An energy investment panel at the recent IHS Herold 20th Annual Pacesetters Energy conference held in Stamford, Connecticut, illuminated best practices for E&Ps seeking capital. Dispensing advice were three capital providers: Oliver Goldstein, managing director of private-equity firm Pine Brook Road Partners ; Jeff Bernstein, senior vice president of research at AH Lisanti Capital Growth, a manager of institutional funds focused on small-caps; and Sam Oh, a partner with private-equity provider Apollo Management.

All agreed on the allure of great managers with great assets, and the indispensible aspect of hedging in today's volatile commodity-price and financial-market environment. On the other hand, they warned companies against trying to do "too many things at once."

Beyond those parameters, however, they noted the important shifts in how they evaluate investments—shifts driven by how horizontal and fracing technology, and the shales, have changed the E&P business landscape.

AH Lisanti's Bernstein said executives' presentations used to revolve around discussions of seismic anomalies and such, an approach sometimes more suited to funding by venture capital. "We gravitate toward exploitation strategies," he said. "Now we're talking about manufacturing energy—how to get the energy out most efficiently. We're looking for managements that are applying statistical process controls when evaluating different production formulas."

Goldstein noted Pine Brook looks for good management and good "rock," meaning a complete management team with strong experience, and a good resource with compelling economics. "We look at single-well economics," he said. The firm places great importance on the processes a company uses, as well as the resource it brings to the table.

A classic rule of investing has been to place a premium on the management team, but today, some funders believe it is less important. Pine Brook still values the leadership team highly. "We look for a complete team, with technical and financial expertise," he said. "We want a CEO who is a good allocator of capital and good at assessing risk. Then we want strength in G&G and drilling and completion expertise; and on the financial side, a strong CFO who can be a partner to the rest of the team in project risk and analysis."

Bernstein said AH Lisanti places slightly less importance on management, because "the quality of the rock outweighs the quality of the management team today. In oil and gas, teams are sometimes good but just too aggressive; however, if you have a great asset, this is a liquid market, and that asset will end up being owned by someone who can exploit it."

Apollo's Oh said management remains as important as ever because of the increasing choices presented by technology. "There is a lot of rock, and the many techniques to extract it can forgive a lot of sins. However, what we're seeing is that because the markets have become more competitive, and acquisition prices are higher, and there are at people's disposal a bevy of choices in technology and techniques, management decision-making at the field level is critical. It can make the difference between being in the top or the bottom deciles.

"As plays mature, management’s ability to drive down costs and stay on budget to complete wells plays an important role."

What are the classic mistakes funders see when companies go shopping for capital?

Strategy drift

One error may involve a focus on new, unconventional strategies to the exclusion of core strengths. "This is most symptomatic at the small- and micro-cap level, where there is limited human capital," noted Oh. "They may have had a long pedigree in conventional plays and now they get to the unconventional, and in the long run, this may have some implications. They may have strategy drift."

Bernstein noted that expectations play an important role. Management teams may have overly aggressive expectations and not be able to deliver. They may feel compelled to be associated with a hot play, or with liquids (a common strategy in today's commodity-price environment), but investors will figure that out quickly. "It is better to just give a straightforward view of your company. In fact, holding something back so you can exceed expectations is a way to create a premium valuation on the Street, because it creates trust," he said.

Goldstein agreed that an error may be to oversell one's story, and not be candid about risks. Another common mistake is not seeking enough capital. The funders agreed on the importance of matching strategy to capital. Be proactive about getting money, they advised.

Pay attention to capital structure, and shore up liquidity, said Oh. "The upstream companies in the past 15 months have been fairly good at shoring up liquidity, but that's important going forward. Then they can focus on what they do well and be insulated from shocks."

For companies heavily in natural gas, adopting a strategy that current gas prices are a temporary phenomenon, and basing a business plan on "when prices get back" to $5 or $6, is not wise. "There's a lot of gas that’s economic at $4.25, $4.50, so management should plan for that environment, and not for 'when it gets back,'" said Goldstein.

Some companies are too distracted by the desire for exposure. They are at every investment conference and devote too much time to press releasing about wells that are "going to be fraced," for example, Bernstein noted. "It's better to focus more internally, concentrating on delivering meaningful results."

Hedge to fight another day

All three agreed that too many companies do not take advantage of hedging. "I still scratch my head on hedging," said Oh. "It's amazing to me how companies don't embrace hedging."

In light of volatility, now more than ever capital structure matters, said Oh. Companies with the best balance sheets and that are well-insulated should survive the cycles. If they can survive the trough, they should do better in the next part of the cycle, he said.

Goldstein laid out Pine Brook's approach: hedge aggressively on production and base exploration activity on a fundamental price outlook.

The advisors also discussed how to right a bad balance sheet. Maturities should be pushed out, said Oh. And, when the windows are open, capitalize. Timing is everything in this effort. "Today, the window is closed versus May, but experience in the markets really matters," he said. Companies can tender, pay down debt aggressively, equitize debt, etc. "It requires capital and discipline, with coordination between management and owners." Again, long-term hedges offer long-term flexibility for planning around budgets.

As for investment horizons and exit strategies, holding periods of five to eight years are common among the panel participants, and decisions to sell are based on many variables: whether the original thesis has held up; whether the rocks are as good as originally thought; strategy changes; or whether management is as good a steward of capital as initially believed. And, markets can present unexpected opportunities, or market malaise can force a longer hold.

Shales' role

In general, timing has accelerated, with some earlier sales in the shale plays.

There is an embarrassment of riches in the shale plays, and shepherding capital has become critical to participate, noted Bernstein. "Don't be the last guy into the play—be early, and don't pay too much."

Goldstein noted two main changes in the nature of investment risks today: First, the amount of capital to derisk a play has grown significantly, with the need to acquire a substantial acreage position in these fast-moving plays. Five years ago, a company might have gotten a small amount of acreage, like 8,000 acres, drilled a few wells, then scaled up to more acreage, he said. But now, prices rise so fast that that approach no longer works. Significant acreage has to be acquired earlier, resulting in more capital required during the de-risking phase.

Second, the shift to unconventional resources means the risk is no longer in finding the resource, but rather in the economics of extraction, completions and the lateral extent of the core of the play. "The nature of the risk has changed," he said.

Bernstein concurred. "Intensity has gone way up. Take-away has become a choke point; paying up for services has become an operational risk."

The advent of technology is a double-edged sword, noted Oh. It has driven recovery rates higher and costs down; but it also has emboldened companies to take on greater risk, because they think they have the tools to solve it.

The amount of capital available has also changed the picture. With more money flowing in, via entities ranging from MLPs to royalty trusts, the market has become more segmented and competitive. Oil and gas has emerged as its own asset class, and as such, more direct capital is flowing in or being formed.

Look for more managements to succeed by buying distressed assets, noted Bernstein. "Those opportunities will increasingly be out there because of the volatility."

The renaissance in North America-based hydrocarbon is here to stay, the funders agreed. Said Oh, "We see it as potentially the best place globally to be investing. More nondomestic companies are investing here, opening up a wider opportunity to have strategic dialogues with foreign nationals, as well as creating different exit opportunities. It's also opened up the number of participants and players."

Contact the author, Susan Klann, at sklann@hartenergy.com.