[Editor's note: A version of this story appears in the Capital Options 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]
You know funding for oil and gas is tight—really tight—when a multi-year low is made in the XOP (S&P Oil & Gas Exploration & Production ETF). The XOP’s collapse in August plumbed depths last seen in February 2016, when West Texas Intermediate (WTI) crude sank to just over $26/bbl. In the recent slump, activity in energy capital markets has dried up, leaving equity and high-yield sectors largely barren.
So where is an oasis to be found amidst the desert landscape of recent capital markets?
Although described broadly as backing “drilling joint ventures,” Sequel Energy Group LLC is focused primarily on what many call DrillCo joint ventures, an increasingly popular way to fill the gap between E&Ps and capital sources. While relatively new, Sequel is well-heeled, having recently provided as much as $500 million in funding to just three JV partners. In addition, with its financial partner, Sequel has the flexibility to offer complex, highly customized financing solutions.
Sequel Energy Group was formed in late 2016 with an initial capital commitment of over $500 million from GSO Capital Partners LP. GSO is the global credit platform of the Blackstone Group Inc. Earlier this year, Sequel and GSO announced the formation of Sequel Energy Group II, backed by a further $500 million, bringing combined capital committed to the Sequel platform to over $1 billion.
The Sequel management team is led by a trio of industry veterans. Based in Greenwood Village, Colorado, the three Sequel managing directors are Jeff Hemphill, Doug York and Dave Kornder.
All three members of the team have extensive industry experience. For example, York began his career with ARCO Oil and Gas. His later moves included a 10-year stretch with St. Mary Land & Exploration, where he eventually rose to COO. In 2006, he co-founded a privately-held E&P named Sequel Energy LLC, focused on acquiring and developing properties in Louisiana, Oklahoma and North Dakota.
After nearly 20 years in the E&P business, Hemphill joined York as a co-founder of Sequel Energy LLC, which developed a significant Bakken shale position in North Dakota. In 2013-2014, the company divested all its producing assets and leasehold.
Kornder has over 25 years of experience in the upstream sector. Prior to joining York and Hemphill in forming the next iteration of Sequel, he served as CEO of Cornerstone Natural Resources, a private equity (PE)-backed company with assets in the Williston Basin, and CFO of Patina Oil & Gas, a public company with assets focused primarily in the Denver-Julesburg (D-J) Basin.
“We’re all operating guys. We’ve been in various E&P companies and in entrepreneurial companies but on the operating side for the vast majority of our careers,” recalled York. “Dave Kornder had the relationship with GSO for many years. GSO wanted to build a drilling JV platform, and they realized early on that they needed a team to really execute their plans in the manner they wanted.”
After working informally together on a couple of opportunities, according to York, the two parties came together to make a formal agreement. “We met the GSO guys and were super impressed by them,” said York. “We formalized the partnership in November of 2016. They made a $500 million commitment focused purely on drilling joint ventures or DrillCos.”
Since late 2016, the Sequel management team has deployed its initial $500 million in three deals. The smallest of the three was a $75 million commitment, although it was later “upsized” with a second tranche of $90 million to make a total of $165 million. It involved “two iterations with the same company,” a PE-backed producer located in the Permian Basin.
DrillCos can offer an attractive option for producers looking to maintain existing development programs, for example, when alternative sources are in painfully short supply.
“The industry is starved for capital. There truly are no buyers,” York said. “Serial buyers are gone, master limited partnerships are gone and the stock market just crushes public E&Ps that add inventory versus developing their organic inventory. Like it or not, the investment world isn’t in love with fossil fuels and energy. There just aren’t a lot of buyers of energy.”
Kornder pointed to the wide “bid-ask spread” for capital as an obstacle for those seeking finance at a time when commercial banks increasingly want to see leverage levels come down in the energy sector.
“The big issue right now is the bid-ask spread on the cost of capital,” he noted. “Some operators think they should still get RBL (reserve-based lending) terms from commercial banks for certain projects, and that’s changed. The banks want to see leverage levels at 2.0x debt-to-EBITDA or lower. There’s this big gap between operators and capital providers right now.”
The attributes of DrillCo financing may address some of the current issues facing producers, said York.
“DrillCos are fitting the needs of a lot of companies in that they are off balance sheet,” he observed. “We take true working interests, so it’s not debt,” said Kornder. “Instead of running just one rig, companies can run two or three rigs—with us taking a working interest and financing it—so they can keep their teams in place and get to that inventory that may be 10 years out.
