Capital Formation

Several sources of capital are more difficult for E&Ps to access, but most companies have a solution—their own money. Abundant free cash flows are bigger than ever before in most cases.

Doug Reynolds, managing director of energy and power at Piper Sandler, said he tracks more than 40 public upstream companies, excluding the supermajors, and calculated they’re on track to generate approximately $80 billion in free cash flows this year.

Doug Reynolds
Doug Reynolds, managing director of energy and power at Piper Sandler. (Source: Piper Sandler)

That will come in handy as the federal funds effective rate shot up to 5.08% at the start of July from 1.68% at the same time last year—and has continued to rise.

“The industry doesn’t need capital. The industry is mostly generating capital—and lots of it,” he said. “Just about every company is free cash flowing.”

Of the nearly $150 billion of transactions between assets and energy companies in the last three years, “most of that was acquired with cash,” Reynolds said.

Cristina Stellar, senior vice president at BOK Financial, agreed: “Companies are flush with cash,” she told Hart Energy. “They have more money than they ever had.”

Cristina Stellar
Cristina Stellar, senior vice president at BOK Financial. (Source: BOK Financial)

Ring Energy CFO Travis Thomas described his company’s standing as “our perfect little free cash flow utopia.” And EOG Resources boasted of a “pristine balance sheet.”

On its Aug. 3 earnings call, ConocoPhillips CFO William Bullock said the Houston-based energy giant has more room to maneuver with so much cash at its disposal.

“We ended the second quarter with a little over $7 billion of cash and short-term investments,” Bullock said. “That really provides strategic flexibility. It supports our investments in these mid- and longer-cycle projects and our shareholder distribution commitments.”

EQT Corp. CFO Jeremy Knop said E&Ps are now operating as a value industry, not a growth industry.

“In any commodity business, what matters is just being the lowest cost, and you can’t be low cost but also small scale with higher costs of capital,” Knop told Hart Energy. "What you’re seeing happening is the industry turning back to the way it’s historically been, which is a low-growth, value-oriented industry focused on free cash flow, in which case the need for external capital is not there unless it’s for something like a big infrastructure project, like LNG or an acquisition.”

The question in the boardrooms is what to do with excess free capital.

“And when you’re buying back equity, not issuing equity, when you’re paying down debt, not borrowing debt, I think the topic of where does capital come from becomes almost irrelevant,” he said.

Thomas Travis
Ring Energy CFO Travis Thomas. (Source: Ring Energy)

Clark Williams-Derry is one of the few doubters among analysts. An energy finance analyst at the pro-renewables Institute for Energy Economics and Financial Analysis, Williams-Derry believes the five supermajors—TotalEnergies SE, BP, Shell, Chevron Corp. and Exxon Mobil Corp.—will see their FCF drop so significantly this year they will need to turn to other sources to continue their capital return to investors.

Other analysts doubt that and see the FCF use as an era of capital discipline that also includes paying down debt and sidestepping difficulty in accessing outside sources of capital.

Analysts and industry leaders see four areas of capital as currently less accessible. First, reserve based lending is more expensive and more cumbersome. Second, many oil and gas investors and some banks have left the space because of ESG concerns, weariness of boom-bust cycles or a belief that fossil fuel demand will not last as the world turns to renewables. Third, private equity firms report that it takes them more time and more work to raise energy funds—and the firms are not expected to raise all that the industry needs. And fourth, there are the higher interest rates everyone is experiencing, making debt more expensive.

Reserve-based lending

Reserve-based lending is still an important component, especially for smaller E&Ps. But higher interest rates and some more burdensome requirements have made this age-old lending instrument less accessible.

Ann Rhodes, managing director at Gulf Capital Bank, said many foreign banks have left the space and small banks have merged with larger banks that do not want RBL exposure. She said the RBL landscape has changed further with companies using RBLs differently now.

“For a long time the industry has thought of an RBL as a permanent source of capital. I think today the industry views that differently. It’s [a] revolving piece that is paid down and then borrowed up. It truly revolves instead of being a permanent form of capital,” she told Hart Energy.

This fits the description of how Ring Energy recently used its RBL—and its strong balance sheet—in the recent $75 million cash acquisition of 3,600 net acres in the Permian Basin’s Central Basin Platform.

Thomas told Hart Energy his company funded the deal with cash on hand and borrowings under Ring’s recently affirmed revolving credit facility. Ring leadership felt it was better positioned to do this after it used some of its FCF, proceeds from the sale of non-core assets and accelerated warrant exercises to pay down $25 million on its RBL.

