Oil and Gas Investor Roundtable: A 2021 Preview

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[Editor's note: A version of this story appears in the February 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

Despite the roller coaster of 2020, Stephens Inc., the investment banking firm, closed six deals representing $6.3 billion in volume, three of those being M&A transactions in the oilfield services space. It also worked on restructuring for Martin Midstream Partners and private-equity-backed MP Resources, and it was involved in California Resources Corp.’s restructuring as well. Recently it’s been adding to its A&D group in anticipation of a busier 2021.

Building on many years of experience, in December, the energy team hosted the third in a series of webcasts that looked at all the major themes that affected the oil and gas industry in 2020 and discussed what they expect in the coming year. Oil and Gas Investor was pleased to be asked to moderate that panel discussion. The topics ranged from how private equity is thinking about the space, to SPACs, to President Biden and the energy transition and the rise of natural gas. What follows is a transcript, edited for length and clarity.

The participants were Keith Behrens, head of the energy investment banking team at Stephens, who was joined on the panel by his colleagues Paul Moorman and Brad Nelson, both managing directors, the latter specifically in Stephens’ energy capital solutions group. Also speaking was Holt Foster, a partner with the law firm Thompson & Knight LLP in Dallas, and Artem Abramov, partner and head of shale research at Rystad Energy, the noted consulting firm based in Oslo, Norway.

A challenging macro

Abramov: 2020 was obviously a challenging year for both E&Ps and all service companies. Last year was actually a transition year for E&Ps toward a new business model; they went from multiyear periods of very aggressive spending, systematic production growth and very ambitious production targets toward more disciplined programs and a focus on free cash flow-generation. And then suddenly we had the unprecedented downturn, especially from the perspective of global liquid demand destruction, which peaked at almost 40 million barrels a day of lost demand in April. Now, many regions across the world are experiencing the second wave [of the pandemic]. So, the recovery in global liquid consumption is not as rapid as many people hoped for in quarter two, quarter three last year.

Only in quarter three did some operators start coming back in a very cautious manner. We actually saw that some private operators came back in a pretty opportunistic manner, a little bit faster than their public peers.

As for the outlook for 2021, I would say Rystad is seeing improving sentiment, especially among our service company clients and suppliers. Right now, we have around 120 frac spreads active in the whole country, oil and gas basins combined. Many service companies are currently assuming 140 to 270 spreads as an average for 2021. There is an overall expectation that we’ll see an upward shift in activity in quarter one 2021, with the majority of operators targeting maintenance capital programs.

We’re not talking about any production recovery in 2021, but we’re definitely not seeing any further sequential declines. It is really flat, for U.S. production levels, somewhere in the 10.5- to 11 million barrels a day range; this is something we could expect in the foreseeable future.

On private equity

Behrens: In the upstream, it’s been really slow. There weren’t a whole lot of new investments made by private equity funds in 2020, and I expect that to be the same going into 2021. A lot of funds have older portfolio companies, and that constrains them from making new investments. They need to take care of those older investments. Where there’s going to be activity with the private equity funds is on the M&A side; there’s been a lot of cramming companies together, and I think there’s some noncore assets that could be sold as a function of that. Or, if the market comes back in A&D, there could be some outright portfolio company sales. Until that happens, new investment activities can be a little slow amongst traditional upstream-focused private equity funds.

Moorman: From an oilfield services and midstream perspective, it’s very consistent with how Keith just positioned it. To me the biggest opportunity out there (at some level, you’ve got to think about it as bifurcated in two pieces) is that there’s a lot of private equity investment that’s been made over the past couple of years. By definition, they are going to have to deal with their energy investments first, so … I think the bulk of the activity is absolutely going to be from an M&A standpoint, whether an outright sale, or some strategic combination, which I think is going to be the preponderance of the activity out there, and where we’re spending the most time.

As for new platforms, private equity is open to the conversation, but they’re being much pickier. With an absence of traditional banks and some of the traditional lending sources, as things start to ramp up there’s going to be a need for new capital to fund things, even if it’s just rehab of existing equipment. I do think private equity could play a role there as well.

Up until this point, the midstream has been a little bit more insulated, as it always is; it’s just a little bit different. We’re definitely seeing private equity have an interest, but like everything else, they continue to be cautious. There have been a lot of pipelines built over the past two years particularly, and with the decrease in volumes, ultimately, what is the right play here: Is it crude? Is it gas? Is it a combination thereof?

