May 8, 2014
Interviewed by: David Snow
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Webinar Replay: PE and the Energy Opportunity

The following is a replay of a Privcap webinar featuring an expert overview of the revolutionary changes to the North American energy landscape and what this means for private equity investors and institutional capital.

The following is a replay of a Privcap webinar featuring an expert overview of the revolutionary changes to the North American energy landscape and what this means for private equity investors and institutional capital.

PE and the New North American Energy Opportunity

David Snow, Privcap:

Hello, and welcome to Privcap. This is David Snow, CEO and cofounder of Privcap. And I’m thrilled that all of you have joined us today to learn about energy game change, how private capital is playing a huge role in the new North American energy opportunity. We are joined by three experts and longtime veterans of investing and advising in the energy space. Before we kick off a great conversation with them, I’d like to ask all of them to briefly introduce themselves and their firms. Let’s start with Jordan Marye from Denham Capital Management.

Jordan Marye, Denham Capital Management:

Hi. Thanks for having me. My name is Jordan Marye. I’m a managing director at Denham Capital Management. We are an energy-focused private equity firm. We invest predominantly in oil and gas, mining and power, and I help lead our oil and gas effort. We’re investing our sixth fund right now, which is a $3.6-billion fund, with about two-thirds of that allocated to oil and gas.

Snow: Great. Anas Alhajji, please introduce yourself.

Anas Alhajji, NGP Energy Capital Management:

Anas Alhajji, chief economist at NGP Energy Capital Management. We are based in Irving, Texas, which is a suburb of Dallas. We have about $13 billion under management—natural resource-focused, mostly energy and upstream oil and gas.

Snow: Jon McCarter from EY, please introduce yourself.

Jon McCarter, EY:

Thanks, David. Great to be here. Jon McCarter, I’m a partner at EY; I head our Americas’ transaction-advisory services group, totally focused on oil and gas and energy, with a 100+ team based in Houston. Also, we have folks in Calgary and all other places around the world that invest in energy. I’m happy to participate today.

Snow: Thank you. Just a quick note to our audience: we will be allowing for questions and we’ll probably have the questions in the final 15 minutes of this webinar. In the meantime, you’re able to anonymously send in any questions you want and we will certainly try our best to get to them.

Why don’t we start with a 1,000-foot view of the energy industry and how private capital’s playing a big role in it. Not only has private equity really been on the rise as an asset class, but it has been making inroads as an important source of capital and expertise in the energy industry, probably nowhere more so than here in North America. I’d like to throw the first question to Jordan from Denham Capital. What is distinct about the current opportunity for private capital in energy that perhaps compares to prior cycles of energy and private capital?

Marye: Thanks. Our dominant view right now, which is probably not unique, is that technology, particularly unconventional technology, has become ubiquitous in its application and that has unlocked two major aspects of our marketplace right now. One, we make more hydrocarbons today and we do that more efficiently than we have in a very long time. That effort has caused a lot of new supply onto the marketplace, but it’s also caused a great constrain in capital, particularly financial and human capital. So, we’re trying now to find and develop opportunities whereby we can invest in this great explosion of technology, focus on assets and people of quality, and apply our capital accordingly.

Snow: Next, a question for Anas. Is that your view? Do you see the constrain of capital—

Alhajji: I would like to expand on that. We’ve been in this business for over 25 years and there are some remarkable opportunities relative to the past. There are three major characteristics now. First, we have continuous improvement in technology. I know technology was mentioned, but we are seeing a continuous improvement in technology. At the same time, we are seeing increasing national and international demand for oil and gas, especially gas. So, here you have improvement in technology, cost is going down, demand is going up, and, since this is a natural resource, we are talking a large resource base, too. So, we have those three major characteristics: continuous improvement in technology, increasing national and international demand, and large resource base. Add to that the favorable political climate in the U.S., especially when it comes to the use of natural gas and the issue of energy independence, then add diversity of supplies in a way we’ve never seen before because that technology unlocks three major plays in areas that were not considered oil and gas areas: northeast, north, and far south. So, when you add diversity of supply to the political climate, to the other three characteristics I mentioned, the stars are aligned.

Snow: Jon McCarter from EY, as someone who’s advised on many transactions in oil and gas space, what do you think is remarkable or notable about the current opportunity?

McCarter: The capital needs out there. We’re probably looking at $25 billion of investment dollars, but if you compare that to the overall transaction flow, you’re only looking at 7% to 8% of the overall oil and gas activity we’ve seen. So, despite the increased interest in flow, if you would look at other industries, there’s still a lot of upside. As we talk to our energy private equity clients, they say that—despite the fact that there might be more players on the scene—they can’t take advantage of all the opportunities they have in front of them. I would love to hear Jordan and Anas comment on that. That’s what we’re hearing in the marketplace.

