Navigating The Energy Transition: Opportunity time for SMID-cap and private E&Ps
The need for oil and gas supply exceeds investor interest in providing capital
I was asked during the Q&A portion of a keynote lunch presentation I gave at Enverus’ EVOLVE conference in The Woodlands (Texas) this past week (paraphrasing): Do you expect there will be consolidation and fewer oil and gas companies going forward? Will the tendency be toward mega-cap companies that are (presumably) better equipped to deal with a super vol macro backdrop, energy transition, ESG, etc.?
My answer: I am not sure there has been a better time in my 30 year career to start a new E&P company...if you can find a sponsor. And there-in lies the conundrum. For the first time in my career, there is too little capital pursuing traditional oil and gas. Mainstream public equity investors are only slowly starting to sniff around the sector. Leading private equity firms only recently decided they were going to sit out commodity-oriented investments in the current funding cycle.
In my opinion, too much credit is being given to Russian president Vladimir Putin as the reason for the better oil price backdrop. Too much faith is being put in the notion that global consumers will no longer want crude oil- or natural gas-based energy due to climate concerns. And for some reason that I will never understand, too few seem to care about how to provide affordable, reliable, secure energy supply to the 3-6 billion people in the non-rich world.
While ultimately all companies need to generate returns for their investors, the strategic options for SMID-cap (small and medium capitalization) and private E&Ps are not necessarily going to be the same as those geared for the mega-caps that tend to be the focus of my research and career. The mega-caps are by definition opting for “going concern” success. SMID-cap or private E&Ps, on the other hand, should almost always either be looking to exploit niche opportunities or act as an acquisition roll-up with a clear exit strategy needed. The last point is critically important: SMID-cap and private E&Ps generally come with an expiration date, usually due to more limited inventory life and the very nature of a niche existence.
We all know the places to be if you are an upstream producer of crude oil: The Permian Basin (Texas) and core OPEC (Saudi, Kuwait, UAE, Iraq, and Iran). Very few dispute the best of the best, geopolitics notwithstanding. Those areas were never really ever out-of-the-money. They are especially appropriate for any company that aspires to going concern status.
The more interesting question is what are the areas that will come back in-the-money in the New Energy Crisis Era that are unlikely to be pursued by the mega-cap E&Ps or Majors? Last week I suggested Canada's oil sands region and deepwater Gulf of Mexico, Brazil, and West Africa. A Twitter follower correctly suggested I add Alaska, an area I have zero excuse for neglecting to include. But this list is far from complete (and super-caps will have interest in many of those specific areas). If you don't care or need to care about exiting as a publicly-traded company, there are a near infinite number of regions, plays, sub-plays, prospects, and ideas to consider.
Non-MegaCaps and non-going concerns need an exit strategy
ExxonMobil and Royal Dutch/Shell from 1910-2010 are the undisputed going concern role models across all sectors—two of the greatest companies in the history of the world. While many of my points and underlying philosophy is applicable to a broad range of traditional energy companies, I have received appropriate pushback that my recommendations may not apply to all companies in various niches. I agree and have never believed in a one-size-fits-all approach to corporate development. This post broadens my Navigating the Energy Transition series to other traditional energy sub-sectors starting with non-mega cap E&Ps.
Ultimately the goal for all publicly-traded companies is the same: to outperform investor-preferred benchmarks. But the end game could vary by type of company. And to be clear, a benchmark isn't necessarily what a management thinks it is. It is what investors, including those that choose to not invest in your company, ultimately measure you to (i.e., who are the investors you want, which may not always be the ones you have).
The common risk all strategies share is cycle timing in the event a company has not achieved “going concern” status. Sustainability of a niche acreage play or acquisition roll-up has always been a question, well before the energy transition era. For SMID-cap and private E&Ps, a main energy transition era risk is exit valuation and what could be diminished investor or corporate support depending on how the transition era evolves. This may be less of a concern for shorter-term investors that would simply look to sell shares at a presumably optimal time. Of course no publicly traded company has zero shareholders, suggesting someone will be left holding the bag if a niche strategy does not successfully transition to going concern status or liquidate.
