What Happened To The IPO Market For Oil And Gas Independents?
A monitor displays stock information on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, May 25, 2018. U.S. stocks bounced between gains and losses as plummeting oil prices rocked energy shares and investors weighed what U.S. President Donald Trump called North Korea's "warm and productive" response to his decision to cancel a summit with the nation's leader Kim Jong-Un. Photographer: Michael Nagle/Bloomberg
There is no IPO market for oil and gas independents today. Why is this? Because the market value of publicly traded shale companies today is less than the cost of replacing the leaseholds, seismic, reserves and drilling inventory that make up their assets. Consequently, cash-rich companies and private equity managers have acquired or merged publicly held companies into their portfolio companies to acquire assets more cheaply.
When will the market again favor private equity managers’ favored strategy of privately acquiring assets and then exiting to an overvalued public market? Simple: when market values exceed replacement costs.
To understand when that might happen, let’s take a quick look at the fundamentals driving today’s market. After that we’ll look at some time-honored ways to view risk and reward.
The supply of public equities in oil and gas is disproportionately smaller than the use and the value of oil and gas in the national economy. “Market allocations” for oil and gas are underweighted now in the public equities market. Until there is a flow back into public equities, independents and their investors must rely upon excellent science to discover the next low-cost play, to drive down current drilling and operating expenses, and maintain positive cash flow. It will happen.
Consumers are short oil and gas for the rest of this year, next year and the years afterward, no matter how much they plan to use. Threats of supply shortfalls lead to remarkable inflows of capital, price increases in the futures markets, surging equity prices, and overweighting of oil and gas equities in the portfolios of institutional investors. Always.
The current price elasticity of demand for oil is negative 0.04. This means that a relatively small change in world supply changes the price (in the opposite direction) by 25%.
This lack of elasticity is what Saudi Arabia used to take aim at U.S. shale drillers in 2014, resulting in a catastrophic loss of capital, 330-plus bankruptcies, 250,000 direct jobs lost and more than $200 billion in lost annual GDP. This lack of elasticity also means that despite current sentiment that the world has plenty of oil and gas and that peak demand is only a few years away, OPEC has succeeded in withdrawing sufficient oil supplies to drive up the price from $40 per barrel to more than $60.
Note that “Peak Oil” supply has always been a quaint fiction — especially so in the price regulated U.S. market in which the notion was advanced. Increased demand and higher prices will draw out more supply, putting upward pressure on prices. The 2009 Energy Journal paper “Depletion and the Future Availability of Petroleum Resources” lays out the supply availability of oil, gas and gas liquids as the real price increases and allows for economic production.
The biennial study of the Potential Gas Committee details that gas resources will last well beyond several lifetimes. The marginal cost of producing natural gas from the Barnett and Haynesville shales was about $1 per Mcf in 2011. That number has only decreased as technology has improved by leaps and bounds.
According to recent data, private equity sponsors have stakes in 350 portfolio companies to which $200 billion of equity has been added since 2014.
Much of this funding went to shore up expensive shale and offshore investments that were bleeding cash at $40 per barrel oil.
These ideas are not new. Time honored analysis
In a 1931 article, Stanford University professor Harold Hotelling detailed conditions under which the owner of a limited amount of natural resources would be indifferent between current production and future production if the forecast price increase of the resource was equal to the rate of interest. Known U.S. shale plays offer the certainty of hydrocarbons — essentially, storage in place — the commercial production of which is entirely dependent upon the current gross margin.
Barring supply manipulations elsewhere in the world, investors today in the U.S. domestic shale plays face the prospect of bringing oil to market when the long run prospects for price exceeding marginal costs are not good and, in fact, while the prospect of price increasing at a rate greater than the rate of interest is decidedly negative.
Yale University professor William Nordhaus forecast in 1979 that the real price of crude oil would increase at the rate of real economic growth. Discounting short run manipulations by OPEC, misguided political responses and reactions by producers and consumers adjusting to these divergences, the real price of crude has indeed increased at the rate of real economic growth for the past 40 years. The manipulations and reactions have provided the volatility needed for smart active investors to realize outsized returns.
One’s level of success depends on what others do. Think John Nash of “A Beautiful Mind” and his paper “Non-Cooperative Games.” OPEC remains the “swing” producer in the global oil market. The U.S. shale plays have improved their costs, but one cannot characterize these high cost producers as “swing” producers because they do not have the incentives or abilities to increase or decrease production at will.
