A version of this story appears in the March 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.

Few people have accused energy of being boring. Frustrating at times, perhaps tone deaf to investors historically, but rarely has the energy sector been questioned as to its capacity to change. Geology and technology have evolved in transformational waves, and the industry has shifted in tandem.

Private-equity (PE) sponsors have also learned to adapt. The three-year downturn in oil and gas since OPEC’s 2014 Thanksgiving meeting initially allowed many PE sponsors to scoop up attractive assets at bargain-basement prices. But it also disrupted certain portfolio company investments and significantly dented returns to investors in several PE firms.

“There are a number of PE funds that can’t raise money anymore,” commented one PE participant.

Of late, the rapid rise in oil prices to more than $60 per barrel (bbl) for West Texas Intermediate (WTI) has not necessarily choked back the flow of attractive assets coming onto the market. After a summer slump in public energy equities, many public E&Ps have resolved to focus on returns to investors rather than pursuing a more growth-oriented strategy. As a result, noncore assets and less-developed acreage are said to be still coming to market from E&Ps striving to keep capex budgets close to, or within, cash flow.

Assets that are freed up by the “return to returns” strategy are one dynamic helping PE-backed companies in their search for new investments. But it is just one side of the coin. With investors in many cases increasingly vocal in warning public E&Ps against dilutive equity issuance—say, to finance an acquisition—their PE peers often have to wait longer to execute an exit strategy. In addition, prior to sale, PE assets often need to be further developed by drilling significantly more wells than previously.

One upshot is that, rather than selling to public E&Ps, PE firms are increasingly exiting through a sale to other larger PE sponsors that need investments of greater size to meaningfully impact their portfolios. According to some observers, a greater percentage of PE funds are now concentrated in a fewer but larger hands, some of which invest in energy as just one of several focus areas.

Among PE investors, there is a “flight to quality.” Fund raises continue, but typically require more time and effort. Natural gas is firmly out of favor; oil is the place to be. PE sponsors are carrying more public equity positions in the wake of fewer outright sales or IPOs of portfolio companies. And public E&Ps continue to sell early-stage assets and show little appetite for “incubating” upstream projects, instead leaving them to the PE sector.

In addition, PE funds are diversifying more broadly. Midstream investments have traditionally been tied into upstream activities, but of late they have extended to royalties, frack sand and oilfield services.

A ‘Super-Active’ Year

Despite swirling currents in public energy markets in 2017, Quantum Energy Partners recorded its most active year, according to CEO Wil VanLoh. The Houston-based firm established 13 new portfolio companies—a record for Quantum—and exited from six portfolio companies. The six exits comprised five sales and one IPO.

“It was a super-active year for us,” said VanLoh. “Rarely does it happen that we’re really active on both the investment front and the exit front. Normally, it’s either a buyer’s market or a seller’s market, and we do a lot of one or the other. But last year was different. Certain regions were buyer’s markets, and other regions were seller’s markets. You could transact in both in significant quantity last year.”

Quantum committed about $3 billion in new equity capital in 2017 and tallied gross cash and stock proceeds from exits of more than $6 billion. Sales included both Vitruvian Exploration II and III, involving Scoop and Stack assets, respectively, as well as the IPO of Permian-focused Jagged Peak Energy Inc. (NYSE: JAG). If Vantage Energy’s sale to Rice Energy Inc. was included (a late 2016 exit), gross proceeds would have exceeded $9 billion.

Quantum now has holdings worth more than $3 billion in public energy equities, according to VanLoh. The improved sentiment toward energy late last year and coming into 2018 has obviously been a positive. However, VanLoh has also taken the temperature of energy portfolio managers as to their views of the sector and, in particular, their sense of E&P managements’ likely adherence to capital discipline.

“We own today over $3 billion of public equities at Quantum through companies we’ve taken public or in which we’ve sold to public companies and taken back stock,” he said. “That would put us among the larger holders of public equities in the energy universe. We’re actively talking to a lot of the ‘long only’ energy funds about their views on public equities. For the first time, they’re being very proactive and working in concert to tell management teams and the boards of these public E&Ps that we’ll penalize you—and have penalized you—if you don’t live within cash flow.”