People have made a lot of investments in water too, which has been sort of the crossover midstream investment. At Stephens we’ve been involved in a couple of situations recently where there’s been a lot of private equity interest in midstream assets, but I think the challenge is the bid-ask spread, particularly for what private equity is willing to pay. Look, they are getting creative and there’s a lot of ways to structure things, which ultimately will allow deals to go forward.

Family offices

Nelson: As you know, Stephens has been a large family office for almost 90 years and … the family really went into the energy space in the ’50s, so we’ve been active for almost seven decades, both in the upstream and midstream business. About a decade ago, we formalized that effort.

We have a full team in our Little Rock office that basically covers about 200-plus families from coast to coast. I would say the average net worth of those families is probably in the $500- to $750 million range; it’s been a very active platform for our firm. Since 2018, we’ve closed about 12 transactions with families; I think we’ve raised about $2.5 billion, give or take.

Pre-COVID-19, we’ve had a number of energy mandates that included family offices, and they’ve been very active. Of course, now, these families are reading and hearing everything that their private equity brethren are, and they’re being awfully selective in this market. Out of our network, I would say 20%, plus or minus, of families will take a look at energy investing.

And as Paul [Moorman] alluded to earlier, there is a bifurcation between midstream and infrastructure vs. upstream. I think these families are probably more interested in looking at cash flowing assets, which are more associated with midstream and infrastructure. We do feel that the upstream sector, being as capital intensive as it is, is going to be a struggle, at least here in the early part of 2021.

ESG issues for investors

Nelson: Pre-COVID-19 and pre-2020, ESG had been a constant conversation, a constant theme, for probably three to five years. For all of us on the panel today, there’s been an active dialogue with all of our private equity relationships. I would say that every fund that we deal with is taking ESG seriously. They either have hired full time consultants to advise them through that transition or process or are working with external parties.

These big funds have to basically align themselves with their capital, have continuous conversations with their capital base. We are hearing them talk to their big investors about what they’re seeking, what they’re needing. You have conventional energy funds that have been investing in the sector for 25 to 30 years; some of those will stay investing along those lines. Then there are funds with multiple strategies that are probably going to include more and more renewable and ESG-focused strategies.

We think it’s a transition that’s been going on for a while, it will continue to happen, and it will absolutely be a priority.

One question we get is, “What are some of the niches or particular verticals that these groups are investing in?” It’s wind development projects, solar, geothermal, battery storage technologies and hydrogen strategies, to name a few—and those would be direct investments.

We’re also seeing groups invest in those services such as software and technology that are also invested into this ESG platform as well. It’s a trend for the last four or five years, and we look for that continuing in 2021.

Moorman: To me, ESG is similar to the safety dynamics that the industry itself imposed upon itself a number of years ago. The industry has taken a lot of steps to cut emissions, do things more efficiently, have less of a carbon footprint, all those sorts of things. Regardless of whether Biden ultimately imposes more restrictions on that or not, to me, the industry is already somewhat [policing] itself.

Biden and the energy transition

Foster: Over the last two years, or even more, there’s been a big push on the ESG side, so at Thompson & Knight what we’re looking at is, what effect is the political environment going to have on any incremental change in that transition? Three things drive how rapidly that transition to alternative energy will occur: the regulatory regime and how that overlays, the investors … and technological developments.

You need to take a step back and look at the politics that drives it. Biden is walking a very thin tightrope, because on one hand, he has the far left of the Democratic Party that really is pro radical change and wants to move toward alternative energy.

On the other hand, Biden is a dyed blue, Wall Street Democrat who understands what Wall Street’s impact is on the economy. And he is beholden to them somewhat, with respect to where capital for his campaigns came from. Biden himself has said, “Look, this transition to alternative energy is not going to be radical; it’s going to be gradual.”

But you’ll see him fund programs such as infrastructure needed for the transition, like charging stations or battery technology. That will create investment opportunities, and when investment opportunities are created, you really start driving that transition.

I think you’ll also see more source-specific regulations on greenhouse gases like on power plants and oil and gas production, as well as carbon credits. There’s a carbon tax credit in process; it’s in the regulatory comment period, but I think you’ll see that emerge more rapidly.

The big issue is fracking. Some people are convinced he’s going to ban fracking, some people think he will narrow his ban on fracking to federal lands. And some people say he won’t do it at all.

What you also need to understand is the United States is not alternative energy-ready. So, if he were to significantly decrease the amount of oil and gas that is utilized for our economy, there’s not a viable alternative yet.

Plus, energy independence, which fracking helps us get, really impacts the global politics, which may play into the Biden administration. These type of rule changes take time; you can’t pivot on a dime.