Exhibit 1 highlights the key attributes of a going concern oil & gas company that I believe will prove resilient in the Energy Transition era:
Double-digit through cycle ROCE;
Fortress balance sheet;
Achieve net zero Scope 1 and 2 emissions by 2050 along with other important ESG objectives and traditional HSE excellence;
Technology leader in oil & gas and emissions reductions;
Attract and retain a talented, diverse workforce.
Strategy examples
With a constructive commodity backdrop and fewer pools of money looking at traditional energy, it is indeed about as interesting of a time to be looking at the sector as I can remember in my 30 year career. Examples of possible strategies for non-mega-cap E&Ps include the following (this is not intended as an exhaustive list):
Acquire acreage/assets that it expects a larger entity will ultimately covet or could lead to going concern status;
Acquisition or roll-up strategy of out-of-favor asset;
Transition long-lived, low decline assets to being a “yield play”, especially during times valuations are especially inexpensive.
Premium, niche asset. Investing in the next great resource opportunity is perhaps the quintessential oil and gas dream. Last week, I highlighted the success of Cross Timbers/XTO Energy (here) in being an early shale pioneer. The strategy is well known so I will spare readers from another 1,000 words on it. I think the big question with this strategy is how will exit potential look as this decade progresses.
The adage often goes that a company can only buy a premium asset when the selling company is ready to sell. This might get flipped on its head. We may have entered a world where buyers can be patient and wait for inevitable commodity volatility or adverse capital market developments. We may now be in a world where even premium assets require a willing buyer; the universe is small and shrinking. We saw this to a degree in 2020—good companies buying premium assets at or near the cycle trough.
Acquisition roll-up. Classically, there was little benefit to SMID-cap E&P diversification. After all, instead of being a pure play on a single asset, the so-called diversified SMID-cap merely had sub-optimal exposure to say three plays which neither reduces risk or raises the potential for superior returns. The "diversified" SMID-cap is classically a worst-of-all-worlds type of E&P company.
Going forward, there likely is a role for the consolidator E&P that is in fact "diversified" across plays/basins. Think of it as a 2020s version of Apache Corp. from the 1980s, fast forwarded to the energy transition era. For the current era, such companies I will guess will be "acquire and distribute free cash flow" rather than the old "acquire and exploit" model that Apache founder and oilfield legend Raymond Plank pioneered.
Exit from acquisition roll-up is not obvious. There may be a need to ultimately enter blow-down mode, i.e., transition to being a yield vehicle.
Long-lived, low decline yield vehicle. A third niche I believe exists in those with long-lived, low decline assets, like you find in Canada's oil sands region. This model may well be a maintenance CAPEX plus modest brownfield expansion combined with a free cash distribution model. For this group of companies, it is possible—key word, possible—that a higher amount of balance sheet leverage could make sense, though the benefit from returning excess cash to shareholders is likely a function of free cash yield. At a high free cash yield (20%+), it may well make sense to have higher balance sheet debt and repurchase shares. It is likely that the key to this strategy is to be certain that maintenance/brownfield CAPEX will remain in check (with geologic maturity the key driver, more so thanservice or materials cost inflation).
The three examples are not exhaustive. There is no one-size fits all approach. But unless you are an executive compensation maximizing cycle rider, there is always a need to outperform a legitimate benchmark over time.
What is the end game for your SMID-cap or private E&P company?
Three possibilities (two good, one bad):
Going concern leader (Good long- and short-term). Become a going concern oil & gas company exhibiting all of the characteristics I highlighted above and in previous posts.
Exploit a niche and sell to a larger company (Good long- and short-term). Exploit a niche that you have identified ahead of others, with the ultimate goal of selling to a larger company.
Cycle rider (Bad long-term, can work short-term). Become a leveraged bet on a commodity upcycle.