But how strictly are E&P management teams likely to stick to these guidelines if oil prices push higher?

“I do think public E&Ps are generally going to exercise tremendous discipline—at least for the near term,” said VanLoh. “There are some companies that are going to try to buy assets. If you’re an E&P in the Permian, you can likely get away with it, and maybe in the Stack. But outside those two areas, there aren’t many places where public companies can significantly outspend cash flow and get away with it.”

Although only one of six exits by Quantum last year was via an IPO, VanLoh was optimistic about future IPOs, provided they were structured to show an E&P’s ability to reach cash-flow neutrality.

“I don’t think IPOs are dead. What investors will want to see is that you raise enough money in the IPO so that you don’t have to come back to the capital markets for two years,” he said. “And at the end of that two-year period, you can demonstrate to the market that you’ll be cash-flow neutral, that you can live within cash flow and continue to grow your asset base.”

“In addition, you have to have a company that has truly core assets in an established play,” VanLoh continued. “You’ve got to be in an area that has good rock, that the public investor base has already bought into, and which has a big-enough position so that you have good runway and don’t need M&A to continue to refill your inventory. And, you need a management team that has run public companies before, and with the proceeds of the IPO plus a possible debt offering, can show cash-flow neutrality in a couple of years and not be a serial issuer of equity.”

If planning an exit via an IPO, the choice of commodity matters, with natural gas setting the stage for an uphill battle, according to VanLoh.

“The consensus among public equity investors is that there is way too much gas, and that gas has little to no chance of breaking out to the upside for a decade or more. And that time frame—if it’s more than a quarter or two—is an eternity to them, so they’re not going to reward a gassy IPO. Apart from a few companies in Appalachia, like EQT Corp. (NYSE: EQT) and Cabot Oil & Gas Corp. (NYSE: COG), which are returning part of their cash flows to shareholders via a dividend, public-equity markets just don’t like gas.”

As for oil, VanLoh pointed to some concern—especially as WTI hit $60/bbl—that there may be a dwindling number of oily basins where E&Ps can build positions.

“A lot of private companies have this fear factor setting in that they’ve got to get oily,” he said. “There are only a few places to go. The Powder River Basin is one area, and you’re seeing a lot of competition out there now. You’ll probably see that happen in another basin or two. It hasn’t happened yet, so we don’t want to tip our hat as to where we think those other areas are.”

VanLoh indicated a Quantum portfolio company focused on the Powder River Basin would soon be announcing a strategic acquisition.

In the generally more mature Eagle Ford Shale, Quantum made a repeat investment with the Vitruvian Exploration IV management team. With a $450-million equity commitment, the team, led by CEO John Thaeler, has acquired 120,000 net acres of undeveloped and highly contiguous leasehold in one of its target areas, including Sanchez Energy Corp.’s (NYSE: SN) Javelina asset divestment.

Other equity commitments by Quantum show the breadth of its investments across the energy space.

For example, in the midstream, a group of PE investors led by Quantum committed $300 million of equity late last year to Oryx Midstream Services II LLC. The investment will enable Oryx to build a regional crude oil transportation pipeline serving the Delaware Basin. The commitment adds to a $340-million investment that the same sponsor group made a few years earlier, bringing the total to $640 million.

The new pipeline system will have an initial capacity of up to 500,000 barrels per day (bbl/d) backed by an acreage dedication of about 300,000 acres. Combined with Oryx Midstream Services I, the total capacity of the Oryx system in the Delaware Basin will be 750,000 bbl/d with more than 850,000 dedicated acres. E&Ps dedicating acreage include Quantum-backed producers Jagged Peak, ExL Petroleum and Crump Energy Partners LLC.

In addition to recent investments in royalties, Quantum just closed an oilfield service investment—its first since 2014—and has its sights on a couple of drillco joint ventures, in which it may partner with public E&Ps to develop inventory that wouldn’t otherwise get drilled for many years, according to VanLoh.

