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| Risk & Reward |
Crude Investments
Eileen Gunn
11/01/2004
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Energy has been in the news quite a bit over the past few years,” observes
Wil VanLoh, cofounder of Quantum Energy Partners, an energy private equity firm
in Houston. “Brownouts in California, last year’s blackout in the Northeast,
high heating prices in winter, rising prices at the gas pump. It’s all brought a
lot of attention to oil company profits.”
The price of crude oil has
garnered its share of attention as well. Driven by rising global demand, aging
supplies and uncertain global politics, oil prices continue their upward
trajectory. Late this summer, crude futures for September delivery hit $44.15 a
barrel, the first finish above $44 since investors started trading these
contracts on the New York Mercantile Exchange in 1983. Meanwhile, natural gas
has reached new highs, topping $6 per million British thermal units through the
spring and summer.
It is no wonder then, that VanLoh and others in his field
are now hearing from many would-be investors. While data on this small corner of
the private equity world is hard to come by, VanLoh estimates that there has
been more capital raised in the past three years than in the prior 10. New
private equity funds that focus on small oil and natural gas companies are
springing up daily, while existing funds are getting bigger. Quantum, for
example, raised its first $100 million fund in 1998. Its most recent fund closed
in March with $345 million. “We were oversubscribed by a factor of two,” VanLoh
says.
TOP VIEW
As crude oil prices climb due to rising demand and geopolitical instability,
private equity stakes in gas-and oil-related companies offer an increasingly attractive investment opportunity. Though committing our assets to an industry
that historically lives by boom and bust can be risky, we can reap impressive,
if inconsistent, returns by seeking out companies positioned for the long term.
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These private equity firms put most of their money to work in small
oil and gas drilling ventures—called E&P (exploration and production)
companies—though some also mix in pipeline companies and oil-related service and
technology businesses. These smaller E&P companies are leaner and can make
money on a smaller reserve than the big guys can, says Christopher Edmonds, the
director of research at Pritchard Capital Partners, an investment firm in
Atlanta that specializes in energy. “They’re usually trying to take advantage of
an edge they have in technology or a particular interpretation of the geology in
a place they know well,” he explains. This gives impetus to drill fields where
the oil reserves had been too uncertain or inaccessible to pursue.
Private
equity firms, such as Quantum, Natural Gas Partners in Dallas and Lime Rock
Partners in Westport, Conn., invest $15 million to $50 million in a portfolio
company which, in turn, buys oil and gas properties from others and tries to
lower their drilling costs. For example, one of Quantum’s companies recently
bought a property from Chevron that produces about 2,000 barrels of oil a day.
“That’s a rounding error to Chevron,” VanLoh notes. “But it was costing Chevron
$18 million a year to operate it. Our guys got those costs down to $6 million,
so that’s $12 million of improved cash flow right away.”
The investors also
hope their companies will locate more oil or gas than had been identified, or
proven, at the time they bought the property (the real estate prices are based
on proven reserves). After three to five years, the companies go public or merge
with a larger company that is willing to pay for the increased cash flow they
got out of their wells. “For any given well, it costs the same amount to get the
oil out of the ground when it’s selling for $25 a barrel as it does when it’s
selling for $40,” notes John Allen, a senior financial advisor with Merrill
Lynch in Sacramento. “So oil is hot right now. If people can find it and produce
it, they’re getting paid well for it.”
Boom And Bust
According to VanLoh, the investments Quantum made in the
last three years have been the company’s best performers to date, a claim echoed
by many in the energy equity arena these days. Yet despite such glowing reports,
fund managers and, to some extent analysts and observers, advise against
investing in oil and gas as a short-term flirtation with current high
prices—particularly when the funds themselves have 10-year life spans. Energy
companies and their investors have learned from the boom and bust cycles of the
1970s and early 1980s, Edmunds says, when wildcatters and bigger companies alike
would “chase high prices, overexplore and overdrill, then go under when prices
went bust.”
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