How Volatility Impacts Energy Valuations
Due to the prolonged period of low oil prices, GPs and LPs are changing how they look for deals. Experts from Aberdeen Asset Management, WL Ross and Co., and RSM discuss how investors need to adapt their valuation approach to indeterminate prices, why investors will see more aggressive writedowns and consolidation, and where in the value chain one should look to invest during the downturn.
Due to the prolonged period of low oil prices, GPs and LPs are changing how they look for deals. Experts from Aberdeen Asset Management, WL Ross and Co., and RSM discuss how investors need to adapt their valuation approach to indeterminate prices, why investors will see more aggressive writedowns and consolidation, and where in the value chain one should look to invest during the downturn.
Energy, Volatility and Valuations Webinar
David Snow, Privcap: Hello, and welcome to Privcap. My name is David Snow. I’m the CEO and Co-Founder of Privcap, and thank you to everyone for joining today’s webinar. It’s a hot topic. We are going to be discussing energy volatility and valuations – a mark of intelligence and best practices and outlook that investors need to understand in this volatile energy market, and with energy, of course, being among the largest subsectors for private equity. Before we begin the webinar, I’m going to ask each of our esteemed experts to briefly introduce themselves and we’re going to start with Shaia Hosseinzadeh from WL Ross.
Shaia Hosseinzadeh, WL Ross: Thank you, David, and good to be with everybody today. So I’m Shaia Hosseinzadeh. I’m a managing director with WL Ross. We’re a value-oriented private equity firm, and I look after the energy business for us both on the private equity and credit side.
Snow: Thank you. How about an introduction from Steve Springer of RSM?
Springer: Good morning, this is Steve Springer. I’m a principle at RSM. I’ve been performing valuations in the energy and mining space for the better part of the last 19 years. Spent a lot of time valuating upstream oil and gas companies as well as, well all sectors, but spent a significant amount of time valuing upstream and oil field service companies.
Snow: Thank you, and finally Jim Gasperoni from Aberdeen Asset Management.
Jim Gasperoni, Aberdeen Asset Management:
Yeah, thank you David. Jim Gasperoni here. I’m head of real assets for Aberdeen Asset Management. As the head of our real assets program, I oversee two pools of capital – discretionary and non-discretionary pools – in both real estate and natural resources. For the purposes of today’s discussion, our natural resources program involves anything from oil and gas investments to agriculture, timber, mining and then anything else that may have a land-based strategy. And we invest and service clients that are primarily US institutions – that’s endowments, foundations and pension plans.
Snow: Thank you very much. Well why don’t we get started? I’d like to start off just by reminding the audience that this is an interactive session. We will be saving time at the end for questions from you, and so the questions are anonymous. Please send them in, and we will pick as many as we can and ask our experts to answer them. But why don’t we start with a question for Steve Springer? Steve, you’re a valuation expert in energy, in oil and gas, and I’m interesting in an over from you. What do investors really need to understand about the specific aspects of valuation as they affect energy assets, especially in such a volatile market?
Steve Sprenger, RSM US LLP:
Sure, sure. I mean we’ll, obviously whether we’re talking uranium, whether we’re talking coal or whether we’re talking oil and gas, current and future commodity prices are obviously of extreme importance. But to that end, the first question is what type of price group do you use? Do you have a good nymex? Is there a good futures curve to look at? Depending on the product that you’re producing – the commodity – there may be something. But even then, you only have a few years out. So understanding what price curve you should be using – price deck is a huge issue – production costs, concept of break-even pricing. That can vary substantially if we’re talking oil and gas. That can vary substantially from one resource play to another, and within a play.
One of the advantage you have, depending on the type of energy asset – we’re talking resources – you do often have the ability to shut down, put that on care and maintenance, wait till prices come back up. So there is some inherent optionality included in that. But if we’re talking more on the oil and gas side, at that point a lot of up-front costs were already committed. So other factors that really come into play are specifically on the oil and gas side, you’ve got to consider the accounting method – whether we’re talking faux costs, successful efforts. And one of the biggest issues, of course, is understanding the differences in resource certainty and that’s true for most commodities whether we’re talking mining or oil and gas. Understanding whether we’re looking at proved reserves and what category. We’ve got proved developed producing, PDNP – proved developed non-producing – proven behind pipe, probable, possible.
