November 23, 2015
Interviewed by: David Snow
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Who Will Survive the Oil & Gas Shakeout?

The drop in oil prices, by conventional wisdom, should have been a catalyst to distressed buying for private equity firms. However, Vance Scott, Americas Oil and Gas Leader for Transaction Advisory Services for EY, says that while some of that action is taking place, there’s still more time needed to assess the playing field. A close look at reserves will give further indication as to who will win and who will lose in the unfolding market.

The drop in oil prices, by conventional wisdom, should have been a catalyst to distressed buying for private equity firms. However, Vance Scott, Americas Oil and Gas Leader for Transaction Advisory Services for EY, says that while some of that action is taking place, there’s still more time needed to assess the playing field. A close look at reserves will give further indication as to who will win and who will lose in the unfolding market.

Who Will Survive the Oil & Gas Shakeout?
With Vance Scott of EY

David Snow, Privcap: Today, we’re joined by Vance Scott of EY. Vance, welcome to Privcap. Thanks for being here.

Vance Scott, EY: Thank you, David. Pleasure to be here.

Snow: The price of oil has dropped precipitously, so many private equity firms have earmarked capital to go after what they thought would be a distressed opportunity in oil and gas. Has that materialized? If not, why not?

Scott: It’s beginning to—it hasn’t materialized yet. The reasons behind it are many of the companies that are in a more leveraged position also protected themselves with hedges. Those hedges oftentimes were 12 to 18 months out, which provided some protection on the price side. Then, when the price declined last year, it sunk pretty quickly down into the December/January timeframe. And there was a bit of a bounce that occurred there. At that point, several of the E&P players went back in and re-established hedges, then also tried to reset some credit positions, which gave them a bit more flexibility. So, I think those are probably the two drivers as to why we haven’t seen as much action as others have predicted at this point in time.

Snow: Do you predict that the distress will begin to unfold as we move forward?

Scott: Yeah. A lot of pundits and experts thought that the fall re-determination we’re going through right now would create a whole series of what would happen at either the corporate level or the asset level. We’re beginning to see some evidence of that, but some analysis we’ve done suggests that the real stress is going to happen in the spring. Now, all of this is predicated on not seeing a rebound in commodity price. If we continue in the $50 regime that we’re in right now and you look at the cash positions and free cash coverage on debt payments and dividend payments, many of the players are going to be forced to do something (we think) between now and spring. Again, barring no rebound in commodity price that would provide some relief.

Snow: Do you think that many of the private equity firms are indeed positioned to be the providers of that capital if this distressed opportunity unfolds?

Scott: Yeah. Many of the private equity firms have funds sitting there and they’re ready to move in. They’re looking to acquire at a good value for themselves, at the bottom of the cycle with some upside, looking to back stronger management teams that they think can drive higher performance. One thing we’ve seen—the game is actually changed in North American oil and gas from where we were under conventional resources. In the past, it was very much focused on very good exploration capability to locate the hydrocarbon. In the shale environment we’re in (source-rock resource environment), the winners are going to be those that can actually operate very effectively and do very good sequenced operations in their drilling and production programs. Private equity’s begun to understand that, so they’re looking for management teams.

Snow: Let’s talk a bit more about the management skills needed to unlock this opportunity. Is there a typical profile of the kind of manager you think is going to do well in the new environment?

Scott: I think the ability to synthesize and understand information more quickly and then to adjust on the fly with that information.

The area where I think the industry could benefit is bringing more of an operations-engineering or industrial-engineering mindset and starting to think about just-in-time manufacturing processes. Understanding what “capacity” really means. A concern I have is this whole lean thinking. If you understand operational theory, you begin to see that you can lean a system out and can actually destroy value because you need capacity in the system at points. And, if you go too lean, you cannot achieve what you need to do because you starve the line in operations-engineering and industrial-engineering language.

Snow: You’ve done some research into the financial positions that companies will find themselves in based on their reserves and the price of commodities.

Scott: Sure. What we did is—because we’re in the transactions business, we’re trying to identify those players that we felt would have to take some type of action, either a restructuring action or looking for a joint venture or maybe even looking for a merger to work their way out of the bottom of the cycle. You look at the financials—[it’s] very important to understand what the free cash flow position is. [It’s important to understand] what the hedged position is and then look at those things relative to the obligations on interest payments and dividends.

Another dimension we looked at is reserve—we call it “reserve resilience.” If you have a large reserve base, you’re in a stronger position to weather the storm we’re in.

Snow: Let’s talk about a major group of players in the oil and gas industry: the MLPs or master limited partnerships. They’ve been big providers of capital and owners of assets in the midstream area, in particular. Have the dynamics changed and is there a new competitive balance between the MLPs and, let’s say, private equity firms?

Scott: Yeah. My perspective on this is that the MLP model is a good model for the midstream and I don’t see that changing other than you think about where they get their capital. Fundamentally, it’s a bond investor that sits back behind an MLP construct. As long as interest rates remain where they are, the MLP will have access to capital. And if they put that capital into something that’s a long, live, reliable revenue asset, that’s a good business model. And it does have a structural advantage from a tax position. I don’t see MLP disappearing soon in the midstream space. I would not have that same opinion on the upstream side.

Snow: Private equity GPs are a confident lot. They tend to exude confidence regardless of the circumstances and many of them who I’ve spoken to who invest in oil and gas are saying, “We feel confident about the future, even if commodity prices remain below where they were.” Technology—or rather, the cost of technology—to get the oil out of the rocks is falling; therefore, that will change the economics and allow us to be profitable. Is there validity to what they’re saying?

Scott: There is validity to that. When…we had the run up to $100 oil, many of the executives of oil companies out there were saying, “We’ve got to do something with regard to our cost structure.” Things were going so well that the service companies were taking a bigger, bigger share of the total value pool in the value chain.

So, when the price of oil declined, many of the independents and the majors went to the supply base and said (there were letters that went out), “We want a 30% reduction right now.” Not all complied, but many did. That was a first step that happened there. That’s caused a reset in cost structure. You see all the action has happened in the service sector in response to that. They’re going to look to take costs out even further to protect their margins and I believe there will be continued financial-efficiency gains driven in on the cost base.

What that does is fundamentally change the overall drilling cost, lifting cost around any of these wells. And if you’re an E&P player, you’re trying to understand the quality of the rock, the reserves that flow out of that. You want to understand what your commodity price is. Then, you project the revenues and you do a fundamental discounted cash-flow analysis on a well-by-well basis. You high-grade and, if you can lower the cost on that drilling, you’ll drill…particularly if you’re going hedge the volumes and can still get the returns that you’re looking for.

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