Energy investors cautiously fill up

Billions of dollars are pouring into private equity energy funds as oil prices plummet, just one reason some industry insiders say investors should expect lower returns in parts of the oil and gas sector.

On Nov. 5, the cost of oil from OPEC, which produces about 40% of the world's supply, fell below $80 per barrel for the first time in four years because of declining global demand.

Much of the private investment in oil and gas had been in exploration and drilling, so-called upstream investments. Falling oil prices could cut investors' returns in those areas. As a result, managers are expanding into other energy-related investments, including pipelines and oil field servicing.

Energy has been a high-returning investment for quite some time, returning close to a net 17% internal rate of return for the 10 years ended June 30 and a net 20% IRR for private equity funds that solely make upstream investments, said Stephen Nesbitt, CEO of Marina del Rey, Calif.-based alternative investment consulting firm Cliffwater LLC. Those returns could suffer should oil drop to as low as $70 per barrel, according to Cliffwater research.

Investor interest in the sector is unabated.

Year to date through Oct. 31, 33 private equity funds directed at the energy sector closed with $31.7 billion, according to data provided by Preqin, a London-based research firm. By comparison, 46 funds raised a total of $39.5 billion in all of 2013 and 38 funds closed on a total of $28 billion in 2012.

The Blackstone Group LP is in the process of raising a $4 billion to $4.5 billion energy fund. Warburg Pincus LLC last month closed on a $4 billion private equity energy fund.

Some see the drop in oil prices as a temporary blip in light of the estimated $100 billion of capital per year needed to fuel natural gas production in the U.S. and the anticipated long-term demand for oil and gas.

Indeed, private equity managers that invest in energy call the falling prices a buying opportunity.

But Rob McCeney, U.S. energy and infrastructure deals partner for PricewaterhouseCoopers LLP in Houston, said oil prices could affect the exploration and production sector. “The same is true across other sectors within energy to a lesser extent,” he said.

This could lower prices for buyers, but also reduce returns for existing investments.

Even if the oil price decline constitutes a temporary blip, rising valuations and increasing leverage are other factors that could challenge returns.

All of the activity is raising warning flags for some.

Michael Underhill, founder and chief investment officer of Capital Innovations LLC, Pewaukee, Wis., believes portions of the energy sector affected by oil and gas prices are poised for a massive correction.

Prices for transactions are high and going higher, especially in North America, he said. “Private energy funds are paying higher valuations by adding leverage,” Mr. Underhill said. “I think we are teeing up for a crisis. It's getting a bit aggressive.”

At the same time, the global supply-demand picture is changing, in part due to the increased shale production in the U.S. and Canada, which could affect investors' future returns, Capital Innovations research shows.

More than half of Capital Innovations' $1 billion under management is invested in energy, including master limited partnerships.

The combination of rising U.S. production, small increases in production by OPEC and declining demand in both China and Europe “created enough of a net supply increase to depress oil prices by 25% from their June peaks,” Mr. Underhill said.

But other money managers maintain the drop in prices creates a buying opportunity.

“We welcome this kind of volatility,” said Sean T. Klimczak, senior managing director in Blackstone's private equity energy group in New York. “Seeing oil and gas prices fall from $110 per barrel to $80 per barrel ... is a wonderful thing.”

Blackstone sold much of its oil and gas investments in the past two years, reaping good returns, he said. Falling prices will “ultimately be an interesting buying opportunity,” he said.

Still, newer energy investments will differ from those made two years ago, Mr. Klimczak said.

Blackstone expects to trim its energy investments in the U.S. to 50% of the portfolio from 81% (as of Sept. 30) in its first fund and make more international investments, in places like Southeast Asia and Europe, he said. Oil and natural gas investment in its second fund, now being raised, is expected to drop in favor of more power, midstream and other sectors. As of Sept. 30, Blackstone's first energy fund had 61% exploration and production, 21% power and 18% midstream, according to a Blackstone presentation to the New Mexico State Investment Council.

Executives at Warburg Pincus agree the drop in oil prices will produce buying opportunities.

“Current prices are within a range of our long-term commodity price expectations and we seek to invest in and grow our portfolio companies throughout commodity price cycles,” said Ed Trissel, spokesman for Warburg Pincus. “However, we certainly pay attention to environments like this for new opportunities to deploy capital at lower costs, acquire assets being spun out or to partner with strong operators in need of additional capital.”

“Most institutional investors believe lower energy prices is a short-term dip,” said David Fann, CEO of TorreyCove Capital Partners LLC, a San Diego-based private equity consulting firm. “From a long-term macro perspective, the bet is that global demand for energy will only increase.”

There are going to be a lot of energy deals, Mr. Fann said, adding: “We are very much in the early innings of the energy revolution.

“The U.S. energy investment opportunity makes it highly likely that the U.S. will become a net exporter of energy in the next decade,” Mr. Fann said.

The best managers have diversified global portfolios across energy sectors and contacts with management teams that have been successful in the past, he said. These managers are having no trouble raising oversubscribed funds quickly. He declined to identify what TorreyCove executives consider the best managers.

Warburg Pincus fund was oversubscribed and Blackstone's latest energy fund's total capital commitments also are expected to be exceed its fundraising target.

Indeed, Blackstone is reducing investors' commitments, according to a presentation given two weeks ago to the New Mexico State Investment Council by executives from Blackstone Energy Partners LP. The council voted to commit up to $75 million to Blackstone Energy Partners II, said Charles Wollmann, spokesman for the Santa Fe-based council, which oversees $20 billion.

The drop in oil and gas prices “certainly makes traditional energy investments more attractive,” said Daniel Cook, research analyst for PitchBook Data in Seattle.

It also makes venture capital type investment in renewable energy, or clean tech, projects less attractive, he said. Indeed, commitments to clean tech managers have been falling and managers have been spending existing commitments. n