And then understanding things like what type of adjustment factors have been applied by the petroleum engineer. What have the geologists considered, and if we are talking about producing assets or assets that are ready to produce, we have to understand what is the historical production look like, what is the decline curve. And of course, one of the big things when we’re talking oil and gas is what’s the appropriate discount rate? And that is a function to some degree of what adjustment factors have been applied in estimating some of those resource certainties. So those are a few of the types of things, the idiosyncrasies that are relevant to energy companies and oil and gas companies that don’t really come into play with a lot of other industries.
Snow: Well there’s sort of two sides of the equation when thinking about energy volatility and valuations. There is the private equity portfolio, and then of course there’s the deal market – the M&A market. Shaia, you are very well positioned to talk about that. Maybe a starting question for you, which is, with record volatility over the past 18 months how has that impacted valuations and M&A activity in the private equity energy sector?
Hosseinzadeh: Well David, people generally can adapt their valuation approach to high prices. They can adapt it to low prices. I think generally what’s quite difficult in the capital markets is to adapt any kind of valuation method to prices that are in determinant. If you look at just consensus estimates for oil, on the front end of the curve looking anywhere from 12 to 18 months out, the dispersions of views is quite remarkable. On the low end you have estimates as low as $20. I think we’re going to probably start seeing people get even lower given where oil is today.
On the high end, in the short term, we’ve seen estimates as high as $75, $80. So that’s a very difficult environment in which, for sellers or buyers, to transact. And that’s really been a driving factor last year for why M&A volumes were down so markedly. It was something like an 80% reduction in M&A volumes.
What’s really, I think, going to drive this next wave of activity – and we think the market’s going to open back up in a meaningful way this year – is that when you look at this time last year, a lot of the companies entered the year out of a fairly robust capital market issuance cycle in 2014. Revolvers were not largely drawn. There was a pretty robust high-yield activity the prior year, and there were hedges in place that sheltered a lot of the spot price movement. So sellers had some ability to be picky and to wait and bide their time for higher oil prices.
Where we are today, I think, is in a much different place. We’ve been through two redetermination cycles, both of which have been tough, but not as tough as maybe some people would have expected. Coming into this year’s redetermination cycle, I think we are going to see a much greater need for either collateral replacement, or perhaps revolver pay-downs. And I think there’s going to be three categories of people. There will be people who can raise equity to pay that down, and that’s a very small portion of the market who will try to do that and have done that. There’s people who will have to basically sell assets, maybe at prices they don’t like, but that’s their only resort to paying down their RVLs or at least shoring up liquidity.
And then the category, which is a growing category and one that seems to be getting bigger by the day, is this cohort of companies that can neither issue equity nor can they responsibly sell assets without meeting the fiduciaries that they have to the various stakeholders. Not just the equity at this point, but also the creditors as well. And for those companies, it’s going to be a mixture of in-court and out-of-court restructuring. And I think that’s really going to be the next leg to this M&A cycle, which is – we can probably talk about later today – which is very different that what drove the M&A cycle over the last five years.
Snow: That’s great. Well there’s a lot of follow-up questions that I’m sure people will have for you, Shaia. But first, why don’t we go to Jim Gasperoni. Jim, you allocate to private equity managers and I’m wondering what kinds of conversations are happening right now between GPs and their LPs with regard to the valuation of energy investments. And how are GPs articulating the approach that they’re taking, or the range of approached that they’re taking, to finding the right valuation.