EnCap Investments LP was able to close out 2017 with a $7-billion fundraise, exceeding its initial target of $6.5 billion, noted EnCap managing partner Murphy Markham. Conditions for raising fresh capital are “more difficult given the market’s apathy toward energy, and there’s clearly been a flight to quality” as a result of the extended industry downturn, he said.

EnCap’s investment objectives remain unchanged: to turn $1 into $2 and to generate a 25% rate of return. Its latest fund, EnCap Energy Capital Fund XI LP, is its 20th institutional fund. As of early this year, its prior Fund X had invested roughly 50% of the fund’s $6.5 billion and had committed 100% of the fund to portfolio companies. Each EnCap fund typically has 20 to 25 portfolio companies.

Markham cited “adaptability” as a key to EnCap’s success. Historically, EnCap has shifted its deployment of capital between an acquire-and-exploit strategy and a lease-and-drill strategy, with the former being dominant a decade or more ago and the latter largely dominating the past 10 years. Today’s mix is said to be roughly 60% lease-and-drill and 25% acquire-and-exploit, with a new mineral strategy accounting for 15%.

EnCap has now invested approximately $1.4 billion in this new mineral and royalty strategy over the past few years. Mineral- and royalty-focused teams, similar to traditional management teams that are focused on building an operated position, are identifying top-tier quality rock and sourcing opportunities in areas with best-in-class drilling economics.

EnCap made a $300-million equity commitment to Pegasus Resources LLC last December. The company’s focus will be on acquiring and managing mineral and royalty properties in established and emerging resource plays, primarily the Permian Basin. Leading Pegasus is George Young, CEO, who most recently served as CEO of Silverback Exploration LLC and previously as president of Collins and Young LLC.

Young is also a nonexecutive adviser to Silverback Exploration II LLC, which secured a $500-million commitment from EnCap following the sale of Silverback I.

A Healthy Oil Price

As oil prices have risen, said Markham, other basins are opening up for investment outside the favored Permian Basin and Scoop/Stack play, to which EnCap has directed roughly three-quarters of its capital in the last few years. The latter still command top quartile economics, but others are gaining ground. Basins opening up to activity are the Haynesville, Eagle Ford and “even the Bakken,” he said.

According to Markham, $60 to $65 oil is a healthy price. “At $65, we believe there’s going to be a lot of drilling opportunities in the Eagle Ford. We are also seeing some good opportunities in the Rocky Mountains, where some tighter formations may have been developed with vertical wells but are now being developed horizontally with very attractive economics. At $60 to $65/bbl, these types of basins are really opening up.”

Markham described the less-than-robust market for public energy equities as “good and bad” for PE.

“The good side is that as we either compete for leases or, more importantly, compete for oil and gas acquisitions, the public market is not active,” he said. “Public companies have been trying to reduce their debt and are not actively pursuing acquisitions. As a result, the A&D market has been very soft. When there is a lack of appetite in the public equity market to fund growth-oriented acquisitions, then the A&D slows down materially. The good news is that we believe it’s a good time to be buying assets.”

The pace of investments has risen for EnCap over the last two years. From an average of roughly $2 billion in investments per annum from 2012 to 2015, EnCap invested about $4.5 billion in 2016 and about $3 billion in 2017, according to Markham.

In terms of equity capital available to be put to work, Markham estimated that with $7 billion in its new Fund XI, coupled with more than $3 billion remaining in its two prior funds, EnCap has approximately $10 billion that can be invested. The typical equity commitment to a portfolio company is $300- to $500 million.

“The negative is we also have portfolio companies that are ready to sell, and we experience the same market dynamics in a sales process,” he continued. “That is, the A&D market is soft, and there are very few public market participants.”

One short-term response, according to Markham, has been to exit via a sale to larger PE sponsors and their portfolio companies.

“Three of our last four sales have been to PE, whereas before it was mainly public entities. Rarely would we sell to another PE sponsor,” he noted. “We’re actually selling multiple companies to typically bigger New York PE firms that are looking to deploy large amounts of capital.”

As an example, Markham pointed to the sale of Eagle Claw Midstream Ventures LLC to New York-based Blackstone Energy Partners LP for $2 billion in cash. Another sale was the $855 million sale of Silverback Exploration LLC to Centennial Resources Development Inc. (NASDAQ: CDEV), which is backed by PE sponsor Riverstone Holdings LLC, also based in New York.