I think you can see some state-level regulatory regimes that will kick in that are more pro green, but that’s going to be in a patchwork way. For example, in California you have significant restrictions on fracking, but in Texas, you do not. For a transition to green energy or alternative energy, from a practical standpoint you have to do that at the federal level, not a state level.

At the end of the day, it is money and technology that’s going to drive the transition. A lot of the traditional oil and gas companies are moving very aggressively into alternative energies, be it battery production, EV, or whatever it may be. You’re going to see a slower transition than some may hope, because that’s going to be buoyed by the realities of the economy, etc. And you'll continue to see oil and gas, but they will be produced in a cleaner, more cost-effective way. And a lot of money will be funded for alternative energies.

Breakthroughs and breakevens

Abramov: We are still seeing continuous and structural improvement in the economics of these producers. A lot of these improvements come from the fact that the U.S. industry has this unique feature: a very long supply chain with so many participants. The lower you are in this supply chain, the less pricing power you have, so when the market gets kind of oversupplied, there is a downturn, like in 2015 and ’16, or 2020 this year.

There is continuous pressure on the suppliers and service companies to propose new solutions. The most significant improvements in the economics, in breakeven prices, have always materialized during these downturns. And operators keep adapting to the price reality which they observe in the current markets.

Some real technological breakthroughs are also happening. We’re seeing continuous automation in several segments of the industry ... there are some new completion methods being adopted by the industry only this year.

In my view, we will keep seeing these gradual improvements in the well economics; this process is not over yet. The U.S. will become even more competitive in the global context in the next two to three years.

On SPACs

Behrens: It’s been good to see the SPAC activity. There’s been no public equity market activity in the energy space, so it’s good to see some activity that is somewhat related to energy. Just an astounding amount of capital was raised for SPACs in 2020, something like $60 billion, which is a record. I think the previous record was $13 billion. There’s actually one energy SPAC that just went public named Breeze Holdings that raised $100 million. And we know of two possible SPACs that were watching that deal.

We think there’ll be two more coming now that we know of … and there’s maybe five to 10 that I could see, focused on oil and gas acquisitions, by the end of the first quarter of 2021. There have also been 13 SPACs raised that focus on ESG or renewable alternative energy. We think some of those will also focus as a sub-sector on oil and gas. And then there’s 30 general-focused SPACs out there, and I think some of those will also have upstream oil and gas as a focus area.

We have one of the SPACs in one of our A&D processes right now, and they’re potentially good buyer candidates. This is a really good thing for the upstream oil and gas space, to have this type of capital come into the sector.

On natural gas

Nelson: Generally speaking, there’s a lot less headwinds facing gas stories than oil, for obvious reasons. As the oil side of the equation fell into a tough market in 2020, particularly on the demand side, gas has certainly benefited
to some degree. At the moment, the rig count chasing gas is about 25% of the total count. The last time the gas rig count was that high was briefly in 2015. In the last three to four quarters, we have seen drilling and completion costs go down by 25% to 30%, and of course, gas is getting the benefit of that.

Operators are seeing their economics or capex on the front end being reduced dramatically. At the same time, we’ve had an uplift in gas prices. As everyone knows, we were $1.50, $1.70 in the middle of 2020, but we’ve been as high as $3.

I would say that the economics associated with these gas stories have gotten a lot better, and they are sustainable.

From our perspective, even if gas does fall off a little bit, we still see a lot of activity at the field level. The three basins that are predominantly gas are very active at the moment, being financed by very good balance sheets.

What about public deal activity in 2021? Again, that’s tough to call, but I would say that there’s a lot of activity on the private side of the equation.

If the numbers and economics continue to play out in 2021, I can see there being some appeal for either gas-weighted IPOs, or even secondaries associated with gas stories. And then, as everybody knows, gas is cleaner than oil, and … since gas is cleaner, it’s easier for these fund managers to dedicate capital to a natural gas story. All that being said, we see momentum for sure picking up in 2021 for gas.

On debt

Moorman: Debt funding in the energy space continues to have a high bar. At the end of the day, it boils down to, lenders ultimately want some certainty that they can be paid back. With the volatility that’s happened, I’d argue … the number of lenders in the space has continued to decrease. Ultimately, companies can best position themselves for 2021 if, at some level, they’re [willing] to develop new relationships.

The traditional senior lender, which may have had a branch on the corner that they knew sort of socially as well as from a business perspective, is really no longer there. So, they’re going to have to work a little bit to develop relationships with these alternate alternative lenders, institutional lenders, that may be in other cities, or that they’ve not known before.

