Energy and natural resources – The outlook for private equity and principal investment

by Daniel Cordell, Director, EMEA Debt & Equity

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  • Energy and natural resources – The outlook for private equity and principal investment
19 May 2020
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With Covid-19 creating so much uncertainty in deal markets, it is easy to assume that the outlook for investors in energy and natural resources assets for 2020 is dismal. Yet while the focus in the short term may be shifting away from typical investments and reallocating towards capturing the contango trade, it looks likely that those that have invested wisely over the past five years will continue to benefit from an upside by the end of this year.

Having spoken to a wide range of participants in the private equity and principal investment space, there is a widespread acceptance that the size of the market in terms of participants is going to shrink, as some investors shift further out of oil and gas towards renewables. But those trading houses and investors that survive the next three to six months with cash and liquidity intact will find plenty of opportunity on the other side.

Talking to Stephan Jansma and Matthieu Milandri at Trafigura, respectively Global Head of Structured Trade Finance and Head of Upstream Finance, there is much activity going on. They told me that in the short term: “There is considerable stress in the industry, even if that will take a few more weeks or months to turn into distressed financings or asset sales, if oil prices do not recover in the meantime. We are spending more of our time on potential financings for larger, higher-rated players in the industry, to enhance their liquidity.”

The pair are bullish on the outlook for deals later in the year: “We believe investment activity is likely to be driven by M&A, either from distressed sellers or large IOCs re-approaching the market for divestments that have been put on hold in H1. While the demand destruction is probably at its peak today, the assets have not fully suffered that stress, as they have been protected by local prices, hedging strategies or other mitigants. It is clear that tomorrow, better opportunities will present themselves. The skill is to know when tomorrow has arrived.”

Chris Newman, Managing Partner at alternative credit manager Audentia Global, says: “Right now, there are legacy investments in the market under considerable strain, as well as a growing opportunity set in terms of new investments coming to market. Depending on which bucket you are in, and your exposures, you could therefore have extremely different views – some investors will be in a very negative position while others will be very interested in buying distressed assets.”

Looking forward, he says: “From a new deployment phase, there are now many distressed assets with strong operational infrastructure and performance with potential to be reworked into very good investments.”

While there is currently little appetite for upstream, traders that have typically operated downstream or midstream now see far more appeal in upstream deals once this immediate crisis stage is over.

Christian Coulter, Managing Director (Principal Investment and Structured Finance) at Mercuria, told me: “Covid-19 has had the effect of temporarily shifting focus away from typical investments towards capturing the contango trade. Most potential upstream opportunities in the current environment are commonly predicated on some form of price recovery, even if just tracking the current forward curve. Why take specific upstream performance risk to capture much of the same investment thesis when you can just store the oil and sell it forward?”

Yet it is the short term nature of the contango opportunity has grabbed a lot of attention, and when it subsides Coulter predicts more of a focus on traditional upstream and energy transition-related opportunities.

He says: “The second half of the year will probably see more upstream opportunities if the market has recovered, probably taking the form of acquisition opportunities and balance sheet restructurings. I expect hedging over longer durations to play a more prominent role in the upstream sector going forward.”

Looking forward, Chris Newman, Managing Partner at alternative credit manager Audentia Global, says: “From a new deployment phase, there are now many distressed assets with strong operational infrastructure and performance with potential to be reworked into very good investments.”

Others agree that now is a good time for investors to look at the upstream sector. One managing director in the energy team at a global PE giant told me: “Pure upstream in the current market is tough, as are services industries. The opportunities are likely to come from restructurings or sales of non-core assets at valuations that may be fair on today’s views but will likely prove to be highly attractive as markets normalise into the medium to longer term.”

Private equity funds, despite sitting on a lot of dry powder, may bizarrely struggle to make large infrastructure investments at a time when equities remain very low, as certain investors will be underweight equities and overweight real assets. One industry source, a former Global Head of Oil at a large investment bank, suggests private equity investors might therefore have a diminished appetite for upstream assets at a time when good businesses are coming to market.

Low oil prices are having a big impact in the Middle East, where we have already seen a flurry of refinery and pipeline deals in the past year. While BlackRock, Carlyle and KKR were snapping up these deals, it looks likely that traders will eye an opportunity to operate a lot more of the value chain. We see traders now far keener to utilise their balance sheets to invest in assets that complement trading, and buying into assets solely for the value of those assets, given the exposure highlighted in the last couple of months to rapid oil price drops.