Gasperoni: Yeah, I would say that obviously – and I’m sure there are limited partners out there in the audience. I think the frequency and the, say the veracity of the conversations have increased. And I would just say these are conversations that have been ongoing since roughly the tail-end of 2014. I guess the first thing I would say is that if you look at a lot of the private equity strategies that most LPs gravitate towards, given it’s private capital, is there some kind of value-add component that you’re able to execute on at the asset level? Given the gap between capital expenditure programs and cash flow from operations, particularly in a reduced commodity price environment, we already saw some downward pressure on the ability to execute using your own income stream which was candidly, historically, the way that most of our managers would fund the increase of production by drilling new wells, etc. So we already felt some of the downward pressure there as part of the go-forward market expectations, I would say on the part of limited partners. And I would say that those conversations were ongoing throughout the tail-end of 2014 and into 2015.
I think now if you start to look at the realization that commodity prices were not bouncing back, even if you had the good fortune of hedging a high amount of your production through 2015, 2016 and in some cases a portion of that through 2017, I think the conversation is around year-end valuations. In 2015, it’s trying to come up with the cohesive arrangement between a DCF analysis that really takes the go-forward forecast of what you think you can reasonably expect from a cash flow perspective. And also try to marry that with some of the other methodologies like comparable transactions, which again, can be spotty and difficult to pinpoint in this environment.
I think the final thing I would say in terms of the conversations with our managers is, when you think about setting aside long-term, patient capital while interim valuations are helpful, I think when you think about what you bought asset for and how you’re managing it and ultimately what type of liquidity you’re going to get in the back-end, I think folks are still taking breath and saying, “In 2015, valuations are important. But most importantly, what’s going to happen through the course of 2016 and what are those 2016 valuations going to pretend for the ultimate profitability of the investment.” And I would say that most of the general partners today are being far more aggressive in terms of their conversations with their investors. And I would just say that we’re probably going to see more aggressive or realistic write-downs, even if those write downs are only temporary.
Snow: I’d like to move to a specific concept within oil and gas company performance, and that’s the break-even price. Steve, I’m wondering if you can walk us through what that means and how it impacts valuations?
Springer: Sure, I mean depending on the resource play, there’s going to be some plays that are obviously lower cost to produce than others. Oil and gas existed at varying depths, so some cost more simply to drill. Some cost more to produce. The type of oil or gas that you get out, the quality, there’s going to be pricing differentials. So by default, there’s going to be certain plays that are going to have a higher or lower break-even. Most of the plays in the US, especially the non-conventional plays, have break-even prices in the $50 and up range. Which is one of the strategies, of course, OPEC was employing by keeping production up high is to knock the US producers kind of out of it – to limit the supply coming online and retain market share.
There’s a couple of slides I attached, I think starting with Slide 19, that indicates based on some of the Woods-Mackenzie data – yeah, you can see that. And I’m not sure how easy that is for folks to see. If not, there’s some additional breakdown on the following couple slides. But these are examples of break-even pricing; again based on Woods-Mackenzie research, that kind of highlights the general break-even price by shale play. And in some cases, by area of shale play. And the idea here is again, production costs vary. Quality of resource varies and understanding one play versus another, and when trying to compare we talked about – mentioned a minute ago, Jim had mentioned the market multiples, transactions that you see.
And one of the areas that we’ve seen folks confused from time to time are comparing transactions that occur not only in different plays, but also at different areas of one play to another. And it can get very tricky these days, as we have spotty information and fewer transactions to look at. But the fact of the matter is that we need to be conscientious and understand what play are we in. What is the break-even pricing? And one of the things that we do expect though over time too, is due to the improvements in oil field service technology, improvements in horizontal drilling and other types of methods. The expectation is that some of these break-evens can drop over time. And so the current that we’re seeing, we expect that it’s going to make producers a little bit more nimble, a little bit more able to produce at even lower oil and gas prices.
Snow: Back to the M&A market, question for Shaia. What does the lending market look like for the kinds of deals that you target in the energy sector?
Hosseinzadeh: The short answer is the capital markets are highly dysfunctional, David, staring with the banks which are pretty critical as I think most of you know, to the energy sector. The banks are retrenching in a pretty significant way, and I’ll give you three reasons. One has generally curtailed the appetite for principle risk across the bank balance sheets. So this means that dealer inventories in the high-yield market are going to be considerably lower, which in turn puts pressure on secondary spreads, which in term is a vicious cycle. And that leads to more expensive, new issuances. And we’re seeing that with a large number of bonds legging down 5, 10, 15 points. Not necessarily because of fundamental reasons, but because people need to offload supply.
