An Evolving Energy Market – Unlocking the Investment Opportunity

Introduction

Easy access to affordable and reliable energy is integral to the modern world. Whether for industry, transportation, heating/cooling or simply turning on the lights and keeping our food fresh, readily available energy powers the global economy. Energy needs in the U.S. and around the world, especially in developing countries, are expected to climb dramatically in the coming years as millions of people in the rising middle class continue to consume more energy. In the industrialized world, the increased demand for energy has emerged in the form of a megatrend – the “electrification of everything,” which includes cars, industrial robots, and computing demand driven by the A.I. revolution. At the same time, how this demand for energy will be addressed is one of today’s pressing questions with important economic, political and social ramifications.

In the US, energy policy will likely be centered around energy independence and security. Perhaps unsurprisingly, fossil fuels seem destined to remain an important element regardless of the increasing market share taken by renewable energy sources. While renewable supply remains the largest source of energy to meet future demand growth, fossil fuels, led by oil and natural gas, continue to dominate existing demand. For example, forecasts looking at the overall mix of energy in 2050 indicate an increase in natural gas and oil supply. Despite enormous advances to reduce costs for renewable sources such as solar, they remain intermittently reliable compared to fossil fuels and not as easily scalable. Assuming fossil fuels – oil/petroleum, coal and natural gas – are not going away regardless of the administration in power, the question becomes which one, if any, has more investment potential and in which part of the market – upstream, midstream, downstream or niche.

Natural Gas – An Investment Opportunity

We believe certain energy-related private equity investments may be a profitable contrarian play for several reasons. This is particularly true for natural gas, which is the cleanest of the fossil fuels and has broad- based utility in homes, as a feedstock for the chemical industry, and as a fuel to meet growing power generation requirements. Most notably, on the back of surging demand in the U.S. and around the world, natural gas has become a transition fuel in the move away from coal. Unlike coal, which is dirty, natural gas is clean, cheap and plentiful, especially in the U.S. which has become a natural gas superpower and the largest producer in the world. In fact, the U.S. already exports significant amounts of natural gas and is set to export even more in the coming years as countries seek to secure reliable energy and new export terminals come online. Further, the supply backdrop is increasingly positive due to industry rationalization and a dearth of capital amidst periodic industry volatility over the past decade. These dynamics have both deterred many players from reentering the space and ensured the companies that remain are generally well managed, well capitalized and profitable. All told, we believe there is significantly more demand for capital than there is supply.

Since first upgrading our view on oil and natural gas companies at year-end 2023 (Private Markets & Hedge Fund Strategy Ratings – Q4 2023), iCapital has become increasingly positive, especially regarding natural gas given its broad-based demand drivers and prominent role as the transition fuel of choice. In fact, after bottoming in Q1 2024 the price of natural gas has more than doubled. Going forward, we believe oil and natural gas prices are likely to remain constructive, supported by a stable output regime, a domestic focus on energy production and meeting growing demand, and increased exports to Europe and Asia. Concurrently, however, there are also structural tailwinds that have been created by a capital mismatch. For example, following losses that occurred when the price of oil collapsed in the second half of 2014 through early 2016, banks dramatically pared back their lending to the sector.² Similarly, private equity investment declined after 2015 when major bankruptcies negatively impacted the industry.³ As a result, industry participants have been forced to focus on operational efficiency, effectively managing their balance sheets and maintaining profitability. Driving free cash flow through operational efficiencies is now a much more important focus.

Surviving companies have had to become more rational, capital wise and increasingly specialized. They have also become quick to right-size their portfolios by divesting underperforming or non-core assets. Among publicly traded energy companies, this trend is even more evident, as many investors are focused on earnings growth, e.g. new exploration and production (E&P). Finally, private equity firms that might have previously been potential purchasers have either scaled back or failed, leaving only a few private equity funds with an opportunistic focus.

Ways to Invest

There are a number of private market opportunities investors may be able to access. The most direct access to oil and natural gas exposure is through E&P investments in companies actively engaged in land acquisition and new drilling or exploration. E&P can be extremely volatile given the discovery risk, development risk, and commodity sensitivity associated with it, and will exhibit a higher volatility of outcomes – more akin to private equity. These companies are often the target of a dwindling number of highly specialized private equity firms which aim to generate high rates of return. Also, these companies often have high degrees of both execution and commodity risk because unlike companies with proven, drilled, and producing (PDP) wells which can more easily hedge production, there is inherent commodity risk and capital markets sensitivity.

Other private strategies include those further down the energy value chain – midstream and downstream investments. Each segment has its own unique mix of pros and cons but generally has a risk profile that is more akin to infrastructure investing. For example, if an investor is more risk averse, they might be interested in a midstream company providing transportation and storage services that generates steady returns, primarily through current income. Downstream investments may include power generation and Liquified Natural Gas facilities.

Finally, there are niche investments, some of which can come with attractive risk/return features. For example, there are numerous PDP wells currently held within large public oil and gas company portfolios. These wells often have drilling lives in excess of 30 years and in a diversified portfolio can produce considerable amounts of stable cash-flow. Market dynamics are such that these public companies are often rewarded (through higher stock prices) by delivered growth, versus holding low/no growth annuity streams, creating an incentive to divest these assets. There are specialist managers who seek to actively acquire and manage these wells, materially hedge the commodity price risk associated with them and at the same time isolate the long-term cash-flow streams. Strategies such as these may provide a lower-risk, less correlated exposure within the overall energy market.

One potential benefit across private energy investment is its tax treatment. For taxable investors, these strategies can often have tax advantages due to depreciation and/ or depletion offsets which can generate attractive after- tax yields. Importantly, these strategies can be more of an annuitized play on overall production rather than a significant bet on the direction of commodity prices.

Conclusion

Investors have often thought of an investment in oil and gas companies as speculative, one highly dependent on the price of the underlying commodity. While these opportunities still exist, in many instances an investor can find a range of high-quality companies which are no longer pure commodity plays. Volatility remains to be certain, and sentiment will continue to impact prices and access to capital, but energy exploration and production has become much more of a manufacturing process – disciplined, more mature with measured upside potential and increasingly well managed downside risk. A fund which invests in these companies may be worth considering for those investors with a desire to capture a potentially contrarian investment opportunity, especially in an environment in which the impact of the fracking technology revolution continues to be felt in the U.S. and globally in the form of cheap, abundant and relatively clean natural gas.