Private Equity Reverts To Acquire-and-Exploit Strategy

DALLAS ─ Facing a tough commodity environment with fewer organic growth opportunities, private equity sponsors are turning back to acquire-and-exploit strategies, as opposed to lease-and-drill strategies, while also becoming the dominant buyers in data rooms for conventional properties, according to EnCap Investment partner Murphy Markham.

Speaking at Hart Energy’s A&D Strategies and Opportunities conference, Markham said that, until the recent crash in crude prices, the onset of the “resource play revolution” meant that the lease-and-drill approach accounted for roughly 80% of private equity activity. This was the mirror opposite of 10 years ago, when private equity strategies were focused roughly 80% on acquire-and-exploit, with only 20% employing lease-and-drill strategies.

But with drillbit economics “challenged,” a trend back toward the earlier strategy split was in store.

“I believe the acquire-and-exploit strategies are where the opportunities are going to be, and we’re seeing a lot more opportunities on that front, despite the market being rather quiet because of the low commodity price,” said Markham. More acquire-and-exploit opportunities would likely arise “as companies need to de-lever” in the lower commodity price environment, he noted.

Portfolio companies using lease-and-drill strategies are also adapting to changing market conditions, according to Markham. For example, acreage may be leased in known producing provinces with “limited initial capital exposure.” Only as drilling success warrants, and “as hard value is created,” he suggested, would capital then be “ramped up” for acreage and drilling.

Given the challenge of lower oil prices, however, traditional drillbit economics are more constrained, said Markham, noting that many resource plays do not break even at a $45 per barrel (bbl) West Texas Intermediate (WTI) price. Even in the low-$50’s, only a handful of plays—the Stack play and certain portions of the Wolfcamp, Eagle Ford and Niobrara, as well as the better parts of the Marcellus and Utica plays—make money, he said.

With private equity funds collectively having $85-100 billion to put to work—and EnCap Investments itself having approaching $11 billion available from three of its funds—“the story is one of lots of capital looking for what are few opportunities,” commented Markham. Transactions to date were around $20 billion, he said, with mergers and acquisitions making up around $13 billion of the total.

The more dominant role being played by private equity in oil and gas transactions—at a time when public markets are largely closed or constrained—is reflected in its “drastically” higher participation in data rooms for conventional properties, he said. “Historically, private equity was probably 40% of the people in the data rooms making the bids; today, it’s 85%.”

In addition to “selective acquire-and-exploit” opportunities amid the current low commodity prices, Markham suggested management teams look for what he acknowledged were likely the “few and far between” greenfield leasing opportunities located in core areas. These were among the “best value creation opportunities” and involved “low-risk drilling through farm-ins/joint ventures with small and mid-size E&P companies lacking liquidity.”

And people are key. Historically, roughly half of EnCap’s investments are made with management teams that is has previously backed, according to Markham.

“It’s all about people,” he said. “Talent and adaptability of management teams will ultimately drive value.”

Markham observed that while current oil prices were “well below threshold levels” needed to meet the multi-year demand growth, light at the end of the tunnel was far from clear.

“Be prepared to weather low prices for the foreseeable future,” he advised.

Robby Rockey, vice president of business development with Fleur de Lis Energy LLC, also offered a cautious view of current conditions, saying the crude outlook is likely to remain depressed for the next 12-18 months. For natural gas, prices could be range-bound for the next three to five years in the absence of a positive macro development.

However, Rockey was clearly more optimistic as regards the logjam opening up in the A&D market.

“We expect tremendous acquisition opportunities are going to come out in the next 18 months,” he said. However, being proactive will be important. “Simply going to data rooms, and chasing the next marketed deal, is not going to be the solution. To come out on top, you need to be creative. Creativity will be key to accretive growth and bridging the liquidity gap.”

Asset deals and acreage deals were still closing at strong metrics, said Rockey, citing “robust” metrics being achieved in the Permian, East Texas and North Louisiana. Producers would continue to “core up,” and bigger, multi-basin deals would come to fruition during the next six to 12 months, he predicted.

In terms of preserving cash flow and generating liquidity in the current low-price environment, Rockey suggested an asset portfolio review, identifying assets that no longer fit the portfolio and that can be divested. If it is an option, he advised trying to tap public markets ahead of a potential rush by other issuers that could risk turning market sentiment negative.

“And for assets that you can’t get to (develop immediately) that are high quality, seek out the right partner to develop those assets,” he said. “It can put liquidity in your system. It keeps you in the deal so you get the upside, and it allows you to benefit from what in many cases is a leaner operating structure and probably more efficient capital, and it lowers your G&A costs.”

Fleur de Lis Energy was formed in February 2014. It partnered with KKR the following month using a “co-general partner model.” The private equity firm has completed three transactions involving assets in the Mississippi Selma Chalk, the Permian Basin and the Rockies. Fleur de Lis Energy has $1 billion of capital available to it, mainly focused on 5-10 year or longer strategies.

“It feels to us that the logjam (in A&D) is opening up,” observed Rockey.