[Editor's note: A version of this story appears in the September 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Private-equity-backed E&Ps are harvesting returns for investors, but—these days—not the old-fashioned way. Traditionally, the return has been via selling the portfolio—full of PUDs and plenty of PDP to demonstrate the acreage has good rock, ripe for tapping.

The buyer, usually a public E&P looking for more future-well inventory—that is, PUDs and, with some extra attention, some of those probables—on HBP leasehold with producing cash flow, would pick it up. The sale—usually within three or five or, pre-shale boom, up to seven years—was the harvest of private investors’ initial investment plus more than 30%.

In the heated Permian, before shareholders shut down further public E&Ps’ acquisitions of more leasehold, one PE-backed leaseholder flipped in fewer than 24 months; even with the capital-gains-tax hit, the sale met the return threshold.

Without public E&Ps wanting more inventory right now, what’s a PE-backed E&P with a build-and-flip model to do? Many are proceeding to harvest upside for themselves, at least, via producing the reserves, instead. They’re drilling those PUDs.

This changes the business model and thus, everything, really.


Ward Polzin joined Enerplus Corp. as U.S. country manager in 2006 after the Calgary-based producer took an interest in the then-nascent Bakken play. Later, as a managing director for Tudor, Pickering, Holt & Co., assignments included advising CNOOC Ltd. in shale joint ventures with Chesapeake Energy Corp.

In 2013, Polzin formed Centennial Resource Development Corp. with backing from NGP Energy Capital Management and focused on the Delaware Basin. The aim at the time was to IPO. Before the offering reached the pricing calendar; however, retired EOG Resources Inc. chairman and CEO Mark Papa picked up the portfolio as the platform asset for his special purpose acquisition company.

Ward Polzin, CEO at Camino Natural Resources LLC.
“Eventually, the
public companies
will want to buy
us for our free
cash flow, or
we will become
public ourselves,”
said Ward Polzin,
CEO at Camino
Natural Resources

Polzin reentered as an operator with NGP-backed Camino Natural Resources LLC in 2017, focused on the Midcontinent. Again, the plan was to build a sizable E&P to IPO. And that’s “lucky for us,” said Polzin, CEO.

While the IPO part might not be in the near future—the public-equity market is demonstrating little interest in even existing E&P stocks—the resulting model of a sizable E&P suits the current commodity-price climate, he said.

“When we started in 2017, before we owned any acreage, our goal was to operate on a larger scale and possibly take that public someday, if that made sense, as opposed to being a small company that wasn’t going to do that—one that was built to create some acreage and flip it.”

In the last year, PE-backed E&Ps that were formed to build and flip to public E&Ps have encountered no takers. “All of us in the private-equity world want to sell. We [at Camino] are not unique to that.”

Camino will eventually do that one way or another, he said. “But we thought, even back then, that bigger was going to give us a better shot at that. So we started off with that attitude.”

Camino’s 115,000 net acres are about 50% in the Scoop play in the southern Anadarko Basin and about 50% in the Merge play immediately north. It’s producing about 38,000 barrels of oil equivalent per day (boe/d) now, making it the largest PE-backed producer in the area. It’s had three rigs at work the past 18 months, “so we’ve had a lot of growth.”

In the past—circa 2000, before shale was a thing—a couple of the rules of thumb PE-backed producers used were that it’s time to sell when internal HR and more than one office-building floor would be needed for the staff.

In this day, Denver-based Camino has grown to 65 employees. The team began with some former Centennial staff and some former Denver-based Vantage Energy LLC employees. PE-backed Vantage built and flipped in the Appalachian Basin, selling in 2016 to Rice Energy Inc., which is now a part of EQT Corp.

The Vantage team members “had the same DNA we had,” Polzin said, “meaning ‘build, run multiple rigs and put all of our eggs in one basket in terms of the play.’”

‘Staying Power’

With a “lower-for-longer” business model, Camino is relying on economies of scale, “needing to be on the bigger side to be big enough to be able to run multiple rigs and multiple frack crews, so we get some volume pricing.”

It is sourcing sand directly from local mines and has long-term contracts for completions. Three rigs are under continuous contract.

“If we weren’t of scale, we wouldn’t be able to do that and, then, we wouldn’t have a lower operating cost. That’s how we’re addressing it: with scale, where the rubber meets the road. Scale allows you to get better pricing, but it gives you some flexibility too in where to drill.

“We can move the rigs around to what’s working best at any given time.”

Camino is focusing on “the things that we think give us longer staying power,” said Polzin.

