Commodity and operational risks for PE

Buying on the cheap does not guarantee a successful investment

MICHAEL J. FIEWEGER, BAKER & MCKENZIE LLP, CHICAGO
BRIAN T. POLLEY, BAKER & MCKENZIE LLP, HOUSTON

Distress in the oil and gas sector has led many to speculate that private equity may provide a solution to the liquidity crisis faced by many companies in the industry. The prevalence of inflexible high-yield debt financing coupled with limitations on banks' ability to lend in the sector is limiting refinancing options, leading many companies to turn to equity infusions, refinancings with non-traditional lenders or shedding assets to restructure their balance sheets. This restructuring activity may provide interesting opportunities for private equity. Indeed, a number of large private equity houses, including Riverstone Holdings, First Reserve Corp., EnCap Investments, and ENR Partners have recently raised funds focusing on debt and equity investments in the industry.

However, buying on the cheap does not guarantee a successful investment. Private equity fund managers must consider the unique challenges posed by companies operating in different sectors of the industry as well as their own ability to value those companies in an environment roiled by volatile commodity prices.

While much ink has been spilled as to the "distressed debt" opportunities in the industry, many private equity fund managers are more operationally focused, without the debt trading experience necessary to navigate the shoals of an insolvency. At the same time, many assets may be available which could benefit from the patient management provided by private equity funds. In this article, we will explore the most significant risks associated with private equity investments in today's oil and gas industry, including those in the upstream, midstream, downstream and services sectors.

At a high level, investors in the oil and gas industry face two main categories of risk: commodity risk, or risk associated with the uncertainty of future market values and the size of future income due to price fluctuations, and operational risk, or risk that is not associated with systemic or market-wide risk, including risks caused by problems with internal procedures, people, and systems. The importance of these risks affect investments in assets in the various oil and gas sectors in different ways.

UPSTREAM

Investments in the upstream sector are tied most closely to commodity price risk. The enormous oversupply of crude on the world market has been caused by the great success of US shale drillers, consistently high yields from the Persian Gulf region and elsewhere, and OPEC's insistence on continuing high production in order to maintain market share. In addition to a world flush with cheap oil, weak global demand growth over recent years means that even if production slows it could take some time for market fundamentals to rebalance.

Because upstream investments are so capital intensive, many assets are highly leveraged and therefore particularly vulnerable to downturns in commodity prices. Many producers are faced with the prospect of producing at a loss to create sufficient cash flow required to service indebtedness.

The high commodity risk associated with the upstream sector has made it less attractive for traditional private equity investors, although distressed investors may find some intriguing opportunities trading in the debt. However, for investors with deep pockets, patience and the ability to identify quality assets, the current market provides the opportunity to find a few jewels.

The ability to hedge against price fluctuations is critical to any successful upstream investment strategy, as is taking a cautious approach to identifying suitable assets. Minimizing exploration risk and extraction costs per unit price should be the main goal for private equity investors in the upstream sector. As such we do not expect to see much activity in the expansion and exploration of new reserves in the near term.

Other considerations in the upstream space include the nature of oil and gas ownership rights, which can complicate investment strategies for non-experts, the high capital requirements of the industry, and environmental issues including required government permits, dealing with waste and wastewater, flaring of ungathered natural gas, and issues associated with endangered species in certain regions.

A final operational risk important to consider in upstream investments is whether the right team of managers is available to handle the investment, since poor management can lead to much higher than expected exploration and production risk. Despite the risks, private equity managers aligned with experienced and strong management teams may be able to position themselves for significant growth if and when commodity prices rebound.

MIDSTREAM AND DOWNSTREAM

Investments in midstream assets, which gather and transport the hydrocarbons, and downstream assets, which process and refine them, can appear more attractive than upstream investments in some ways. For example, share prices for US refinery assets, while tapering off somewhat lately, have seen significant appreciation as a result of the decrease in input costs in the United States.

The fee-based structure of many midstream companies, including pipeline operators, insulates them from the direct commodity risk exposure faced by upstream assets and service providers. In addition, the capital intensity and complex permitting requirements associated with these assets can provide a barrier to new entrants that would erode profits. Of course the stability and capital intensity of these assets make them attractive to infrastructure funds and other investors who have lower return expectations than many private equity fund managers, and as a result the competition for quality assets is likely to remain fierce.