Second, the office of the comptroller of the currency has instituted the shared national credit review, or as it’s affectionately known by some people, SNC. And what that means is that our BL facilities, reserve base lending facilities that most people, the banks included, would argue are money good are going to be curtailed going into the balance of this year. And that’s quite meaningful when you consider that for some of these companies, that’s almost 50% of their cap structures. Now they’re not being curtailed because the banks believe their going to lose money on them. But they’re being curtailed because there not as profitable a business as they were given the risk-weighted assets that have to go against them.
And then finally, if the first two are not bad enough, oil is now down to a level where 90% of the US doesn’t make money. So if you’re sitting at the risk committee with your partners that are an investment bank and arguing for a client, unless you’re prepared to argue for an oil price near-term strip and beyond that’s at a material increase – I mean we can debate whether or not the strip market is realistic. But that sort of makes a very difficult conversation with the risk committees of the banks, many of whom may not have an appetite to underwrite strip prices plus a big premium to keep those facilities in place.
So that’s a pretty deadly trifecta of factors, both for existing company valuations. If you think of a traditional lack, which DCFs are a big part I think as somebody else was talking about earlier, of valuating these companies. And it’s also, on the new deal front, when you think about the growing inventory of LBO bridge loans, which is a new development not just in energy but just generally in the market. It’s starting to look a little bit similar to what we saw – although not as significantly as to what we saw – in 2007, 2008. So this is clearly going to have a material impact on the volume of deal flow, valuations and on what it means for people that are going to put incremental capital to work.
I would like to make one comment, and come back to something that was talked about earlier in terms of looking at break-evens. I think one of the things that investors are learning, and perhaps not in the most pleasant way, is that E&P companies are remarkably opaque. It is very, very difficult not matter how many reports you find on a particular play, to go from that high-level, top-down analysis and to be able to overlay a meaningful framework to look at raw quality. And really the only way to do it is to have a county by county assessment, be able to understand things like how laterals are being landed, completion techniques. Things that are very granular that need sort of boots on the ground to do. And I think that will play very much against both people who have exposure in the fixed income markets, but also against people who perhaps are putting money to work without the benefit of that full knowledge. And I think there’s some implications there about valuations and deal flow, which we can come back and touch on. But I thought that was an important point.
Snow: I have a question for Jim from Aberdeen. Jim, this has been touched on before, but I’d love to hear it in a bit more detail from you. What kind of tools and pivots can a manager turn to to mitigate the effect of the falling value of commodities? Considering that private equity is an actively managed strategy, what do you expect your managers to have by way of toolkits to deploy?
Gasperoni: Yeah, I would say just again, getting back to the original thesis, the reason why you invest in private capital is because you believe that A, there’s an opportunity to exploit some sort of an efficiency. And that is either market driven or at the property. The second is that you have to be partnered with a skilled operator. And look, I would say a couple of things. The first is that one of the benefits you have of owning the asset in the well head rather than buying the commodity pure is that you can work A, both sides of the ledger. You can – there’s so many things that are outside of your control, one of which is commodity price. Can you actually control the flow? In other words, can you produce or not produce?
The second is, is the other side of the ledger which is the fact that you can actually also manage the cost side. We’ve talked about the fact that break-even costs are actually a variable depending on A, where you are and B, how can you manage the role of the producer versus the service provider? My expectation in this environment is that the managers are using all of the levers within their control to manage their way through this. And I would say the second thing, and again, I think this is when you talk to limited partners about one of the important things about being in a co-mingled fund for example with a lot of other limited partners who presumably have the same outlook, the same time horizon, the same orientation around risk. One of the skills a manager needs to have in this market price environment is the ability to manage that LP base and to collaborate, be construction and to the degree that you think there’s going to be some stress on an asset level or a portfolio level, to be able to talk with your limited partners and find a way to manage through this in some way that doesn’t cause permanent impairment either to that asset or to the fund itself.
