Will the Grass Be Greener as a Private? A Focus on SMID-Cap Traditional Energy

Corporate Strategy

Super-Spiked first addressed the question here in September 2022 of whether the grass would be greener for a large-capitalization oil & gas company to be privately owned rather than publicly traded. In this post, we revisit the pros and cons of ownership structure with a focus on SMID-cap traditional energy. Key conclusion: while not appropriate for every SMID-cap, the various cross currents facing traditional energy suggests a private ownership model may well be preferable for companies with out-of-consensus investment strategies that public equity investors place less value on even in the best of times.

A few points of clarification:

• Privately owned does not necessarily mean private equity backed.

• Realistically, the smaller the market capitalization, the greater the opportunity to go private (Occidental Petroleum may be a notable exception given Berkshire Hathaway’s growing ownership stake).

• The merits of potentially going private will vary considerably based on the quality and nature of a company’s assets, its management team, how it is thinking about future investment opportunities, its current capital structure, its sponsors, and numerous other considerations.

• This is not intended as a one-size-fits-all discussion; rather, it is a topic that at least some traditional energy companies should consider among their strategic alternatives.

Why revisit this subject now in the midst of a possible banking crisis, with all the energy transition uncertainty, and given a Super Vol macro backdrop? It’s exactly for these reasons and the resulting valuation hit the publicly-traded sector has taken that it is a subject worth revisiting.

To summarize the stress points:

• Banking crisis: As we discussed last week, the banking crisis (or whatever it is) is likely to accelerate the end of European banks and insurance companies as being relevant to traditional energy. Access to capital we believe will remain more challenging for traditional energy in coming years irrespective of whether a company is publicly-traded or privately-owned.

• Energy transition: The perpetual fear that oil and natural gas demand will roll over in some coming year, even if it isn’t this year or next or the year after, is contributing to discounted valuations for publicly-traded companies. Energy transition fear and uncertainty could continue to diminish the valuation uplift that usually came with being publicly traded.

• Super Vol macro backdrop: High volatility has long been inversely correlated with equity valuations in all sectors. There are too many economic, geopolitical, and energy specific cross currents to think we will be breaking free from boom-bust price cycles any time soon. Similar to the previous point, high commodity volatility coupled with energy transition uncertainty may diminish the historic valuation premium associated with publicly traded energy equities.

The goal of this post is not to be defensive or defeatist. On the contrary, we are trying to solve for how individual companies can thrive over the next decade given the macro backdrop we expect. Historically, the phrase “macro backdrop we expect” would be synonymous with “commodity price forecast.” If only the world were still so simple. The goal for any company, public or private, in any sector is to generate superior risk adjusted returns for its investors. How best to achieve that is the purpose of the Corporate Strategy post series.

Exhibit: Despite a strong rebound in 2021-2022, Energy still trails the S&P 500, new energy technology companies, and bubble stock darlings over the long run

Source: Bloomberg

The end game conundrum of being publicly-traded as a SMID-cap

As a reminder and discussed (here), there are three good long-term outcomes for publicly-traded traditional energy companies:

• Outperform the S&P 500 (or corresponding major benchmark if not US-based) over 5, 10, and 20 year increments.

• Sell or merge with another company.

• Liquidate and return all cash back to shareholders.

And two bad outcomes:

• Purgatory: Fade to “living dead” status where the company trails the S&P 500 and becomes irrelevant to most investors, though otherwise remains viable.

• Bankruptcy and the elimination of equity value.

Many SMID-cap energy companies start out exploiting a niche asset or strategy, e.g., Permian Basin shale E&P, Marcellus gas E&P, onshore US refiner, pressure pumping oil service company, etc. In order to be a going concern, expansion beyond the original niche strategy is almost always ultimately required. For those that do not sell to a larger entity or do not successfully diversify, we often end up with the bad-case outcome of purgatory where a company simply trades up and down with the commodity price cycles and badly lags broader indices over the long run. It is this “living dead” outcome that we are trying to avoid.

The conundrum is that public equity investors typically want a SMID-cap energy company to have the following characteristics:

• Pure-play in some niche that has a differential growth and returns opportunity.

• Predictable year-over-year volume growth and cost characteristics if an E&P.

• Exposure to the hot play if an oil services, midstream, or downstream company.

Investor concerns typically arise when a company starts exhibiting any of the following:

• Maturity in the play that drove its premium valuation, which we might define as reaching the “half-life” of development of “Tier 1” inventory (using US shale play language here, but this can apply to any region).

• A previous “organic growth” company starts making acquisitions.

• A company takes steps to diversify away from its original business area.

With US shale showing signs of reaching its half-life coupled with the major macro factors identified above of diminishing capital markets access, energy transition uncertainty, and a Super Vol commodity backdrop, there is a need for new approaches to traditional energy. It probably makes sense to no longer default to the idea that being publicly traded is a superior inevitability to being privately owned.

The benefits of being publicly traded no longer seem clear cut

The classic rationale for being publicly traded includes:

• Superior access to equity and debt investors.

