June 10, 2014
Interviewed by: David Snow
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‘Exponential Growth’ in Energy Capital Needs

The shale and energy evolution in North America has led to vast growth in the amount of capital needed to take advantage of the opportunity. Riverstone founders Pierre Lapeyre and David Leuschen discuss technology’s role, how PE is poised to take advantage of the opportunity and the controversy over fracking.

The shale and energy evolution in North America has led to vast growth in the amount of capital needed to take advantage of the opportunity. Riverstone founders Pierre Lapeyre and David Leuschen discuss technology’s role, how PE is poised to take advantage of the opportunity and the controversy over fracking.

“Exponential Growth” in Energy Capital Needs

With Riverstone Holdings Co-founders Pierre Lapeyre and David Leuschen

David Snow, Privcap: 

Today, we’re joined by Pierre Lapeyre and David Leuschen of Riverstone Holdings. Gentlemen, welcome to Privcap. Thanks for being here.

Both of you are energy veterans and you run one of the largest private equity firms in the world—certainly the largest in the energy space. Energy is a hot topic and the private capital going into it is tremendous and looks like it’s set to grow. I’d love to get your thoughts on what the interesting opportunities are.

Starting with a question for you, David. Both you and Pierre have been involved in this for a long time. You’ve seen many different cycles. You’ve seen technology change. What stands out today as the most notable or exciting features of the current energy investment opportunity?

David Leuschen, Riverstone Holdings:

Today, it’s probably obvious to any viewer that the shale revolution or energy revolution, which is largely a North American factor today, is creating exponential growth in the capital needs for the industry. We’re a terrific beneficiary of that. The amount of capital the energy business requires today is many times what it was 10 or 15 years ago. We use a number of something like $1.5 trillion a year of spend in the business, plus another $500 billion to $1 trillion of M&A activity, which is our opportunity set. That number is up substantially from 14 years ago when we created Riverstone. Again, it’s largely attributed to the shale revolution because of these new production techniques in all the expensive wells that go into horizontal drilling and hydraulic fracking, among other things.

Deep-water drilling is another area where there’s exponential growth in the capital needs; it’s creating a real opportunity set that we never would have imagined 14 years ago.

Snow: Pierre, talk a bit more about why so much more capital is required. Is it that the technology works but it simply takes more capital to get to the energy that previously wasn’t thought to be accessible?

Pierre Lapeyre, Riverstone Holdings:

Yes. It’s essentially that. The real reason is that the intensity is three, four or five-fold, in some cases, versus the history or historical conventional activity. This is principally because the service costs are three to four times what they were before, in order to do long, horizontal, lateral drilling, as well as the fracking you’ve heard about. That is very capital intensive. The good news is that while it’s capital intensive, you get at reserves or resources that we’ve known to exist but haven’t been able to figure out before how to produce. You can get a lot of it relatively quickly. Overall, even though it’s substantially more capital intensive, the economics are extremely attractive.

Snow: Talk about the role of private capital in the broader energy landscape. How has that changed compared to other forms of capital or other corporate organizations that could try to accomplish the same goals?

Leuschen: One big change in the last dozen years or so in the energy business is that three or four factors have created a new opportunity for us. One is the turnover among management, where management teams are readily available to us. There are an accelerating number of those teams.

Management teams are our oxygen. Without them, we’d be out of business. But there’s the combination of the availability of management teams and the availability of acreage. One very nice thing about the oil business is that traditionally, over time, acreage turns over. It’s not unlimited life, and that’s forced some big companies to give up some of the best acreage, particularly in deep water, in certain parts of the world.

In the shale plays, you’re seeing a lot of turnover of the acreage today. Again, that allows or is a good inducement for the creation of these build-up teams. Private equity is perfectly poised to create those build-ups and I’m both amused and flattered that some of the biggest companies in the industry (we won’t name names here) have come to our doorstep basically to try to buy the companies that we birthed.

Lapeyre: I completely agree with what David said. The only thing I would add is that ours is very flexible capital and it’s incredibly focused.

We can try new things, which is what led to the shale revolution to begin with. We can do them relatively quickly and in a way that produces a profitable result in a fraction of the time that might exist inside a much larger, more bureaucratic, more tenure or strategic-planning kind of model in the business.

Snow: Let’s talk about some subsectors or specific opportunities within the upstream opportunity that are the most capital intensive. Can you walk us through where the capital would go and what the money’s being spent on? Deep-water drilling is something a lot of generalist LP investors may not know about. What are the capital needs there? What are the nuances as far as putting capital to work in that opportunity?