Private equity investors will need to focus on legal issues that can impair value including the unique regulatory issues tied to FERC and common carrier rules, potential carbon regulation and other environmental issues and costs associated with permitting and maintenance. Finally, counterparty risk associated with upstream customers must be taken into account when valuing and operating midstream and downstream assets, to ensure that exposure to large counterparties is appropriately hedged.

SERVICES

The downturn has hit the oilfield services sector particularly hard. Service companies, which may provide anything from drilling equipment and expertise to helicopter shuttle service to offshore rigs, are often the first to feel the squeeze of a downturn as their clients' profits begin falling and the service companies are pressured to cut costs by reducing salaries or headcount.

Private equity made significant investments in the sector during the shale gas explosion, many of which are now significantly under water. Given that recent history, private equity has not shown much appetite to re-enter the market for companies in the oilfield services sector. There may still be opportunities in the services sector, though, including infrastructure supporting worker populations in fields that remain active, software, business services and logistics, in particular where the target has a unique proprietary advantage through the ownership of valuable and protectable technology.

When evaluating services companies, private equity sponsors should focus on the proprietary nature of the target's technology and processes - reviewing patents and potential competing technologies. In addition, the ability to assemble and maintain a strong management team, typically a differentiator for private equity, is key to successful investments in this sector.

While services companies are suffering from the lack of E&P activity, the sector does offer private equity the ability to make smaller investments focused on operations and technology than investments available in the upstream, midstream and downstream spaces. This in turn allows private equity funds to bring their traditional focus on operational improvements and strong management to bear on assets trading at significant discounts to their recent high valuations.

OFFSHORE OPPORTUNITIES

Each of the sectors discussed above can be divided into domestic and international markets, and it is worth considering investments outside the US as a separate and distinct class of investments. Recently certain international oil and gas companies have been pressured by shareholders to reduce capital expenditures on riskier exploration projects or less productive assets in favor of rebalancing and redeploying capital toward more productive and more profitable assets, in some cases to strengthen the balance sheet in the current low price environment. This could create opportunities for PE players with a higher risk tolerance, as companies may in some cases divest foreign assets at bargain prices as part of a strategy to refocus on core strengths.

Some offshore investments may look even more attractive with the strong US dollar, since that is the currency in which most assets are priced. For Asia, in particular, the commodity price slump could result in greater PE investment as banks and financial institutions become more reluctant to provide debt funding. Particular regions in which private equity has sought returns include China, Russia, Brazil, Southeast Asia, and Africa.

Certain risks are unique - or at least more pronounced - in the context of offshore investments. Any private equity fund considering oil and gas investments abroad must consider sovereign (or political) risk associated with the local government. Consider whether the particular jurisdiction has in place well developed institutions of conflict management, including courts. Focus on the potential risk of asset expropriation, and the extent to which certain relationships with government and national oil companies will have to be carefully managed.

The potential for double taxation or other tax inefficiencies could come into play in certain countries, and offshore investments could also create exposure through exchange rate fluctuations. Other issues that can create challenges include identifying the right local talent to manage operations, local laws surrounding liability of fund managers and corporate governance standards, the jurisdiction's anti-money laundering and anti-corruption laws, and the availability of exit strategies in the particular locale.

There is no one-size-fits-all approach to private equity investing in the oil and gas industry, and any investment strategy must be tailored to the particular fund's goals and risk preferences. The risks associated with PE investments in oil and gas assets vary depending on the particular sector, region, and other characteristics of the target.

Significant due diligence into potential targets and local co-investors or joint venture partners may be necessary, and exercising caution in contracting will help mitigate commodity pricing risk. Start with the exit in mind and work backward, keeping in mind the risks of the particular sector or region. With investments in the oil and gas industry, careful planning at the outset can substantially reduce risk and ultimately maximize returns.

ABOUT THE AUTHORS

Michael J. Fieweger is the Global Head of Baker & McKenzie's Private Equity practice and a partner in the Chicago office. Fieweger represents private equity and venture capital funds, institutions, family offices and hedge funds and strategic acquirers in their formation and global acquisition and investment activities. He also has a background in corporate finance.

Brian Polley is an associate in Baker & McKenzie's Houston office and advises on energy mergers and acquisitions, along with private equity transactions and project development in the US, Latin America, and around the world. Polley also advises clients on securities matters and corporate governance as well as national security reviews of foreign investments (CFIUS).