Energy markets are notoriously cyclical, and capital markets can be fickle. But rarely have there been such complex crosscurrents in energy as there are at this moment. In the public markets, energy equities have suffered dramatic downdrafts, but have recently proven receptive to capital raises by select E&Ps. In crude oil, plummeting prices have now seemingly stabilized, but are forecast to fall once again when—according to many projections, but not all—West Texas Intermediate (WTI) reaches maximum storage capacity levels at Cushing.

For some long-standing private-equity sponsors, these may simply represent additional nuances to factor into the traditional energy cycle. With large portions of the public capital markets still in gridlock, and crude prices at steeply discounted prices versus nine to 12 months ago, conditions for private equity appear attractive. And as sponsors look to deploy capital, there is no shortage: One estimate suggests $60 billion to $100 billion is sitting on the sidelines.

Private equity is also proving to be far from a one-way street. Sponsors are generally advising E&P portfolio companies to slow down capex programs, just as their public E&P counterparts are doing. At the same time, sponsors remain alert to opportunities that may mean moving quickly to put capital to work at elevated levels to take advantage of the distressed industry conditions. And the spectrum of potential investment vehicles may be considerably broader than in the past.

Wil VanLoh, president and CEO, Quantum Energy Partners, said the private-equity firm likes to have lots in the kitty so as to double down when things get "ugly, as they are now; we love these times."

Downcycle strategies

Mostly, it seems like business as usual—apart from when it isn’t.

“If you’ve consistently been in this business and seen the cycles, the good news is that you don’t get rattled,” Mike McMahon, managing director on the energy investment team at Pine Brook Partners, said. Even as portfolio companies take steps to reduce capex, they should also be prepared to act boldly if the right opportunity presents itself.

“We’re telling all our management teams that if they know a good area, in which they have a strong sense as to where the good rocks are located, they should go ‘on offense,’” he said. “The gating item is that it has to be in their backyard; we don’t want them stepping out into new areas.”

In these volatile times, how do you shift tactics to go on offense?

“If they find these kinds of opportunities, then whatever the amount of capital that is available to them nominally today under our existing arrangements, we’re telling them to double it in their minds.”

Similarly, Wil VanLoh, president and CEO of Quantum Energy Partners, talks of using the downdraft in energy to add to existing investments.

“We like to always have lots of equity in the kitty to double down when things get kind of ugly, as they are now; we love these times,” VanLoh said. With cash flows protected by multiyear hedging programs, and Quantum’s use of only “very modest” debt, “we’re not wringing our hands, worrying about plummeting cash flows and the banks redetermining borrowing bases for our portfolio companies,” he said.

What prospects lie ahead for private equity amid the volatility in equity and commodity markets?

With a 26-year history in private equity, NGP Energy Capital Management can provide perspective on cycles. Tony Weber, managing partner, steers talk of energy investing away from simply the commodity price level—in itself not necessarily an indicator of good or bad times to invest—instead focusing on the process by which future net revenues, based on the prevailing commodity price, are discounted according to the risk associated with differing reserve categories.

“You have to just take the prevailing price, and make sure you’re underwriting these investments in a way that’s safe, in which you can protect your principal, and which earns a reasonable rate of return if the execution on those assets is good,” Weber said.

“Underpinning all that is backing really high-quality people,” he continued. “At the core of what we do every day is to partner with technically savvy management teams that know how to acquire, operate and exploit energy assets. We do that in the coffee shops of Midland and Calgary and Tulsa.”

When institutional investors pull back from funding high-yield bond issuances, that's a great time for private equity to enter the market, according to NGP Energy Capital Management managing partner Tony Weber.

Weber views the weak capital markets for energy, particularly energy high yield, as a positive signal for private equity.

“When institutional investors are pulling back from funding new high yield bond issuances, that’s usually a great time for private equity to enter the market,” he said. Noting the firm’s long-time acquisition and exploitation strategy, he said the firm has bids out on upstream properties, “and we’re starting to win. And a lot of that is conventional. We’re in the midst of closing on some nice acquisitions.”

Conversely, when the capital markets were “frothy” in 2013 and parts of last year, NGP took advantage of the buoyant markets to exit numerous investments, allowing it to make more than $5 billion in distributions to investors over a 24-month period. Distributions reflected good rates of return, according to Weber: mid-20s percent returns on investment and between two and three times investors’ original investment.

“It was a very robust time for exiting investments,” Weber said, noting that exits by NGP portfolio companies included a half-dozen IPOs. “The capital markets were wide open, and we were able to get a lot of those companies into the hands of the public shareholders.”