That means drilling the PUDs. “To a certain extent, we are harvesting that upside for ourselves by basically creating cash flow quicker than we might have otherwise.”

Polzin sees the shale era in its middle innings today. “I don’t know if it’s the fourth and the fifth, but, in the first three innings, [PE-sponsored producers] were building inventory and a public company would buy that inventory because it needed it.”

Now, public E&Ps aren’t getting paid in share valuation for their surplus inventory; “therefore, they’re not paying us for it. So you’re not seeing much A&D.”

Public E&Ps are being told, instead, to be cash-flow positive; so, now, PE-backed E&Ps are working toward that too. “Eventually, the public companies will want to buy us for our free cash flow, or we will become public ourselves,” he said.

Another option is to return the cash flow to the PE investors. That means “we need to drill more of those PUDs now, turn them into cash flow and start dividending back to investors.”

In the past, “you almost never dividended back to your [PE] investor. You sold and that’s when everyone got their money. Now it’s ‘How can we get our investors their money piecemeal in dividends?’ and the only way to do that is to drill some of your future now.”

As private E&Ps are looking to create returns via producing reserves, the drilling program is different too. In the past, the goal was to prove all the acreage, putting in at least one well per section.

“Now, we need to pull back a little bit, and those drilling those PUDs are stepping out less and proving more. You’re really more intensively drilling what you already have as opposed to broadening it.”

‘On Paper’

The capital structure is different too. “It doesn’t necessarily mean you have more debt. I think, on one hand, you have to be a little bit more conservative.”

PE-backed E&Ps might have less debt, actually—on an absolute basis, such as in comparison with production. As the current situation is new to the PE model, “since you plan to be here longer, you have to make sure you have a debt facility and you are using it appropriately.

“Most companies need to be careful. You can’t bet the farm, so to speak.”

To build based on debt while thinking “‘I will sell in two years;’ I don’t think that works anymore. I would think more people would have debt facilities, but I would think they’re using them more conservatively on average than they have in the past.”

Camino formed its initial leasehold in four acquisitions, consolidating about 95,000 net acres that were producing about 10,000 boe/d. It leased another 20,000 acres and traded 30,000 of the initial footprint for a different 30,000 “in a hundred small deals” in the past year and a half.

Meanwhile, the growth in production—from 10,000 boe/d to 38,000—has come entirely through the drillbit. In its Scoop leasehold, where the Woodford is deeper than in the Merge and the Stack play—“the wells are bigger. It costs more, but, obviously, you get bigger EURs and bigger production rates.”

The production growth has come “really just from the quality of the wells.” The Scoop comes with more natural gas—about 50% gas—as it’s deeper, thus more cooked. “As you get deeper, you get bigger wells, of course, and more gas in your boe. It’s not worth as much [as the liquids], but the incremental volumes equate to good returns.”

Could there be private-private consolidation? “Yes, on paper,” Polzin said. “But I think one can argue both sides of the fence that ‘Well, private to private is easier to do than public to public.’

C&J Energy Services Inc. employee Shane Dennis prepares the frack gun to complete Teal’s Boening pad.
C&J Energy Services Inc. employee Shane Dennis prepares the frack gun to complete Teal’s Boening
#4H during a zipper frack of it and Boening #3H. (Source: Tom Fox/Oil and Gas Investor)
Liberty Oilfield Services “Apache” crew workers check connections between fracking stages on Teal’s Boening pad.
Liberty Oilfield Services “Apache” crew workers check connections between fracking stages on Teal’s
Boening #3H and #4H. (Source: Tom Fox/Oil and Gas Investor)

“But I can also see why you could argue just the opposite.” He expects some private-private, but “I don’t think there will be a ton more because one of the problems is neither side has liquidity, still. You’re merging two private companies into one, which is better because it’s bigger.”

But it’s not a liquidity event. “At least in a [sale to a] public there is a liquidity event. Maybe it’s just stock, but you can at least sell it.”

Nevertheless, “I think you will see more private to private. Right now, all these have occurred just within the same [PE] family. Once you step out of [the family], I think it’s a lot harder—but not impossible.

“I think they’re so complicated they will be one-off events. But there will be some.”

‘Eat The Meat’

In the Eagle Ford, NGP- and Pearl Energy Investments LP-backed Teal Natural Resources LLC is three years into its timeline. It has roughly 25,000 net acres, producing some 6,500 boe/d, about 66% oil. It kicked off a one-rig program in January with a six-well commitment. It has transitioned now to keeping the rig at work continuously.