And again, if I can use a corollary. I think a lot of us who invest in real assets, who’ve been around for a while, in some ways this feels a bit like 2008, 2009 if you’re looking at a portfolio of real estate managers where you had had a number of high-quality assets being managed by a lot of high-quality managers. And some of those managers were able to manage both A, the assets, and B, the relationships and the dialogue with their limited partners differently. And I think that it’s both pulling those levers at the asset level and also dealing constructively with your limited partners. Because as you can image, limited partners have cause for concern and need to be comforted that A, there’s a plan whether that plan is Plan A that they are executing or there’s a Plan B that you can pull off the shelf. And if there isn’t, how can we work collaboratively to make sure that this has a positive outcome?
Snow: I’d like to remind the audience that they can begin sending in questions as soon as now. We’re going to have about six more minutes of conversation, then we’re going to get to your questions. I already see some good questions have been sent in. Maybe a follow-up question about valuable methodologies for Steve and for Jim, if Jim you want to answer it. Steve, what do you see as some common mistakes or maybe misguided valuation policies out there? They’re uncomparable focusing on the…
Springer: Yeah. Yeah, we see…right. We do see a lot of that. I’ve seen all kinds of things over the last several years. Sometimes we’ll see inappropriate price curves being used to value the assets, inappropriate decline curves if we’re talking upstream oil and gas companies. The discount rate can be a big one. I mentioned before the concept of adjustment factors. That’s one of the areas I think I see on the private equity side I see that missed a lot. The reliance upon the PV-10 resource calculations, but not checking whether or not those have been risk-adjusted. And depending upon the resource certainty, the risk-adjustment factors can be pretty steep because what a lot of folks use is the 10% discount to value the reserves, right? Well in many cases I see that 10% discount rate being used to value un-risked resources as well.
So even – whether we’re talking about proven developed producing or even something in the PUD category – the proven undeveloped category – there’s a difference in resource certainty. The PUD category is not producing right now. And certainly on the probable and possible side, the adjustment factors can be pretty steep – typically a good 50% adjustment factor for the probable, and very often something in the 10% range for the possible. And so depending upon how much of the asset or the resources are in the proven category versus the probable P2, P3 type category can make a huge difference in the valuation. So that’s one of the biggest issues I see.
I often see oil and gas. I’ve seen oil and gas assets valued issuing – you mentioned comparables. In a lot of cases you’ll see folks looking to a set of guideline public companies to get a feel for what the value might be. But very often, you’re looking at diversified companies that have interest in various plays across the US, maybe even globally. And their portfolio is very different looking than valuing a single asset in the Eagle Ford area in the Bakken. And so that’s one of the areas I’ve seen that folks have missed.
I mentioned the adjustment factors, and that is probably one of my biggest pet peeves. And there is slide I did add on that, Slide 18, that this is based on a recent SPEE survey. I think the most recent from 2015. And this is just a survey of what folks are applying to conventional and unconventional resources. And again, this is something that I see missed probably more often than not when I look at a lot of valuations performed by private equity, by other folks that are less engaged in the actual industry. So I’d say that’s one of the common pitfalls, and I did mention looking to the wrong comparables, understanding whether or not those assets, they have asset in similar plays. And then also understanding whether or not they’re diversified, what their debt to capital is. There’s all types of other things that can affect those types of multiples, and I’ve seen MVIC to EBIDTA looked at a lot versus MVIC to EBIDTAx. So there’s various types of multiples that are much more applicable to upstream oil and gas that are not the typical valuation multiples that you would use to value other types of companies in other industries.
Springer: Jim, I don’t know if you have anything to add there.
