Distress in the oil patch is spurring a new type of joint venture

Joint ventures between oil and gas explorers in the U.S. and their foreign counterparts helped fuel the shale boom. They’re coming back in a new iteration for the bust.

The difference this time: Shale explorers are partnering with Wall Street financiers to raise money for drilling, instead of overseas rivals.

Typically, private equity firms invest in energy by buying entire companies or providing capital to startups. Last year, U.S. oil and gas companies struck a half-dozen joint venture deals with private equity firms totaling at least $1.4 billion. In December, an affiliate of Fortress Investment Group agreed to provide National Fuel Gas Co. with as much as $380 million to fund wells in Pennsylvania, while Blackstone Group LP’s credit arm closed a similar deal in July with Linn Energy LLC.

Such transactions could accelerate this year as explorers face a cash crunch amid a rout in commodity prices. They are essentially a source of off-balance sheet financing for producers with good land but less than stellar credit. The way they are structured makes such deals akin to a homeowner renting out a room to keep the lights on.

“It’s tough times in the oil patch,” said Ron Gajdica, co-head of energy acquisitions and divestitures with Citigroup Inc. in Houston. “The traditional ways of raising money are not available.”

Temporary Stake

Joint ventures with private equity firms are fairly complex but have a simple premise. The investor pays for a certain number of new wells in exchange for a temporary majority stake in each well it funds. After booking a specified return, the financier surrenders most of its ownership interest back to the explorer.

They make sense right now because low commodity prices means producers are facing budget shortfalls, and they’re losing access to other types of funding.

U.S. crude fell 5.8 percent Monday to $30.34 a barrel. Last week, oil closed below $30 a barrel in New York for the first time in 12 years.

Bond sales by energy companies with less than prime credit fell 22 percent in 2015 to their lowest level in four years, according to data compiled by Bloomberg. Oil and gas explorers saw bank credit lines cut by an average of 5 percent in September and October, when lenders conduct one of their bi-annual reviews of loans outstanding to drillers. Analysts are forecasting even steeper cuts this spring if prices don’t rebound.

Drilling Costs

Private equity firms are also eager to invest in energy, and by some estimates have amassed as much as $100 billion in recent years for oil and gas deals.

“There is a lot of discussion,” said Michael Byrd, a partner with Akin Gump Strauss Hauer & Feld LLP in Houston. “I’m aware of one investor in this type of transaction that has looked at somewhere in the neighborhood of 200 of these transactions, but only closed on a handful of them.”

The last time explorers were so active in seeking a partner to cover drilling costs was about seven years ago during the U.S. shale boom, as Chesapeake Energy Corp. and Devon Energy Corp. established joint ventures with explorers from China and Europe. Many foreign companies booked losses on those deals after natural gas prices collapsed.

Protective Measures

The more recent pacts are designed to protect the private equity shops from that fate. So far, they have tended to be much smaller. The joint ventures are set up as temporary partnerships with a pay-as-you-go structure, and investors have oversight over where wells are drilled. The money also isn’t used to develop virgin prospects that may or may not pay off.

“The parties have a very good understanding of what type of production they can expect from the wells, what the wells are going to cost,” said Anthony Speier, a partner with Kirkland & Ellis in Houston. “These deals are usually focused on assets where the companies have proven that their completion technology works.”

The latest partnerships and earlier joint ventures are both innovations to the classic farmout deal — a company bringing in someone else to do some drilling because it can’t afford to — a staple of the energy sector for decades, Speier said. Buyout firms including KKR & Co. began developing the blueprint for the recent deals about three years ago to fund small, private companies with no access to the traditional debt and equity markets, he said.

The idea began catching on last year with larger explorers as their options for raising capital narrowed, he said.

Disappearing Runway

“A lot of companies are very quickly running out of runway,” Speier said.
EnerVest Ltd. may consider a drilling partnership when oil and gas prices eventually rebound and it ramps up production across its 33,000 wells in 17 states, according to John Walker, the Houston-based company’s chief executive officer.

Having a partner in some of these areas “would allow us to put a lot more rigs out there,” Walker said. “When prices go up, we’ll see more of them done.”

EnerVest negotiated a drilling partnership last year but tabled the discussions as energy prices slid and it decided to halt drilling everywhere, he said.

Sliding prices aren’t the only thing that can make drilling partnerships difficult to navigate.

Shale wells tend to dwindle over time after initially gushing. If it takes too long for the investor to make their money back, wells could be running dry by the time an explorer takes back ownership of them.

“The operator team is going to do a lot of work with little to show for it,” Citigroup’s Gajdica said. “Operators don’t want to be working for somebody else.”

The complexity of these partnerships also means they can take a long time to come together, and may fall apart before an agreement is signed given the volatile nature of commodity prices.

They make sense only in certain areas such as the best parts of the Permian and Eagle Ford Basins of Texas, or Marcellus Basin in the Eastern U.S. This is because investors are generally seeking returns of about 15 percent, so the wells have to be able to pay out far better than that.

“For it to be attractive, we need to be drilling wells at 25 percent to 30 percent,” EnerVest’s Walker said.

If oil and gas prices keep falling, explorers may not be able to find places to use the money they lined up. For instance, Linn Energy has yet to draw any of the $500 million that Blackstone Group’s credit arm agreed to provide in June. Last year, the company cut its capital expenditures program and halted a bond buyback program because of lower commodity prices, making it unlikely that Blackstone would make a sufficient return.

Also, a drilling partnership won’t necessarily stop a company from collapsing.
Magnum Hunter Resources Corp. struck a $430 million drilling finance about four months before filing for bankruptcy in December.

Despite all the challenges, some drilling partnerships announced last year seem to have worked out. ArcLight Capital Partners LLC paid out more than one-third of the $67 million it committed to Rex Energy Corp. as of September, according to company filings. That enabled Rex to grow production while cutting spending.

Legacy Reserves has drilled at least six wells in the Permian Basin with funding from a $150 million partnership it established in July with TPG, according to company presentations.

“While it’s too early to comment on production rates, we and TPG are pleased with our execution of the program,” Paul T. Horne, Legacy’s CEO, said on an earnings conference call in November.