This story is sponsored by First Reserve
The Organization of the Petroleum Exporting Countries meeting in November 2014 was an inflection point for the oil and gas industry. OPEC opted not to cut production to halt a slide in global prices; thanks to oversupply, prices plummeted. Originally thought to be a six to 12-month dip similar to that seen after the global financial crisis in 2009, five years later it’s clear that was a much more relevant transition point.
Today, with supply and demand relatively in balance, the industry focus is on driving efficiencies, explains Alex Krueger, president and CEO of First Reserve. Backing a thesis that commodity prices will be the root of success just won’t cut it, and energy private equity must proactively create value.
How far on the journey to efficiency has the industry come?
Whether you’re an upstream oil and gas producer, a midstream operator or refiner or petrochemical processor, or whether you’re a utility company, there’s an extreme focus on driving efficiency to generate free cashflow. This is where we are for the foreseeable future, as the industry has really hindered itself with its past performance and its inability to deliver a sufficient return on capital during the preceding years.
We’re still in the early stages of the ability to drive further efficiencies and change the mentality of the industry to one that’s focused on continuous improvement and on profit margin as opposed to an industry that historically had been focused around geology driving outperformance; with the size of discoveries compensating for the expense of developing a project.
What does a good energy investment opportunity look like right now?
At First Reserve, we think you need to understand the interaction between the upstream, the midstream, the downstream and the services and equipment that span them all.
As the US industry has gone through this growth spurt and has identified new resources in new basins or revitalised old basins such as the Permian with much more production capacity than it ever had before, all the infrastructure along the value chain is getting stressed. Approximately 50 percent of the oil and gas pipelines in this country are north of 40 years old, and they’re largely fully utilised. That, coupled with the consistently increasing focus on safety and protecting communities from environmental hazards, as well as the regulation that supports this focus, has meant there’s an increasing need and requirement for preventative maintenance spending and for ongoing inspection, repair and maintenance of these ageing bits of infrastructure, as well as supporting the same quality-assurance needs for new infrastructure being put in place.
This is an investment theme we identified early. In fact, a majority of the investments in our most recent fund are in the equipment and services space around this ageing infrastructure and asset integrity theme. These are businesses that generally generate a cash return on equity capital on day one, and we have been able to utilise our network to identify consolidation opportunities and organic growth avenues. There are many smaller participants that benefit from consolidation and scale, and benefit from some increased professionalisation around the quality of their business offering. That’s where a private equity partner can really add value to these businesses. Also, this is an investment theme that supports our focus on ESG as a firm, specifically with respect to concerns for safety and the environment.
What’s the best approach to the energy sector in the current environment?
Something we consider critical is the flexibility to invest across the energy landscape. We are an allocator of capital, whether it be assets (including midstream and downstream, petrochemical, utility, and upstream oil and gas) or equipment and services and manufacturing, anywhere across that value chain. The ability to have our views on the midstream informed by our views of the quality of the basins and the operators feeding those assets, as well as our views of the upstream informed by what’s happening in the services and equipment space and what efficiencies are being driven there, is incredibly important.
On top of that, we believe it is critical to have the flexibility to shift your strategy and portfolio as circumstances dictate. In a $120 a barrel oil environment it’s hard to buy oil and gas assets if you don’t expect oil will stay at $120, so you need to have the ability to tilt the portfolio where required, and that perspective is informed by a comprehensive understanding of the industry.
Has volatility in the energy sector driven competitors away?
Returns in the industry have lagged the rest of the economy generally since the GFC. The energy industry has been marked with more volatility than we’ve seen in general industrial, and the S&P’s track record since 2009 has been an incredibly consistent deliverer of value for investors. Generalist private equity firms have fared well over the last 10 years at a time when energy investors have experienced a lot of volatility, and post the 2014 downturn, you have not seen a recovery in many investments made pre-2014. Therefore many investors have been shying away from energy: public and private equity investors as well as credit investors alike.
Today, the industry is still incredibly capital-intensive, but the public equity markets, the credit markets and the private equity markets have all pulled back their willingness to provide capital. That has created some tremendous opportunities. Strategics who have typically been very acquisitive in the past don’t have the support of the public markets to do as many acquisitions; many of those historic acquirers are looking to divest non-core businesses, and that’s a very target-rich environment for new opportunities. We’re seeing lenders provide less financing, so pricing has come down, and the level of risk put on these businesses at the time of acquisition is lower with lower leverage levels. On the private capital side, we’ve seen generalists shy away from the space and less energy private equity competition.
How have discussions with LPs changed over the last decade?
For the last couple of years, the tone of investors has been very mixed. Many express the sentiment that they are frustrated with energy investments not meeting their expectations.
Plenty of others are taking a contrarian view that the space is compelling given the lack of available capital and attractive valuations in an investment climate that is otherwise feeling expensive. First Reserve witnessed a fair bit of momentum building around that view during 2018, and then Q4 2018 happened where the energy space and oil prices got hard hit and that rattled investors yet again.
There’s concern around volatility in valuations and performance, coupled with the reality of a lack of opportunity for monetising older investments due to lack of capital. Many investors are overallocated in energy because they haven’t been able to get realisations out of older funds.
In 2018 we looked at over 80 oil field services businesses in detail, of which we believe only 10 transacted. So, there’s a growing backlog of businesses looking for an ownership transition and not being able to realise it. Those are compounding issues for investors who are managing their portfolio allocation.
We’re focused on diversification in the portfolio, investing across the energy value chain, shifting away from direct commodity price exposure. We’ve focused on minimising commodity price exposure where we can, and that extends to monetising assets and selling companies.
“Many investors are overallocated in energy because they haven’t been able to get realisations out of older funds”
How have you dealt with lack of liquidity?
We’ve been building businesses to attract strategics and other sponsors. We’ve also focused on preparing our businesses to pursue an exit path on an expedited timeline, because volatility in commodity prices drives a volatility in sentiment, and the ability to get a transaction done is limited to fairly finite timelines. It comes with some hardship; the value of holding those businesses does not get fully realised in our ability to monetise them.
What are the main risk factors today?
The real concern in the industry has to be more around the geopolitics of oil and the risk that brings to short-term price signals, whether that’s the risk of trade war tariffs or other economic impacts derailing the 10-plus year expansion that we’re on, or whether it’s the risk of sanctions with Iran driving up prices because of concerns over supply and exports from the Gulf region. You have positives and negatives at play in how people think about the risks to supply or demand in the shortterm, but realistically, if you think longerterm, we need plus or minus $55 per barrel oil to keep meeting the demand growth that’s going on in the world. So, the keys are discipline, diversification and resilience. That’s the kind of portfolio First Reserve has built, and we’re staying focused for the future.