The six IPOs providing an exit strategy for NGP were Parsley Energy Inc., Rice Energy Inc., RSP Permian Inc. and Memorial Resource Development Corp. in U.S E&P; and Seven Generations Energy Ltd. and Northern Blizzard Resources Inc. in the Canadian E&P sector.

NGP recently replenished its capital base by closing in January its latest fund, NGP Natural Resources XI LP, with total commitments of $5.325 billion. Weber estimated the fund’s capital would be deployed over a period of three to five years. Capital is typically committed 80% to the U.S. and 20% to Canada, where NGP has been active since 1990 and enjoys a strong reputation, according to Weber. Midstream typically accounts for 10% to 15% of investments.

Assets managed by NGP now total about $15 billion. Market conditions favor NGP’s continued use of its acquire and exploit strategy, which has long been its strong suit, he said. “We’re sticking with what we’ve always done: backing teams to go out and make acquisitions and exploit under-managed assets. We’re buying existing producing assets with upside potential today.”

To realize upside from an acquisition today, the acquired assets should—given proper leverage and hedging—first provide an acceptable base level rate of return. Thereafter, proved undeveloped reserves (PUDs) may become more economic as commodity prices move higher, or as a result of new technology being applied to the reserves.

“Of those, I’d much rather bet on our team finding additional molecules than hoping for an extra $5 per barrel,” observed Weber.

In terms of the impact of the crude price collapse on the NGP portfolio companies, “we have very few portfolio companies that are not thriving,” Weber said. He attributes this success to not overleveraging the companies’ balance sheets and to strong hedging programs. “Every time we make an acquisition, or go into a drilling program, we hedge those underlying volumes to protect that investment.”

Part of NGP’s strategy includes developing younger professionals in the energy space through what it calls its “Leaders Under 40 Program.” Weber calls it a “differentiating factor,” under which NGP makes somewhat smaller capital allocations—typically $25 to $40 million—to firms led by a younger generation of oil and gas professionals.

“We have a dozen or so portfolio companies in which we’ve invested that are managed by people on the sunny side of 40 years old. And their track record is every bit as good,” he said.

One of the several assets combined to form Memorial Resource Development was the prolific Terryville complex in Lincoln Parish, Louisiana. Development of the Terryville assets was led by two engineers who “knocked the cover off the ball” with NGP’s initial funding of Wildhorse Resources.

Micro-level insights

At Kayne Anderson Capital Advisors, private equity is geared to the “middle market” segment of the industry, to take advantage of opportunities where its specialist knowledge of regional and industry factors—rather than macro trends influencing commodity markets—comes into play.

“Our strength in investing is very much at a micro level, based on unique insights that we have. That’s where we generate our returns and where we stay focused,” said Chuck Yates, managing partner in the energy private-equity team at Kayne Anderson.

“Of course, you can’t escape the impact of the macro part of the equation,” Yates said. “We do have a broad view of what we think is going to happen with product prices, but we are candid when we say, ‘While we can’t predict product prices, we do prepare for them.’”

The Kayne Anderson team invests in opportunities where it is confident that it knows something that the market does not, which typically comes in the form of a unique engineering insight, Yates said. The firm’s ability to formulate a proprietary viewpoint is no surprise, as roughly half of the partners are practicing reservoir engineers. “We’re able to see how a new technology can solve a problem in West Texas, and then we can work with our portfolio companies to apply that technology in other basins.”

Kayne Anderson’s portfolio companies focus on opportunities in the middle market, transactions of $300 million and below, according to Yates. He cites the firm’s initial $50 million capital commitment to Treadstone Energy Partners LLC as exemplifying the results that can be attained by applying new technology in a basin.

Treadstone Energy paid $18 million for Fort Trinidad Field in East Texas, which was producing 70 barrels of oil equivalent per day (boe/d) at the time. The plan was to reenter the old, producing zones, primarily the Buda and Georgetown, and apply modern technology, including Wolfberry-style fracks. The prize, if the program worked, was a field with a drilling inventory of some 500 wells. The field, with production exceeding 10,000 boe/d, was sold for $715 million in July 2014.

“What West Texas player who knows how to do a Wolfberry frack is going to be interested in buying an $18 million field in East Texas?” recalled Yates. “It probably wasn’t worth their time. But because we play this niche, middle-market area, we’re able to see those opportunities, and we’re able to apply what we call the ‘technology transfer.’”

How has the downdraft in oil prices affected the Kayne Anderson portfolio companies?

The firm’s latest fund, Kayne Anderson Energy Fund VI, which raised $1.6 billion, as well as its Fund V, made investments using a base price deck for WTI of $85/bbl. Importantly, investments were also stress-tested at $60.

