Realism In The Downcycle

The private equity sector has raised and is raising billions of new dollars to invest in energy these days. During the late lamented boom, investors were eager to get a piece of oil and gas, and now, they want it perhaps more, believing that oil and gas prices have nowhere to go but up and to the right.

In April, one of the industry’s most well-known firms, First Reserve, unveiled one of its biggest international deals yet, a $1-billion agreement with Petróleos Mexicanos to jointly pursue large-scale infrastructure opportunities across the energy value chain in Mexico. The first project, the landmark 744-kilometer Los Ramones pipeline system, is already under construction. It will move natural gas from the Eagle Ford Shale in Texas to Mexico, with full commercial operations expected sometime in 2016. Additional infrastructure projects for Mexico are being pursued, and other strategic partners, such as BlackRock Inc., are also involved.

To that end, First Reserve and Pemex teamed up with Houston investment banker Tudor, Pickering, Holt & Co. to hold the Mexico Energy Strategic Summit in April. All three firms made presentations, and the event also involved local partners and international energy companies discussing the opportunities and challenges in Mexico’s upstream, equipment and services, midstream, downstream and infrastructure sectors.

Helping to lead the charge is Alex T. Krueger, promoted in February as co-CEO of the private equity firm based in Greenwich, Connecticut. Krueger had been president and before that, a managing director in London, where he oversaw the doubling of the U.K. office over four years. He is also the co-head of First Reserve’s buyout funds; the firm closed its 13th such fund with $3.4 billion in third-quarter 2014.

From the late 1990s, Krueger led the firm’s mining strategy, initially in the U.S. and subsequently including investments in coal assets in the Czech Republic, China and Australia. He helped create Alpha Natural Resources for the firm, when the coal industry was out of favor.

He is a director of DOF Subsea, a leading provider of subsea services to the oil and gas industry; Calibre Global, an engineering services group for the resources and infrastructure sectors; and Mountaineer Keystone, an E&P company in the U.S.

Since its inception in 1983, First Reserve has raised more than $30 billion and been involved in more than 550 transactions from oil and gas upstream and midstream to coal, FPSOs and numerous service and equipment companies. Last summer it closed the $2.5 billion First Reserve Energy Infrastructure Fund II, and in December that fund committed capital to Navigator Energy Services, which is building a crude gathering system, the Big Spring Gateway System, in the Midland Basin.

We talked with Krueger recently to get his thoughts on the opportunities he sees at present, possible outcomes of the downturn, and to learn more about the Mexico initiative as well as other matters on his plate. He told us, “First and foremost, I believe the opportunity set for energy is massive. It’s the only out-of-favor sector almost globally today, so it attracts a lot of attention from investors. I think it’s a time to be incredibly disciplined … but our current pace doesn’t change much from what we expected 12 months ago.”

First Reserve co-CEO Alex T. Krueger believes it’s more valuable to be prudent than optimistic at this point in the cycle.

Investor: How did this Pemex deal come about?

Krueger: It evolved fairly organically; some portfolio companies we own or have owned have been active in Mexico for some time. With the energy reforms now taking place, and the opportunities we see, we got more focused on how we are in a position to work with those organizations. There is clearly a need for more capital than they can bring to bear, so we thought, how can we be a strategic partner?

The Los Ramones project is a pipeline system from the Texas border, but it’s broken down into four sub-projects and we’re investing in the two southernmost parts. A consortium ultimately will operate it, and we’re a member along with some other strategics.

This pipeline system will be a core backbone of new infrastructure to bring more natural gas to rural areas of Mexico, to shift their economy away from oil and give them access to cheaper hydrocarbons so vital to Mexico’s future. We do see the opportunity in Mexico as being very broad and we think there will be sustained interest in investing in infrastructure there for some time. I think you’ll see more from us as it relates to Mexico.

For infrastructure, about one-third of our portfolio is assets located outside North America, so this asset will fit well in our largely OECD-focused, diversified set of assets, mostly in the midstream and power and utility spaces.

Investor: You’re optimistic about Mexico and with good reason, but how do you view the current marketplace generally, and what is your outlook for a recovery?

Krueger: Fundamentally, there is no significant tacking of the boat for us. But I do think this probably takes three years for the industry to fully recover. I think it could be 2018 before this gets sorted out from the supply and demand side and prices recover.

Investor: That’s a pretty pessimistic view!

Krueger It’s more valuable to be prudent than optimistic at this point in the cycle.

Investor: In light of that, how are you handling this with your portfolio companies?