“By paying down our RBL and growing our liquidity quarter-over-quarter, we had the funds available to pay all cash for the deal,” Thomas said. “We negotiated an effective date five and half months before the anticipated close so we can use the asset’s cash flow to lower the cash out of pocket at close.  The deal also has a $15 million deferred payment. … So, basically, we’ve got an interest-free loan which we can use the acquisition’s free cash flow to help pay down.”

Thomas said Ring relies on RBLs because the company is too small for the high-yield market. That could change in the future as Ring focuses on responsible growth through accretive M&A.

Ryan Keys, president of the private, Dallas-based E&P Triple Crown Resources, said RBLs have become less accessible in the last five years.

“The requirements have become so burdensome and onerous,” Keys told Hart Energy. “There are only a few companies that can qualify for that kind of capital. It’s also risky because it changes the amount. The revolver itself changes.”

Keys said some small companies have turned to high-yield bonds which he said are wrongly referred to as junk bonds.

“That’s become more popular because of how volatile the revolvers are,” he said.

In another sign of how much has changed, Mari Salazar, senior vice president of BOK Financial, said senior secured debts are virtually gone now.

Investor flight

One major access to capital challenge was created by many individual and institutional investors leaving the space because of ESG concerns, declining returns since the shale boom and a belief held by some that fossil fuel demand will subside.

“You are seeing the pool of investors around oil and gas continually shrinking. The pool of private capital has indeed gotten smaller overtime,” said David Deckelbaum, managing director at TD Cowen. But he added, “When you look at the need, the truth is there isn’t very much [capital] need for anyone right now.”

Whether it is a necessary show of leadership or genuine confidence, industry leaders have consistently expressed faith that strong returns will lure investors back. Some say some investors have already started to return, but companies are not taking their investors for granted; they are aggressively returning capital in dividends and stock buybacks.

In a bountiful show of cash, Coterra Energy announced on Aug. 7 that it would return 184% of its second quarter FCF to investors. “Our cash position has afforded us the luxury to transact counter-cyclically on share repurchases,” Coterra CEO Thomas Jorden said in a statement. Coterra is able to do this because it has “tons of cash on hand,” according to Gabriele Sorbara, a managing director at Siebert Williams Shank & Co. He said Coterra can draw on the high FCF it exited the last quarter with and from its cash on hand.  

Jeremy Knop
EQT Corp. CFO Jeremy Knop. (Source: EQT)

ESG issues might have driven some investors away, but Knop said he believes it is coming full circle for companies like EQT. He said banks have approached EQT asking if the company could take more capital “at the expense of others in their portfolio” because they are looking to replace investments in companies with low ESG scores.

Private Equity

Private equity firms talk up oil and gas as a great investment, but have also said it takes more time and work than ever before to raise energy funds. When Billy Quinn, managing partner of Pearl Energy Investments, led his Dallas-based firm to close a $705 million fund in May, he told Hart Energy the effort “was just brutal” and left him feeling it is difficult to raise private equity money for conventional and transitional forms of energy.

Reynolds said the private equity firms enjoy good returns with previous investment, but the pool of new limited partners is smaller.

Mari Salazar
Mari Salazar, senior vice president of BOK Financial. (Source: BOK Financial)

“It’s just not as large as it was during the boom a decade ago when people were just throwing money at the sector seeking growth,” he said.

Keys said new funds raised by private equity are depending on the same investors, and the big exits are much less significant than they appear.

“They’re just recycling the same dollars back into the oil patch. It’s not new money,” he said.

BOK Financial’s Salazar said private equity funds are smaller, and the firms are increasingly facing a greater issue of aging investments.

“They have investments that have been around 5, 6, 7 years,” Salazar told Hart Energy. “At some point they are going to sell those companies. That’s just a reality.”

Angie Gildea, national sector leader for energy at KPMG, said many private equity deals are stalled awaiting more rulings and requirements that have yet to be formulated since the Inflation Reduction Act became law.

Higher interest rates

Higher interest rates are an issue for everyone, including the energy industry. Energy companies said they address that issue by using their FCFs to pay off debt. But Keys said the higher interest rates push smaller companies to alternatives.

“For the small and midcap companies, it’s going to be really expensive—double digit, 11, 12, 13, 15% interest,” he said. “It’s so expensive it’s like you can go raise equity for that. An equity investor is going to be fine with that same return.”

Sorbara said FCF use for debt repayment is more common among smaller E&Ps, while larger companies use their FCF for investor returns.

Gildea said the problem with interest rates is not so much their magnitude; it’s the uncertainty they cause. She said interest rates need to stabilize for deals to happen.

“The buyer needs capital, but you have to agree on evaluation,” she said. “When there’s uncertainty in the market often times buyers and sellers have a hard time coming to an agreement around the price.”