Unconventional resource plays have drawn serious attention and dollars from private equity over the past decade. But not everyone agrees on how PE should participate in the ongoing unconventional spree.

Oil and Gas Investor asked several top private-equity executives about their respective position on funding unconventional plays. There are a variety of ways to get into these plays, from backing a private management team to providing project finance for large public companies. Each has a different experience that informs their perspective. Collectively, these perspectives may light the path that led the industry here, and possibly the road ahead.

Worldwide oil and gas capex spending is at all-time highs, despite becoming increasingly inefficient.

History of success

As far back as 2000, EnCap Investments LLC had begun to participate in the development of unconventional oil and gas resources. Starting in the Barnett shale, the company has now funded 25 full-cycle unconventional ventures. Managing partner Gary Petersen says it has been willing to invest in unconventional resource plays or shales throughout the U.S., and is likely the largest private-equity shale player by deal volume in existence today. Despite this apparent shale bullishness, Petersen says EnCap’s activity has been driven by economics . (For more on these deals, see “EnCap Engages,” in the March 2011 issue.)

Marty Phillips, also a managing partner, says the firm doesn’t care how plays are classified, despite having a bullish and successful record backing unconventionals. He says the nomenclature has been incidental to the investment success, and that EnCap attempts to invest in the most economic plays regardless of their classification.

“To participate in this market, you need a large fund,” in the $3-billion-plus range, says EnCap Investments managing partner Gary Petersen, top.

The firm’s management team wants to be in plays in the top quartile of economics in the U.S. It just so happens that many of those recently have been unconventional plays, where EnCap’s investments have yielded a three-to-one return. Phillips says the track record of the industry shows that shales are working better than non-believers might think. Add to that the fact that all of the majors, which exited onshore U.S. plays upwards of two decades ago, have mostly made their re-entries via shale-acreage acquisition.

“We are not suggesting that unconventional investing is not without its challenges,” says Phillips. He acknowledges that the need for large, upfront capital commitments to drill an unconventional program is not for every investor class or company, and that risks need to be managed.

“To participate in this market, you need a large fund,” which Petersen suggests is in the $3-billion-plus range. The variability in well performance characteristic of unconventional plays means investors must be able to drill a volume of expensive wells in a diverse portfolio of acreage. Phillips says there is a shortage of teams with deep experience in unconventional resource development that can be given a capital budget of that size and use it wisely.

A large part of the risk-management strategy, according to Petersen and Phillips, is aligning with the right industry partners—those with the expertise and history in the plays in question—in order to convert the risk in unconventional to engineering risk as opposed to geological risk.

Entering any play at the right time is important to EnCap, which like most firms, wants neither too much drilling risk nor to pay astronomical amounts for acreage that is already de-risked. Through its various equity commitments, the firm is seldom first into a play, but might be an early entrant. Its clients exploit conventional targets simultaneously while gaining understanding of unconventional components of a play, if possible. Once EnCap is in, the questions are whether it and its limited E&P partner can develop the right well architecture and use the right frac technology and the right proppants to mitigate service costs while maximizing reservoir recovery, says Phillips.

Marty Phillips, a managing partner with EnCap Investments, notes teams with deep experience in unconventional resource development that can be given a large capital budget and use it wisely are in short supply.

“That’s what investors pay us to do,” says Petersen, who points out that if the E&P company is in top-tier plays, it should have the best economics. In return, EnCap has distributed a good deal to its investors. Since the economic collapse, it has distributed $5.5 billion, a majority of which was related to exits from investments covering nearly every unconventional play. Petersen and Phillips look to a bright future of further unconventional investment opportunity, and have portions of several funds yet to commit.

“We still have a lot of investment power, and new unconventional plays are continuing to evolve,” remarks Petersen, who says there is a lot of work to be done in plays like the Tuscaloosa Marine shale, the Niobrara, and others.

Mind the cycle

The chief executive officer of NGP Energy Capital Management, Ken Hersh, seems a bit more cautionary. Though not entirely dismissive of backing unconventional activity as a private-equity player, he warns that valuations tend to rise quickly.

“When these plays get hot, valuations get bid up and we tend to be early sellers,” he says, noting the cyclical nature of the industry.

“We tend to not get in the way of these cycles when they move. We have seen the cycles so many times before, and we like to put it in perspective.”

Gas-shale production represents about 20% of total U.S. gas production, leaving another 80% to pursue, Hersh says. With 10% or less of U.S. gas wells sunk in shale, “It’s a big wide world out there.” There is unconventional exposure in all of NGPs portfolio companies, some of which lie in and around conventional targets. This is a situation that is particularly exciting to the firm.

Though not dismissive of backing unconventional activity, NGP Energy Capital Management chief executive Ken Hersh warns that valuations tend to rise quickly.