Leuschen:  That’s one of the unsung parts of this story that you don’t read about. We all read about the shale revolution and horizontal drilling and hydraulic fracking, but really, a huge driver of the success of this business today is the fact that success rates have improved dramatically in the offshore. Obviously, technology is a very big part of that. What we call “well control” is a very big part of that, meaning as you drill more wells, you’re going to be more successful on the incremental well because you have all the data of the previous wells to leverage off of.

The availability of those management teams I mentioned earlier, our capital, technology, and the turnover of acreage has allowed companies like us to birth 12 companies in the water today. We have eight in the Gulf of Mexico. Virtually every one of those was a startup or a build-up. In some cases, it has allowed us to compete with the very large companies in this business because the technology is relatively flat.

Snow: It sounds like especially upstream, more capital is required but the risks are more controllable or at least you know what is in the ground. What are the nuances between the different upstream strategies—like deep water and shale—that investors should understand as they’re looking at how and where their capital is being deployed in these upstream strategies?

Lapeyre: I would say, maybe broad brush, there are three. One is, “Are you taking exploration risk?” which is generally the most risky thing to do. The other is, “Are you taking exploitation risk?” meaning it’s a known resource and you’re trying to figure out to develop it.

Those are the two main risks we would deal with on a day-to-day basis historically from when we first started the firm. What the horizontal drilling and fracking injected into the business is more of the “learning-curve risk.” That’s when you go to the shale plays—you know the resources are there. The question is, can you find the right mix of techniques, technology, frack fluid “cocktail,” etcetera, that lets the rock release the oil and gas that you have?

That’s the third leg, so to speak, of the stool that’s come into our business over the last four to five years. It puts a huge premium on where we think we excel, which is using our long history in the business—part on the private equity side, part on the agency side—to know the proven management teams that are specifically good in those geographic or geologic areas.

The three are very different, especially today in the shale universe or unconventional universe. People tend to think the business has become a somewhat mindless mining operation, that if you have enough money, you can get at it. Our portfolio and experience would tell you that is not the case. Every shale play is not the same. Within a given shale play or unconventional resource, you can move a mile left or right and get very different results.

The premium is always on the same reason we founded the firm—operations first. Then, a proven management team, and last, what you think of as more financial engineering for private equity.

Leuschen: Another of the unsung elements of this revolution on the shale side is the ingenuity of the energy business. If you go to a good energy conference today and you dive down into the smaller companies that are presenting, you’ll be into the fifth or sixth derivative of how they’re “mixing the cocktail,” as Pierre called it. They’re figuring ways to go essentially from what we used to call the “carpet-bombing” approach to fracking, to a smart-bombing approach. That is creating dramatic changes in the economic picture strictly from operations, as Pierre said. You’re looking at expected recoveries or EURs (expected ultimate recoveries)—it’s a number we use in this business a lot, or “tight curves” that you hear about. The tight curves or some of the older shale plays have gone up exponentially as we’ve learned how to use those cocktails and how to run the drill bit better than we did in the past.

That’s a very exciting part of our business. That’s why, when we’re asked by investors or different constituents in our business, I always say that when you ask a question about shale, you have to realize you’re usually asking what I call the “snapshot.” (“What does it look like today?”) I say, “We look at the movie,” which means we look at what used to happen five or 10 years ago, what’s happening today, and what’s going to be happening in the future. Or, we look at an old shale play where we can do what private equity has historically done, which is to exploit or suck on the straw harder, to find a way to make something that’s not economic for Exxon or one of the big companies economic for us.

Another relatively unsung part of this business is in the whole shale revolution; big companies have moved towards shale. It means that the amount of conventional or non-shale resources available to folks like us has gone up exponentially. A big part of our success in the recent past has been exploiting non-shale, old resources like the tired Shell, Gulf of Mexico, or old heavy oilfields in Canada. There are many examples of this where, simply by redirecting capital into the drill bed, using new techniques, sucking on the straw harder, we can actually create a very attractive private equity investment.

Snow: I’m interested in your views on the Mexican opportunity to invest. Also, it’s worth noting that your firm recently opened an office in Mexico City. Why is that notable and what does that say about your view on the opportunity there?

Leuschen: We are cautiously very optimistic about Mexico. We look at it from a macro standpoint. With the U.S. headed towards 10 million barrels a day of production, Canada having the possibility of about five, and Mexico having two or two and a half, with a possibility of getting to five, you’ve got a very exciting and interesting North American block in the energy picture of something that could be 20 million barrels a day of production.

