[Editor's note: A version of this story appears in the June 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.]

It may be “the city that never sleeps,” but a good part of New York—as with other money centers— is in snooze mode as regards energy. After all, the S&P energy weighting comes in at a mere 6% or so. Sell-side firms strive to portray the depth of investor indifference with new adjectives for “apathy.” The latest: “sky-high apathy.”

But amidst the skyscrapers in the city, there are some investors who see opportunity. Private-equity (PE) sponsors have developed new strategies or have invested in new subsectors. Mezzanine finance shines as an option when other capital market options are limited. Sell-side and buy-side firms in some cases perceive a turn in investor sentiment from somber to selectively more constructive.

An early/mid-April visit to New York came on the heels of a disappointing first quarter for energy, in which the XOP (SPDR S&P Oil & Gas Exploration & Production ETF) performed poorly, down nearly 8%. This was despite a 4% move higher in the 24-month crude strip price, noted a Jefferies research report. Analysts often link energy equity moves to forward strip prices rather than to the current oil spot price.

If, as an example, the back end of the commodity curve were to strengthen, how much could energy equity prices rise? As of early April, end-year 2019 and 2020 West Texas Intermediate (WTI) prices stood at a little more than $56 per barrel (bbl) and $53/bbl, respectively. If these rose to around $60/bbl, it would offer upside of 39% and 69% to large and small/mid-cap stocks, according to Tudor, Pickering, Holt & Co.

But this was not the prevailing sentiment in offices above the streets of Manhattan. Instead, energy participants are focused on pursuing the business lines they have carved out for themselves away from the largely becalmed energy capital markets.

Kimmeridge Energy Management Co. LLC is a PE firm with a decidedly different approach: Its focus is on making direct investments in unconventional oil and gas, which are managed by an in-house operating team. This is in contrast to a more traditional model in which PE sponsors recruit management teams that operate assets they acquire.

The investment framework used by Kimmeridge works to the advantage of its limited partner investors, according to the company, in that there is a single ”promote” or carried interest potentially earned on investments made directly by Kimmeridge. By contrast, traditional PE structures incorporate promotes potentially earned by the PE sponsor as well as its management teams making investments.

‘Archaic’ Model

“The big difference for us is that we own and operate all our assets directly. Our view is that the ‘double promote’ model in PE is archaic,” said Ben Dell, founder and managing partner with Kimmeridge. While a 20% promote at the sponsor level is common to both Kimmeridge and other PE firms, putting dollars to work directly—without an intermediary management team—means Kimmeridge investors forego what otherwise may be a further 10% to 30% promote, according to the company.

Given the difference in structure, “if we perform just in-line with our peers, we’ll outperform them,” said Dell. “I think we’re also earlier, faster and more disciplined in making investments. If so, then not only will we outperform on a gross basis, but we’ll easily outperform on a net basis.”

Kimmeridge was founded in New York in 2012 and has since raised approximately $1.7 billion, including more than $1 billion last year. Founders Ben Dell and Neil McMahon covered energy on the sell side at Sanford C. Bernstein (now AllianceBernstein), before moving to the buy side at Bernstein in 2010. At that time, the third founding partner, Henry Makansi, formerly of Warburg Pincus, joined the team.

In December of last year, Kimmeridge announced the final closing of its fourth fund, Kimmeridge Energy Fund IV (Fund IV), at its $400-million hard cap. As of mid-April, the fund was about 58% invested. A typical fund comprises six to eight investments. Kimmeridge funds do not employ leverage. The commitment period for investors is three years vs. a more typical five- to seven-year period.

Shorter Duration Funds

“Our history is to have shorter duration funds, deploy capital rapidly and, ideally, return capital quickly, and then go back out with new products,” said Dell. “I would rather undersize the fund, deliver the money back to investors and give them the option of investing back with us rather than having capital sit undeployed for years, which I believe is going to be a big problem for some of the mega funds.”

Kimmeridge now has several funds under its umbrella. A little over a year ago, it had its final close on a $500-million Permian-focused minerals fund, which is now approaching 67% deployed. It also has two co-investment vehicles alongside Fund IV. One, which raised $188 million, co-invests in the Powder River Basin (PRB). The second, at $65 million, supplements Kimmeridge’s new public-equity strategy.