Overall, the stress tests worked in the sense that fund investments were able to generate 25% internal rates of return (IRR), assuming a WTI price down to $50 and a 25% reduction in oilfield service costs. These findings applied to 85% of the two funds’ investments on a dollar-weighted average basis, said Yates, “with only one or two plays having fallen out and in need of a higher oil price.”

Kayne Anderson's investing strength is largely at the micro level, based on unique engineering insights, according to Chuck Yates, managing partner.

In terms of oilfield service cost reductions, Kayne Anderson was out early—starting in October—in insisting that all its portfolio companies understand what level of oilfield service costs reductions would be required for them to generate 25% IRRs on their wells, using a flat $50/bbl WTI price assumption.

Pine Brook Partners is telling its management teams that if they know a good area where there are good rocks they know well, to go on the offense, according to Mike McMahon, managing director on the energy investment team.

“We were proactive in getting our portfolio companies out in front of the curve, and getting them working with the service companies so that we could continue to develop plays,” Yates recalled. Given a goal of achieving a 25% overall decrease in service costs, “we feel that we’ve already achieved two-thirds of that reduction, with a really good line-of-sight on the remaining third.”

Portfolio company performance has not been weighed down by significant debt levels. In large part, according to Yates, this reflects a strategy often employed by Kayne Anderson: assembling play acreage; testing the play for what works best and introducing modern technology; and developing the play to the point it can be turned into a manufacturing process that will carry an enhanced value—in all likelihood through a sale—in the hands of a larger player.

Debt levels have been “modest,” he said. “Frankly, until you’ve drilled 15 to 20 wells, you usually can’t access bank debt.”

Kayne Anderson expects remaining capital in its Fund VI to be invested over the next couple of years by companies that have already received commitments. Prior to the fall in crude prices, fund distributions over a 12-month period came to $1.3 billion, reflecting, in part, sales of portfolio company assets in the Rockies, Mississippi Lime and the Permian.

A macro view

Quantum Energy Partners, founded in 1998, has a philosophy that draws upon a broad industry macro viewpoint, while concentrating its portfolio on a focused set of E&P management teams.

“We do a tremendous amount of industry macro work here,” VanLoh said. “We feel that if you have a handle on the long-term trends, it’s easier to understand the direction of the market, even if you’re not precise on timing. We don’t try to predict prices on a given day or month.”

Even as oil prices have dropped dramatically, prompting Quantum to slow down portfolio companies’ capex programs “across the board,” VanLoh is enthused by potential bargains he sees on the horizon.

“Acreage prices have come down all across the country in plays that we know we want to be in over the long term,” he said. “We’re just as active as we’ve ever been. We don’t have a bunch of problems in our portfolio, so we’re able to spend most of our time being very offensive with our existing companies, while also looking at lots of new opportunities.”

Additionally, whereas start-ups by E&Ps may have been the mainstay of new entrants to Quantum’s portfolio prior to the slump in crude prices, “the spectrum of opportunities that we’re looking at today has become much broader,” he said. Moreover, there is no preconceived formula. “We always start with a blank sheet of paper.”

These investments may take a variety of structures to accommodate E&Ps that are “scrambling” to find ways to maintain projects while not outspending cash flow. Among those cited by VanLoh were a variety of joint-venture possibilities, including drilling joint ventures and acquisition joint ventures, as well as PIPEs (private investment in public equity) and structured debt deals with upside from warrants.

Quantum has typically worked with a small, focused selection of E&P management teams. “We’re big believers in having a much smaller number of companies than many of our peers, and have them be exceptional teams, and concentrate our investment dollars in those really good teams,” VanLoh said.

With commodity prices impossible to control, Quantum focuses “on the variables that we can control,” VanLoh said, with management selection at the top of the list. The ability to execute is the No. 1 priority. This means having the requisite reservoir, G&G, and drilling and completion expertise to identify the best rocks and drill and complete wells in line with estimated costs to deliver projected initial production (IP) rates and estimated ultimate recoveries (EURs).

And with commodity uncertainty, “We hedge a lot,” VanLoh said. While many public E&Ps tend to hedge out only 12 months, the average term of hedges held by the Quantum portfolio companies is over three years, with some going out five years. “We look at it almost like life insurance. You don’t try to guess when you are going to need life insurance and buy it. You just make sure you always have it in place. If you’re wrong about commodity prices, it can wipe you out.”

Not surprisingly, Quantum uses “very modest debt,” according to VanLoh, and the firm’s portfolio companies focus “almost exclusively on top quartile plays.” Quantum has mapped some 200 sub-plays throughout North America, and updates the database to review the top 25% in search of 10 to 15 plays with the best risk-adjusted returns.

