Northam Takeaways #1: Outlook for the Upstream Sector

At the end of May, the Energy Council hosted an advisory board with sixteen senior executives in the North American energy sector. The esteemed advisors reflect a diverse range of both E&P operators, investors, financiers, digital leaders, OFS players and traders across both the private and public spaces. These included the likes of; 3P Energy Capital, AlixPartners, ConocoPhillips, Continental Resources, Diversified Oil & Gas Corporation, Enverus, Equinor, Grant Thornton, Houlihan Lokey, Kimmeridge Energy, Lean In Energy, Pontem Energy Capital, RedBird Capital Partners, SailingStone Capital Partners, Siguler Guff & Company and the Carnrite Group.

The discussion flew by, tackling a range of pressing topics that have emerged due to the dual market dislocations of Covid pandemic and the energy transition. With an energy sector in flux, the Energy Council sought to bring these actors together to alleviate fears, discuss barriers and find solutions to their greatest concerns.

A&D and Market Consolidation

The market has been awash with Acquisitions & Divesture (A&D) activity over the past 6-9 months, as a consolidation of the market takes place following the disruptions caused by Covid-19 and the subsequent shocks to the oil and gas prices. While there was a broad agreement that the value of assets in the market has been of fair value, one private equity investor felt there was an overvaluation of assets after seeing their ‘fair value’ bid rejected and the asset selling for more than double the offer – with “limited capital chasing limited supply”.

The general consensus is that capital is cautiously returning to the sector as the oil price bounces back to 2019 levels.

Nevertheless, it was agreed that the market required consolidation in order to create the cost efficiencies that provide confidence in sustainable business models. In turn, this will allow them to deliver strong free cash flows and prove capital discipline, despite seeking a low growth model that will mitigate oversupply.

In order to promote this market consolidation, there needs to be a reconsideration of expectations by both operators and investors. Without changes to incentive structures and compensation, companies will chase volume growth on short term projects that will likely result in a return to the old ways of boom-bust cycles. All feel this would be detrimental to the sector in terms of sustainability and what the consequences are for attracting generalist investors back to the sector.

 The best strategies herein would be to reward cash flow driven capital performance, not simply seeking growth for growths sake – but only maintain necessary state growth to return capital to investors.

Oil Price Outlook on Macro Trends

It is widely accepted that there has been a withdrawal of major international banks from the upstream sector, as they seek to defer and mitigate exposure to climate associated risk. The result of this vacuum, there has been an emergence of large family office funds seeking to provide alternative capital, in lieu of traditional institutional loaners.

The viewpoint one takes on the impact of capital in the sector is dependent on two main factors; where is the capital being invested (what type of asset), and whether there are short-term versus long-term expectations.

The reticence from some corners comes as a function of the energy transition and the impact it may have on risk-return profiles, especially considering if there is another price shock in the near term. Investors and loaners are seeking risk appropriate deployments of capital, and this may lead to a strengthening of the prices for domestic product as operators seek low growth – wary of a second supply glut.

Capital Availability

As has been noted, international banks have been exiting the energy lending space – particularly shrinking Reserve-Based Lending (RBL) loans in part or entirely. On the operator side, they are seeking to agree term loans that, although more expensive, provide greater stability.

Meanwhile, Private Equity investors are under similar pressure from banks to get their ESG structures in place. Without them, domestic lenders may be unwilling to engage and PE players may have to look overseas where there are vastly different ESG expectations.

As IOCs and  Oil Majors divest from regions and assets with high emissions exposure, these assets will be picked up by less concerned actors. The Asian market needs and wants hydrocarbons en masse over the next decades, and as they have different investor motivations, they may seek to engage with US domestic operators to secure a steady supply. In this instance, it may be easier to acquire international dollars from a regulatory perspective.

While there remains a committed base of investors who are dedicated to the industry, they are carefully picking and choosing assets where they can focus on fiscal discipline, cash flow and capital performance. These buyers are generally looking at underlying commodities among the 2-3 year terms being brought to market by the financial institutions.

One significant barrier to engagement is the ambiguity in the federal leasing and permitting arena, what may or may not be possible is dependent on greater clarity from this regulatory perspective.

Public vs Private Markets

There has been a distincnt divergence in the structure of private versus public operator’s business models, with the private sector now taking on a higher percentage of permit and drilling activity. It comes as a result of their ability to be more flexible and responsive to price signals than publicly-traded companies.

This approach has impact investor sentiment, where the discipline of public operators may not be sufficient in attracting capital against the aggressive approach by private operators. As US supply growth develops and private operators make in-roads, it may be a precursor to public operators fraying in their commitment to fiscal discipline

If successful, private operators could ramp up activity in anticipation of selling production capacity to the public side – impacting the supply-demand balance and the approach by investors. It is therefore important to understand private operators long-term intentions, which could be affected by Biden’s incoming infrastructure spending plan.

ESG and the Energy Transition & Regulatory Environment

The tight-rope walk to balance the desires of the investment public to promote an ESG mentality with the perspective of traditional O&G operators – is the current challenge facing the North American oil and gas sector. How to merge the side seeking returns, with the side seeking to maximize decarbonisation.

While nearly all operators will have some kind of ESG compliance project in the pipeline, investors and financiers are now demanding to see actual action over future intentions. To acquire capital a company must demonstrate three factors; capital discipline, low growth return of capital and address the “E-side” in ESG.

Yet there is a distinct barrier in that ESG frameworks lack consistent frameworks, and without an insutry standardization of emissions tracking data – there is a skewed picture of what gains are being made. One suggestion was to look toward the European market where regulation has played an increasingly large role in defining emissions metrics, but there is a worry about who will be making those standards.

European investors are remaining within O&G in the short-term and investing that capital into alternative energy sources. This will likely become an increasingly prominent move by North American operators as they seek to attract capital from more ESG motivated funds, however there is an uncertainty herein with the type of regulation being enforced. The regulatory environment will define how operators and investors go about developing projects and seeking capital.

Digitalisation

The digitalization of technologies in the O&G sector is appearing to be a surefire route to successful mitigation of emissions by creating the next level of efficiencies and taking costs out of the system. As these efficiencies build and costs fall, O&G companies will become more attractive projects for capital deployment. This in turn will result in a better and more efficient consolidation of the industry, which will bring back some of the investor confidence in the sector.

North America Assembly is taking place in Houston, Texas between 13 – 14 October 2021. Find out more >>