Private equity funds also continue to receive pressure from their investors around oil and are therefore shifting focus towards gas and LNG markets, as well as renewables. Many industry sources expect infrastructure capital to move towards renewables and telecoms and certainly LNG and the right energy transition investments remain attractive to all potential backers. Nevertheless, the age of traditional oil and gas is not yet dead and there is still a good decade of solid returns to be maximised.

Will competition hot up between the cash-rich and asset-heavy trading houses and traditional private equity firms chasing the same investments? Trafigura’s Jansma and Milandri think not: “We believe that PE firms and traders generally prefer to play at different levels of the capital structure,” they say. “Traders, although there will always be exceptions, have demonstrated a preference to deploy capital in the form of debt, which is actually complementary to what PE firms do. So, we believe we are likely to see more cooperation between PE firms and traders, as even the best deals may be more difficult to finance than before.”

Coulter, too, expects more cooperation than competition. “There are fewer and fewer players on the principal side and partnering on deals makes increasing sense,” he says. “Different parties can often bring unique skills or perspectives to a particular investment opportunity. I also believe trading houses have less appetite for being the sole owners of assets and see increased rationale for partnering with others.”

Larger energy infrastructure projects may have trouble getting finance, according to Newman. He told me: “Those projects are all out of banks more or less; regulatory change has almost moved this entirely out of the banking system. As a result, there simply is not the same technical expertise and risk appetite yet in the fund space to take on mandated lead arranger-type positions in these structures, and usually they must be syndicated to a large investor base. This could be a very challenged area of finance going forward, along with aviation finance, shipping finance and project finance, which have almost all been absorbed by default to larger funds even though that is not yet a natural place for them.”

He argues that independent credit providers outside of the banks are going to be increasingly in demand to fill the financing gap: “Given changes in bank regulation and its effects on funding, in the current market I would say the most interesting opportunities are working synthetically with banks and corporates in risk participations on physical commodity transactions. The structures of these are still quite attractive and operationally sound, for instance those within commodity trade and structured finance, and have institutional scale for investments.”

Stephan Jansma says, “It is clear that tomorrow, better opportunities will present themselves. The skill is to know when tomorrow has arrived.”

Audentia’s principal investment strategy is in physical commodity transactions, either via synthetic securitisation with banks or directly alongside corporates. This type of investment activity is growing strongly and the opportunities look set to grow exponentially.

Newman adds: “It is clear that devalued assets are going to become attractive as values reset, but the timing of this is deeply correlated to the unknown final effects of Covid-19 and the subsequent effects on global demands. Most likely it will be Q1 next year at the earliest before new opportunities will be monetised in this sector, with Q3 and Q4 I think a period of asset re-allocation within the fund sector.”

In the renewables space, others anticipate that competition will remain fierce. One global head of M&A at an oil and gas giant told me most commodity houses and private equity investors will struggle to compete with those investors that have a lower cost of capital, such as pension funds, infrastructure funds and utilities.

Much will come down to liquidity going forward, says Marie-Christine Olive, Head of Natural Resources Corporate Banking EMEA at Citi. “Investors are very focused on balance sheets, leverage, cash, liquidity and covenants,” she says. “Investors do not feel able to price companies appropriately at present – there are simply too many unknowns. They are still cautious in case they need to raise cash to fund potential redemptions, and there is a clear recognition that companies need to be prudent and manage for downside scenarios. Investors do expect more companies to defer or cancel previously announced dividend payments and there is a reasonable amount of sympathy for this.”

Those that have invested with adequate checks and balances over recent years now stand to benefit in the race to capitalise on distressed situations in energy upstream and midstream sectors. As one private equity source concludes: “The traditional energy sector is still facing headwinds but the demand fundamentals remain unchanged long term. It is essential to be disciplined in making investment decisions. Competition for capital allocation between renewable energy opportunities and traditional energy opportunities will undoubtedly increase and there will be a renewed focus on the risk/return profiles for both.”

Still, some see plenty of opportunity to seize deals. “If you can take a long term view, it is a good time to look at the upstream sector,” concludes one investor. “We are looking to areas that may be less competitive as other funds, such as infrastructure, retreat, or where we see a secular trend, such as LNG as a transportation fuel. Asia remains a growth area and we are always looking for opportunities to invest in the region.”

Most expect investment activity to ramp up towards the back end of this year as the market normalises, when the clear divergence between the winners and losers of the current crisis will emerge.

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