“Top quartile plays will be the most economic at high prices. But at low prices, they may be the only plays that have any economics, so you can still drill wells even in the downcycle,” he said.

While acquisitions are still relatively hard to close due to the continued wide spread between the bid and ask on properties, Quantum has been able to do a good deal of organic drilling, with good returns, according to VanLoh. Quantum has also been “very successful” in farming into public company acreage, some of it being “core of the core” acreage that wasn’t available 12 months ago.

Lower crude prices are causing the cost structure in the U.S. oil and gas sector to become much more competitive, VanLoh said. “People like to say there is not a lot of elasticity in costs, meaning costs can’t come down that much. But 10 years ago, Quantum was making great returns when oil was $45 to $50 per barrel. The phenomenon of $80 to $100 barrel oil is a relatively short-lived, recent phenomenon.

With the selloff in crude, "we're absolutely skewed towards acquisitions," said Lime Rock Partners managing director Townes Pressler.

“I think that, within 12 months, many of the plays that were uneconomic at $50 per barrel are going to be economic again,” he said. “And with service costs coming down to whatever levels are needed to get rigs running again, the U.S. oil and gas industry is going to be able to make good returns in a $50 to $60 per barrel price environment. This is one of our arguments as to why we don’t see oil prices shooting back up to where they were any time soon.”

Quantum’s most recent fund, Quantum Energy Partners VI, which raised about $3.4 billion in equity commitments, has already made three new investments totaling about $1 billion. Typically, the upstream sector accounts for 75% or more of fund investments, with investments to date split roughly evenly between oil and gas. Midstream and oilfield services each generally make up 5% to 15% of investments. “We’re looking at a lot of distressed-type opportunities in oilfield service now,” VanLoh said.

Notably, Quantum has drawn interest from overseas investors, including sovereign wealth funds. “There clearly is a desire, at least at the sovereign wealth fund level, to put capital into U.S. energy hard assets,” VanLoh said. “Relative to other parts of the world, there is actually a rule of law here. In the less developed world there is not the same level of certainty and thus more risk with respect to the rule of law.”

Over the past six months, Quantum has deferred several potential exits of portfolio companies due to the steep selloff in crude. The last exit by a portfolio company was Rio Oil and Gas LLC, which was sold in a series of transactions to Concho Resources and Diamondback Energy for a total of $585 million in September 2014. Quantum has subsequently backed essentially the same management team in their new venture, Rio Oil and Gas II LLC.

It’s the rocks

Pine Brook’s McMahon describes various “lines of offense” for private-equity players in the current environment. One is having good management teams and arming them with—as described earlier—an equity commitment that potentially may be twice the previous nominal commitment if conditions are right. Another is more tricky—getting the “the moons to line up”—but centers on having good rocks.

“It starts with good rocks,” he said. “From an investing point of view, focus on the core of the core in a play. And if you can’t get into the core of the core, make sure you’re in the first ring outside it. Once you get out of the core of the core in any of the key basins—whether in the Bakken, Eagle Ford, Marcellus or Permian—you’ll find there’s tremendous variability in rock quality, which translates into great uncertainty in economic returns.”

Getting the combination of good rocks, a good management team and a strong balance sheet may not always be easy. “If you have good rocks, an okay management team and a weak balance sheet, you can inject capital, whether it’s in a public or private company,” he said. And, if necessary, a new CEO could accompany an injection of fresh capital. “But if you have bad rocks and a bad capital structure, don’t waste your money.”

In terms of operating adjustments in the lower oil price environment, “it comes down to re-calibrating your economics and focusing capital where you think you can get private-equity returns. And part of that may be not spending that capital right now,” McMahon said. “We’ve throttled back on both drilling and completions. After all, why bring on flush production in a sloppy market, when roughly 50% of the well’s production comes back in the first 12 to 18 months?”

McMahon indicates a tilt towards more development drilling, versus exploration, given the industry’s absence of new play discoveries of late that might have justified the higher risk.

“What that tells me is you should focus more on development drilling, either through acquisitions or drill-to-earn arrangements. And you differentiate yourself by having a management team that can drive down costs and tweak the completion formula to get better IPs and EURs,” he said. “That’s where the money’s going to be made; it’s going to be more ‘operational,’ not necessarily ‘explorational.’”