“Coming out of December into the new year, we thought we could see where the commodity market was going to shake out and also see where our well performance was going and show the repeatability of the stacked/staggered program we started last year,” said Erik Holt, chief commercial officer.

What will the next two years be like? “Two years ago, you were thinking, ‘Delineate the acreage and drill wells.’” The aim was to “save enough of our inventory for the next buyer. That has completely changed.”

Now, the tack is “that, rather than keeping meat on the bones for the next owner, we need to be eating the meat. Where we have the best opportunities to drill great wells, we’re going to drill those wells and eat the meat rather than save it for the next owner.”

It’s anyone’s guess where the market will be in two years, “but we feel confident we’ll be in a good position. We have a healthy amount of great inventory. We’ve had great results on some of our more recent wells, and we know we can control our destiny by drilling those locations and bringing that value forward through the drillbit.”

In terms of capital structure, “now you want to make sure you’re not just looking at execution risk. You’re also looking at balance-sheet risk—preserving the health of your balance sheet.”

Erik Holt, chief commercial officer at Teal Natural Resources LLC.
“One way we
know we can
control our
destiny and have
meaningful returns
is by ramping up
development,” said
Erik Holt, chief
commercial officer
at Teal Natural
Resources LLC.

Past PE-sponsored E&Ps started with buying undeveloped acreage with equity and used additional equity to appraise the acreage with delineation drilling. Teal acquired HBP properties that provided a PDP base, thus cash flow and collateral for a credit facility.

“The equity we’ve deployed to help fund our development program during the past two years is only a fraction of the total equity we’ve called,” Holt said. “Everything we’ve been doing to date has roughly just been off cash flow and also our RBL.”

Today, rather than expecting returns through a sale, PE sponsors are looking for the returns promised to their investors via the drillbit—positive cash flow to “start bringing some of that money home” with distributions.

“So, at a certain point, you do have to walk the tightrope. Do we want balance-sheet health or leverage up—either through some sort of second-lien facility or some sort of credit facility or a Drillco that allows you to preserve your balance sheet but also accelerate your development where you’re getting cash?”

A pair of water lines leads to Teal’s Boening #3H and #4H pad while being fracked.
A pair of water lines leads to Teal’s Boening #3H and #4H pad while being fracked, as trucks carrying boxes of frack sand line the gravel road. (Source: Tom Fox/Oil and Gas Investor)

It’s what the equity sponsors want where sale isn’t possible. “One way we know we can control our destiny and have meaningful returns is by ramping up development.”

Say this goes on beyond year five, would Teal simply continue to drill and produce its leasehold until there’s just no place to put another well?

“If things stay stagnant the next five-plus years, we’re going to do everything we can to accelerate our production where we can pay off that equity at a rate of return we targeted for our investors.”

Small Fish Or Big Fish?

In this world, deals that will get done are where buyers see credit-accretive or, at least, cash-flow-neutral assets—if not cash-flow positive. “When you look at public E&Ps’ earnings, no one is trumpeting type-curve projections or IP rates. What we’re seeing is, ‘How quick can we get to free cash flow? What can we do to improve total shareholder returns?’”

Skye Callantine, president and CEO at Felix Energy II LLC.
“The typical
business model
for companies
like ours is to
consolidate a
position, prove
the economics
and ultimately
sell the asset to
a company with
a lower cost of
capital,” said
Skye Callantine,
president and
CEO at Felix
Energy II LLC.

At Teal, the business is being built as one that would be—to a buyer—cash-flow accretive, improving EBITDA and the debt ratio. “And that’s where I think you can see some activity in the M&A market.”

And the sellers, since they’re likely to get stock rather than cash, have to use “a different calculus.” Depending on who the public buyer is, the equity component of the purchase might not be a good deal? “Right.”

Rather, Teal is looking at buying. “If the market is saying now is not the time to be sellers, now is maybe the time to be aggressive and be buyers.

“You ask yourself, ‘What fish are you in the pond?’ and I think this market is really making people identify whether they want to stay in the shallow end or jump in the deep end and become a much bigger company.

“It’s been a psychological shift. In this market, scale is rewarded, and we’re going to be looking to add scale with the right opportunities.”

Teal’s leasehold is in Lavaca, Karnes, Live Oak, Atascosa and DeWitt counties, Texas. In addition to Eagle Ford, it has Austin Chalk and Buda potential. For now, it’s focusing on demonstrating the dual-bench potential of the Eagle Ford.

“We definitely have potential for Austin Chalk, but we really want to focus on the Eagle Ford.”

Is there potential for a greater return by harvesting rather than flipping? “The way we look at it is that, as long as we do what we can control and we do that well, the opportunity to grow or monetize is always going to be a lot more abundant.”

