August 15, 2012
Interviewed by: David Snow
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Craig Jarchow: Investing in Fracking’s ‘Holy Grail’

Required viewing for any investor with a serious interest in the changing energy space. The world’s energy industry is going through revolutionary change driven largely by technological leaps made in the natural gas business – and investors who understand how and where to capture the value of these new extraction techniques will profit handsomely, says Craig Jarchow, a Managing Director at New York-based Pine Brook, a major investor in the energy space.

In a fascinating interview with Privcap’s David Snow, Jarchow explains why new “fracking” techniques represent a long-sought “holy grail” in natural gas extraction, describes the third-wave technology behind the fracturing of “crappy rock,” and discusses the political and environmental challenges that still face companies that use fracking technology. As a private equity investor, Jarchow discusses how his firm seeks to create cash by partnering with the best project management teams, gives his analysis of the very competitive landscape among energy-sector investors, and explains why sand from Wisconsin and Minnesota is in high demand.

Required viewing for any investor with a serious interest in the changing energy space. The world’s energy industry is going through revolutionary change driven largely by technological leaps made in the natural gas business – and investors who understand how and where to capture the value of these new extraction techniques will profit handsomely, says Craig Jarchow, a Managing Director at New York-based Pine Brook, a major investor in the energy space.

In a fascinating interview with Privcap’s David Snow, Jarchow explains why new “fracking” techniques represent a long-sought “holy grail” in natural gas extraction, describes the third-wave technology behind the fracturing of “crappy rock,” and discusses the political and environmental challenges that still face companies that use fracking technology. As a private equity investor, Jarchow discusses how his firm seeks to create cash by partnering with the best project management teams, gives his analysis of the very competitive landscape among energy-sector investors, and explains why sand from Wisconsin and Minnesota is in high demand.

David Snow, Privcap: Today, we’re joined by Craig Jarchow of Pine Brook. Craig, welcome to Privcap today. Thank you for joining us.

You are an expert at investing in the energy sector. And of course, that’s a big topic. There’s all kinds of things we could talk about.

But I’d like to start out with what is arguably the most exciting development within at least US energy, and that’s all of these new technologies that are now bringing natural gas out of rocks that were previously just rocks. And so before we get into the private equity opportunity, maybe you could kind of set the stage for us by talking about how we got to the point where we are now with the technology and the ability to extract so much natural gas of these shales.

Craig Jarchow, Pine Brook: Sure. It’s been a long time coming. Hydraulic fracturing, which is the driver of a lot of this change, has been around since the ’40s and ’50s. I think back to my days as an oil finder, which is how I started my career.

We would always ask ourselves, what is the Holy Grail of oil and gas and energy in general. And that was simply, each and every time we asked ourselves that question, getting just a little bit more oil and gas out of the rocks where we knew it already existed, from existing fields, just a few percent. And we never thought it would happen, but it’s happened.

And it’s happened through horizontal drilling. In days gone by, we used to drill vertically. Now we drill horizontally, a lot of our wells.

And through the fracturing, we open up more rock to the wellbore. And through that, we’ve achieved the holy grail, and that is getting more oil and gas out of rock, which has completely changed the industry. And the US has gone from being relatively resource scarce to now beating Saudi Arabia for natural gas and finding much more oil as well.

Snow: Well, there has been, even within fracking, as you define it, there’s been a progression of new kinds of technology. Can you talk about where we are now? Where’s the cutting edge as far as the ability to extract from certain kinds of rock?

Jarchow: There have been different waves. The first way was extracting more natural gas out of shale. And that happened in places like Texas and the Barnett Shale, which was really the first example. And it has progressed to getting more oil out of shale as well. That was the next wave.

And now we’re really on a third wave, where we’re getting more oil and gas out of what we call crappy rock, that is, rock that’s not beautiful, clean sandstone, which is a sort of rock that we’ve produced from before. It’s rock that’s imperfect, but nonetheless has a lot of oil and gas in it. And there are a number of plays, as we call them, emerging both in the US and Canada and around the world where we’re dealing with crappy rock. One of them is called the Mississippian play in Oklahoma and Kansas, which we’re involved in. And this is a very exciting, very big play.