“We tell our management teams to adapt to the environment,” added Markham. “If you stay focused on the most economically advantaged opportunities, you’re going to have an asset that is marketable. This in turn has enabled us to continue to monetize assets during this downturn.”

Tony Weber, managing partner with NGP Energy Capital Management LLC (NGP), cited two key factors in support of prospects for PE sponsors. One is the return to returns philosophy being adopted by some E&Ps, which holds returns to investors as a priority over unfettered growth. The other turns on a sharply tightening supply picture for oil as demand stays strong in a synchronized global economic recovery.

On global supply/demand fundamentals, Weber painted a bullish picture for oil, predicting a need for the industry to add 19 million barrels per day (MMbbl/d) of new production by 2020 to 2021. This assumes a runoff in supply of some 16 MMbbl/d, aggravated by a slowdown by the majors in authorizing major new projects, coupled with annual demand growth of about 1.5 to 1.6 MMbbl/d for both 2019 and 2020.

What other major assumptions are built into the NGP forecast?

Annual global demand growth of 1.5 to 1.6 MMbbl/d is forecast to come mainly from non-OECD regions: China, India and Southeast Asia.

Meanwhile, the U.S. is expected to continue a pattern of production growth driven by advances in technology, according to Weber, who cited a 35% or greater improvement in efficiency in drilling and completing horizontal wells in each of the last five years. “It’s been dramatic,” he commented. “We’ve taken huge leaps in technology capability.”

However, horizontal drilling activity concentrated in the U.S. has a “supply issue” in that decline rates are typically 30% or more in the unconventional sector, noted Weber.

Terrific returns, big decline rates

“Those big horizontal wells are terrific for returns on equity, but they come with big decline rates,” Weber observed. “When you couple that increase in demand with that big drop in productivity per well, it says we’re going to have to fill a hole of almost 20 MMbbl/d in 2020 to 2021. And you’re going to get there in large part through driving production in major U.S. basins: the Midland and Delaware basins; parts of the Scoop/Stack/Merge play; the Eagle Ford; and the Gulf of Mexico.”

The focus on North America, said Weber, is because “that’s where the growth engine resides; that’s where the capital is; and that’s where the rule of law is best. Now is a terrific time to be in this business.”

Also shaping the industry is the return to returns philosophy, noted Weber. Among its key tenets: “Don’t outspend cash flow in any meaningful way just to get growth. Stick to the core of the core of the best basins. Don’t stress balance sheets by taking on a lot of debt. Don’t issue new stock. And by all means don’t issue new equity to grow.”

Recent weakness in the A&D market continues, said Weber, with many of the larger public companies declining to participate in bids for assets. Further, some large E&Ps are selling a portion of their inventory of drillable locations and acreage.

“Who’s going to fill that gap? PE buyers are stepping in to fill the gap,” observed Weber.

Investor sentiment continues to favor the Permian, where competition is “a little tougher,” but the larger opportunity set for PE lies outside the Permian, according to Weber. For the past couple of years, NGP has invested not only in the Midland and Delaware basins, but also in other areas: the oil window of the Eagle Ford, parts of the Scoop/Stack/Merge play, and parts of the Denver-Julesburg (D-J) Basin.

“Given where the dial in technology is set, and where the dial in commodity prices is set, those are the places where we can get our targeted rates of return,” said Weber.

In line with the lackluster A&D market, “the good news is that valuations are appropriate, so we can actually put money to work,” said Weber. “But at the end of the day, you’re probably going to have to hold portfolio companies a little longer, and you may even have to take them public yourself. That said, with a typical PE fund life of 10 years, we don’t have to find an exit in two or three years.”

Historically, most of NGP-backed portfolio companies have exited via an outright sale, noted Weber, while a handful have gone public. Since 2014, NGP-backed E&P companies have participated in more than 50% of all North American E&P IPOs, he added, and include former portfolio companies RSP Permian Inc., Parsley Energy Inc. (NYSE: PE) and Rice Energy, along with current portfolio company WildHorse Resource Development Corp. (NYSE: WRD). “We’ve taken more companies public than anyone else in the energy-focused PE business in the past four years.”

