by G. Allen Brooks

Last Tuesday, we attended two interesting meetings in Houston at which the role of private equity in the energy sector was highlighted.  It was evident after listening to the five private equity investors who presented at these meetings that each sees continued opportunities to deploy capital in the energy business, but they all acknowledge that the industry’s outlook has changed materially over the past nine months and that the industry is not likely to return to its prior condition for some period of time – although exactly how long that time will be is subject to debate.  Reinforcing the view of a changed industry was the fact that we saw and met numerous bankruptcy attorneys and work-out investment professionals at the functions.  

The vultures are circling but they don’t have anything grasped in their claws, yet!  It suggests to us that the bottom for this industry has not yet arrived.

Michael Ryder, senior managing director in the Blackstone Private Equity Group (BK-NYSE) and a member of the investment committee for Blackstone Energy Partners II, spoke at the Private Equity Breakfast to a full house of some 250 professionals.  Mr. Ryder is responsible for the fund’s investments in the oilfield services and midstream sectors, although his talk was about his organization’s total energy investment exposure as well as observations about the energy private equity industry and the outlook for oil and gas markets.  

Mr. Ryder described the success of his firm’s energy focus as Blackstone Energy Partners II was able to raise $4.4 billion in under six months.  According to Mr. Ryder, Blackstone’s two energy funds, along with its access to other private equity money managed by Blackstone gives him and his partners $8 billion to invest in the energy industry, making it the largest pool of uncommitted money in the energy sector.  Given the size of this capital pool, Blackstone prefers to write a smaller number of larger checks, meaning it looks for very large energy transactions.  

In discussing the state of energy private equity investing, Mr. Ryder pointed out that the industry raised approximately $50 billion in each of 2013 and 2014.  For 2015’s first quarter, the industry has raised $15 billion in new capital.  These are significant sums of money.  Mr. Ryder estimated that there was about $200 billion of uncommitted capital available within the energy private equity industry.  He also suggested that the top three investing groups - Blackstone, EnCap and Natural Gas Partners (NGP) – currently hold about $15 billion of uncommitted capital in search of opportunities.  

To show how energy has become a significant investment sector within the private equity business, Mr. Ryder showed a chart that looked at the amount of private money invested each year in energy as a percent of total energy merger and acquisition (M&A) activity.  In 2000, energy, broadly defined, represented less than 2% of energy M&A.  In 2014, private equity energy investing accounted for slightly over 20% of energy M&A deals.  For this year’s first quarter, private equity energy investing was running at a 20% rate, but has now fallen as a result of the recently announced $70 billion purchase of BG Group (BG-NYSE) by Royal Dutch Shell (RDS.B-NYSE).  

In discussing his outlook for the energy business, Mr. Ryder stressed that if you exclude the 2008-2009 correction, this downturn marks the end of a nearly 14-year energy bull market.  His reasoning for excluding the downturn of 2008-2009 was it happened as quickly as did the rebound that the industry barely had time to make any structural adjustments.  As he put it, “this is the correction that cleans it up.”  If one accepts his characterization of the industry’s recent history and the current state of affairs, then companies will undergo much more significant change than what is currently being contemplated by their managements or most outside investors.  We tend to agree with Mr. Ryder’s assessment largely because we believe the debacle of 2008-2009 was in response to a global liquidity crisis.  Once governments, corporations and the public realized that the global financial system was not about to collapse, most economic activity restarted, which largely explains the quick snapback in oil demand and the recovery in oil prices and industry activity.

As Mr. Ryder surveys the current state of the oil and gas industry, he is optimistic the supply and demand imbalance is not great and that demand will grow for both fuels, thus leading to higher prices in the foreseeable future.  One of Mr. Ryder’s concerns about the pace of the energy industry’s recovery, however, is how readily public debt and equity markets have welcomed energy companies.  In fact, he said that he was surprised by the industry’s reception during the first quarter of the year.  This sentiment was echoed by the four energy private equity investors who spoke later that day at the Houston chapter of the Association for Corporate Growth (ACG) lunch.  