While the absence of a double promotes in Kimmeridge’s direct investment model is a key factor in delivering returns to its limited partners, there are also other advantages to the model, said Dell.

“We control capital allocation between our assets on a daily basis,” he said. “Every asset is competing against each other; there’s not a line of credit out for each asset. You often see the major funds deploying $500 million with a management team when there are no immediate plans for it. When money goes out the door for us, we’re actually putting it straight into the asset.”

In-House Knowledge

“We also have better operating control,” Dell continued. “We can move faster, make quicker investment decisions and, more importantly, we retain the knowledge over our operations across basins in-house. It doesn’t leave us when a management team sells an asset and then walks out and starts negotiating with other PE funds about a next round of capital. Our knowledge remains in-house, contained within the organization, with our operations team in Denver.”

In terms of defining its strategy, Kimmeridge believes that “the business is inherently simple: You have to find oil and gas cheaply and generate high-cash margins,” according to Dell. “I tell investors that our business is to develop unconventional resources at the front of the North American cost curve and to access as cheaply as possible assets with the lowest cost and the highest cash margins.”

With greater scope to control finding and development (F&D) costs, “you really have two scenarios: One is to be an early mover and to take on the geologic risk of de-risking an asset. The other scenario is to do land aggregation work that no one else wants to do,” he said. “Our core business involves building a portfolio of opportunities around those two strategies.”

As examples, Dell cited its acreage in the Delaware-Central Basin Platform as “more of a de-risking play,” while the PRB exemplified a strategy of land aggregation. In the latter, the firm’s first lease covered just 40 acres, he recalled. Since then, Kimmeridge has organically increased its position to roughly 30,000 acres at “a materially lower price” than recent larger transactions.

“We already have production,” said Dell. “We already have well results that confirm our PRB thesis.”

What was Kimmeridge’s thesis going into the basin?

With improvements in completion technology catching up to levels on par with the Delaware, “you’re seeing a comparable uplift in well performance,” said Dell. “You have multiple, stacked overpressured zones that are attractive for unconventional development. We think the Niobrara is the most repeatable, highest-quality unconventional play in the basin.”

Public-Equity Strategy

As with its PRB opportunities, Kimmeridge also has a co-investment vehicle to supplement a public-equity strategy. In effect, the concept of purchasing public E&P equities came about as part of the firm’s land aggregation strategy. The result is that Kimmeridge has acquired positions amounting to about 8.1% of shares outstanding of Carrizo Oil & Gas Inc. (NYSE: CRZO) and 4.8% of Resolute Energy Corp. (NYSE: REN).

“We bought into public equities in Fund IV as part of our Permian aggregation strategy,” explained Dell. “Right now, the cheapest way to aggregate land at the front of the cost curve is through public equities. If that opportunity arises, what our limited partner investors want us to do is to aggregate positions at the lowest possible cost—and that doesn’t necessarily mean having a landman on the ground taking a 50-acre parcel if we can do that through some other methodology.”

A Schedule 13D filing by Kimmeridge with the Securities and Exchange Commission indicates two specific actions it has asked Carrizo to “strongly consider.” One is for Carrizo to “completely divest its Eagle Ford position to pay down debt and become a Permian pure play.” The other is for Carrizo to “merge with another operator with Permian overlap to increase scale.

“Our involvement in public equities is very different in that we’re long-term holders—we understand the strategic direction, what needs to happen in the space,” commented Dell. “We know the assets extremely well. In many cases, we own the minerals around them in our mineral fund, or we’ve been an operator in that area before.”

But a move to take a position in a public E&P by Kimmeridge should not be considered merely symbolic.

“When we invest in a public company,” said Dell, “we underwrite the view that we would ultimately own the company at that price point if we had to. That’s our thesis. Do we like the asset? Do we like the valuation? If I had to buy 100% of it at that price, would we? Absolutely. Ultimately, we would run the company if we needed to. We have the capacity to do so. And we would do it a lot cheaper.”

Dell is a strong advocate for major consolidation among the many E&Ps active in U.S. producing basins.