Marye: So, we agree. It’s a very exciting time to be investing. The capital needs for our business have never been greater and we have an evolving marketplace, which leads to this location, which is always a great environment for which to invest. We would, though, urge carefulness and caution in this marketplace. As the supply stack of hydrocarbons, particularly on this continent, essentially re-sorts itself due to evolving technology, it’s important to focus on what is broadly called “asset quality.” That means low funding and lifting cost, loss of running room and expansion capabilities for a given asset, and proximity and access to infrastructure development. Also, all those characteristics that we call asset quality need to be shepherded by the very best people we can find in the marketplace. So, we see in the marketplace at large the human capital having been bifurcated over the last 20 years or so, with many folks very senior in their careers and many folks very junior. It’s our view that you have to parse both asset quality and people quality in this marketplace in order to be successful.

Snow: I’d like to dig deeper into why all of you believe there’s such a capital need in the energy asset class. Let’s throw the question over to Anas. Is it simply that the technology required to unlock a lot of these energy assets is quite expensive and therefore requires a huge concentration of capital?

Alhajji: First, we have to acknowledge that oil and gas is a capital-intensive industry, regardless. But, there are several issues we have to consider when we answer this question. First, compared to other countries, the U.S. does not have a national oil company owned by the government. For example, compare that to Saudi Arabia. Saudi Aramco spends $25 to $40 billion a year and you have only one board and one man on top. So, it’s an easy decision for a massive amount of money to be made. Unlike the U.S., we are talking about thousands of companies. Some are small and independent, and there are many boards, many people to make those decisions. In a sense, we are always talking about money because we always ask for money, unlike one company. The issue here is that we have continuous technology advances and we need to pay for that, so that needs more capital. We have high declining rates in oil and gas, when it comes to shale and tight rock. That needs a continuous flow of capital meeting the growing domestic and international demand because we are seeing growing demand, especially for natural gas, and that needs more capital. And despite all the gains we achieved in recent years, we’ve seen new plays and we’ve seen movement to the core areas, toward low-cost areas. This movement needs more capital. Any way you look at it, we need more capital.

Snow: Jon from EY, when speaking to the operators of these independent energy companies, are they aware of private equity as a source of capital but also as a source of expertise and even a broadening of the network?

McCarter: They’re becoming a lot more aware. This industry has some of it because of the commodity price exposure, but has thrived on alternative sources of capital. Whether it be joint-venture arrangements with other corporations or partnerships with sovereign-wealth funds or even private equity, this industry has always been very open. And, as they achieve their capital needs, if anything, you’re going to see them be more open. And—Jordan and Anas alluded to this—the other big theme related to capital requirements is this market dislocation and the fact that we don’t know where these new resources are; we don’t have the infrastructure. That provides momentary opportunity, from a prospect perspective, which fits nicely into the private equity investment window. I see a lot of my clients taking advantage of that opportunity.

Snow: I’ll throw out a follow-up question. Can we have more detail about why it is that corporate capital—capital from some very large energy firms—isn’t speaking for the entire opportunity? These are very well capitalized companies. Why is private capital getting opportunity when there’s so much capital on the corporate side?

Marye: My view is there’s just a lot to do. The large and even medium-sized strategics have such high organic-growth inventories now that they are focused not so much on exploration and extension of their existing resources but on full-scale development of their existing resources. Over the last five or six years or longer, large public E&P companies have been rewarded for accumulating resources and the public markets have now demanded that they morph their strategies into delivering on those resources they have captured. So, there’s an almost myopic focus by the large companies on their internal organic growth opportunities, which represents I don’t know how much of the marketplace, but only a fraction of the actual opportunity set out there. So, private capital can come in and take advantage of those things. Moreover, we see a lot of large companies now selling lots of assets in an effort to scale their focus to things within their capability. And the logical buyers in those contexts today are private equity-backed oil and gas companies.

Alhajji: I agree and I would like to add that, generally speaking, the majors came in late to the game. It was the independents and mid-sized companies that bought the shale and oil and gas resources. The majors came in late and, in some cases, they paid a heavy price and they bought some areas that are not as lucrative as others. Also, from the shale revolution in the last few years, we learned some lessons and some are not in the industry for a long time. For example, never say never. The other lesson is that the only constant is change. In the last three years, we learned that that change is happening very fast and is getting faster over time. Only those who can keep up with that change can reap the largest benefits from the resources that exist today. Because of their size, the majors are slow to react. In general, they take a longer point of view than the independents and smaller companies asking for private capital. Therefore, the corporations and big corporations cannot keep up and we need private capital to fill the gap.