Mr. Ryder displayed a table listing all the public energy company equity and debt offerings conducted during the first quarter, which totaled $320 billion in new capital for the industry.  With public markets open, energy companies are now finding cheaper sources of capital available than if they had to rely on private equity.  This diminishes the opportunities for Blackstone and the other private equity funds.  In Mr. Ryder’s view, the availability of public equity and debt funding not only pushes out the timing for opportunities for private equity investments, but it also extends the current downturn beyond what it would have otherwise been.

At the ACG lunch, four well-established energy private equity managers expounded on their views of the energy world and the opportunities and challenges for them and their portfolio companies.  There was a universal theme among the presenters, which was that they are company builders so they are less concerned about managing the downturn and more focused on being positioned for the upturn.  Statements such as “don’t cut to the bone” in dealing with the downturn because you will lose your ability to grow, and focus on how to position for the next upturn by adjusting your cost structure and concentrating on new technologies, were indicative of the views of these managers.  There was an overwhelming theme of technology among the four, as they see it as critical to their portfolio companies’ successes and every one of them wants to be positioned to buy more technology to broaden their positions.  

In discussing how the energy industry and private equity’s role may play out during the current downturn there were several insightful comments.  These energy-focused investors believe there is a lot of new capital available to companies from non-dedicated energy private equity funds.  That becomes a challenge as it increases the competition for good deals.  On the other hand, they see their world of investment opportunities as being bifurcated more between companies with low leverage and those with high leverage, rather than business lines within industry sectors.  They believe that in today’s energy climate, the commercial banks are under pressure to minimize their bad loan portfolios and therefore will be less flexible in dealing with troubled companies.  That could open the door for capital coming from the shadow-banking world.  Private equity is not a part of that world as it is regulated under the Dodd-Franks financial legislation.

What will these private equity managers be on the lookout for amidst the industry wreckage?  They will be focusing on good businesses that were improperly capitalized.  They will shun bad managements and bad business models, but those companies with good managers and solid business plans that were underfunded will be attractive candidates.  

While there were many comments made about the energy industry’s macro environment, one of the more cogent observations compared the price history for natural gas with that of crude oil.  The thought was that as natural gas prices have settled into a trading range of $2.50 to $4.00 per thousand cubic feet that has lasted for several years, it is quite possible that crude oil prices might settle into their own range encompassing both sides of current price levels, or a range of $45 to $65 a barrel.  The manager offering up this observation believes that as natural gas prices established and remained within the range despite cold winters and storage level questions, managers of companies active in the dry gas sector have had to adjust their thinking and operations.  He believes that change will become imperative for those managers dedicated to the crude oil market.  Clearly, he was referring to exploration and production company managements and not oilfield service companies as they are not as commodity-specialized.  

We came away with several impressions from the two presentations and our discussions with fellow attendees.  First, as we mentioned earlier, the vultures who circle over every disastrous industry are circling over energy with high expectations that road-kill victims will soon be available.  Second, there are a lot of smart investors looking for the right opportunity to “buy into the energy industry at the bottom.”  To us, that means there is too much money chasing a limited number of quality investments.  That also likely means pricing on deals initially will be too high.  The private equity investors believe these early investors may have to wait longer for the returns they are traditionally expecting.  Fortunately, or unfortunately, the availability of public money is delaying the typical industry cycle pattern for private equity returns.  

The uniformity of thinking among private equity players is a bit scary.  Group-thought is usually not a successful strategy.  The volume of public capital is not only surprising, but discouraging if one believes the industry needs to experience pain before a true recovery can begin.  Lastly, in looking at the presenters and the audience, there were very few present that experienced the 1980’s forced re-structuring of the energy business following the bullish experience of the 1970’s.  In our discussions that day, we encountered another old-timer who referenced the 1980’s downturn starting in 1982, three years before when most who look at the industry’s history think it began.  We were there then, and this guy had it exactly right.  This industry is headed for significant change.