Is private equity investment in the energy sector getting too hot?

The energy industry is large, complex, capital intensive, global and growing — all important characteristics that have captured the attention and, more importantly, the capital of private equity investors worldwide.

In 2012, the aggregate amount raised by energy-focused funds came close to surpassing the highs achieved in 2006 and 2009. Funds now in the market are targeting more than $30 billion in commitments, and that number does not even include generalist private equity firms with an allocation to energy, according to Preqin. This shift has limited partners wondering if there is too much private equity capital chasing the energy sector. The simple answer is: No.

The size of the market, the long-term growth prospects and the complex nature of the energy value chain will continue to present investment opportunity. The massive capital spending requirements to meet expected global demand dwarf the amount of private equity capital available today. The challenge for LPs will be to determine which private equity firms will be most successful in capturing this opportunity.

Energy is a global industry and, over the long term, will be driven by the needs of emerging economies. The rapid industrialization, urbanization and motorization of the non-Organization for Economic Co-operation and Development economies is expected to contribute to more than 90% of future global energy demand growth.

In fact, global demand for energy across all fuel types is projected to grow nearly 1.2% per year over the next 20-plus years, largely driven by these non-OECD economies, particularly China, according to the Energy Information Administration-International Energy Outlook 2010 and International Energy Agency-World Energy Outlook 2009. Whether the investment dollars are needed in the U.S. or China is less relevant. What is relevant is the magnitude of these numbers and where the opportunities are for private equity:

• Strategic investors are predicting that the next decade will experience the most rapid growth in global production of tight oil and shale gas;


• The equipment and services sector will need $16.6 trillion over the next twenty years;


• Midstream and downstream sectors will demand $4.1 trillion infusions of capital over the same time frame, according to IEA World Energy Outlook 2011; and


• the resource sector will need $17.8 trillion over just 10 years to maintain and expand energy supply availability, according to the IEA report.

In North America, the application of new technologies to abundant shale resources has helped to transform the U.S. into a major supplier of natural gas and the fastest growing non-OPEC oil producer in the world. The continued development and integration of technology across the energy spectrum will be essential to meet future demand. These technologies are intended to increase oil and gas production, make equipment and services more efficient and effective and move product from supply centers to demand centers.

No other country in the world can match the type of growth expected in the U.S., and we expect the gains to continue, with oil production reaching 8.9 million barrels per day in 2016. According to the Energy Information Administration, the U.S. imported 886,000 barrels per day of crude oil from the Gulf Coast in 2010 and, by March 2013, imports had fallen to less than 40,000 barrels per day. In addition, U.S. crude oil exports to Canada have increased to almost 100,000 barrels per day in the first quarter of 2013 from 24,000 barrels per day historically, meaning that almost 1 million barrels per day of oil has been diverted to other countries. Despite uncertainty around commodity pricing in the short and medium term, the U.S. energy market will continue to develop and the cost advantage of a domestic resource supply will persist to the benefit of the industrial and manufacturing sectors.

This is a complex and technical sector wrought with ongoing legislative and regulatory change that requires continuous oversight and review. Anyone reading or watching the news has seen that the space even has its own lingo — “fracking”, transformers, MMCf, NGL, non-conventional, generation, OPEC (ok, so most of us knew this one already). The list goes on, and it helps to illustrate that energy investing is not for the typical middle-market private equity investor with little to no sector expertise. Or at least that investor would have little hope of achieving top-quartile returns in this market.

Compounding matters further, the higher levels of technical complexity in new energy developments have led to a significant escalation in costs for the services and equipment needed. High degrees of sector complexity, coupled with supply/demand dislocations, often create an environment ripe for private equity — and for investors well-versed in the space — to take advantage of the opportunities inherent. As with any investment in private equity, selecting the right investment opportunity and management team is only part of the battle. Overseeing effective implementation and driving towards an ideal exit is also necessary to generate outperformance against investors' benchmarks.

The sector as a whole is extremely capital intensive, and there is enormous unmet demand driving the need for investments by private equity and strategic investors. Infrastructure needs will continue to grow to support increased production, transportation, processing and delivery. With a private equity investment space deploying just more than $300 billion per year, the energy investment component is expected to be near insignificant to the broader energy sector needs. We believe experienced private equity investors will have their pick from the outperforming, risk-adjusted investments in upstream, midstream and power. Limited partners interested in the space need to either educate themselves on the opportunities and the risks or outsource to those who are in order to benefit from this market-changing opportunity.

Andrea Kramer is a managing director, and John Shea is investment director on the fund investment team, at Hamilton Lane.