Gasperoni: Yeah. No, I would just echo your comment. I think that the typical thing that when we talk to our managers after getting the valuations, is the temptation to apply one set of assumptions across an entire portfolio. And as I think we’ve seen and we’re going to continue to see, it’s as much where you are as the type of asset you have. And I think that just like everything else, it doesn’t lend itself to some kind of a homogenous set of assumptions that you can apply across a US portfolio, even if it’s all shale because not all shales are the same. And I would say the same thing, it even gets exacerbated if you’re looking internationally. So I think that those are the types of things.
And the counter argument there is that maybe the derivation of those assumptions has some applicability in terms of how they are arrived at to create a steady-state set of assumptions that can be applied across. But I think those are the types of things that we typically have conversations with when we see valuations.
Snow: Great, well I think it’s not too soon to go to questions. We’ve got a lot of questions, and so I will ask our experts to keep their answers piffy. Why don’t we start with a question for Jim and Shaia. The question is, where in the value chain are you looking to invest during this downturn? Are you more interested on upstream, downstream or midstream in this environment. Shaia, without giving away any proprietary playbooks, what do you think about where the greatest value can be found?
Hosseinzadeh: Sure, and let me just preface it. I want to come back and hit on something that I think the panelist were talking about in terms of valuation. And I’ll make it brief. It’s really, really important to understand the rocks. And you can make spreadsheets say a lot of different things. But fundamentally, this is a technological – and a disruptive technological change here in the US. And whether it’s your iPhone or whatever your favorite technological revolution is, it will render a number of products that came before it obsolete. What that means for here at home in the lower 48, is that there will be plays that might look good on a spreadsheet, but will really not be competitive or strategic four, three years down the line, even if you believe in a recovery. There are examples of that. One particular play that I won’t name but is particularly problematic, is one that produces ten barrels of water for every barrel of oil that comes out of it. Things like that that are very infrastructure constrained or alternatively require a lot of infrastructure, will be difficult.
As for the question on where we’re focused on, I think if you think about the transmission mechanism from – I think maybe Steve or Jim used the real estate example, which I think is a good one. If you think about the transmission mechanism of this cycle, it was high stable oil, lots of credit and lots of M&A. And so that’s sort of transmitting its way now through a low oil and expensive credit into a lot of different sub segments of the marketplace. We think that right now E&P, upstream, is a much attractive place to be. The midstream sector has been quite problematic because I think there’s been this perception in the marketplace that upstream can reduce volumes substantially, and midstream is protected by the contracts. I think we’re going to see a number of re-pricing and restricting there in the next six months. So I think midstream has the potential to be interesting, probably not quite there yet.
When you look at services, to us, that’s a very difficult sector to invest in until you start to get some visibility around oil prices. And not all segments of services are created equal. Some will be in secular oversupply because of productivity gains. There’s a mega trend of doing more with less. You don’t want to be on the wrong side of that. And then there is an underlying trend, which is higher CapEx intensity per well. So I think at some point services does become interesting, but right now these companies don’t throw off cash flow. There is not a lot of terminal value unless you can put your finger on what EBIDTA is and the multiple is. So that is probably more of a late cycle play.
Snow: Jim, do you agree? Where in the value chain do you find the most interesting opportunities to capture value.
Gasperoni: Yeah, sure. I think just to level set our typical focus. So yeah as a real assets program, we look for two things. One, to get as close to the land as possible and the second, to be in areas where you can have the greatest amount of control. As a consequence, you can imagine that while oil field services one could make the argument as a shadow play on real assets. We tend not to focus there as a point of philosophical underpinning. Although, we would tell you that when we were getting calls from our limited partners last year about what we thought was interesting, we thought that if you were interested in oil field services, that that was an area that was probably going to show the stress much earlier than some of the other areas.
So I would tell you that we primarily focus on upstream and midstream. I would say today that some of the areas that we find interesting and we’re investigating are kind of at the small end of the deal size range in the upstream sector. And the reason for that is because again, we think that there is going to be a separation over time between profitable basins and less profitable basins. And again, even within those basins you have to be pretty specific about what you’re looking for. So we just think that at the end of the day, that we think the lower end of the deal size range here – on shore – is interesting. Are we doing a lot there? The answer is today, not really. We’re spending a lot of time looking, betting understanding how everything’s going to play out over the next say 6 to 12 months on the upstream side.
