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Convert financial statements from the energy industry’s last 50 years into text and you’ll uncover a tale worthy of Steinbeck. Epic failure offset by staggering success, multiple generations of dynamic characters gaining maturity and wisdom—or not—and a story arc covering everything from the oilfields in Oklahoma to the oilfields east of Eden.
The 1973 Arab oil embargo was a severe crisis for the U.S., but not a financial one for oil and gas companies. They were flush with cash as demand was at a record high. Unlike the way they run their companies today—but still, not so long ago—E&Ps were spending, some said, like a “drunken sailor.”
“They were making a lot of money, production was on the decline, and they were diversifying into other things,” Hinds Howard, a portfolio manager at CBRE Investment Management, told Hart Energy. “It felt like a pretty flush time. That’s the time when they started to go out and acquire and become conglomerates.… There wasn’t a lot of stress in terms of getting cash.”
But crashes were on the way, along with massive reorderings of finances and innovative work on financial devices.
Some stories have compelling characters introduced mid-story who loom large, but eventually recede into the background. In the last 50 years of oil and gas finance, two of these characters would be Reserve Base Lending and Master Limited Partnerships. Known by their acronyms, RBL and MLPs, these innovations were created for the industry.
Haynes Boone partner Buddy Clark spent years researching RBL’s origin for his book, “Oil Capital: The History of American Oil, Wildcatters, Independents and Their Bankers,” and found that Continental Illinois Bank and Trust came to Houston in the late 1970s and created RBL, an entirely new financial device and unique to the industry’s unknowable assets.
“They introduced this revolver [loan] that just transformed the businesses for the local bankers,” Clark said. “The revolver was, ‘Here’s your line of credit, we’ll look at what you have as far as production every six months, and it will go up and down.’”
In recent years, RBL reliance has waned as interest rates climbed and many banks left the upstream sector. In a sign of how capital constantly moves and morphs to fit changing circumstances, private credit is emerging as one way to fill the void.
Nimesh Bhakta, head of investments for the Americas for the Swiss energy trader Vitol, said his company recently moved into the private credit space to meet some of the capital need.
“We are stepping into that space, especially in this higher-rate environment,” he said. “The risk-adjusted return profile is simply too attractive to ignore.”
MLPs got their start in 1981, when Houston-based Apache Corp. (now APA) formed Apache Petroleum Co., a publicly traded limited partnership.
“It was called Master Limited Partnership because it was a bunch of drilling partnerships that Apache owned that they aggregated into one master limited partnership to trade on the exchange,” said David Oelman, a partner at Vinson & Elkins.
It was a hit, at least for a time. Other oil companies copied the idea, as did other businesses, especially real estate. Burger King and the Boston Celtics basketball team were MLPs for a while. MLPs birthed a new batch of billionaires, but they proved to be a shooting star of finance.
“It was too good for too long,” Oelman said. “Trying to grow and increase the dividends at the same time was a pretty tough trick to pull off. When commodity prices cooled, their growth prospects cooled, and they had too much debt.”
MLPs still maintain a presence in midstream oil and gas, among them Plains All American Pipeline, MPLX, Enterprise Products Partners, Energy Transfer and EnLink Midstream. Howard remembers his grandfather, Jackson C. Hinds, the former EnTex CEO, singing MLPs’ praises. Howard now writes a weekly newsletter about the remaining MLPs. They have nowhere near the heft they once did, he said, but they served a purpose and left a legacy.
“The structure was used by very intelligent people to the ultimate benefit of the infrastructure of this country and also to themselves—and that’s capitalism. And at some point, there were excesses and those excesses led to some pain,” Howard said.
Oil and gas is a well-known story of dramatic boom-bust cycles. Capital dried up quick during the busts, with caution and some innovation comprising efforts to piece new financing together.
EnCap Investments was an example of that caution and incrementalism—and it was an example of how energy financing evolved. Four employees of a Dallas bank decided to form their own company in 1988, just a few years after the price of oil had crashed. They offered mezzanine loans and gas producing property-acquisition funds because that is what institutional investors, new to fossil fuel investing, would accept.
EnCap kept reforming its financial devices at the intersection of E&P needs and lender ability. The firm morphed into a private equity giant while other ambitious newcomers such as Quantum Capital Group also emerged as multibillion-dollar powerhouses. Some private equity firms turned to the shale boom when opportunities dried up in the dot-com bust, and left when shale enthusiasm declined as ESG concerns emerged.
With the height of the shale boom past, private equity’s presence is sharplydiminished. Stephen Trauber, a retired investment banker, said it will never be such a dominant player in oil and gas again.
“There’s too many forces against fossil fuels,” he said. “Many of these large private equity firms that had energy arms [are] facing a lot of backlash across their other funds by being invested in the energy sector. Most of these large private equity firms decide … ‘We have plenty of other places to put our capital. We don’t need to be in the energy sector.’”