In recent decades, OPEC works backward to assign quotas based on their assessment of world demand and non-OPEC production. OPEC’s quotas were designed to provide an intersection of supply and demand at a forecast price. OPEC often got it right, but when it failed to respond rapidly to China’s 2008 increased demand (necessary to replace coal to clean up the air before the Beijing Olympics), OPEC inadvertently created a new competitor; the U.S. shale plays. By 2013, it was obvious that the U.S. shale plays had encroached on OPEC market share and that OPEC would employ another Nash response, predatory pricing.
Martin Shubik is a titan of game theory and value investing, and in his Dollar Auction paper, he describes a game that investors must avoid. The auction is for a dollar bill. It is won by the high bidder, but the second-place bidder must also pay out his bid while gaining nothing. The Dollar Auction describes perfectly what happens when nations go to war; the winner survives (sometimes barely) and the loser is wiped out.
For some investors, the game also describes the challenge faced when too much money chases too few assets. Investors can find themselves upside down or bidding more than one dollar to win the asset, just to stay in the game.
The shale drillers that survived $40 oil are those who followed the dictum of Michael Porter’s book “Competitive Strategy” – be the lowest cost producers. For commodities, it is the only strategy that succeeds over the long run.
Private Equity Game
Private equity sponsors have become larger and larger over the past 20 years. Portfolio companies backed by hundreds of millions of dollars are rarely allowed to make money on new discoveries and new drilling. Nowadays, they are kept on short leashes and directed to infill drilling of known shale plays that commonly have inbound costs of $30,000 to $40,000 per acre. Ouch! These numbers are reflected in the publicly traded companies adjacent to the private companies in the shale plays.
Here, we see that the efficient market hypothesis and Stephen Ross’ Arbitrage Price Model begin to work against outsize returns for the shale play companies and especially against those that have to pay a premium price for entry. In this instance, the sponsor may be better served by making a long-only bet on NYMEX and avoiding the liabilities of owning an operating company.
The time horizons of sponsors do not match those of their pension fund and endowment investors. Institutional investors typically invest in oil and gas as a hedge against increasing energy prices and for diversification. Private equity sponsors have shorter horizons (generally not more than seven years for a fund) and, consequently, their portfolio companies have shorter time horizons. With cycles and manipulations by OPEC occurring over years and even decades, there is often a mismatch of timing among capital providers and their investments.
Where is the opportunity now?
Let’s define microindependents as small oil and gas ventures that have the potential to be company makers. The companies have a competitive advantage in proprietary science and perhaps a portfolio land position. They may or may not have production, but no one can dispute the risk-reward profile they offer to investors. These are not the one-well projects with the prospect of a trillion cubic feet (TCF) payoff but the portfolio of a half-dozen targets with a TCF payoff. It is difficult for a microindependent to be so well diversified but easy for a private equity portfolio company to assemble a portfolio of such geologically independent targets. $50 million to $100 million of investment is needed to get one of these companies over the threshold. No one forgets the lesson of Newfield Exploration’s first 11 busted wells and the success that came with the 12th, which paid for first 11 and more. This approach does not exclude shale plays per se, but it excludes the strategy of paying top dollar to buy into the current roster of producing shale plays.
Investment strategies that provide investor exposure to upside beyond simple oil price increases will dominate. The options pricing models, however limited, argue in favor of equity investment in assets with higher risks coupled with high potential. See, for example, the Cox, Ross, Rubenstein model or Stanford professor Myron Scholes’ recent work that directs investment managers to move away from “average” or “The Black Swan” by Nassim Nicholas Taleb of New York University.
Profitably selling oil and gas is the first exit. Fundamentals and risk analysis never go out of style.
Ed Hirs is a BDO Fellow for Natural Resources and a UH Energy Fellow at the University of Houston. He teaches energy economics courses to undergraduate and graduate students within the department of economics at the University of Houston. He is also Managing Director for Hillhouse Resources, LLC, an independent E&P company developing onshore conventional oil and gas discoveries on the Texas Gulf Coast. Previously, Ed was CFO of DJ Resources, Inc., an early leader in the Niobrara Shale. He holds a Bachelor of Arts with honors and distinction in Economics, a Masters in Economics, and a MBA from Yale and holds the CFA designation.