The energy sector is coming back to life after a challenging 2020 – good news for private debt owners and private equity issued by energy companies. But despite signs of recovery, the pandemic and related global economic slowdown are bound to cause some long-term recalibration, which has implications – and creates some new challenges – for the valuation of private securities from the oil patch.
As energy asset valuation experts, we undertake more than three dozen private energy valuations every quarter, including equity and debt investments. Typically, our portfolio valuation team’s generalist members prevail on us for help with diversified private equity or private debt funds’ energy-related positions because of the market’s unique characteristics. These include:
- Industry-specific financial ratios that can impact valuation such as enterprise value/production, EV/reserves, EV/acreage;
- The significant variability of businesses within the sector – and the sometimes uneven impact of regulatory changes on different players;
- The importance of understanding and evaluating expert third-party analysis, such as reserve reports for E&P companies;
- The specific tone of the M&A market and debt financing options in energy and;
- The interconnected nature of the energy value chain, where issuers – primarily midstream entities – may have complex contractual relationships and significant commercial exposure to downstream suppliers and upstream customers.
Going into the new year, many of the energy-specific factors we evaluate have been affected by the pandemic and related economic dislocations, not to mention the potential for legislative and regulatory change from new leadership in Washington. Let’s take a more detailed look at some areas where we are seeing, or expect to see, the most disruption.
Acreage under assault
One of the most striking developments related to post-pandemic energy market softness is the aggressive discounting of undeveloped acreage, even as oil prices have nearly rebounded to pre-covid levels. In transactions we have followed, buyers are proving to be less willing to pay up for undeveloped acreage. At the same time, non-distressed sellers remain reluctant to relinquish the cashflow at low multiples. Indeed, in some deals in the Permian Basin, little (or in a few cases, zero) value was ascribed to undeveloped locations, notwithstanding detailed and bullish reports on their underground reserves. Per Enverus, Permian deals averaged approximately $9,200/acre in 2020; about half of what they averaged during 2019. Average Permian valuations peaked in 2017 at roughly $29,000/acre.
As valuation professionals, we can’t ignore this trend and must reevaluate whether allocating material value to undeveloped acreage remains reasonable. Minimally, if acreage is fringe or not fully delineated, it may be worth much less than what was paid for it over the last few years, despite similar current oil prices. Against this backdrop, it’s more important than ever to clearly document support for any acreage multiples to avoid auditor/regulator issues.
M&A perking up
Clearly, deal activity in E&P has been accelerating as petroleum prices firm up and the economy emerges from last year’s malaise, although still down from historical levels. And deal activity and multiples certainly inform our valuation of energy assets. But again, it is important not to extrapolate too much when the assets in question are more speculative. In recent M&A activity, there has been more focus on near-term cashflows versus underlying intrinsic asset value. The E&P transactions that are getting done are less about adding inventory and more about companies with solid balance sheets merging with other solid companies to achieve greater synergies.
Also, all the large public company deals were largely cash-free with little-to-no premiums to the target company’s share price, and all had significant Permian exposure. We would expect there is now a backlog of non-core asset divestment opportunities given that the merged companies now have expanded portfolios.
Within midstream, dealflow in the last few months has been even more circumscribed than in E&P, with a continued focus on corporate simplification and select activity around targeted pipeline, storage and processing assets. However, the activity could pick up in 2021 as the macro environment stabilizes and midstream players look to increase size/scale to compete better and offset greater negotiating power held by E&Ps given increased upstream consolidation.
The financing environment
Is the E&P bankruptcy wave now behind us? After being shut out of the credit market for nearly a year, many companies with reasonable leverage and yields under 10 percent are currently enjoying a window to refinance and push out debt maturities. We would expect levered E&P to continue to file or refinance as current long-term oil prices around $45 only provides for a marginal full-cycle return.
One development worth watching: With the uptick in oil prices, there appears to be some appetite among financial buyers for creative financing solutions such as the sale of overriding royalty interests (ORRIs) and volumetric production payments (VPPs), thus extending a potential lifeline to stressed E&P companies with a prohibitively high cost of capital in traditional credit markets.
We have seen similar refinancing activity among public companies in recent weeks/months in the midstream space; less so among privates. In general, midstream players were not in as challenged a financial position as many E&Ps, but numerous small, over-levered companies remain.
In the midstream context – and even more so, oilfield equipment and services (OFS) – we are closely tracking capital expenditure by E&P companies. With upstream operators focusing on cashflow and paying down debt, marginal midstream and OFS enterprises could remain stressed. Midstream operators with scaled assets in place, limited capital expenditure needs and capital discipline could see significant cashflow leverage in any sector rebound.
The new sheriff in town
After four years of extremely accommodative regulatory policies from Washington, energy market participants are anxious about what the new Biden administration means for the sector. As a candidate, president Biden put global warming at the forefront of his campaign agenda. If anyone doubted his seriousness of purpose, among his first policy shifts was rejoining the Paris Climate Accord and shutting down the Keystone Pipeline development.
The broad implications of an accelerated energy transition cannot be ignored over the long-term. Many would argue peak demand now seems within view. As such, we try to take a more practical and nuanced approach when determining the present value of energy-related financial assets. That includes looking at near-term pricing and the ability for some midstream companies’ existing assets to be retrofitted for new purposes beyond carbon-producing fuels – for example, hydrogen transportation, given greater investor/commercial interest.
The Keystone Pipeline is a good example of the necessity for nuance. The shuttering of a multinational pipeline development – and heightened regulatory scrutiny for other long-haul pipelines, suggesting few if any new crude oil or natural gas pipelines will be green-lighted in the US, at least for the next four years – might seem bearish for midstream operators on first blush. But absent new long-haul pipelines, it is fair to consider whether the commercial and transaction values for existing US pipelines/assets increased with the news.
With in-the-ground assets not worth what they used to be, uneven M&A activity, operators still feeling cashflow stress, and a tougher regulatory regime, the energy sector – and private asset values within the sector – face their share of challenges. But after a year of extraordinary pressures and dislocations brought about by a global pandemic, those challenges feel more “normal” and are more readily quantifiable with the right level of expertise.
Jeff Birnbaum and Chris Walling are senior vice-presidents in the Private Portfolio Valuation Practice Group at VRC.