McCarter: I would agree with that and, to summarize, private capital is in a better position to be nimble and maybe have a bit of a different risk appetite. That’s what we’re seeing as we see the shale revolution develop.

Snow: I have a question for all of you, following up on Jordan’s point about human capital. When you invest in private equity and private capital, ultimately you are backing humans who then go out and look for opportunities and create value. What should investors understand about the landscape for talent in the private equity energy space in order to make better decisions? What kinds of management teams would be best situated to be able to take advantage of the opportunities out there?

Alhajji: In most cases, we try to back the management teams that have been with us for a while and have had a successful track. Sometimes, we try to inject new blood into those teams or, if we studied a new team and we feel it fits with our model, we look at them seriously. Generally, we’ve been very successful along those lines. And, given the amount of capital we manage now, we have enough teams to manage our business. But there is still a lack of talent nationwide and that’s been going on even before the shale evolution. We have shortages, however. We are seeing two trends right now: major institutions and universities are trying to catch up, especially in the new play areas, and they are producing human resources to meet future demand. At the same time, we are seeing people in middle management in big corporations realizing their potential with privately backed capital.

Snow: Different thoughts on the importance of human capital and how private capital is and should access it.

Marye: Sure, maybe a couple. It’s our experience that the most important component of success on management teams is technical excellence. Especially on the upstream E&P side of our business, it comes down to the geologic and mechanical risk and aspects of the assets we’re working with. So, technical excellence and whatever a given management team is setting out to do are fundamentally crucial. Also, a thoughtful and cautious outlook with respect to capital allocation and capital efficiency. The way to be successful in this business in the long term is to make your wins as large as possible and your losses as small as possible. You can only do that through thoughtful, incremental capital allocation and making sure each dollar allocated is as efficiently as possible. We see that in experienced management teams that have been investing with us for a number of years and in a number of iterations. We also see that with young management teams who are out to do it for their first time. But it’s those crucial traits. And, I will echo the point that it seems like this recent unconventional technology boom over the last six or eight years has motivated an increase in graduates from major universities of technical people—that’s very positive. But, for folks in that middle-management role, they are relatively few and highly sought-after. It’s very important that we recruit and identify the right folks with the right level of experience and horsepower to go capture some of these opportunities.

Snow: We are already getting some great questions from our audience. We’ll take time at the end for questions, but if anyone out there wants to shoot over a question now, please do. I’d like to throw one to our three experts that’s very important. We’re talking about the energy opportunity in North America, which includes Mexico. Of course, Mexico recently had… at least the beginning of a process of reform to its energy sector. Can any of you comment on how interested you are in that opportunity and how big a deal this is? Let’s start with Jon.

McCarter: Obviously, it’s an area of most interest to clients. I’d love to hear from Jordan and Anas on their view on private equity and how they fit in. The corporate funds, whether on the upstream side or even with services companies, want to spend a lot of time talking to us about our contacts with the government there, what’s happening, and what our thoughts are. We’ve been waiting for this opportunity for over 10 years. It seems it’s been inevitable and there’s been a lot of movement in a short period. There’s a role, personally, for private equity. Whether it ends up being a service company opportunity where it’s a customer base versus direct investment remains to be seen. That’s what I want to hear from Jordan and Anas. But, it’s a great investment opportunity for all sorts of companies going forward here.

Marye: We agree that it’s a very positive development and we’re enthusiastic about Mexico making the reforms as they have. Our point of view is cautious and, if not, we are in a place of “show me” with Mexico. We’ve seen behavior like this from other countries where the internal ability to create oil and gas revenues has lagged over time. There have been incentives put in place to motivate outside foreign investment, which comes in and then, essentially, is expropriated either over time or all at once. Argentina’s a great example of that, as is Venezuela. So, we would be extremely cautious at this time with respect to Mexico but, over the years, if there’s a demonstration of stability and thoughtfulness and policy, we would look very hard at the country in the coming years.

Alhajji: I agree and I would like to add one point: if you look at most of the energy changes—and here, we’re talking about the word “energy”—most of it is related to the power sector and downstream. They are talking about upstream, but most of the talk and the changes in the law are in the power sector in downstream.

Snow: We have a lot of great questions and these dovetail nicely with what we wanted to accomplish on this webinar. I propose that we move to some questions from our audience. There’s a great one I’ll throw out, having to do with assessing the performance of the management teams backed by private equity firms. The question is: How do you differentiate a management team’s track record from the impact of commodity prices? How do you evaluate actual operating talent? That’s the old question about how you tell if someone’s smart or just lucky. Anas, how does your firm, NGP, try to parse a team’s track record?