Variations on these three strategies exist, with the “exploit a niche” a catch-all for (1) early play entree; (2) acquisition roll-up; (3) long-lived yield vehicle, etc. The yield vehicle may be the one option that doesn't fit into either going concern leader or selling to a larger entity.
For many of the professional investors reading this, the third option—cycle rider, which is a leveraged upcycle bet—will be seen as the default for traditional energy. This group of investors, which dominate the sector, believe in the notion that they can always sell their shares at a profit by correctly timing the cycle (commodity macro or company specific). I lived in that world for the first 22 of my 30 year career; it is not the focus of Super-Spiked. The reason this is the dominant traditional energy investment theme is that most companies have not given buy-and-hold investors a reason to stay invested. I suppose the ultimate fault lies with management teams and boards that have attracted an investor base commensurate with mediocre historical performance.
How do we eliminate the living dead that pervades so much of traditional energy? In my view, it is not OK that so many companies generate such poor profitability over such long periods of time. I have respect for the professional investors that can time macro or company cycles well. That is not my focus.
So to the non-mega cap traditional energy executives reading this, I ask you: Why does your company exist? What is your end game or purpose? If you are not on-track for going concern status, you need a reason to exist and an exit strategy to transition to the next venture.
Avoiding the cycle riders
As noted, some investors are able to earn out-size returns timing the cycle riders well. It is not my core focus, but is worth understanding. It is paradoxical, but institutional investor short-term-ism aligns well with cycle riding management teams.
The basic story goers like this:
STAGE 1 (HOPE): Oil prices rally off of a trough and initially “capital discipline” holds;
STAGE 2 (BOOM): The E&P company returns to growth mode, organic or acquisition, and benefits from a leveraged boost to the cyclical upturn via more production and more debt;
STAGE 3 (PEAK): The highest level of CAPEX happens at the highest point of the cycle;
STAGE 4 (CRASH): The cycle inevitably turns down, share prices collapse, and investors dump the shares.
Key psychology drivers:
When the cycle turns up, it feels good...real good;
Recency bias and hope are the ultimate drivers;
Fake conservatism occurs via some language about using a discount to the current strip or not giving credit for upside resources, etc.
How investors and corporates align:
The vast majority of institutional investors are trading the sector based on a 6-12 month view, especially in this grouping of companies;
Management optimism is aligned with investor shorter-term-ism through the duration of the upcycle, as both benefit from leveraged, pro-cyclical investing;
When the cycles turns, investors flee. However, in many cases, executive compensation structures reward pro-cyclical gains without (meaningfully) penalizing downcycle realities.
As a reminder, over 2011-2020, oily E&P returns on capital averaged negative 1%, below the yield on US Treasuries (pretty amazing given ultra low interest rates) and share prices did meaningfully worse than a 0% return. During that period, investors correctly recognized there was no apparent fundamental purpose for traditional energy to exist as an investment option as confirmed by the massive de-rating that simultaneously occurred. No management team, board member, or investor should ever want to revisit that bleak past.
How does energy transition impact the end game for non-mega cap E&Ps?
Opportunities and risks for non-mega cap E&Ps during the transition:
A high and volatile price environment is a favorable backdrop for those that can recognize and adapt to what is likely to be an overall constructive commodity backdrop.
The lack of competition from European Majors, national oil companies, mainstream private equity, and super-cap US oil companies suggests investment opportunities will exist.
The desire of larger companies to streamline operations and optimize/maximize returns on capital suggest opportunities will exist for well-sponsored non-mega caps.
New risks that arise from the energy transition era:
If the goal is to sell to a larger company, an environment where super-caps are being held to a higher standard of capital allocation and ESG commitments suggest the market of willing buyers will likely be smaller going forward.
In an environment where investors are concerned (justified or not) about long-term crude oil demand, it is possible that terminal values are lower than was historically the case, including during periods of commodity price optimism, resulting in lower exit valuations.
Long-term capital market access, especially in Europe but possibly the United States and Canada, is not guaranteed.
So if you are trying to avoid purposely or accidentally turning into a cycle rider, there must be some different course of action that is needed going forward relative to past cycles.
