Pump jacks operate at dusk near Loco Hills on April 23, 2020 in Eddy County, New Mexico. (Photo by ... [+] Paul Ratje / AFP) (Photo by PAUL RATJE/AFP via Getty Images)AFP via Getty Images
The demand for shale producers to become self-sufficient with less reliance on outside capital is intensifying.
The withdrawal of private equity, long a crucial investor in the shale sector, will take a significant toll on many shale companies, particularly smaller producers that lack strong balance sheets.
Private money is behind as many as 500 oil and gas companies in the United States. These investors have little appetite for new outlays in the sector, and many are looking for ways to profitably exit the sector, perhaps for good.
The increase in the price West Texas Intermediate (WTI) to $60 a barrel has helped the sector, improving cash flow and reopening debt markets for many companies. And while it has boosted share prices – energy is the top-performing sector in the S&P 500 so far this year – equity markets remain selective, and the path to going public remains challenged
That removes a critical exit strategy for private equity-backed oil and gas companies. The recent flop of Vine Energy’s initial public offering – the first IPO since Berry Petroleum’s back in 2018 – demonstrates the challenge.
Haynesville Shale gas-only producer Vine Energy is a well-positioned company with more upside than down. Vine was hoping for an initial offering price of $16 to $19 a share, but only received $14 per share. Blackstone Group BX , Vine's private equity backer, took $60 million of the $301 million offering.
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Vine shares now trade around $11 and their IPO offers a cautionary tale for other private firms. While market conditions have improved compared to a year ago, these are not a good time for shale producers to go public.
There isn’t the appetite for public offerings due to fewer dedicated energy mutual and hedge funds and commodity price uncertainties due to lower demand. That could change later this year on the back of tailwinds from returning energy demand and potentially higher prices, with some like Goldman Sachs seeing $75 oil right around the corner. But oil and gas IPOs shouldn't be viewed as a surefire solution in a public equity market increasingly focused on environmental, social and governance (ESG) issues.
Mergers and acquisitions (M&A) have in the past been a profitable exit strategy for private equity-backed companies. Trend is played out, however. The sector's top players have already gobbled up the most attractive companies.
One of the few remaining prizes was Permian producer Double Point Energy, which recently sold to Pioneer Natural Resources for $6.4 billion – the biggest public-private deal in the U.S. upstream industry in a decade.
Many privately-owned shale players see the writing on the wall. Their response to the exit dilemma is to squeeze as much cash as they can from these companies, and WTI’s jump to $60 provides an opportunity for one last cash grab.
That situation has prompted a resurgence in private shale drilling and fracking activity, which has been the primary driver in the U.S. oil and gas rig count in recent months. The Baker Hughes BHI rig count jumped to 432 from less than 300 in early November, right before the arrival of Covid-19 vaccines invigorated oil prices and stocks.
The risk is that the surge in private shale activity overtakes the “restrained growth” narrative that has defined public operators since last year. Larger-than-expected production growth could depress WTI prices and hurt producers and oil services companies.
Private shale producers should also recognize that these retro “big growth” strategies won’t make them any more attractive to potential M&A suitors or public investors, however.
Indeed, after Pioneer PXD bought Double Point, its first order of business was scrapping the latter’s 2021 growth targets and making sure shareholders knew that it would reduce drilling and hold volumes flat this year.
Chasing growth and extra cash flow may help private equity cut some of its losses, but it likely won’t recoup all its investments. Between the start of 2015 and the end of 2019, 136 private funds closed after raising an aggregate of $86 billion to spend in oil and gas, according to Preqin, a financial data provider.
A better strategy is to improve performance at these companies by focusing on free cash flow, ultimately attracting attention from consolidators and possibly the public equity market. That's especially true if a supply crunch develops in the next few years and oil prices shoot north of $80 a barrel.
The shale sector will deliver record cash flow this year, even if WTI prices are as low as $50. Public companies have led the way here, but there’s no reason that their private counterparts can’t join the party with a bit of patience and perseverance.