Alhajji: Generally, our model is more complex than just one question. I think my colleagues would agree that they do the same thing. The process is very complex and lengthy, but I want to mention one important point about NGP: if you try to correlate commodity prices with the performance of NGP, the correlation is almost nonexistent. There’s a tiny correlation that is not significant. In our model—and I think my colleagues will probably have the same model—there is little correlation with commodity prices; therefore, that goes into the way we choose management teams.

Marye: I would echo that we’re looking for management teams as operators who can develop assets efficiently and at scale. In a commodity business, you are certainly subject to the vagaries of the commodity price, but our job is to isolate that, to diminish it as much as possible, to focus on being on the low end of the cost curve, and to create assets of values in a variety of commodity-price environments. So, it is true that we have made money in expanding commodity-price environments and we have made money in declining commodity-price environments. And the things I spoke about earlier—focusing on quality of people and quality of assets—are how you do that. As for the mathematical ability to separate all those things out, we spend a lot of time with our LPs talking about that sort of thing, but it’s more complicated than the time we have here.

McCarter: Yes, David. I’ve been very impressed, particularly, with the funds that are very experienced and spend a lot of time in this industry siphoning through management teams. Despite the human capital shortage you talk about, many management teams do not make the cut on getting investment from the most active energy private equity funds. I’ve seen management teams that looked impressive on the surface, but did not make the cut, because these funds are really scrutinized. It’s as simple as even if they’ve been successful, everyone on the team, they haven’t done it together, per se. Again, it’s incredible focus on the folks that are the most successful in the space.

Snow: Here’s a great follow-up question from someone in the audience: How often do you pass on an opportunity purely because you think the management team is not up to snuff, even if other aspects of the business plan seem attractive? Jordan, is it 100% of the time you will pass on an opportunity if you’re not comfortable with the management team?

Marye: In that narrow context, yes—100% of the time. We start with people. Our business is driven by people. Excellence in our business starts and ends with excellent people. If we find a particular investment opportunity that comes with a strong but incomplete management team, we will spend time and effort to help bolster that team through additional resources before we do a deal. But again, our business starts and ends with people. So, for management teams we do not think have the characteristics to be successful, regardless of the compulsion of a given project, we will let those opportunities go by.

Snow: Here’s an important question that follows on the theme of human capital. I don’t know if we’ll be able to dig very deep into it on this webinar, but the question is how do you avoid overpaying for assets or overpaying to partner with the best teams, given the amount of capital and competition that has come into the space? It sounds like the billion-dollar question. Let’s start with Anas.

Alhajji: Again, back to the model. This is a very complex model that everything has to fit and everything has to check to be able to hire that team. I’ll be happy to provide some slides for anyone who requests them to show them the exact process, that everything has to check. Back to the commodity price, too—all the data on the correlation between the performance and the prices. Unfortunately, we have only a few minutes to answer those complex questions. But, in general, there is very lengthy questioning. Think about going to a bank to apply for a loan—the paperwork you have to file and the background you have to do and check. We have to do multiples of that when we work with a team. It’s a very complex process.

Snow: Switching gears a bit, we’ve spoken about Mexico. Let’s pick a spot, a play in the U.S. that we got a question about from someone in our audience. It has to do with the Permian Basin, which is in Texas and New Mexico. A question for Jordan: Given what this audience says is the amount of competition in the Permian Basin, are you still interested in that area? How do you stay competitive, stick to your guns, and go after the targeted returns you go after?

Marye: The premise of the question is probably correct—the Permian Basin is a very active place right now for large and middle-sized companies, and for small, privately backed companies. The Permian Basin is extremely large and comprises four or five sub-basins, making it as large as the state of Washington. That said, whenever we make an investment—particularly in a place as nuanced and localized as the Permian Basin, the Midland Basin, or the eastern Midland Basin where we’re currently active—we’re looking for asymmetry in opportunity and information, essentially, an edge. We’ve backed a team called Tall City in the eastern Midland Basin that, through a competitive period, has assembled a large acreage position and drilled a number of horizontal Wolfcamp wells. That investment is going very positively. There’s still opportunity for folks who have the local access and knowledge to navigate the various opportunities in the Permian Basin, along with the operational ability to drill increasingly more mechanically complex and expensive horizontal wells. The Permian Basin is an exciting place to invest right now. It’s one where the nuances matter.

Snow: Jon, do you agree on the Permian Basin?