Krueger: We’ve worked with them on improving their balance sheets through our own capital and third-party investments, and some JVs. We worked aggressively with them in December and January on budgets and how to look at inventories, and how to leverage their prior knowledge, because these management teams have been through downturns before.

The objective we have with all our portfolio companies is to recalibrate their long-term plan so they can manage their business for what we believe is a longer-term downturn. I think we’ll see more volatility until we resolve the supply-demand problem and I think there will be more minor supply-demand shocks and geopolitical risks.

Our philosophy is, if you’re going to go through the planning process, you have to go through the exercise of how you’ll manage in the worst-case scenario, but also be ready for the upside. You have to be realistic.

Investor: What sort of deal flow are you seeing in this environment?

Krueger: We’ve seen an increase in deal flow recently, in the last quarter, but we expect more in the second half of 2015 or in the first quarter of 2016, and we think corporate M&A flow will follow suit. I think once M&A gets going in the service and equipment sector, there’ll need to be a response from competitors, which would then increase the deal activity, and I expect the same timeline for the E&P sector.

I think we find ourselves in a market environment where it continues to need to season before we see much deal flow, as buyers’ and sellers’ expectations are still quite different at this point. Buyers need some more time to get comfortable with wherever the bottom is and to see if this is the time to act on a deal that delivers results in a sustainable way, as opposed to catching the proverbial falling knife.

Investor: What about on the E&P side?

Krueger: The E&P sector faces two challenges right now: one is, obviously, the commodity price, and the second is the liquidity that has contracted. Leveraged oil and gas companies have less liquidity and that affects their activity levels. There’s a lot of interest in selling assets, but that’s not always so attractive in this environment.

There will definitely be different winners and losers. The recipe for success is to find the right opportunities and execute on those. Clearly a lot of assets will become available, but whether they are the assets you want to buy is the real question.

Investor: What format does your buyout fund take—do you acquire a firm outright, merge it with someone else, or form a JV?

Krueger: All of the above. We typically pursue either control of a company or we provide growth capital to let them invest in the sector. We have been positioning ourselves as more production services and equipment-oriented than investing in drilling-related ideas at this time. About a third of the portfolio is in partnership with corporates, where supplying growth capital can be transformative to a business. Maybe the capital wasn’t there due to its size and scale, or a division of a larger business was underfunded and needed to be spun off and funded on its own. We bring in financial capital but also human capital, placing new people on a board, or we’ll recommend upgrading management if that is helpful to drive the growth we see is possible.

Investor: What are your thoughts on the fact that there is so much capital looking at this sector now, including private equity funds and the strategic buyers?

Krueger: I think there is some risk that all this capital is coming back into the sector too quickly and will only delay the “necessary pain” that the industry has to go through, to improve its cost structure and come out the other side sooner rather than later.

Investor: During this downturn there is still talk about whether the shales are economic.

Krueger: The real question is, what is our view on how to participate in the shales at this stage? We think we’re in the later innings of delineating the opportunities, so we’re focused on how to unlock the intrinsic resources, as opposed to adding acreage to sell on to the next guy. It’s now about how to generate profit and cash flow.

Investor: So the service companies play a very important role in your portfolio.

Krueger: One of our theses is, how can these companies bring down costs and improve the recoveries, to improve the economics? How do we focus on working in the best-case shale plays that can be sustainable investments, instead of focusing on what is the rig count going forward? Our view is that the rig count is going to be volatile and that it had to go down, although we didn’t expect it to go as low as quickly as it has.

That volatility is one reason why we focus on production-oriented businesses. For example, we own Hoover Container Solutions. They supply modular containers for bulk liquids and chemicals storage at well sites. It’s not high tech and not too sexy. But with all these new wells that have been drilled, as they start to age, they’re going to need onsite storage of chemicals. It’s a good basic business of the kind in which we like to invest.

Investor: Tell us a bit about your infrastructure business.

Krueger: Besides the Los Ramones pipeline, another example of a portfolio company in our infrastructure funds is a partnership with Petrofac, a very large contractor globally with a concentration in the North Sea, the Middle East and North Africa. They owned three FPSOs as part of the solution they provide to their customers, but that’s a very capital-intensive business, so we effectively capitalized them via a JV. We own 80% and they own 20%. That allows us to release that capital back to Petrofac to run their business.

Investor: What was your most recent upstream deal on the private equity side?

Krueger: One of our most recent deals was backing Deep Gulf Energy for the third time, under Richard Clark. They focus on developing deepwater discoveries and pursuing low-risk exploitation in the Gulf of Mexico. We’ve been working with them for the past 10 years. They’re an experienced team, the bulk of whom came out of Mariner Energy.