“We need to see consolidation in the public space,” he said. “The sector is massively disaggregated, with too many operators repeating the same activity set. What the industry needs is ‘zero premium’ combinations, where synergies and cost reductions increase returns to the shareholders, and SG&A is removed and management compensation is redesigned based on absolute performance.”

More Than A Check

David Albert, a managing director based in New York with The Carlyle Group, said that while alternative asset managers focused on energy have ample capital to put to work, energy companies are no longer simply seeking capital—they want solutions.

“Companies with whom we work need more from us than just a check,” he said. “They want to know we understand their businesses, that we’re flexible, and that we can work with them to overcome the strategic and financial hurdles they face.”

Albert is the co-head of the Carlyle Energy Mezzanine Opportunities Fund II, which raised $2.8 billion, more than twice the amount of its predecessor fund. Individual investments can range in size from $50 million to $2 billion or more due to Carlyle’s ability to tap into the capital from co-investment funds.

“It feels like alternative sources of capital are now in a better position than they have been for a while,” observed Albert. “Capital markets are challenged, and companies don’t want to overload on bank debt after getting burned in the last downturn. And yet, in the current environment, energy-focused management teams are finding a lot of attractive opportunities to pursue.”

“We’ve got a lot of capital, and we’re actively seeking to deploy it,” he continued. “The key to doing so successfully is partnering with high-quality companies that wish to grow, but are currently capital-constrained.”

Companies with no shortage of opportunities, but are lacking capital, include both small private companies and large public companies, according to Albert.

“Even investment-grade, multibillion-dollar market-cap companies are constrained and being forced to prioritize their drilling inventory,” he said. “That means that large amounts of attractive investment opportunities don’t make the cut and are left on the sidelines to pursue in later years.”

Accelerating Asset Developments

“The problem is that equity markets don’t typically place huge values on undeveloped assets to be developed at some unknown point down the road,” he said. “For these companies, Carlyle can provide capital and solutions that accelerate development activity without materially, if at all, negatively impacting the company’s credit profile.”

Carlyle is fortunate to have developed relationships with many ‘blue chip’ companies in its latest fund.

“Late last year we invested $300 million with Black Stone Minerals LP, the largest publicly traded oil and gas mineral rights company in the U.S.,” said Albert. “Earlier in the year, we announced a $400-million drilling partnership with Baa1/BBB+ rated EOG Resources [Inc.]. We also closed on a $1.2-billion preferred investment with privately held Hilcorp [Energy Corp.].”

Albert cited Carlyle’s energy mezzanine fund as “one of the few places you can turn to if you’re looking for capital, and you’re not willing to give up governance to a control-oriented private-equity firm. That’s what makes us different: We’re not looking to tell EOG or Hilcorp how to run their businesses. We can invest throughout the capital structure. In our partnership with EOG, for example, we hold a direct real property working interest.”

Constructive Mezzanine Partners

Carlyle’s energy mezzanine team seeks all-in rates of return above those generated by the high-yield market but lower than those targeted by traditional private equity. That said, according to Albert, “If someone is going to take our capital, our cost of capital is typically less important than our ability to not only act quickly and provide one-stop-shop capital solutions, but our willingness and desire to be constructive partners.”

In the fund’s November 2017 deal with Black Stone Minerals, it purchased the entire $300-million tranche of Series B Cumulative Convertible Preferred units issued by the company to support its acquisition of mineral rights assets owned by Noble Energy Inc. (NYSE: NBL). Although the company’s market cap was close to $3.5 billion, public markets were not optimal as a source of capital. This was due to the short execution timeframe of the acquisition and uncertainty over market depth prevailing at that time for publicly placed convertible securities in energy companies.

The Black Stone Minerals investment was structured with a 7% coupon and a 15% conversion premium over the trailing 20-day, volume-weighted average price.

Dislocated Markets

John Moon, managing director and head of Morgan Stanley Energy Partners (MSEP), points to continuing investor skepticism and a significant dislocation between equity prices and the commodity as factors that have tended to sour public capital markets—but place a premium on private capital.