Some important parts of energy finance have come full circle. The first wildcatters once turned to wealthy individuals and families for capital. Now, family offices are showing up in increasingly greater numbers. Private equity is back in the energy space, but this time it’s investing in the energy transition. The Mideast is in crisis again, as it was in 1973, and U.S. oil and gas companies have plentiful free cash flows, as they did in 1973 when demand was high.
The drilling partnerships of MLPs are gone, but the innovative packaging of E&P assets continues. John Donovan, founder and managing partner of Donovan Ventures, said his private equity firm sponsors Energia, a company that packages wells as a private investment.
“We’re packaging 100 wells and then saying, ‘Here’s the stream of production … and, in exchange for no AFEs [Authorization for Expenses] and no capital calls, you’ve got to have this pure access to the commodity without the leverage, without the G&A, without everything else,’” Donovan said.
The story arc
The culmination where trials and tribulations forge defining character development comes with free cash flow and how it is handled. The oil and gas industry’s main characters, the E&Ps, experienced this, having come to learn the error of their ways in reckless spending to pump everything out of the ground. Boom-bust trauma and investor flight have turned E&Ps into pillars of capital discipline.
“For a long time towards the end of the 20th century and the first maybe 15 years of this century, oil and gas companies in the United States were spending money like a proverbial drunken sailor,” said Pavel Molchanov, a managing director at Raymond James & Associates.
“Every penny of cash flow that comes in the door, they were reinvesting that in the drill bit, in new wells, in new production.… What put an end to that finally is it was such a disastrous experience for the industry that it massively changed the psychology of management teams.”
Painful busts and scores of bankruptcies forced companies into a new era of maturity and careful spending. E&Ps are paying off debts and returning capital to investors in the form of dividends and stock buybacks.
“It absolutely works,” Molchanov said. “Look at the stock.… A lot of these stocks are at all-time highs.”
Kassia Yanosek, partner at McKinsey & Co. who writes about energy in Foreign Affairs, said a significant the-more-things-change-the-more-they-stay-the-same element of the story concerns the price of oil.
“There was uncertainty around supply in 1973 and where [supply] was going to come from. I think in today’s market, the uncertainty is, ‘Where is the demand?’” she said, explaining that the energy transition threatens future demand for fossil fuels.
The next chapter
Global investment in clean energy technologies is outpacing spending on fossil fuels, according to the International Energy Agency; more than 60% of the world’s $2.8 trillion in energy investments in 2023 will be in clean energy. Energy financiers have rearranged their efforts around this new reality, with much of the analysis and caution that the boom-bust cycles have so harshly taught.
Brian Blakeman, CFO of Tailwater Capital, said the Dallas-based private equity firm skips over investing in solar and wind to instead invest in clean energy’s infrastructure.
“We’ve been involved in the shale stage and we understand the relevance and constraints that were presented during that time. There was a tremendous need for infrastructure during that time, and our team is focused on identifying those areas of opportunities that will present themselves during the energy transition,” he said.
This fits with Yanosek’s characterization of equity investing in clean energy.
“They look at energy transition and say, ‘Ah, that’s the asset class I want because those assets are going to be here for the long term,’” she said.
Carefully calibrated steps toward the energy transition also show in how the supermajors devise their investment strategies. Rachel Schelble, head of corporate carbon management and infrastructure at Wood Mackenzie, said supermajors invest in energy transition incubators and startups more to keep tabs on emerging technologies than for a return on investment.
These cautious approaches contrast U.S. companies with the Europeans’ recent rush—and then retreat—from heavy investment in the energy transition.
“We saw a real divergence where the Europeans said, ‘I’m going to invest in the transition, and that’s where I’m going to head.’ Whereas the U.S. producer said, ‘I’m going to stick with our core traditional business,’” Yanosek said, adding that she was speaking in broad brushstrokes. “That was a divergence that hadn’t happened really in the past 50 years. And that divergence is now showing up clearly in valuations; we’re seeing the BPs and Shells trade at a 45% to 50% discount to the [U.S.] oil and gas majors.”
She said today’s global trend in energy funding is a shift from public to private financing. In a reversal of the storyline from 50 years ago, Yanosek said the Mideast oil giants are not trying to change the world with an embargo, but are sprinting to stay on board with the world’s transition to cleaner energy.
“Many of these sovereigns are saying, ‘We want to make sure that we’re going to be part of the future.’ So much of the dollars for the private markets are also coming from the Middle East,” she said.
“You could say that, not unlike 1973, we are shifting again to a world where the Middle East is increasing in their role in the current dislocation in the market, shifting its dollars to the transition.”
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