Outside the upstream sector, NGP has allocated 15% to 20% of its fund investments to midstream, oilfield services and other businesses, where it has chalked up a “strong track record with a relatively small percentage of our capital,” according to Weber.

One recent investment has been in Black Mountain Sand LLC, which was “born from the idea we’re spending a tremendous amount on sand when drilling and completing these horizontal wells.” Black Mountain Sand is led by founder and CEO Rhett Bennett, whom Weber described as a “serial entrepreneur working to turn a cost center into a profit center.”

In January, Black Mountain Sand was poised to open the first of two in-basin sand mines in Winkler County, Texas. The mines are located “within 75 miles of hundreds of active rigs in the most prolific basin in North America,” said Weber, and can deliver the company’s “Winkler White” sand at a discounted price relative to competitive sands traditionally brought in from Wisconsin.

“We’re building a world-class sand company, led by a very, very savvy business manager,” commented Weber. “It’s a one-off, unique business plan that is designed to take advantage of today’s market forces in the industry.”

Based in Dallas, Pearl Energy Investments LP is led by managing partner Billy Quinn who previously served as co-managing partner of Natural Gas Partners. Last summer, Pearl Energy closed its second fund, Pearl Energy Investments II LP, with total commitments of $600 million. Its typical commitment to a portfolio company is between $25- and $75 million.

Quinn takes a measured view of the impact of the late December/early January run-up in oil price.

“The front-month price may be up in the low $60s,” he noted, “but the commodity curve is steeply backwardated. We tend to focus on the three-year and five-year strip. The three-year strip is up a few bucks, but the five-year has only gone from $51 to $52, to $53 to $54/bbl. So you’ve had a buck or two uplift in the back end of the curve, but you’re still hovering in the low $50s.

“Clearly, there’s a belief that whatever is happening at the front end of the curve is not sustainable,” Quinn continued. “And until people believe it’s sustainable, there’s going to be a reluctance to deploy capital, particularly on the public-equity side, where markets have been weak. But if you’ve got cash and are looking to buy, it can be an interesting time to be making acquisitions.”

With capital markets “basically closed,” said Quinn, Pearl Energy is finding both unconventional and conventional opportunities at “what we feel are reasonable prices.” Split roughly 50:50, the former are mainly in the Eagle Ford and the West Texas and New Mexico Delaware, while the latter are in East and West Texas and the Rockies.

With Quinn’s prior career experience with NGP, Pearl Energy and Natural Gas Partners have in several instances worked together to establish portfolio companies.

For example, Dallas-based Teal Natural Resources LLC received a $125-million commitment from the two PE sponsors, with each firm making an initial commitment of $62.5 million. Teal has built a position of more than 15,000 net acres in the Eagle Ford, comprising Karnes, Live Oak, Atascosa, DeWitt and Lavaca counties, and is actively looking to expand further in the region. The company’s recent drilling program is focused on Atacosa County, where it is targeting the Austin Chalk. It also has plans to target the Eagle Ford in Lavaca and DeWitt counties.

The Teal Natural team is led by CEO John Roby, who has significant experience in the Eagle Ford. The management team is “patient, diligent and resourceful,” and after closing a second acquisition last year is looking forward to “pretty robust development efforts in 2018,” said Quinn. “At $55/bbl or more, the math in the Eagle Ford looks pretty compelling.”

Based in Houston, Kayne Anderson Energy Funds, the energy PE arm of Los Angeles-based Kayne Anderson Capital Advisors LP, has a middle-market focus and plenty of flexibility in finding opportunities. With nearly half of its staff comprised of engineers, some of its best opportunities stem from smaller, early-stage assets coming to market, according to managing partner Chuck Yates.

“That’s our bread and butter,” said Yates. “If you lease 50,000 acres and you drill 10 wells, you still have a lot of capital to spend over the next three to five years before it’s a self-sustaining field. That’s the kind of asset we typically like to acquire because we think we have a competitive advantage. We like figuring out what technology to bring to bear, whether it’s bigger fracks, or different completion designs, or whatever the case may be. We’re very focused on engineering at Kayne.”