There are probably three key ways [companies] can set themselves apart.

They’ve got to prove themselves to be operating a profitable business that produces free
cash flow.

They have to minimize the quantity of debt that’s ultimately necessary, and what I mean by that is—from an oilfield service perspective—leverage of one to two times is probably a realistic goal. For midstream, maybe you get up to three times.

“I think these families are probably more interested in looking at cash-flowing assets, which are more associated with midstream and infrastructure.”
—Brad Nelson, Stephens Inc.

The last thing would be to figure out ways to set themselves apart from an operating model perspective, whether that’s becoming a market leader in their particular niche, whether their services or niches are considered to be more defensible, and/or just having a better ESG reputation out there. All those things are going to be important.

Foster: Starting in mid-2019, you saw most of the bank and lending institutions either limit the amount of exposure they had to the oil and gas sector, or decide they’re going to pivot out of that sector altogether. We think banks are going to continue to hold that approach for 2021. And so, we’re seeing a number of different alternatives.

Other financing options

Foster: People in the private equity world are some of the smartest people in the industry, and they have lots of tools in their kit. The banks initially were asking for overriding royalty interest (ORRI) throughout the process, particularly toward the end of lending, so that was kind of an equity kicker. But as banks tend to exit, the ORRI is not as viable an option, not as many people are looking for just that small tranche.

Rather, you’re seeing a number of other items. First, there’s net profits interests, which are analogous to an override royalty interest, but you have exposure to management or costs. So, it’s a structured financing that has many more restrictions and is more complicated and tax driven. And it’s when most of that money is going for the acquisition or the development of the assets, as opposed to just an operating loan or an RBL [reserve-based loan].

They take a lot of time to do, and once they’re in place, it’s very difficult to sell the assets by the grantor without a number of consents. So, you’re seeing companies and private equity funds reach into their toolkits and do a number of things.

First, there’s still a lot of roll-ups to save G&A. A lot of these nontraditional lending sources—be it hard money lenders, private equity funds, family offices or whatever—a lot of them are coming to the industry and saying, “Hey, we will loan you money.”

You’re seeing a lot of these companies issue debt in lieu of equity, but these debt products are structured like equity. The economics are more similar to what an equity investment might have been the year before. But the beauty about it is, because it’s debt, you can get a security interest in the asset and you have priority over the equity.

I’m seeing preferred equity; with asset values being down, some people who are bullish on the long term of energy are stepping in because they’re getting assets. You may have up to a billion dollars invested, but you’re getting preferred equity at a valuation that is literally pennies on the dollar. You’re not only able to prime the existing common, but you’re coming in at a significant pro-lender valuation, or pro-preferred equity valuation.

The nuance is, if you’re trying to bring in a new management team to manage those assets, or if you’re trying to keep a good management team that just happens to be a victim of a bad economy, what do you do with their incentive units? Do you ratchet their incentive units down so that they kick in at the lower valuations, without making the original equity providers feel like they’ve been shortchanged?

I’m even seeing real creative things such as seller financing, where a company says, “If I can get money now that I can put on my books and make a distribution, even if it’s an ultimate loss, but a distribution to my investors, I am willing to take a slug of money up front and even do a seller financing over the next one to five years, which is something crazy you wouldn’t have seen beforehand.”

We’re also seeing “IUs,” incentive units for capital providers. The borrower tells them, “Hey, if you come in for preferred equity or a debt instrument, and if we meet a certain threshold, if we have a home run, then I’m going to give you an incentive unit or profits interest.”

Companies are realizing that the banks are kind of closed for business, so it’s kill or be killed, and they’re being very creative.

On restructuring

Behrens: I think it will continue, at least for the next six months or so, until demand comes back. There are still a lot of heavily levered companies out there that are in challenging situations. There have been a lot of bankruptcies, where those companies have emerged with better balance sheets, so I think they’re in pretty good shape. But there’s a lot of high-yield issuers out there, with maturities that are coming due, but there’s just no high-yield market for them to refinance into. Those companies are pretty challenged right now.

Generally, the banks kicked the can down the road in the spring, hoping there’d be a quick recovery out of COVID-19, but that didn’t happen. [Coming] out of the November 2020 borrowing base redetermination season, there could be some restructuring activity.

We do have a light at the end of the tunnel now with all this positive vaccine news, but some companies aren’t going to make it until demand returns. It takes a while for demand to return.

If M&A doesn’t pick up, restructurings will be strong. And then there’s always private equity deals. There are some bottom fishers out there in tough times that are looking for deals. Maybe the sources of those deals aren’t really traditional private equity groups as much going forward; maybe they’re high net worth groups, but there’s definitely going to be private equity deals to be done.