No matter the market, “what truly dictates great opportunities is being able to execute what you can control and do it well. Sometimes the opportunities will be more obvious in a more stagnant market.”

Deepening The Bench

Operating in the Delaware Basin, EnCap Investments LP-backed Felix Energy II LLC is also in year three. Will it exit before or in year five? “Very good question,” said Skye Callantine, president and CEO.

“The market has changed much. We are preparing, on the asset side, for however long it takes. My guess is it will take at least a couple of years,” he said.

A runner travels under the gateway to downtown Yoakum, Texas.
A runner travels under the gateway to downtown Yoakum, Texas, at sunset in late July near Teal’s Boening pad site. On the Lavaca-DeWitt county line, the city was built on an 1835 land grant and was a gathering place for cattle along the Chisholm Trail. (Source: Tom Fox/Oil and Gas Investor)

The previous Felix proved 80,000 net acres for Stack, selling it in 2016 to Devon Energy Corp. In the Delaware today, it has seven rigs at work on its 60,000 net acres. Current production is some 50,000 boe/d.

At Felix II, the business model is different from that of Felix I. “The typical business model for companies like ours is to consolidate a position, prove the economics and ultimately sell the asset to a company with a lower cost of capital.”

Today, “our strategy is to increase the value of the enterprise and convert more of the inventory to cash flow.”

That requires more people—a lot more people. “That’s been a material change— the additional personnel it takes to sustain a large capital program to drill more and more inventory.” The capital it’s needed—to drill all of those locations—has also increased. “Those are probably two of the biggest changes: more people and more capital.”

The skillset within the team is more specialized than in a prove-and-flip model. “We might have had one guy who managed drilling, completion and production. Now we have multiple specialists in every discipline.”

In the past, a typical PE-backed E&P would build takeaway to the lease line, so to speak—essentially, gathering infrastructure. In Felix II, management has formed Felix Midstream and Felix Water, separate companies that share space in Felix’s Denver headquarters and have the same ownership.

In the water business, about 30% of revenues come from third-party sales. When getting started, Felix expected the midstream- and water-business potential would represent untapped upside for the buyer.

“We definitely identified the opportunity, but our intent early on was to sell that opportunity with the rest of the assets.

“All we are doing now is executing on the plan we designed and built for a buyer. So we’re doing the development. We just decided to go ahead and fund it ourselves and operate it—both the upstream and midstream,” said Callantine.

This new world is more capital intense. “We’ve grown our production 100 times in three years, so, to have that type of production growth, you need to invest beyond your cash flow.

“So we’ve been deficit-spending every year the last three years.”

The capital program has been efficient and well economics are strong. “So we’ve been able to get cheap debt to fund that growth. With our relatively large cash flow, we likely won’t be doing deficit spending much longer. We will be cash-flow neutral at the current activity level or cash-flow positive at reduced activity.”

Minding The G&A

Achieving neutral—then, positive—cash flow has been difficult for public E&Ps. “That’s one of the reasons why our industry is not doing so well today,” said Callantine.

At Felix, “we have a far better cost structure than most public companies our size. Our G&A [general and administrative expense] is a multiple lower than most. More importantly, the team and culture we have built generate an incredible amount of value with fewer people.”

Felix’s spend on G&A is approximately 3% of its capital budget. “At our level of activity in both upstream and midstream, I expect we are one of the most efficient companies in our industry. I’m very proud of what our team has accomplished in what is turning out to be a very difficult time in our industry.”

One public E&P’s investor reported in July that it believes the producer is losing money every time it drills another well and called on it to cease drilling.

Among PE-backed operators, meanwhile, Felix’s G&A profile may or may not be typical of all. “I think it is how you define our peer group. Most companies like us have [already] sold. There aren’t many large-scale private operators left in the space.”

He counts maybe a couple in the Delaware and maybe a couple in the Midland Basin. “The ones with quality assets definitely have a material advantage in cost structure, including G&A, real estate, planes, executive compensation, debt service, etc.”

With challenges come opportunities. In this timeline of the industry, “having a stable investment program where you have a stable rig count allows us to get better service pricing, better equipment. It allows us to get more efficient.”

The availability of services is likely the greatest opportunity. “There was a time 18 months ago, if you needed people, there were no people or equipment available. Now you can get pretty good people and equipment and at a good price.”

It’s a buyer’s market in the Delaware, Callantine said, however, “we’re not looking to grow through acreage. There is an opportunity for some, but it’s not an opportunity we’re interested in right now.”

