“What the private equity funds did is put some of their own dough in the deal. Then they syndicated large amounts of money internationally. We did the Samson thing,” Eads explained. “It was stunning to see the demand behind KKR.”
Eads noted that foreign buyers have specific needs when investing in the U.S. The first is a quality operator.
“What is happening today is the challenge the industry faces in terms of actually developing these assets,” Eads explained. “We went through a period where you assembled acreage in a play, de-risked the play, then flipped the assets. That world is largely over, in my view. If you look at the business today, you have to build to last. You have to be prepared to own it and develop it for a long period of time, and that is a real shift in terms of how the business is going to function going forward. Secondly, foreign investors are brand-conscious.
“One thing about the Asians in particular is that capital is highly concentrated,” Eads explained. “If you go to China, there are only four people you need to talk to: the three Chinese oil companies plus China Investment Corp. If you can’t access those three or four companies you are wasting your time. And they don’t want to talk to anybody who is not Chesapeake-sized. The challenge for independents is how do you access that capital? I think the intermediary for that is going to be private equity.”
Eads outlined how the Chinese became important investors in business arrangements such as joint ventures, including the December 2011 Chesapeake CNOOC deal, which is the largest individual joint venture to date.
“I was directly involved in the conversations with the government, and I can tell you the government is not going to let the Chinese invest directly on a large scale in the U.S.,” Eads recalled. “They are going to permit joint ventures but they are not going to permit the Chinese to buy one of our big independents. That’s why you’ve seen China go to Canada because the Canadian government is open to that. But our government is not open to that and I don’t see that changing anytime soon. So Chinese capital has to flow into joint ventures. I believe the truth of the matter is the Chinese have already picked their dance partners now, and so a real interesting dynamic is that additional capital from China has to flow through private equity.”
Foreign buyers are looking for three kinds of deals, according to Eads. First, they want a platform. He cited the example of Statoil ASA $4.7 billion acquisition of Brigham Exploration Co. in October 2011 as Statoil transitions from an investor in joint ventures to an operator in the North American land sector. Foreign firms that have been non-operators now want to become operators.
Secondly, deal flow is headed to Canada in the near term, partly because of a more open environment for foreign investment, but particularly because players in Asia are looking at importing North American natural gas as LNG. As LNG projects earn permits in North America, foreign investors will want to own gas reserves, and the focus for doing so is in Canada.
Third, foreign investors prefer partnering with premium operators. Some of that is practical, according to Eads.
“These large acreage positions that people talk about, like the emerging Utica or big positions in the Eagle Ford, take lots of rigs to prosecute,” he says. “The challenge the industry has today is actually drilling the wells.”
Eads recounted the story of going to a major oil and gas company with a high-quality unconventional asset.
“They looked at our business plan. The business plan said: You’ll have to operate 25 rigs within three years. They said, ‘we can’t do that. We’d like to own the assets. We love the rocks, but the operations people don’t have the bandwidth to get that done.’ ”
Eads continued: “That is the biggest change I’ve seen. If you give me a really good asset to sell today, I’ve got to find someone who not only has the money but has the operating capability to go forward.”
There are several items influencing the role of foreign capital in the acquisitions and divestitures market, according to Eads.
“The companies that own the acreage don’t have enough money, and that is going to lead to more of what we have seen in joint ventures — asset sales and, in some cases, company sales.
Secondly, private equity and sovereign wealth funds will assume a more prominent role in the business.
“What you see is all the big generalist firms like KKR, Blackstone and Apollo are building out their energy capability in response to what their investors want, and I think these firms are gong to be big factors in our business,” Eads said.
Contact the author, Richard Mason, at email@example.com