• A premium valuation versus private market values.

• An easily valued, publicly-traded currency that could be used in M&A.

• Liquidity for investors.

The aforementioned macro challenges call into question whether the first three points are still true. The liquidity point would still hold, but whether it offsets the handcuffs that exist for publicly-traded companies in the type of environment that may persist in coming years is not clear and is worthy of debate.

The next 10 years: Opportunities for SMID-cap energy

I believe the US shale pure-play model will no longer be the only game in town looking out over the next decade. Interesting areas of investment for SMID-cap energy companies include:

• Long-lived, PDP (proved developed producing) reserves onshore the United States and Canada.

• Offshore opportunities in areas like the Gulf of Mexico, West Africa, and possibly Brazil (fiscal/government concerns may offset Brazil’s favorable geology).

• Numerous conventional oil and natural gas opportunities around the world, especially in countries that are not major oil or natural gas exporters and where the opportunity for more favorable fiscal terms and government relations is possible.

In terms of company characteristics, I would suggest the following types of companies may be better off being privately owned rather than publicly traded:

• Diversified E&Ps with lumpy CAPEX, free cash flow, and production outcomes.

• A company with long-lived, PDP assets pursuing a variable dividend yield model.

• A company operating in any number of non-US conventional asset plays.

The benefits of being privately owned versus publicly traded include:

• Freedom to return capital as or when conditions allow without worrying about whether investors are “giving credit” for the pay-out.

• Freedom to invest. This is a big one. There are almost no publicly-traded companies today where the market is willing to under-write growth CAPEX of any kind (Hess in Guyana an exception).

• No more investor conferences and no more being lectured to by 30-something hedge funders focused on monthly performance increments!!! At least in my time, those following energy were experienced and dedicated to the sector. That no longer seems to be as prevalent as the sector’s relevance has diminished in public markets.

Issues that won’t go away via private ownership:

• Diminished access to capital markets and insurance. While the historic advantage of being publicly traded may no longer exist, it’s not like access to capital and insurance would be any better as a private.

• ESG. This of course is a longer topic than this quick mention will allow. In my view, substantive ESG has long been considered by most investors across public and private companies. The very reason to be privately owned is often for improved and more responsive governance. A privately owned company will usually want a diverse skillset represented in its management team, though fortunately without the public accounting of various identity groups. Oil spills or other forms of environmental harm are not OK in the private model anymore than they are as a publicly traded company. As a private company, you can, however, skip the corporate speak, virtue signaling part of ESG that most public companies are guilty of doing. No more glossy brochures!

• Shareholder activism. As a private company, if you are not performing well, a major investor or sponsor is likely to pull the plug sooner than what you often see with publicly-traded companies. Clearly the nature of “activism” is different. One might argue it will be quicker and more definitive for private companies.

Which publicly-traded SMID-cap companies should go private today?

Sorry for the trick sub-heading question. As you know, Super-Spiked does not engage in a public discussion of individual company outlooks. The reality is that the vast majority of existing publicly-traded companies are most likely to remain publicly traded (unless sold via M&A). The goal of this post is not to start a broad movement toward private ownership.  Rather it is to push the more thoughtful management teams, board directors, investors, and capital providers to think about the best way for companies to earn outsize returns relative to risk for the coming 5-10 years in light of the expected macro environment.

⚡️On a Personal Note: 54

It’s a birthday weekend for the publisher of Super-Spiked. 54 sounds pretty old. But so did 50, 45, 40, 35, and 30. Basically every birthday after turning 21. For me, having adult children changes the nature of caring about one’s own age. I care most about their health and happiness. Everything else is secondary including my own age. Moreover, I don’t feel old. Other than wishing I still could grow my hair long, I don’t “wish” I was younger.

When my children were younger and I was earlier in my career, they still came first but I felt the pressure to ensure I worked enough so they would be in a position to easily survive without me. Breaking Bad is a Top 2 all-time favorite show for me…I totally get Walt White’s motivations. Fortunately, success at Goldman Sachs means I did not need to engage in illegal methamphetamines manufacturing. I have enough self awareness to know that I would be a terrible drug dealer.

Key positives of being older:

• I have seen a few cycles, which helps a lot with my role at Veriten and on various boards.

• My GHIN index has never been lower, my core strength never better, and I can touch my toes without bending my knees. This may less be a comment on age than the fact that physical fitness is inversely correlated with being a covering Wall Street analyst.

• If my current professional affiliations went away tomorrow, I could easily fill the time with golf, guitar/drums, and travel. It is that freedom of association that allows freedom of opinion.

Key challenges of being older:

• Recovery times are slower…2 beers or whiskeys is the safe zone.

• Naturally curly, long black hair is no longer an option.

• You realize there is no age where you will ever stop worrying about your children’s health and happiness.

Past birthday celebrations came with more hair…and more beers…pictured below are best friends from the college “gap year” I spent in Albuquerque…that part of the journey is for a future post

Source: Photographer was unknown college friend in Denver, circa 1990 (i.e., 21)

⚖️ 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.