Smaller, Early-Stage Assets

In terms of deal flow, “we think there’s as much opportunity as we’ve ever seen to invest,” said Yates. “We’ve certainly been as busy as we’ve ever been. There’s a lot of supply and limited competition for the assets we like to target. There aren’t a lot of folks who have the engineering capability we have to lean in and look at these types of assets. And bear in mind that it’s in the context of smaller, early-stage assets: 10 or less modern wells on sometimes 25,000 or 50,000 acres.”

Yates sometimes compares the firm with the farm system in baseball, where Kayne targets Double-A players that it can develop and send to the majors. In reality, the firm now has 28 portfolio companies under its umbrella, each funded with an equity commitment ranging from $50 million up to $300- to $400 million, with an average of $150 million. The companies have nearly 20 drilling rigs running.

Roughly two-thirds of the commitments it makes to portfolio companies are with management teams that Kayne has worked with previously. According to Yates, “the single biggest thing that you look for in a management team is someone who shares your view of risk. At the end of the day, if you both view the risk-reward trade-off in the same way, you’re much more likely to have a successful partnership. If they don’t view risk similarly, you’ll probably end up disagreeing on projects and never get anything done.”

Whereas public markets would historically finance a broad range of energy assets, they have recently become “very discerning,” according to Yates. Using the analogy of a beach ball vs. a softball, if the broad range of energy assets that could previously be financed would fit into a beach ball, what public markets will finance since the downturn “maybe fits into the size of a softball,” he said. “But if you have a quality asset, and you have delineated it, you can still get it sold.”

Like certain other PE sponsors, who used to sell mainly to public companies, Kayne has in recent years started to realize exits through sales to other PE firms. Once assets have been delineated to where an inventory of locations is deemed “repeatable,” they are often better suited for a larger PE sponsor that can more efficiently run a “manufacturing operation,” said Yates.

In seeking new assets that may prove economic, the Kayne Anderson team is not shy about challenging popular assumptions. For example, in much of the downturn, it was often assumed that economic plays were limited to the Permian Basin, Scoop/Stack and possibly one county in the D-J Basin, because “that’s the only good rock,” recalled Yates. “We just didn’t think that was true. There were other factors that also came into play as to why rigs were running in the Permian Basin.”

Technology Factor

Granted, the Permian has great rock, but the heightened rig activity also reflected that many E&Ps in the basin had clean balance sheets, he noted. By contrast, one could cite poor rock quality in the Powder River Basin for rigs having exited the basin entirely by the spring of 2015, but other factors were the debt-heavy balance sheets of some participants, notably Chesapeake Energy Corp. (NYSE: CHK), and the fact that new technology had not yet been applied to the basin, he said.

“I think you could talk about that same dynamic—technology not yet being fully applied—to several areas in the U.S.,” observed Yates. In addition to the Powder River Basin, one example is the Texas Panhandle, where thousands of horizontal wells have been drilled for gas. Historically, oily wells in this area were uneconomic, but only a handful were long-lateral wells with modern completions, and the industry has been slow to re-enter this area due to legacy gas wells holding acreage, according to Yates. This is one of the many areas that Kayne believes could be rejuvenated by advancements in technology.

After evaluating rock quality and other factors, Kayne Anderson has now established a portfolio company in the Powder River Basin. It hopes to also add a portfolio company in the Panhandle.

Perhaps more striking is that Kayne Anderson has two portfolio companies that “are very long the Bakken right now,” according to Yates, with its portfolio companies holding about 100,000 acres and running four rigs. Like other basins, E&Ps in the Bakken were drilling long-lateral wells before oil prices plummeted and the basin’s differentials widened dramatically. But much bigger completions, with more stages and more sand, had not been applied at the time, and only later came into use—along with narrowing differentials—to improve the basin’s economics markedly, recalled Yates.

“Seeing that, we decided to invest big in the Bakken over the last couple of years, because we saw a basin where changes in technology just hadn’t been applied yet, particularly on the completions side. And we’ve been encouraged by what we’ve seen,” he said.

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