ESG, climate and the conflict with mega-cap going concerns
For smaller E&Ps, the notion of spending extra capital to capture methane or proactively deal with other environmental issues is not as clear cut as it is for larger players. It's one of the ironies of the enviro/climate crowd: I have always thought they were targeting the wrong group of companies. Large companies indeed have areas for improvement, but overall they are much better incentivized to think about traditional HSE as well as the newer ESG and climate considerations. For a smaller company that may not think of itself as a going concern, it is less obvious you would look to be an ESG or climate leader (though some do strive for this).
In an ideal world, larger companies would figure out a way to motivate standard setting and self-regulation via its industry trade group. In some areas this may be starting to happen, e.g., Canada's oil sands via its CCUS Hub. However, on the topic of climate and methane, industry is not where it needs to be (or will end up being). It's not clear to me why larger companies are willing to spend more to meet various net zero and reduced methane targets yet are giving smaller players that do not face the same degree of pressure or scrutiny a free pass. Why?
⚡️ On a personal note...
I spent a recent long weekend visiting family in southern California and had the opportunity to visit Joshua Tree National Park (highly recommend) and Palm Springs. As we were driving toward Palm Springs from L.A., to my family's shock and horror a massive onshore wind farm had over-run the beautiful desert landscape. I am not exactly a hard-core environmentalist but would ask: is a desert just empty dirt or is it a marvel of biodiversity and ecological amazement that is worthy of our protection? Is trying to reduce our carbon footprint a higher priority than all other ecological and biodiversity considerations?
That wind farm is an absolute monstrosity. It is big, ugly, and an absolute crime against an otherwise stunning landscape. Instead of shutting the Diablo Canyon nuclear plant, California ought to consider instead dismantling the Palm Springs wind farm.
The worst part was that over our three days in the region, the blades never moved much. The lush green around the luxury hotels in Palm Springs suggest that there is indeed demand for 24/7 energy. I don't think the amount of wind power we observed could have re-charged my family's collection of iPhones, iPads, and MacBooks. I always ask my children: since it's your climate future that some are so anguished over, are you OK forgoing internet when the wind isn’t blowing? And are you on low battery mode to conserve power? Spoiler alert: No one on Earth is wiling to sacrifice internet or the ability to re-charge devices.
As a family, we have yet to drive by a wind farm that generates noticeable power. The one on the way to Cape Cod or on the road from Edinburgh to St. Andrews or the one (singular) down at the Jersey Shore are never moving. Yes, we tend to drive more during the day which I suppose is the answer windmill-bulls will cite. And the wind farm near Palm Springs may be using an older technology from what I understand.
I am on a quest to find a wind farm that is generating big power. I would welcome suggestions, or, better yet, please post videos of a working wind farm you have observed first-hand.
⚖️ Disclaimer
I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.
Regards,
Arjun
Appendix: Super-Spiked Energy Transition Playlist
It's been a while, but this wind farm discussion has prompted a new addition to the Super-Spiked Energy Transition Playlist, the 1982 Priest classic Riding on the Wind. It's a great video from the US Festival in 1983 that hopefully at least a few of you might remember and was actually held not too far from the location of the aforementioned wind farm. The full Super-Spiked Energy Transition Playlist can be found here.
"So if you are trying to avoid purposely or accidentally turning into a cycle rider, there must be some different course of action that is needed going forward relative to past cycles." Perfectly captured the issue - cycle riders would say that it's hard to see how a commodity industry selling a product that is fungible can ever really be an industry where specific companies generate above-average returns over many cycles. That makes Exxon and Shell's historical performance that much more impressive!
Question: could this cycle be genuinely different than past cycles because ESG and shareholder pressure to restrain capex may significantly prolong this upcycle?
Arjun, thanks for letting me relive those exciting cycle rider days of the 1990's!
As you know, the wind turbines work most of the time down here in the Lone Star State. Particularly along US90 or I-10 in West Texas. We just don't put them up in Big Bend