“The markets are still dislocated,” said Moon. “The prevailing environment is one in which investors are somewhat skeptical, and they’re saying, ‘If your assets are so great, show me the money.’ The markets are in a show-me mode. Investors want to see positive cash flow.”

MSEP makes equity and equity-related investments in middle-market companies mainly in North America. The majority of investments have been in oil and gas, but they can be in companies “engaged anywhere along the energy value chain,” according to Moon. Investment size ranges from $50 million, with co-investments, to as much as $250 million.

“Right now, we are very busy,” said Moon. “With public producers’ new-found capital discipline, limiting capex to within cash flow and selling off noncore assets, you’re in a really good place if you’re a PE firm with capital looking for opportunities.”

MSEP invests in a wider range of energy sub-sectors than just the upstream sector, which has become increasingly competitive, said Moon.

Oilfield, Midstream And Water Management

In March of this year, MSEP closed an investment in a Canadian oilfield service firm, Specialized Desanders, Inc., based in Calgary, Alberta. The company specializes in providing patented, high-pressure equipment that removes sand and other solids during a well’s flowback and production process.

“The company has long-standing relationships with top Canadian E&Ps, and its patented technology is beginning to rapidly penetrate the U.S. market,” said Moon. “Specialized Desanders will continue to play a growing role in enabling the next generation of completion techniques.”

The Canadian investment follows majority equity investments made in the latter part of last year in two U.S. midstream firms. Houston-based Durango Midstream provides traditional midstream services to producers in Texas, Oklahoma and Kansas, while XRI Blue, based in Midland, Texas, is a water management and pipeline transportation company serving upstream producers in the Permian Basin.

Durango Midstream is led by Richard Cargile, formerly president of midstream operations with Energy Transfer Partners. The investment by MSEP is designed to expand Durango’s existing gathering and processing operations in Grady County, Okla., which support the growing Scoop-Stack and Merge plays, as well as its operations in Wheeler County, Texas, to support producers in the Anadarko Basin.

XRI Blue is “the largest supplier of nonpotable source water in the Midland Basin,” according to Moon. “The team set out to find the deep aquifers with high productivity, but also hold some level of salinity so that it’s a constant supply source—even in drought conditions—and not needed or suitable for livestock.”

In addition, sources close to MSEP have shared that they expect to execute the next E&P deal through an investment in Presidio Petroleum LLC, which will acquire an E&P with assets in the Anadarko Basin. Presidio is led by co-CEOs Chris Hammack (formerly of Trinity River) and Will Ulrich (formerly of Atlas Energy).

While these private capital sources have moved the ball forward in their specific fields, those covering public energy equities made their way over a rocky road in the latter part of the first quarter. But are they beginning to see a glimmer of brighter prospects on the horizon? Could investors begin to direct meaningful money into the sector?

Not Believing $70/bbl

Bob Brackett, senior research analyst with AllianceBernstein, is suitably circumspect. The energy sector is “underappreciated. There aren’t a lot of generalists clamoring to build positions,” he observed. “Clearly, people don’t believe in the current spot price for Brent above $70/bbl, and nor should the market give credit for the $70-plus price we might be enjoying for a little bit.”

Brackett said investor skepticism is because the recent upswing in spot crude prices has its roots largely in an “OPEC discipline recovery” combined with a “geopolitical recovery,” neither of which carries as much weight as demand and supply fundamentals. He estimates energy stocks are embedding around $55 to $60/bbl, roughly in line with the 12-month crude commodity curve as of mid-April.

Bernstein’s price deck projects Brent averaging $56/bbl this year and $60/bbl in 2019, while WTI is expected to average $50 and $58/bbl, respectively.

Brackett pointed to U.S. Energy Information Administration (EIA) data showing that recent U.S. crude production, including NGL, was running 1.9 MMbbl/d higher than a year ago. In addition, he noted that U.S. rig activity had grown by more than 130 rigs since last November. Assuming a four-to-six month lag from rig approval to first production, the incremental impact on output has yet to be seen, he said.

As to the possibility that U.S. production may fill a gap in production left by OPEC’s so-called “Fragile Five”—Algeria, Iraq, Libya, Nigeria and, in the greatest straits, Venezuela—the question is whether “the pace of those declines continue, or do they bottom out?,” said Brackett. But, again, it comes down to a call on geopolitical events, he commented. “It’s all very ‘wait and see.’”