On the midstream side, I would tell you we find that also interesting. And I think it’s – I’ll just reiterate something that Shaia has just said. I think if you think about where private equity can play a meaningful role and you look at the appetite, and I would say the veracious appetite for cash flowing infrastructure assets over the last say five to seven years. If you wanted to play the infrastructure game because you wanted to buy something that had an attractive yield, you probably shouldn’t be doing that in private capital. After you pay fees and lock your capital up, we just didn’t think that that was a good risk-adjusted trade.
We did think that selectively, you could probably find interesting opportunities in development provided that particular opportunity had the right orientation around capital at risk. We actually think today, and I would say I think one of the things that people tend to forget is if you have an off-take agreement – even if it’s take or pay – you’re still relying on the credit quality of whoever it is who’s making that payment. And from our perspective, we actually think that that was something that people tended to forget. That it was going to be insulated from anything that happened in the upstream sector. And I actually think that there may be some opportunities for a skilled midstream investor to cherry pick some assets that may be under some stress. So I think those are probably the two areas that we see playing out over the next say year to 18 months that we’ll be looking at.
Snow: Great. Steve from RSM, a question for you from the audience. Any insight on the upstream oil field services industry? How will it evolve over time in light of the low oil price, i.e. consolidation, bankruptcies. And how do you see the OFS landscape two years from now? A bit of a…
Springer: Sure, sure. Yep, yep. If I could completely see the future, no but I think first of all oil field service companies were able to hold out for a little while. A lot of folks were hoping the price was going to recover. Obviously at $28 oil, we’re not looking at a recovery any time soon. Futures prices are going up to $40 even two years out. But yeah, there’s been obviously a substantial decrease in oil field service company market caps as well. While they’re not directly impacted by the lower oil price, obviously demand for drilling, demand for other services dropped substantially. Globally, they were looking a little better than they were looking in the US. But as far as – I think part of the question was regarding consolidation, bankruptcies. On the oil field service side, we’re talking about companies that have substantial assets. They’re capital intensive as well.
There’s a good degree of debt financing on that end too. And so oil field service companies are certainly feeling the pinch. A lot of them are highly levered. The EBIDTA’s not where it was, so we are going to see more bankruptcies there. We’re going to see a lot more consolidation and of course, we’ve got the Baker Hughes Halliburton combination still looming right now. I think it’s still waiting on approval. I know they’ve gotten some flak from the European reviews at this point. But we can expect to see, I think, a lot more consolidation in the industry. And a point I made earlier about the companies becoming more savvy, more nimble, finding ways to produce at lower prices. I think we can expect that down the road. Whether or not that’s going to occur within the next two years is debatable, and so in the meantime, I think you could expect that there will be substantially more consolidation – a lot more deal activity in that sector.
Hosseinzadeh: And it’s Shaia. If I could maybe just make two observations on that, cause I think it’s a good question. We were running something like 1,100 oil horizontal rigs before this whole downturn started. Today we’re running around 400. That’s a 60% contraction. If you look at oil field services, a good portion – more than half – are commodity businesses with low barriers to entry run by mom and pops. If you layer on top of that the fact that we are going to have secular overcapacity, we are not going to go to 1,100 rigs because the production per rig places like the Eagle Ford has doubled. That’s a very negative picture, and I think there will be bankruptcies. I’ll agree with Steve. But I think what will happen here is another round of expensive education for a number of distressed private equity firms that don’t have energy capability, that look at these companies on a multiple of prior cash flow or on liquidation value of equipment, and look at the bonds or the bank debt and think those would be interesting fulcrums.
I think the only real way to make money in the oil field service sector is either to bet on a big recovery which is, for most of us in the private equity business, not a very attractive business model over time. Or it’s to find a very defensive niche with barriers to entry. And that’s very difficult to find in the oil field services sector. So I think we’re going to see a big wave of bankruptcies, and I think one of the things that are going to come out of it is that we’re going to see new lows for valuation and new lows for liquidation on equipment that haven’t really been tested before.