But Hersh says NGP has crafted a portfolio that resembles the actual North American market: 80% conventional and 20% shale. NGP is active in the Midcontinent, Texas, Oklahoma and Canada in both kinds of formations. Hersh says he doesn’t care whether plays are conventional or not, as long as the value is there, and the risk-return is appropriate.

NGP must have seen some value in particular positions in the Niobrara, Haynesville, Granite Wash, Bossier and Cana Woodford, as the firm was a co-sponsor of the Kohlberg, Kravis, Roberts & Co. LP-led leveraged buyout of most of Samson Investment Co.’s assets for $7.2 billion. Not every unconventional play passes muster, however.

“We find it imprudent to chase valuations up when not all of the plays provide the right risk-return relationship. Some have great risk-return. By focusing on valuation, we sort out those that have gotten ahead of themselves,” says Hersh.

Build models, then companies

Not everyone in private equity is unequivocally positive or negative on unconventional resource investments. Offering a balanced view is Wil VanLoh, president and chief executive officer of Quantum Energy Partners LLC. While Quantum has been intentional in making investments in the unconventional space, VanLoh approaches such projects with what he describes as “cautious optimism.”

Public company return on unconventional project investment has fallen far short of what has been declared.

“The industry has evolved from one focused on conventional reservoirs to one focused on unconventional reservoirs,” he says, acknowledging that in order to be a successful energy investor over the next decade, private equity must have exposure to shale plays as well as to tight oil and gas plays. He says he is now marking oil and gas time as “Before Shale” and “After Shale.”

“Many of private equity’s early success stories in these unconventional plays were more luck than skill, resulting from owning conventional assets in a particular basin only to wake up one morning and find that there was a new shale play underneath the acreage you already owned,” he suggests. The industry has changed, and a successful investment strategy has to change with it.

“These times are very different than what we experienced in the 1990s and early 2000s, when the primary strategy of energy private-equity funds was basically an underground real estate game–buying long-lived producing assets, putting as much debt on as possible and cutting costs,” he says. Back then, many private-equity-backed companies might drill only two or three wells over a four- or five-year time span.

That model will not do in the present industry environment. Investors and management teams must contend with much more technical, execution and cost risk. A typical E&P company can spend tens of millions of dollars on land before drilling its first well, and then have to drill up to a dozen wells that can cost upwards of $10 million per hole, all before truly knowing if the play is going to be economic, according to VanLoh.

“Many oil and gas companies disappeared during the 1980s and 1990s, but the companies that survived by the time we started Quantum in 1998 typically possessed some sort of a competitive advantage. They were great operators, they were extremely cost-conscious and they knew how to extend the life of a field,” he says. Dealing with a distressed price of $10 per barrel oil has that effect.

But from 1999 to 2008, the industry had the wind at its back as oil prices rose about 1,300% and natural gas prices were likewise up about 700%. At that time, a profitable model was easy to execute: just buy some assets, hold them for a few years, then sell them. But that paradigm had consequences.

“The decade of rising commodity prices dulled the focus on superior execution and cost management.”

Getting lucky and flipping land is one thing, but VanLoh says that Quantum seeks to back unconventional players led by a CEO that has been a successful capital allocator in the unconventional space previously, and who has assembled an experienced team. That team needs to be “steeped in geophysics, geology, reservoir engineering, drilling and completion technology and land – all in the unconventional arena,” says VanLoh. In an environment of sub-$4 per thousand cubic feet, there is little room for error and only the most experienced and disciplined teams will find success.

Private-equity providers have moved into unconventional resource investments at many different levels.

Changing dynamics

VanLoh suggests that not all shale plays are created equal and, even within a particular shale play, they are much more heterogeneous than most people think. Using publicly available data for various publicly traded shale players, his team calculated the difference between stated internal rates of return in investor presentations and their five-year average return on invested capital (ROIC), found in corporate financial statements.

What they found was a huge delta. The average IRRs listed in investor presentations ranged from 50% to 80% on average, while the average ROIC from their publicly filed financial statements ranged from 5% to 10% on average. VanLoh is not surprised.

“This always has been and always will be a 10% to 15% rate of return business. There are projects that do much better and there are projects that do much worse, and you can’t forget to include the cost of land, infrastructure, G&A, interest and busted plays,” he stresses.

If public companies with access to some of the best acreage, the best people and technology, and economies of scale, can only generate high single-digit corporate ROIC, it bears asking how private equity can make money in this environment. VanLoh has a few ideas.

“First, you partner with the best people that have successfully executed the strategy for which you are giving them money,” he says. He is convinced that PE needs to back people who know how to let science guide them to the best areas, secure the right acreage at a good price, design and execute on the right drilling and completion program, and do all this while keeping a lid on costs.