What money has flowed into energy has been focused mainly on large-cap value names that have taken definitive actions—not just talk—in implementing shareholder returns, such as stock buybacks and dividend increases, according to Brackett. Leading the way in creating the most market cap to date this year have been names such as Anadarko Petroleum Corp. (NYSE: APC, +25%), Hess Corp. (NYSE: HES, +19%) and ConocoPhillips Co. (NYSE: COP, + 18%), he noted.

Bernstein undertakes quarterly studies that, most recently, aggregated fourth-quarter earnings for the top 60 E&Ps. The findings were that, if the E&P sector were a single company, it would have earned, at $55 oil, roughly $3 per share in “clean” earnings on $12 per share of DD&A (depreciation, depletion & amortization—being used here as a proxy for average capital invested per year).

“That’s a 25% return on capital. That was really good business when WTI was $55/bbl on average, and it’s even better today with crude $10/bbl higher,” said Brackett. “You buy oil when it’s below marginal cost, and you sell oil when it’s above marginal cost, and that applies similarly to oil-linked equities. We’re in a world where the price of oil makes these shale businesses phenomenal.”

Too Much Money In Shale Hands?

So what’s holding back investors from going long the sector to capture these returns?

The market hesitation is “either that the spot price has got ahead of itself so that we need a little lower price to balance the market,” said Brackett. “Or we need to see a lot of supply roll over from outside shale, whether it’s due to geopolitical factors in OPEC countries or whether it’s the offshore production cycle finally rolling over.

“It feels like we got here too quickly, and we’ve put too much money in the hands of the shale guys.”

Brackett sees a lack of major new projects being authorized as causing offshore production to turn down by the end of 2019. Meanwhile, geopolitics can cut both ways, he added. Conflicts can take output off the market, “but you need to keep unrest low enough so it doesn’t start destroying demand.”

As for Concho Resources’ recent combination with RSP Permian Inc. (NYSE: RSPP), Brackett saw it as a recognition that “scale matters” in areas such as accessing rigs and completion crews, as well as paying for gathering and water-handling systems and securing firm transportation to markets. Adjusting for production, the price paid for acreage of $75,000 per acre was a “high watermark,” but not unreasonable.

Substantially all of RSP Permian’s acreage was top tier acreage, said Brackett, and paying up for core acreage may be the right move if it delivers $5/bbl F&D costs (e.g. $6-million well cost for 1.2 MMbbl of reserves) rather than $20 F&D costs in fringe areas (e.g. $6 million for 300,000 bbl). Even $100,000/acre, or $2.20/bbl in added costs, makes sense if base F&D costs are $5/bbl, he noted.

(This assumes three zones are developed, with eight wells/zone, for 24 wells/section. At $100,000 per acre, a 640-acre section burdens each well with $2.66 million, or $2.20/bbl on 1.2 MMbbl of reserves.)

Consolidation Ahead?

Over time, Brackett sees the possibility of further consolidation among the Permian E&Ps.

“If two of the smart guys in the Permian say, ‘Let’s get together, because scale matters,’ somebody should listen to that message,” he observed. “You would expect the small- to mid-cap players with good acreage to look around on their own, or for the large caps to come and make them an offer.”

More broadly, what else may attract generalist investor interest in the energy space?

“E&Ps have to compete on real metrics,” said Brackett. “What attracts a generalist is a predictable business model, so the better behaved the E&Ps’ businesses are, the better the prospects. And we have to recover from the perception that E&Ps are cowboys that spend 120% of cash flow, and you never see any cash flow back.”

E&P senior analyst Betty Jiang covers 22 small- and mid-cap names for Credit Suisse, with roughly two-thirds of her names having some Permian exposure. Jiang estimates that the Permian Basin accounts for about 75% of projected growth in U.S. oil production, but she has looked to other basins for her top E&P recommendations in light of increasing Permian takeaway issues.

Credit Suisse’s price deck reflects a “more tempered” outlook on U.S. production growth, with WTI prices projected to average $66 and $65/bbl, respectively, for 2018 and 2019. Credit Suisse’s long-term price assumption is set at $60.