“At first, the terms of a DrillCo may appear expensive, if you view it purely as a financing vehicle,” continued Kornder. “But if you view it more like the farm-outs that we did in earlier industry days, it’s more ‘down the middle,’ because we’re taking drilling risk right alongside the operator. You can’t earn commercial bank-like returns and make this thing work.”
With the recent deterioration in energy market conditions, Sequel is targeting an overall return in the “high-teens,” up from the “mid-teens” prevailing 18 to 24 months ago, said York. “And for us to make these Drill-Co JVs work, the program operating returns need to generate at least a 30% internal rate of return at the current strip.”
But targeted returns are tied chiefly to the quality of the operator and the risk inherent in the rocks. “We might do something closer to mid-teens with a high quality operator and a more core area.”
Sequel noted that typical DrillCo structures focus on a carry, return hurdle and post-reversionary interest, with capital partners in many cases providing 90% to 100% of pre-reversion drilling and completion costs. In contrast, Sequel targets a 70% or lower working interest for itself. A non-reversionary structure has been used in three of its last four transactions.
Sequel has avoided so-called 90:10 deals (in which pre-reversion splits call for the capital provider to bear 90% of costs and the operator 10% of costs), because the parties’ interests are at risk of becoming “misaligned,” according to York. “We want to provide creative solutions for high-quality operators in need of drilling capital that are not just ‘in the DrillCo box.’”
In terms of the asset characteristics it seeks, said Hemphill, Sequel wants a drilling joint venture to comprise “an area with a type curve in which we have a lot of confidence. And we need a big enough set of wells that we feel comfortable that, statistically, we’re going to hit that type curve on average. We’re not looking to prove up a different zone or a different spacing.”
Sequel typically targets an investment of $100- to $300 million, with an average well count with that size deal of 20 to 35 wells. The good news is that, as of mid-August, Sequel had dry powder to the tune of 100% of its second $500-million commitment from GSO. While not on the horizon, with GSO as its sponsor, “we could do a $500-million deal if it were the right deal,” commented York.
As a measure of its growth, Sequel’s net production has increased from zero in November 2016, to over 45,000 barrels of oil equivalent per day (boe/d) as of December 2018, noted York.
Interest in DrillCos is now more widespread, according to Hemphill, having grown from an initial circle of smid-caps and private operators to a broader group of large-caps and PE-backed E&Ps.
“I think people see the value in it,” he commented. “The public producers are sort of trapped in the need to generate free cash flow, and their financing options are extremely limited. At the other end of the spectrum are the private-equity guys, where there are typically no exits now for their portfolio companies, and there’s very little M&A activity right now.”
As for the PE-backed producers, “we’re seeing a lot of demand currently from that group,” he added. “Their options are they can just sit on a declining asset, or they can bring in a JV partner to help fund the drilling program and grow their production and EBITDA for an eventual exit. Many of those PE-backed teams were never set up with a capital commitment to operate programs for five years or more.”
In addition to the two tranches to a Permian producer, totaling $165 million, mentioned earlier, Sequel has made capital commitments to two Utica E&Ps from its initial $500 million from GSO. One of these was a $200-million commitment to a “very large privately held company in Ohio.” Another was made to Eclipse Resources Corp. of “close to $300 million,” including cash recycled from its prolific wells.
Eclipse and Blue Mountain Resources Corp. merged in early 2019 to form Montage Resources Corp.
In looking at new opportunities, Sequel has not limited itself to deals in the Utica play and Permian Basin, said Hemphill. It has also reviewed transactions elsewhere: the Bakken, Denver-Julesburg, Eagle Ford and Midcontinent, for example.
Importantly, the financial flexibility provided by GSO has played a key role in allowing Sequel to take on what management says have been “some pretty complex transactions.” For example, one transaction included a significant acquisition component, requiring cash at closing, but also paved the way to signing a
disproportionately larger DrillCo deal as part of a combined transaction.
The Sequel team is quick to praise the added creativity and flexibility it has with its GSO sponsor.
“GSO’s flexibility was a fantastic help in getting that deal negotiated and closed,” recalled Kornder. “GSO was highly creative. The transaction was by no means a cookiecutter deal.”
“We’ve coordinated very closely with GSO on an ongoing basis,” added Hemphill. “It’s almost like the lines blur between where we stop and they start, and vice versa. We’ve worked in lockstep with GSO.”
“Part of what makes our story unique is the relationship we have had with GSO that marries our skillset with their Street credibility and deal making skills,” said York.
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