Also in the Delaware, NGP- and Pearl-backed Colgate Energy LLC was formed in 2015. James Walter, co-CEO, said Colgate has been funding development from cash flow and its credit facility since January 2018. “So our development cost of capital is in the mid-single digits.”

It has two rigs at work and expects to add a third in the fourth quarter. “Most of our leasehold is HBP at this point, so we have a lot of flexibility in our drill schedule,” Walter said.

He sees this market resulting in a “better business that should allow Colgate and our investors to realize a greater return than we would have received in a stronger market. The tradeoff is that the investment hold is longer, and it takes a lot of hard work to get there.”

‘Cruel’ Situation

At Camino in the Anadarko Basin, Polzin said the opportunity derived from the current industry environment is “definitely the consolidation part, meaning there are smaller companies that are private that just weren’t built to be here a long time and built to operate long term.

“They may not have the drilling team or the operations team. We have that.”

Camino has seen more opportunities to purchase smaller companies. “That’s the good news.” Being big, “we’ve seen that opportunity to buy. You can trade acreage that’s 30 miles away from another piece of acreage. You have more options, which ultimately leads to more operated, longer laterals, which has been the goal of everything,” he said.

K Brew
The K. Spoetzel Brewery ships more than 6 million cases of beer to states throughout the U.S. each year. The company reports at its homepage, “We think our founder, Kosmos Spoetzl, would be pretty proud.” (Source: Tom Fox/Oil and Gas Investor)

Another opportunity—and it’s not necessarily one for Camino’s model, he said—is for nonoperators. “In the tough timeframe we live in today, [an operator] would rather spend capital dollars on operated acreage than nonop. Because of this, we see a lot of nonop. That creates a lot of opportunity for the nonop players.

“We’re seeing that more often in our acreage and in the Midcontinent overall.”

Where to from here for the industry? With $55 to $60 oil, “it feels like it’s $45 because of the trough we’re in in [asset] valuations.”

The upstream M&A industry works—or doesn’t work—depending on public E&P investors’ and potential investors’ valuation of these stocks. “They’re really at all-time-low multiples.

“Given that upstream public companies are poorly valued, the private guys will be poorly valued. It all rolls downhill.”

The difference between $50 oil and $60 oil is enormous. “Our industry at $50 oil cannot provide what the public investor is asking, which is, ‘I want you to grow your production and within cash flow and I want you to pay a dividend and I want you to buy back some stock.’”

It can work at $50 but, for the industry overall, it really works at $60. “The past couple of years, we’ve been bounded by this $50, $60 world, which kind of puts you on the edge.

A bee looks for pollen in a bush outside the K. Spoetzl Brewery in late summer. Known as the peacock flower, Mexican bird of paradise and many names, this bush prefers a climate where frost is rare. (Source: Tom Fox/Oil and Gas Investor)

“It doesn’t mean we’re going bankrupt as an industry by any stretch. But can we deliver everything that’s asked from us at this price deck?” The strip in the mid-$50s is, “to me, a very cruel kind of situation where we can’t deliver everything the market wants. And we have to figure it out, right?

It means slowing growth. “[Industry] is still growing in production, but we’re not growing quite as fast as we were six months ago.”

Is a $60 world enough for shareholders to let public E&Ps start buying again? “I don’t think so. I don’t think it’s enough.” It would have to be $60 for a while—at least a year. “And we really have to not buy until that happens.”

That doesn’t count for mergers of equals like the Callon Petroleum Co. and Carrizo Oil & Gas Inc. deal announced in July. “That’s not buying; that’s MOEs [merger of equals], which are great. We need more of those; long-term, that makes a ton of sense.”

More time is needed for other M&A, “which is terrible for our company and many others.” A couple of good quarters won’t count, “which is too bad. We need a couple of years.”

At Felix, Callantine said the current A&D stalemate is “probably healthy. Some of the things I say may be a little controversial, but clearly our industry is struggling right now, which is why companies like us continue to exist.

“And I think it will play out over the next couple years—what needs to be corrected to attract investor interest again.”

Capital discipline is No. 1. “As an industry, we’ve used cheap capital to drive down margins to unacceptable levels and lost many investors on the way. I’m confident the same people that drove the energy revolution in the U.S. will figure out how to make our industry more attractive to investors over time.”

In Felix’s neighborhood, he is impressed with many public E&Ps, including Diamondback Energy Inc., Concho Resources Inc. and WPX Energy Inc. “All have excellent management and good assets. They have everything going for them; very forthright people who are smart and know how to run a good business.”