We want to be an integral part of building that, so we can’t ignore Mexico. Talking Mexico is like imagining that, up to this point, we haven’t been able to invest in Canada and then somehow we got a phone call from Toronto and the whole country is open to folks like us. It has to be something we focus on.

It comes with many issues that will be obvious to your viewers and perhaps they’re more learned than we are about some of those issues. But we tend to investment-spend on the front-end and we start small. We’re very humble when it comes to the kind of opportunities we expect there. The real orientation we’ve taken to Mexico, which is good, is one of core competence and expertise being transferred at a technology transfer toward Mexico.

Snow: I’d like to switch gears a bit and talk about the renewable space. A lot of attention gets paid to the shale revolution in North America and that’s where a lot of the capital is going. But despite the fact that both of you are from oil-and-gas backgrounds, you have invested in renewables. Do you have an appetite to continue investing in renewables? What’s your analysis of what the important opportunities will be there going forward?

Lapeyre: We always have a continued appetite. It is a much tougher industry sector or vertical as you may think about it versus the conventional energy business for a number of reasons. One is the return thresholds are definitely lower; it needs more support whether that’s high alternative prices or some subsidy to compete against the conventional business. Two, it takes a lot longer. It’s not yet an industry.

We haven’t had enough investment and physical infrastructure on the renewable side for that to become a very active business yet. A lot of that “Get your toolkit out and fix it and make it better” isn’t there yet because everything is greenfield new development. It’s still very high-cost, so it takes an enormous amount of capital, it takes a long time, and the returns are lower. Last and most important, finding highly talented, proven operators on the renewable side of the business is a much tougher challenge than on the conventional side of the business.

In the same way horizontal drilling and fracking helped open new doors on the conventional side of the business, there are improvements and technological changes that will do the same in renewables. But it is a tougher business and I would characterize it as not yet an industry, in the classic sense.

Leuschen: What we’ve learned, somewhat painfully, in our business (where we’ve made upwards of about 25 investments) is that world-scale works—world-scale solar, world-scale wind. The service companies that are key to building those businesses like offshore wind—they work. But we don’t have any special core competence in the agricultural-based businesses and we will tend to avoid those in the future.

Snow: Final question for both of you. This is back to the oil-and-gas side of things and has to do with a strong and vocal anti-fracking sentiment out there. How worried should investors be about this sentiment? What do you say to investors when they express worry?

Leuschen: The overarching view from Riverstone would be that we focus on absolute best-in-class management teams. We focus on best practices as it relates to how and when and where you drill wells. We could give you many examples of that, but we’re operating at a level that is the absolute highest of any company or group of companies in this business. It’ll be the bad operator that ruins it for everybody and we don’t want to be that entity. We have total focus on expertise and best practice.

Snow: The evidence shows that fracking is safe, by and large?

Lapeyre: If you look at the numbers of wells that have been drilled and fracked in miles or feet or number of frack stages versus accidents, the answer is yes, overwhelmingly. But, as David said, the focus has to be on not confiscatory regulations such that you’re so constrained you can’t do it, but making sure that the fines or oversight are sufficient such that everyone is driven to be a best-in-class operator and to do what is correct.

As you can imagine, there’s a lot of emotion around the topic, but when you peel back the layers of the onion and look at the biggest concerns, the industry has addressed a lot of those in the way they drill and frack the wells. It is very different from what is often portrayed in either the written word or the video media.

Leuschen: We live in a global village and we have to be mindful of that. But, if you look at the evolution of objections that have been raised about fracking, one you almost never hear anymore is groundwater contamination because it’s been so easily demonstrated that a horizontal frack two miles below the surface has virtually no possibility other than through the vertical hole, which is the old oil business, has nothing to do with fracking, and has almost no possibility to contaminate groundwater.

Today, the issues tend to be more around seismicity or earthquakes and there’s a body of knowledge being built there. They’re imperceptible to humans but there is some evidence that fracking has, in some cases, caused small earthquakes. There’s the issue around methane leaks in gas wells. Methane is not friendly on a global-warming basis. Then, the third issue, which is concerning us a lot today and was off our radar two or three years ago, is the whole issue of transportation by rail and safety issues around that.

We own tank cars. We’re in that business to some degree. Again, it’s about best practices and best-in-class management, but there will be regulation evolving around that and we will support that wholeheartedly.

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