On 2021 supply/demand

Abramov: A few months ago, many people were saying that it would be a W-shaped recovery. I think now we’re heading toward the environment where another market crash is not impossible, at least before we really get to the structural recovery phase. I think market volatility will remain pretty high in the foreseeable future.

When it comes to the oil industry specifically, we have two sides of the equation; we have demand, and we have supply. Even in the most optimistic scenario, we see global liquid consumption averaging 97-, 98 million barrels a day next year, which is basically 2% to 3% below where we were in 2019. But as I said, this is the most optimistic scenario, where so many different things have to contribute to the demand positively in the same direction. Most likely demand will average somewhere in the 95- to 96 million barrels a day range.

In particular, jet fuel consumption is lagging … Even if you vaccinate the whole world, there will be some structural behavioral shifts, and we think people won’t travel as much as they did previously, so it will take several years for the airline industry to truly recover to preCOVID-19 levels.

On the supply side, I would list three main factors, which we should all watch. First, we shouldn’t forget about uncertainty around U.S. oil supply. We feel there is quite strong consensus about 2021 right now, but we need to remember that the U.S. oil industry has a very long track record of outperforming consensus estimates on the production side. Maybe we’re not talking about the same magnitude of outperformance as we saw in 2018.

We might get some positive surprises for gas production, but it will be negative for the global supply-demand balance. Then we have Libya, which came back very quickly. The government of Libya already announced that it’s returning to 1.2 million barrels per day. Some people don’t believe it. I could tell you that we monitor Libya with satellite data in near real time, and it’s almost back to the level when they were producing [that much.] But to maintain these production levels next year will require them to invest quite a lot; a lot of damage has been made during the shutdown phase.

And finally, there is the OPEC-plus strategy and behavior of some key members. If they really go back from 8- to 6 million barrels per day cut already from January, any demand weakness can send oil prices back to the $40s, probably, in the short term.

One quick comment about the longer-term perspective: I would say that we are almost confident that there will be at least one other upcycle for the oil industry before global liquid consumption peaks structurally.

Most companies revised their long-term oil consumption peak; they moved it closer in time. We now see global oil consumption peaking somewhere at 102-, 103 million barrels per day in the late ’20s. But the actual dynamics are very complex.

The most significant structural changes are happening within the transportation segment. Specifically, I mean light duty vehicles, where we see a rapid penetration of EVs, as we move toward the ’40s. It will take a little bit longer for trucks and buses to see full adoption of EVs. So global oil consumption in these segments will continue growing into the mid-’40s.

Petrochemicals will probably grow through the late ’40s.

Even with all these growth sectors in the medium term, we have all these other smaller segments, which combined account for around 25 million barrels per day of oil consumption. That’s agriculture, buildings, industry use, power segments, and energy’s own use. These segments have been declining structurally since 2010.

We don’t anticipate that the long-term peak in our consumption will be much higher than the pre-COVID-19 consumption records.

Parting thoughts on the recovery

Foster: I’m optimistic. It would be depressing to say otherwise. But I think that you have seen a transition as the year 2020 progressed, where people are starting to have a little bit more faith in the economy. I think some of the concerns about politics and who the next president is going to be have resolved themselves.

While there’s still a separation between the bid-ask, I think people are starting to get comfortable that maybe there’s not a falling knife. I think creativity is going to be rewarded. I think patience is going to be rewarded. But as money moves out of the industry, that’s going to create opportunity for those that are willing to put money in, and hopefully we can all participate in that.

Nelson: At Stephens, we agree with everything that Artem and his firm are saying, and of course, we’re reading a lot of the data and numbers that Artem and others are publishing.

Looking at the last two down cycles that we’ve come out of, one a decade ago being the credit crisis, and then, 2014 through mid-2016, the recoveries were real, robust, fairly rapid. After a little bit of a healing period, you saw capital being deployed pretty quickly.

Our view, at the moment, is that we are cautiously optimistic. We feel like there will be a recovery, albeit methodical and cautious. Coming out of the credit crisis, and then coming out of 2014 through 2016, you still had quite a bit of capital, net-net, coming back into conventional energy. I think the difference today is you’ve got quite a bit of capital either sitting on the sidelines, not quite sure if they want to get back into conventional energy or not.

We’ve all talked about ESG and capital going into renewable strategies, and that certainly competes for capital with conventional activities. I would say that gas will probably recover quicker than oil based on what we’ve previously discussed.