By: Thomas Lee – Argus Media – Private equity (PE) investors are accelerating a shift away from the US shale oil sector amid diminishing returns caused by the Covid-19 pandemic.
Over the past decade, private equity firms have poured tens of billions of dollars into the US oil and gas industry, especially as the shale revolution gained full steam. Their funding helped spur the shale oil boom that followed the last market slump in 2015-16. But the luster was already wearing off shale oil before this year’s slump as returns diminished, with PE capital invested in oil and gas firms falling by 45pc between 2017 and 2019, from $118bn to just over $64bn, Pitchbook data show.
And PE is unlikely to underpin an investment revival this time. To get PE dollars, “the industry is going to have been consistently profitable for the first time”, US bank Stephens’ managing partner Jim Wicklund, says.
Private Equity firm Warburg Pincus recently told investors it is pulling back from investments in the oil and gas sector. Earlier this year, PE giant Carlyle Group sold its nearly 8pc stake in Chesapeake Energy, just before the producer filed for bankruptcy protection with nearly $12bn of debt. In total, 90pc of the combined debt — or $46bn — from producers filing for bankruptcy this year belonged to PE-backed firms, US law firm Haynes and Boone says. The average debt held by bankrupt PE-backed producers was more than four times that of their non-PE-backed peers.
Some observers argue that PE’s exit from oil and gas is only temporary and that investors will return once the industry recovers. But others say the situation has permanently shifted. Institutional investors have been exiting the oil sector in favor of technology firms with higher growth potential, fewer regulatory burdens, and lower costs. Covid-19-related oil price volatility and the growing environmental, social, and governance (ESG) stigma of fossil fuel firms have scared off investors already tiring of shale’s dismal record on shareholder returns.
Effectively, “the private equity market is closed to E&P companies”, law firm Sidley’s energy partner Jim Rice says. As a result, energy initial public offerings have largely disappeared, depriving Private Equity firms of the exits they need to recoup investment and earn returns. This is one reason US independents will need to consolidate to survive, Pioneer Natural Resources chief executive Scott Sheffield told the Reuters Future of Oil and Gas conference on 1 December. Pioneer recently agreed to acquire fellow Permian producer Parsley Energy for $4.5bn. “There was a lot of capital that went in, but most of them had very poor returns,” Sheffield says. “They have to have an exit mechanism. They were built to flip. Those days are gone.”
Hard bargain for Private Equity
There are still some quality assets for PE firms to pick off for the right price. For example, Kimmeridge Energy recently paid $140mn for a 2pc share of revenue interests for Callon Petroleum’s operated oil and natural gas leases, a transaction known as an overriding royalty interest. But producers that need to raise cash will find that PE investment terms have become a lot tighter. Patrick Gimlett, managing director of AllianceBernstein Private Credit Investors, says he will only lend to companies at loan-to-value ratios of 55-60pc, which means a borrower would have to offer a down payment of 40-45pc of the loan to secure it.
Given the pressing issue of climate change, companies will also find themselves under growing environmental scrutiny. “We require best of class in ESG,” Kimmeridge Energy managing partner Henry Makansi says. “Otherwise, they can’t get our capital.” And Private Equity has moved away from the traditional “equity line of credit” investment model in which it backs an outside team to find drilling opportunities. Instead, firms only want proven wells that already produce energy. Overall, “there is a permanent increase in the cost of capital”, Rice says. “It feels pretty dire.”