December 2, 2001, was a day of infamy for thousands of people. On that date Enron declared bankruptcy, trading at a paltry $.26 per share after topping the scales at more than $90 per share a few months earlier.
That is also the time that Midland entrepreneur Tripp Wommack sees as the beginning of prime time for private equity.
Many people confuse private equity with venture capital, so here is the difference: The word “venture” shows that VC is about funding a new venture—a startup. Private Equity, on the other hand, involves money, or equity, being injected into an existing enterprise. While they are both about outside money boosting a business, they usually come in at different points.
“I’d day that the PE era began in earnest when EnCAP and Natural Gas Partners became really large, successful, dominant energy private equity firms,” said Wommack. “A lot of the Enron people ended up at NGP and EnCAP.” Both of the latter are still around and deeply involved in the oil and gas marketplace.
Since 2010, with oil prices rebounding from the $150 per barrel of 2008 and the short bust that followed, “you’ve seen a proliferation of every size of equity fund.” Funds often specialize in one area: upstream, midstream, or service companies.
PE funding drove the land rush over the last 10-15 years wherein Permian players could form new companies and buy up acreage. But that rush has not panned out as expected for many of the funds, as returns have languished. “They [PE firms investing in oil and gas] look to generate in the 30 percent-plus rate of return,” said Wommack. The challenge is that “Many of them achieved it for a long, long time. People observed that and said, ‘We’ll start an equity fund [also].’”
By that time, however, the market became flooded. “And because of that, the rates of return would stretch—people would take a little more risk or a lower rate of return,” he observed.
Just as a glut of oil itself drops prices and reduces investment, this glut of investment cash has begun to create a self-correcting scenario, said Wommack, in which fewer dollars are flowing into the Permian. “It hasn’t been performing as well.”
Because mergers and acquisitions (M&A) are often driven by PE money, that activity also has slowed to a crawl.
“It used to be so abundant. All these companies that popped up, that bought all this acreage—some of it no good—they’re figuring that out now,” he said.
Mistakes were made in other ways as well—almost anyone professing knowledge could get PE money and start an oil company, Wommack said, during the boom. “Now, no one can.”
There has also been a paradigm shift in the endgame for PE and even publicly traded companies. Growth at any cost has been replaced by a “live within your means” mantra.
“In the old days, as long as you were growing production and adding acreage to grow production, that was okay,” said Wommack. “The thought being, ‘down the road we’ll be really profitable.’” But patience for profitability has run out, and investors are looking for black ink.
“The formula used to be, I’m going to back you, I’m going to give you more equity [for an existing company], you’re going to take that and you’re going to build up production, and then we’re going to sell it—and then we’ll make three-to-one in five years,” he explained.
In reality, the three-year plan was never realistic and now, with M&A markets dead, many firms are stuck with unsellable assets. So instead of selling for a profit, PE backers need the asset to stop spending and start showing a profit now.
He recalled one time when the three-year formula did work, for an E&P he backed, along with “family and friends.”
Wommack sold the company in 2008, when oil was $150 per barrel and right before the the bottom dropped out, a case of very fortunate timing. “At the time we sold, there were a lot of private equity-backed companies,” he said. One of those bought the company from Wommack and associates.
The focus on making money instead of expansion is one reason for recent rig count drops, even after pipeline constraints have begun to be relieved. The thinking is, “Don’t go drill that $12 million well—keep your $12 million, make money, don’t dip into your cash, don’t go borrow more money, live within your means.” Even a good well will take a while to pay out, and investors prefer for existing wells to be paid for first, instead of extending credit out further.
The elephant in the room with PE is the issue of control of the company. A Dan Fogelberg song once said, “It’s never easy and it’s never clear / Who’s to navigate and who’s to steer,” and there can be a tug-of-war in PE situations. Wommack noted that entrepreneurs are usually visionaries with long-term goals that involve more than just making money today—whereas PE companies are usually more focused on short-term profits—two goals that often conflict.
“The attraction is, if you get a private equity partner, your capital is pretty much unlimited,” Wommack said. “You can get $50 million or $100 million or $200 million, and you don’t have to borrow. And you can avoid leverage.” Ironically, however, many PE firms encourage traditional borrowing in order to drive up the rates of return. When the investor is seeking 30 percent returns and the cost of bank borrowing is 10 percent or less, that’s considered cheap money.
But, in most cases, the entrepreneur loses much control of the company, although some PE firms are easier to work with than others, according to Wommack, who has worked with private equity several times on startups in E&P, service, and disposal endeavors.
Another challenge is the “Purgatory Economy” of $50-$55 per barrel. It’s not hell, like $30, nor heaven, like $70—and “It’s hard to make much money. No one is just killing it at $55 oil, regardless of what they tell you.”
That is not only true for E&Ps. Service companies are also struggling.
Even at the higher reaches of $65 per barrel, heights that were reached earlier in 2019—“At that point in any past cycle, service companies could go to the E&P companies and raise rates. In this past cycle, that has not happened because the equity firms and the public markets are saying [to the E&Ps], ‘Live within your means.’ And one of the ways they can live within their means” is to hold the line on expenses, including service rates.
The alternate version of the Golden Rule has been, “Whoever has the gold makes the rules,” but it’s not that simple. Without gold, even if it’s someone else’s, growth may stagnate and opportunities may quickly sail out of reach. And with gold from someone else, opportunities flow in but the rewards are shared.
Which is better? There is no single right answer. But most oilfield companies of all sorts stand at that fork in the road at some point, and they must consider the alternate destinations and the costs to get either place before deciding which road to choose.
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By Paul Wiseman