“We generally have a more balanced view of U.S. oil production,” said Jiang. “We see U.S. crude production growing sustainably by 800,000 bbl/d a year, excluding NGL, which is a more tempered view than some of our peers. We think forecasts of over 1 MMbbl/d black oil growth are not sustainable given the decline curves of these companies and some of the takeaway constraints they’re facing in the Permian.”

In addition, Jiang pointed to data projecting a sharp drop in production from major projects coming on in non-U.S., non-OPEC countries. Previously authorized projects due to start up in 2019 are forecast to contribute output of just 560,000 bbl/d, down from 2.6 MMbbl/d in 2018 and 1.5 MMbbl/d in 2017.

While a potentially tightening macro view is welcome, Jiang’s coverage companies do not need $60-plus WTI prices to make good money. Even at a $50 to $55/bbl price range, they all “all generate very attractive returns and strong cash flow,” without experiencing cost inflation and takeaway issues that emerged in the Permian at $60/bbl and higher.

Where Are Bargain Hunters?

The conundrum is that—in spite of attractive valuations, sustainable growth and capital discipline—“we’re still not seeing the bargain hunters come back into the energy space,” according to Jiang.

While some uplift has occurred in the back end of the commodity curve since early April, what changes the status quo in a more meaningful manner?

Generalist investors are likely to be pushed into “refreshing” their view of energy when they “feel pain” from having an underweight position in or no exposure to energy, according to Jiang. This will likely coincide only when there is a “sustained upward move” in the commodity, but “the returns are set up to be all the more attractive when investors do look at energy again.”

In terms of M&A, Jiang said Credit Suisse’s viewpoint may be “out of consensus” in thinking that combinations may be less prevalent than some in the investment community expect. “And the reason for that is not for the lack of sellers, but for the lack of buyers. Because of investor pressure for capital discipline, a producer is less likely to go out and pay a premium for a publicly traded E&P.”

This means combinations are limited mainly to “mergers of equals,” a category into which Jiang included the Concho-RSP Premium deal. “But not everyone has the premium currency to do deals accretively,” she said, citing Concho, Diamondback Energy Inc. (NASDAQ: FANG) and Pioneer Natural Resources Co. (NYSE: PXD) as the only E&Ps with such a currency. Pre-deal, Concho’s stock was trading at roughly three EBITDA turns higher than RSP’s, she noted.

In terms of current top recommendations, Jiang’s list contains no pure-play Permian names, since Permian E&Ps face “a wall of worry” on several fronts: takeaway issues on both oil and gas, triggering wider differentials; rising oilfield service costs; and produced water takeaway needs. “We’re running out of pipe capacity on both products,” she said, noting increased requirements for trucking and/or rail and risks of further logistical bottlenecks. As a result, Jiang cautioned that the EIA’s projection for second-half U.S. production growth may be too high.

Instead, Jiang’s top recommendations, as of April 31, include WPX Energy Inc. (NYSE: WPX), Continental Resources Inc. (NYSE: CLR), Viper Energy Partners LP (NASDAQ: VNOM) and Extraction Oil & Gas Inc. (NASDAQ: XOG).

It’s a slow process, but generalist investors are gradually being won over to the energy space, according to Joe Allman, Baird’s senior research analyst in New York. Because of energy’s renewed focus on generating cash flow and, ideally, free cash flow, “I’ve met with generalists who are now more attracted to the energy sector due to this strategic shift,” he said.

Time To Pay Attention

“It’s a market. Some investors are skeptical, but some have heard what E&Ps are saying and believe it,” said Allman. “Energy currently has a relatively low weighting in the S&P, but some smart investors are probably going to see that as an opportunity and say, ‘We’re likely closer to the bottom than the top in energy, so it’s time to start paying attention.”

Allman generally views M&A activity as an isolated event—more “one-off” in character—and doesn’t anticipate a surge in activity following the Concho-RSP combination. “Until companies realize they need more inventory and have a tough time growing their inventory organically, I don’t expect to see a slew of M&A deals,” he commented.

Allman continues to view net asset value (NAV) as a key valuation yardstick, even as some research firms have de-emphasized its importance.