Pine Brook’s latest fund, Pine Brook Capital Partners II LP, has invested approximately $1 billion of the $2.43 billion raised when the fund closed in early 2014. The fund specializes in financial services as well as energy, with the latter focused on the E&P sector. McMahon said none of the portfolio companies were under “financial duress” but did not rule out new capital to strengthen balance sheets. “I’m not saying we won’t inject new capital, but we’re not talking about material amounts of equity.”

Pine Brook also considers the oilfield service sector to be a “high priority” area going forward. During much of the past two years, according to McMahon, the fund was in many cases outbid when companies came onto the market. “Often we didn’t make it to the second round,” he recalled. “But I think the oilfield service sector is going to be a very good place to put money going forward.”

The intent is not to take on a “vulture” role as regards oilfield service companies caught in the downturn, McMahon emphasized. “We want to find good companies, with good products and services, and good managements, and be their favorite partner who can inject some growth equity.”

A patient strategy

Like Pine Brook, Lime Rock Partners focuses on both the E&P and oilfield service sectors. The two sectors typically are weighted roughly evenly, although in the most recent fund, Lime Rock Partners VI LP, there are seven E&P investments and two oilfield service investments. Capital invested in the two sectors is split roughly 60:40, respectively, with significant committed but as yet not invested capital in the E&P sector. Lime Rock’s sixth fund raised $825 million in capital commitments in 2013.

With the selloff in crude, “we’re absolutely skewed towards acquisitions,” said managing director Townes Pressler. “Last year, we sold a bunch of investments. We’ve re-backed a number of teams, and each of those teams has dry powder for acquisitions. My view is that it’ll take a while for attractive acquisitions to become available. Sellers will start with the ‘bottom of the bucket’ assets first.”

Having sold companies and distributed more than $1 billion to its partners over the past 18 months, Lime Rock’s strategy is to be patient.

“Patience is the word of the day with us and all our companies right now,” said Pressler. “Over time sellers may come to sell their better assets. It’s going to take a while for buyers and sellers to come together. If you’ve seen $100 per barrel oil, no-one wants to sell at $50 per barrel.”

The lower-than-traditional weighting of oilfield services in the latest Lime Rock fund reflects what had been more competitive conditions in the sector until recently.

“In the past three years there was a lot of competition. Valuations went up as generalist shops moved into the market, and it was hard for us to find oilfield service opportunities that were attractive from a valuation and a business point of view,” Pressler said. Taking advantage of the strong market, Lime Rock exited a number of its historical oilfield service investments, including EV Offshore Ltd., a downhole camera company, and UTEC International, a surveying services company. Both investments were in the earlier, fifth fund.

In the E&P sector, Lime Rock exits included Black Shire Energy and Chinook Energy Inc., both in Canada. In the case of the former, Lime Rock went on to back Imaginea Energy Corp., founded by the former CEO of Black Shire. In the U.S., it sold its interests in PDC Mountaineer LLC, based in Appalachia, as well as in Augustus Energy Partners LLC, which was focused in the Rockies, and it exited from its first venture with Capstone Natural Resources, focused on the Central Basin Platform of West Texas.

Late last year, Lime Rock renewed its relationships with the Capstone and Augustus teams, backing Capstone Natural Resource II and Augustus Energy Partners II LLC. Other portfolio companies include CrownRock LP, working the Wolfberry play in the Permian with a long record of success, and Endurance Resource Holdings, targeting the Bone Spring and Avalon in the Permian. Lime Rock also recently partnered with Battlecat Oil and Gas, focusing on South Texas. On the gas side, it has backed Vantage Energy in Appalachia.

Pressler acknowledges that there has been some housecleaning in the Lime Rock portfolio to exit what were “challenged” situations.

“We really cleaned up the portfolio, and have by and large a well-performing portfolio of companies, even at this lower price,” he said. “And with our new companies we have a lot of committed dollars, but not a lot of invested dollars.”

A typical commitment by Lime Rock is $50 million to $150 million, with an expected holding period of three to seven years.

Clearly, with substantial private equity on the sidelines, there are numerous funding opportunities for E&Ps that match up with sponsors’ criteria. Cumulatively, do these private-equity sources bear much influence on total capex spent by the industry—and thus shoulder some of the responsibility when critics suggest the industry spends itself into a downward spiral in commodity prices?

Total capex spending in the industry in 2014 was approximately $200 billion, NGP’s Weber points out, of which private equity accounted for only about 12% to 15%, with the rest being funded mainly by public equity and debt markets.

“I don’t think private equity had much to do with an oversupply of crude,” he said. “The bigger moving parts are the waves of capital that ebb and flow as public capital markets open and close. Our involvement is not changing the macro picture for our industry; we are a participant. We are, however, instrumental in helping small and medium-sized companies grow, and grow well.”