“You can’t just say ‘Give me the EOG frac,’” jokes VanLoh, emphasizing the importance of correct application of technology.

“Think about it this way— I can give you the numbers to a combination lock, but without the correct order, you still cannot open it.”

Second, VanLoh says, PE must capitalize portfolio companies to enable them to play the statistics. Unconventional plays inevitably boil down to the simple math of getting enough acreage in the right plays and in the right parts of the right plays. If you don’t have enough capital to spread around your bets, the numbers are against you. Acreage acquisition has a fuse, and that is shorter now than it ever has been.

“It is amazing how over the past couple of years, the cycle time has massively compressed from when you can acquire acreage for just a few hundred dollars an acre, until it costs you thousands of dollars an acre,” says VanLoh. Where the tightrope between drilling risk and acreage cost used to be measured in years, it is now measured in months.

This creates a tight window to be what Quantum considers an early adopter of a play, or in the early developing stage. VanLoh is prepared to pay more for acreage he knows has a higher success rate, rather than buying in at the earliest stages for the lowest acreage cost, when fewer successful wells have been drilled. But being well-funded to manage the probability of success is not sufficient for VanLoh and his team to make returns.

“This is because even with a great team, adequate capital and lots of acreage, the learning curve is still very steep. While the industry continues to apply learnings from one play to the next play with greater speed and accuracy, no two plays are exactly the same,” he says. For confirmation, one need only look at Chesapeake Energy Corp.’s activity in the Haynesville shale. After drilling more than 500 wells in the formation, Chesapeake’s costs were considerably higher and EURs considerably lower than investor presentations touted, he says.

Wil VanLoh, president and chief executive of Quantum Energy Partners LLC, approaches investments in the unconventional space with “cautious optimism.”

That, says VanLoh, is more than a learning-curve problem. The implications about the industry’s return on invested capital in unconventional plays to this point concern him. Indeed, VanLoh’s analysis suggests that very few of the shale-gas wells drilled to date are economic at $4 per Mcf—and alarming assertion, considering rigs continue to run in many gas plays even as the gas price dawdles below that mark.

There is a final component to VanLoh’s point of view that shows his reaction to a change in the industry he believes has already happened. Quantum chooses to be in top-quartile plays, not just for better production on a well-by-well basis, but because he believes portfolio companies must be designed to be going concerns, not just meant for a quick flip.

“There is a lot of unconventional oil and gas in North America and while you could get lucky and get out before having to drill a bunch of wells, you better be prepared to invest your own capital to fully develop your assets. Relying on the ‘greater fool theory’ is not a strategy in Quantum’s investment playbook,” he says.

Over the past five to seven years, most of the industry’s traditional acquirers have retooled themselves into resource-play companies with multidecade drilling inventories. VanLoh is convinced the old model of “build and flip” cannot be relied upon exclusively as an exit in the future. That’s not to say he won’t try to sell attractive assets. But when an E&P builds to own, decision criteria change.

While he is convinced that a lot of money is still to be made in unconventional investment, VanLoh is sober and ever-mindful about the failures in unconventional development, failures that have come and gone much more quietly than the winners.

Patrick Hickey, senior vice president of EIG Global Energy Partners, says the shale boom has created significant capital demands that match his firm’s investment strategy and risk profile.

“For every success story you hear about, there are multiples more that were not successful,” he says.“We are an optimistic industry, which is what enables us to continuously push the technological boundaries and supply our country with relatively cheap domestic energy. But that same optimism is what enables us to ignore the many failures our industry experiences. That said, it’s a healthy dose of ‘cautious optimism,’ in partnership with great management teams, that makes it possible for private-equity funds like Quantum to generate exceptional returns for investors.”

Another way private equity is investing in unconventional reserves came to light when Chesapeake Energy Corp. announced it would launch a new vehicle—CHK Utica LLC—in which EIG Global Energy Partners and its limited partners invested $815 million via a perpetual preferred instrument. CHK Utica LLC will hold 700,000 net leasehold acres on which Chesapeake expects to run at least 10 rigs through 2016.

EIG’s relationship with Chesapeake dates back to 1991, when the firm funded pre-IPO development-drilling capital for Chesapeake. EIG senior vice president Patrick Hickey says this is a way for his firm to gain unconventional exposure with an acceptable risk profile.

“The Utica investment provides an opportunity for EIG to partner on the ground floor with the preeminent shale player in the U.S. Our inhouse technical staff reviewed the available data and was comfortable with making an early-stage investment in the play,” says Hickey. The early results in the Utica are very encouraging, and Hickey says the capital-intensive, highly technical, early-stage nature of the program is a good fit for EIG’s strategy.

“The shale-play growth over the last five years has created significant demand for capital and matches EIG’s investment philosophy and risk profile, as the development tends to be repeatable.”