Snow: Is that the Latin term, crappy rock?

Jarchow: That’s the term of art. That’s a highly technical term.

Snow: So people who have a lot of crappy rock on their property should now be very excited.

Jarchow: Exactly.

Snow: Well, let’s get to the private equity opportunity. It’s one thing to say that it is now possible to extract more energy resources from places that that was not previously available, but how do you make money from that? Where do you put capital, and from a private equity investor’s point of view, what should they know about that opportunity?

Jarchow: Well, this is a classic dislocation. This is a case where technology is changing an industry, and the opportunities out there are immense if you know where to invest, of course. We at Pine Brook invest in companies that create cash flows. We don’t buy cash flows the way buyout firms do. We invest in building businesses.

And the businesses we back on the energy side, to a large extent, go out and find these new plays, these locations, these basins for applying these technologies. So we have a number of companies in our portfolios that have been leaders in finding oil and gas in this Eagle Ford play in Texas and the Mississippian play in Oklahoma and Kansas. That’s where we find the opportunities, backing very strong, very knowledgeable, technically savvy teams in these new plays, these new places to find oil and gas.

Snow: But in the current environment, don’t teams like that have– isn’t there a huge battle to throw capital at these kinds of groups? How do you keep valuations to a reasonable level given the interest there is in putting capital to work in this particular space.

Jarchow: Well, I think certainly there’s a lot of money coming into this space. It pays to have been around the industry through thick and thin. So we certainly at Pine Brook have some substantial networks.

I think the better teams are actually quite sophisticated in picking their investors. They want investors who first of all understand what they’re doing, understand exploration, understand geology, understand engineering, and also capitalize them so they can withstand the inevitable dry holes. In some locations, oil and gas is probably the only business where you could be wrong most of the time and still make money. We do drill dry holes.

And as investors, we need to understand that that’s going to happen, not get scared, and ultimately capitalize the companies who can withstand dry holes and live to fight another day. That’s a big key. So the sophisticated teams look for investors who understand this.

Snow: To what extent is there a technology risk when you invest in a team? Is the technology commoditized, or do certain groups have an edge by dint of the technology they’re working with?

Jarchow: When I started my career, the major oil companies had a lock on technologies. As a matter of fact, hydraulic fracturing was invented by a predecessor of Amoco, which is a company that I worked for first in my career. But nowadays, technologies are widely available.

And this is because of the wonderful entrepreneurship we have in this business. So that most every companies, including the companies that we back, have access to the technology. What you have to do in investing in technology and backing teams that use technology is be careful that you don’t have a solution in search of a problem. You have to start with the problem first.

That is, where do you want to go to find oil and gas? Is it the Mississippian play in Oklahoma and Kansas? Is it the Eagle Ford in Texas? Start there, and then once in that play, ask yourself, what technologies do I need to win to succeed, rather than the other way around. That’s the key to winning with technology.

Snow: A question that has to do with the places one would go and the ways that one would get the buy in to explore in certain areas. I was driving around upstate New York recently on vacation and saw several signs in front yards in very small towns up there that said stop fracking in New York. So my question to you is, should investors be worried about the environmental– or to what extent should investors be worried about the environmental and political complexities that surround the issue of fracking?

Jarchow: Well, we definitely should be worried about it. I think the industry in general does not do a good job getting out ahead of these issues. When it comes to fracking, certainly I think we owe stakeholders, landowners, people in political office, solid answers, factual answers, as to is fracking a danger to our water resources or not.

Those of us who know something about it think very strongly, and indeed there have been studies done that indeed, it’s not a threat to the water resources. But the decision makers, the stakeholders, deserve factual studies that demonstrate this to their satisfaction. And the industry needs to get ahead of that.

There are legitimate concerns about wellbore construction. We do drill through aquifers, and there are very good regulations making sure that the wellbores are properly constructed so that there’s no danger to the water resources. So this can be managed. We as an industry need to do a better job getting out ahead of this and getting the decision makers, the stakeholders, the answers they need.