“Over the last 10 years the energy stocks have tended to trade close to 100% of NAV [all sources],” he said. “There are periods of dislocation, when the average stock trades at a pretty significant discount to NAV, and I think we’re currently in a period of dislocation.”

As of mid-April, the median stock of Allman’s coverage traded at 82% of NAV, or an 18% discount. Two weeks later, the median stock traded at 89% of NAV, or an 11% discount. By the end of the month, the Baird E&P Index was up more than 12% in April, noted Allman.

The motivation for E&Ps to adopt a “strategic shift,” in which they embrace traditional metrics of free cash flow, dividends and return on capital employed (ROCE), etc., can be attributed to several factors, according to Allman.

One is that, after bankruptcies and many instances of severe financial stress in the downturn, E&Ps have been “scared straight,” a term used to warn juveniles against a life of crime. Other factors include investor insistence on prudent capital allocation at a stage in the industry’s evolution that should prioritize returns rather than, for example, further acreage acquisitions.

In terms of stock recommendations, Allman favored as of May 1 large-cap EOG Resources Inc. (NSYE: EOG) and small- to mid-cap SM Energy Co. (NYSE: SM), which Allman described as “one of the most productive operators in the Midland Basin.” One other, categorized as a “fresh pick,” is Parsley Energy Inc. (NYSE: PE).

Difference In Sentiment

Shawn Reynolds works on the buy side as portfolio manager for the Global Hard Asset Fund at VanEck Associates in New York. Founded in 1955, VanEck specializes in managing “real assets” in such sectors as energy, precious metals, diversified miners, chemicals, railways and other infrastructure. Energy makes up the largest component of the company’s roughly $4 billion in assets under management.

“I definitely feel a difference in sentiment toward the energy space,” said Reynolds. “Although we haven’t seen any new big institution come in yet, we’ve seen inflows from existing clients rebalancing at the end of the quarter. In addition, we’ve seen one of the largest investments in the fund we’ve ever seen, which we believe is reflective of a greater allocation to the hard asset space.”

Reynolds points to a paradox facing the industry, namely that valuations, in term of Enterprise Value (EV)-to-EBITDA, have been on a downward slide when, he argues, they should be on the rise. But, first, he said, the industry “has got to become relevant to the market. Everyone likes to compete against their fellow E&P or their fellow oilfield service guy, but few investors care about the space these days.”

Compared to an earlier era, when E&Ps tried to build NAV by adding meaningful reserves through exploration, “the high-risk search for reserves is mainly over,” he recounted. For the last 10 years, the shale play has largely involved choice of basin, selection of target formation, expanding play perimeter, etc., he continued. “That was the investment stage.”

“Now it’s time to actually harvest everything we’ve done for the last 10 years,” he said. “And the way you do that is to be prudent in capital allocation, execute on your plan, and generate returns on capital and a return of capital, whether it’s a dividend or a share repurchase.”

But the key part of the story is that “shale allows you to follow a business model that you didn’t have with an exploration model,” said Reynolds. “With exploration, you couldn’t think about returns. You had to think about where your next barrel was going to come from, almost at any cost. You never knew. That was the risk; it was almost all geologic.”

In terms of valuation, the shale industry “should, if anything, trade at a premium to historical levels because you’re largely eliminated risk,” he observed. “You’ve got amazing visibility of production and a technology that has only got better in terms of lower and lower costs. It’s a different industry. If you tell me my risk is lower and my growth is better and more visible, that deserves a higher multiple.”

With the Global Hard Asset Fund also heavily involved in the mining sector, its experience with the miners during 2012 to 2017 showed what could be achieved in a similar resource sector.

After several years—and some CEO departures—the mining stocks were paying dividends, Reynolds recalled, and the question with some was what would be done with all the cash. The mining stocks were rewarded with higher EV-to-EBITDA multiples, which increased from 3 to 4 times EBITDA to 8 to 9 times EBITDA—levels that were “almost too expensive,” he said.

The advice from Reynolds to energy producers: “Don’t give me, ‘You can’t do it.’”

Chris Sheehan can be reached at csheehan@hartenergy.com.