McCarter: Definitely. At one point, you saw private equity funds go to great means to avoid certain of their portfolio investments to not invest in the same play or have less in the same play. And I’ve seen in talking with certain clients that, as they grow their businesses, they acknowledge that they’re going to have some of that cross-play activity. The Permian is probably the example that’s been used the most. There is a lot of churn as it relates to opportunity there and it’s been one of the most prolific basins we’ve ever seen in the U.S. I’m sure we’ll continue to see a lot of investment there.

Snow: This may be a topic we can close with, that we have a question from the audience about: the penetration of private capital into the overall oil and gas space, the M&A market. Do you see private capital continuing to grow as a percentage of the overall mergers and acquisitions taking place? What do you predict in five to 10 years? Obviously, a “crystal-ball” question, but it’s fun to ask. Let’s start with Jon from EY.

McCarter: If you look at the dry powder that’s lined up, whether it gets put to work or not, we’re at an all-time high. It’s private capital, so it’s hard to know exactly what the dollars are but, as I predict there’s over $100 billion staring at the space. As I mentioned earlier, it remains an underserved market. You could easily see a doubling of the kind of annual value you see going into the space. I would love to hear what some of our private firms on this call think also.

Snow: Anas, what are your views on the future of the energy space and the penetration of private capital into that space?

Alhajji: Generally speaking, the pie is going to get larger. But the percentage probably will stay around what it is today. This year, we’re having to spend about $200 billion between Canada and the U.S. That’s the total spending. It’s going to get larger, but the percentages could stay the same. In a sense, we still need more private capital, but as a percentage of the total, it’s going to be the same.

Marye: Yes. I agree wholeheartedly with the sentiment that at least the notional capital dollars that come into the marketplace will continue to increase. That’s certainly the case on the upstream, midstream and services side, where private equity has been a major participant for a long time. It’ll be interesting and not in a place where we invest regularly in the downstream market. Traditionally, you’ve seen very large deals from private equity get down in the downstream we’re finding in marketing space. It’ll be interesting to see whether or not more investments are made and if they morph in size and style over time, but I don’t have a view as to whether that will or won’t happen.

McCarter: David, one other thought. Most of your energy private equity money you’ll see invested will continue to be in North America. That’s where it’s happened. But our latest energy private equity survey indicated an interesting trend where folks thought more increased activity, maybe not relative to North America, was going to happen in places like Latin America, Asia Pac, Africa, and the Middle East. So, maybe not the funds we have on the phone today, but there are increased interests in certain funds to go more international than they have in the past.

Alhajji: Just one comment. We need the corporations and the majors to continue to spend because that’s the only way we can sell to them. The idea of the increase in the private investment is good to a certain limit, but after that, it will be difficult to sell to the majors.

Snow: We do have a question here, which hopefully bodes well for the future of talent entering the private capital energy space given, as all of you have said, the scarcity of talent. Someone is asking about how Denham and NGP go about hiring for their own firms. You identified talent at the operating level, but what kind of people are you looking for to join your own teams and how do you find them? Let’s start with Jordan.

Marye: We don’t recruit undergraduates, but we do look for folks who have graduated from great public or private schools all over the world who have distinguished themselves in their degree programs and who have gotten an apprenticeship completed in either a corporate financial or an engineering role. I went to LSU, worked at an investment bank for a number of years, and learned the transactional and corporate finance side of the business that way. Then, I started with Denham as a junior person. That’s a typical track. We also have had folks come out of engineering programs who have worked at upstream E&P companies for a period of time, then gotten their MBAs at a top program, and then come and work for Denham. Those are the typical tracks we look for. We don’t recruit very often, but when we do, those are the people we’re going for.

Alhajji: We have a similar process. First, take what we call the “associates.” We take them from top universities with at least two years’ experience in the banking sector or any other financial institution. Then, they work for two years and they go for their MBA at one of the Ivy League universities. Then, some of them come back to NGP and some find jobs elsewhere.

Snow: We are butting up against the outer limit of our time, so I’d like to thank our three experts very much for joining us today and sharing your expertise and your views on an exciting market. I hope we can invite all of you to come back to a Privcap program. Now, an internal announcement from Privcap: In June, we will be releasing a special report, essentially a collection of in-depth video programs, research and articles about the private capital energy space. Finally, stay tuned—at the end of this year, in December, we will be hosting a conference in Houston that will be a deep dive into many of the topics we discussed today on this webinar. I hope all of you tuning in can attend and even be part of the editorial lineup that day. Please contact us if you are interested.

For now, gentlemen, we promised to be on time and to deliver a succinct overview of the market, so again, I’d like to thank all of you for joining us today. Also, thanks to the audience for tuning in to a Privcap webinar.

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