Snow: I’m sure you get asked this quite a bit, but to what extent do commodity prices effect your ability to make money in your investment strategy?

Jarchow: Well, oil and gas both are commodities. And the name of the game in a commodity business is to make sure that you’re not the marginal producer, that is, the most expensive producer. Ultimately, when you’re producing a commodity, it’s a game of musical chairs. You don’t want to be the last person standing with the most expensive source of that commodity when prices go down.

So we at Pine Brook actually have a big database of all the basins, the plays out there. And we’re able to compare cost. We want to make sure that we’re well away from the margin in choosing the plays that we choose to pursue. And by doing that, we can focus on volume. We want to make sure that we produce a lot of oil and gas in the areas that we choose to prosecute, to get after.

And secondly, we want to stay away from the margin. And when you do that, everything else takes care of itself. Because ultimately, trying to forecast oil and gas prices is just not a recipe for success in this business.

Snow: Well beyond exploration and discovery, what other types of businesses are of interest to you as you survey the natural gas opportunity?

Jarchow: Well, we do have this dislocation, this fundamental change in our business. So there are all sorts of knock off opportunities. And if you look at a shale play, be it gas or oil, there’s a whole entrepreneurial ecosystem that exists around these plays.

You have the frack equipment. You have the sand for the proppant. You’ve got the well heads. You’ve got the pipes. You’ve got the pumps.

You name it, it’s all part of the system that ultimately is an ecosystem. And ultimately, the knowledge of the exploration and production aspects of the business, that is where these plays going, where will they emerge, what are the ways, informs our ability to invest in services.

So for instance, we just sold a company that was in a pumping business. They created and sold down hole pumps. And it was our view, with this fracturing going on, that there would be just much more oil production in particular going on in the US. And so we went out, started this company with a team we knew before.

And in a couple years, they were able to create a substantial presence in the Permian basin and elsewhere. And ultimately, we just sold the company. That was an example of seizing on our exploration and production knowledge, identifying the plays in which we wanted to be, and picking up a piece of that ecosystem and creating a wonderful opportunity for someone to buy us out.

Snow: Quick question, I’m just curious, where does the sand come? I take it there’s a substantial amount of sand needed for this. Where are you sourcing sand?

Jarchow: Yeah, you’d think that sand would be just plentiful. Anyone that goes to the beach, you look at all the sand out there, and how could that be something in short supply? But there’s sand, and then there’s sand.

And what you need for oil and gas operations is really good sand. And by that, we mean something that has– and this is getting a bit technical– a very high crush strength. It doesn’t crush easily.

Sand is very well rounded and very pure, and it turns out there are relatively few places in the world where you can find that, Wisconsin being one in that general area, and Minnesota as well. Not many other places. So real opportunities to look elsewhere in North America and worldwide for these really good sand deposits.

Snow: So Wisconsin and Minnesota are the Saudi Arabia of sand?

Jarchow: Absolutely.

Snow: That’s great. That’s great to hear.

Jarchow: Great sand there.

Snow: Just a general question, and I think we can end there. And thanks again for joining us. Just within private equity, some of the largest firms now, generally speaking, are energy specific firms.

Now I know that Pine Brook invests in energy but also in other areas like financial services. Is it surprising to you to see the growth of energy specific firms within private equity? And do you think this is a sustainable trend, where this particular investment strategy will become a dominant subgenre within private equity?

Jarchow: I think that you will always have a subset of firms that choose to play in this sector because it does require knowledge that only comes with time. There are good and not so good investors in the oil and gas space. Some of this expansion has been driven by the fact that oil and gas prices, at least oil prices now, are high and are likely to remain high.

But ultimately, this is a cyclic business. And we don’t know when oil and gas prices will go down. All we know is that they will.

And when that happens, probably some of our competitors will leave this business. We’ll stick it out because again, our goal is to stay away from the margin and to go for volume and not predict prices. And our business will be just fine, as has been demonstrated by our track records over the past 20 to 30 years.

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