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Lackluster M&A market could upend private equity's upstream model

The lack of M&A activity in upstream oil and gas may have permanently altered the way private equity does business in the sector, Haynes and Boone LLP partner Buddy Clark said Jan. 15.

In a wide-ranging discussion on the health of the upstream segment, Clark explained that having M&A largely halted has put significant pressure on private equity. Instead of providing funding to a small company to allow it to become established then cashing out when the company is bought by a larger competitor, private equity firms are now finding no market for the producers they have bankrolled.

"The investment model for private equity was to find the right people, invest money, have them drill one or two wells and then flip it," said Clark, who is the co-chair of the corporate law firm's Energy Practice Group. "The question is, will that model ever come back?"

Instead of looking to sell their holdings ― at a loss ― at the first opportunity, private equity firms could be better suited to change their approach to investing in producers. Clark suggested they look into a "new model" and scrap the idea of making short-term investments in independent producers.

"That's the new model; hold onto [their position] for a while. Make it a real company … get a team that can develop it," he said. "It would be healthy long-term if it flipped from a nine- to 18-month investment to, 'Where will we be in 10 years or 20 years?'"

Where independents will find themselves later this year is a tough question to answer. Judging from his conversations with clients, Clark said there is no real consensus on whether things are improving for producers or if 2020 will be another difficult year.

"If there's one thing they agree on, it's that they're glad the last decade is over," he quipped. Even though the shale revolution pushed oil and gas production to all-time highs, a half-decade of low prices and a surge of investor discontent rocked the sector in the 2010s. With the debt markets largely closed off to producers, danger could be looming for companies with lackluster balance sheets.

"They're looking at the light at the end of the tunnel and it's probably a train," Clark said. "It's going to be the haves and the have-nots, and there are probably more have-nots."

The lack of M&A activity has added further difficulty for producers in financial stress, as the odds of another company coming to their aid are slim. Most of the producers that have made acquisitions over the past two years have been promptly savaged by investors, giving them more reason to stay on the sidelines.

"The majors aren't being rewarded for increasing reserves … they're being rewarded for living in cash flow," Clark said. "Look at [Callon Petroleum Co.]; they got slammed [for acquiring Carrizo Oil & Gas Inc.]"

Another reason M&A activity has been weak, he said, is the continued struggle between ask prices and bids to find common ground. As has been routine since the 2014 oil and gas price collapse, distressed companies have found their asking price for assets remains well above what potential buyers are willing to offer.

"We have a client with four bids out in data rooms and the sellers aren't exactly jumping on the bids," Clark said. "[Sellers] don't get the bids that satisfy their investors and pull them back. There's always interest at the right price, but until the difference between the bid and ask is narrowed, you'll see companies go into bankruptcy and hide out there for a few months and hope the market turns around."

The first clear look at the state of the industry in early 2020 could come soon, as Haynes and Boone begins to tally the number of bankruptcies in the first quarter and see if there has been any reduction from 2019.

"We're going to see some more in the first quarter, some that were teed up in the fourth quarter [of 2019], then a spurt in the second quarter and hope that's it," Clark said.