Snow: Shaia, I’m going to ask a follow-up question from the audience. I’ll let you decide whether or not it’s in your wheelhouse. The question is, assuming you anticipate more bankruptcies in 2016 – and you just said that you do – for the O&G sector, how do you view the prevalence of pre-pack or RSAs as compared to a more sudden, tumultuous filing? You might want to define RSAs for those who are…
Hosseinzadeh: Sure, restructuring support agreements. Excuse me. We’ve looked at the universe, and I’ll focus on upstream for the moment because A, it’s bigger. B, it’s probably more investable than services. If you look at upstream, this is a sector that had one turn of leverage for the last decade prior to shale. That increased to two turn of leverage post shale, pre-OPEC. Today we are plummeting towards five turns of leverage. And this is a sector that trades on average – on a good day – about six times EBIDTA if you believe EBIDTA is the right metric, and we don’t. But we’ll just use that as an example.
We estimate that at current oil prices, two-thirds of the industry is going to either restructure or go in bankruptcy or go away. Now that doesn’t mean that two-thirds will actually go in bankruptcy, because we don’t think spot prices are going to be sustained for an elongated period of time. But that gives you an order of magnitude of fact of what the depth of this downturn is. The specific question on RSAs versus pre-packs versus free falls, I think will largely have to do with the composition of the equity and the creditors.
If you’re looking at situations where you have a public company with disparate bond holders, the outcome is going to be very different than a situation where you have a sponsor-backed company. The sponsor has been buying up the debt, and they’ve been in conversations with a number of the creditors. So I think the one trend though that probably will come out of this is you’re seeing a large number of management teams approached by their creditors last year for up-tiering transactions. I think the next logical phase of that for more sophisticated creditors is to approach with an RSA and try to minimize the process risk and bankruptcy. The real wild card here is going to be the equity.
If you were to survey the market, more than half of the people out there – in the numbers that I’ve seen – believe that oil is going up. There’s a lot of debate as to what that number is, but there’s a lot of consensus that it’s going up. And so the valuation fight you’re going to get into, particularly for good assets on where the value breaks and where the fulcrum is, is I think going to be the most problematic component of this.
Snow: We have time for probably just one more quick question. So why don’t we throw the last one to Steve from RSM. The question is about renewables. Do you see a flight of capital towards renewables?
Springer: Yeah, I mean there may be some capital moving towards renewables. But at the end of the day, I think in terms of where the opportunities are when you have assets that are priced very low on the O&G side, depending on the renewable that we’re talking about the lower energy prices, lower commodity prices, affect the competitiveness of the renewables. So they become more competitive when the alternatives, the conventional fuels are priced at higher levels.
So when we have low gas, we have an abundance of gas. In the US, I think it gets tricky. I think I saw a question regarding PV projects and utility scale on that end too. There’s good opportunities on that end as those technologies are developing, especially when you talk about concentrated solar PV. That the efficiencies there are improving substantially, but in terms of a flight of capital, I’m not sure that I would agree that there’s going to be substantial flight of capital to renewables because of the value opportunities right now in other areas of the industry. So again, I think fuel competitiveness, pricing. And certainly in the US we’re seeing some of those renewable tax breaks starting to diminish. They’re being lowered over time for certain renewables. So it makes the competitiveness of those alternatives even more – well it makes it more difficult for them to compete.
Snow: If this conversation is of interest to you, I highly recommend that you consider attending Privcap’s annual private equity energy conference in Houston. Energy Game Change 2016 will be December 8 in Houston. Please mark your calendar. In the meantime, I would like to say that the webinar is going to wrap up now. It’s a fascinating topic, certainly one that deserves more commentary, and yet we have to bring an end to the webinar. I’d like to thank our three experts. Thank you very much for sharing your insights. We’d like to thank the sponsor of this webinar, RSM. And I hope everyone has a great rest of day, and please come to Privcap for all your private equity thought leadership needs. Thank you.
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