Independent oil and gas producers have increasingly turned to private equity to fund their operations as capital markets have pumped the brakes on their involvement with the sector, industry observers said recently.
Lenders have pressed shale drillers for more disciplined spending and strategic planning, but less risk-averse private equity investors have been drawn to the producers' growth-minded plans, panelists observed on March 12 at CERAWeek by IHS Markit. While the capital markets are interested in working with established producers, private equity firms have shown a willingness to help other companies get and stay off the ground.
Brian Falik, the chief investment officer for Mercuria Energy Trading, Inc., said his company is interested in helping producers reach the "escape velocity" to get out of debt and generate consistent cash flow.
"We find good producers, good teams that can get there but are not in a true equity position … we'll take that risk and help extend the runway," he said.
In the case of private equity, Falik said, returns may take a back seat to relationships. If a firm is familiar with a potential partner and knows they have a track record of success, then it is more likely private equity will be willing to support them.
"From our standpoint, we're backing the producers we have known for a long time, that have shown capital efficiency and improved operations," Falik said. "The best operators, the most efficient players make sense."
Over the past two years, most independent producers have changed their game plans from attempting to grow rapidly — and rapidly growing debt in the process — in an effort to boost their net asset values and, in turn, their share prices. That approach has recently been scrapped at the demand of impatient investors, who were less interested in growth than a return on their investment. Even though producers are now increasingly focused on returning free cash flows to shareholders, the rate of return has not been enough to impressed lenders.
"Now investors are looking at another model, which is returns versus price per share, and they're looking at the S&P 500. The 500 has 5[%] to 6% free cash flow, and independents are flat," said Timothy Perry, the co-head of oil and gas investment banking for Credit Suisse Group AG. "We think it'll be closer to 4% next year."
Perry said the industry has entered "shale revolution 2.0," and the credit markets are no longer interested in funding growth for independents. Instead, companies will have shown the markets that they can successfully exploit their existing asset base.
"We know where the best rocks are. Now the emphasis is on efficiency," he said. "We're going to look at companies that, in a relatively short period of time, can develop free cash flow."
As a result of the change in approach, Perry said, Credit Suisse now believes the rate of production growth in the U.S. will not meet expectations set a few years ago.
"I think growth in the Permian and the Lower 48 will be much slower in the next five years than people were expecting two or three years ago, and it all gets back to corporate returns," he said. "Things have really changed in the last 12 months."
One area where private equity may be more hesitant to get involved will be in dry gas plays, which Falik said are being overshadowed by production coming from liquids-rich areas.
"I think investment will come, but with the continued [superior] price of oil … that continues to be a very difficult issue, to invest in dry gas plays, because you get so much associated gas from oil plays," he said.