Energy investing: Keeping Asia’s lights on

Private equity firm are increasingly comfortable getting natural resources the hard way. Last week, Warburg Pincus made its sixth investment in the Gulf of Mexico, heading up a group that committed $1.1 billion to Venari Resources, a Texas-based oil-and-gas exploration start-up. It specializes in deep-water drilling, a risky but lucrative business with no more than two wells delivering the goods for every four sunk. A few days later, a consortium led by Apollo Global Management acquired EP Energy, an unconventional resources explorer with a strong line in shale gas, for $7.15 billion.

These deals are in many respects born of technology. The pockets of oil and gas that Venari is chasing lie beneath many layers of salt and their location couldn't have been accurately identified without the assistance of seismic imaging. North American shale gas, meanwhile, has become commercially viable thanks to the development of hydraulic fracturing and horizontal drilling technologies.

For private equity in particular, better information is aligned with boldness. A clutch of players in North America - buyout firms with broad expertise as well as smaller specialists - now have more than a decade of exposure to real energy assets, and investments have performed favorably against their counterparts in the alternatives class. These firms are not venturing into the unknown (in most cases, oil majors are already present) but they are willing to go further than before.

"When you go into a new basin, there can be many years between origination and prosperity, which is a problem for private equity, but there are now emerging basins that have moved along the delineation curve and you can enter later in the cycle," says Jonathan Farber, co-founder and managing director of Lime Rock Partners. "The size of private equity funds has also grown to the point where new energy-focused vehicles are going out and raising $1 billion or more. That's what you need to do exploration."

The Asia angle

The Venari and EP Energy deals have something else in common: Asian investors. Singapore's Temasek Holdings is part of the Warburg Pincus group, while Korea National Oil Corp. is among those who joined forces with Apollo.

The link between growing Asian demand for natural resources, current commodities prices and the future commercial viability of global exploration and development projects is there for all to see. The region's national oil companies (NOCs), as well as a growing number of government-linked groups such as sovereign wealth funds, are entering the asset class, but few Asian GPs are following suit.

In addition to the longer investment horizons traditionally associated with natural resources, many firms are uncomfortable operating beyond the realm of their expertise - in terms of industry and geography. Early movers in Indonesian PE profited from direct investments in mining and oil and gas; ancillary services to the natural resources sector remain a compelling play across the region. There is little evidence, however, of Asian private equity moving further afield to marry regional demand with global resources.

"Based on known reserves today, Asia doesn't have sufficient resources to meet its current and projected demand. As a result, the trend for sourcing investment opportunities in geographies that are further afield will continue," says Jason Cheng, co-founder and managing partner at Hong Kong-based Kerogen Capital. "Chinese private equity that is able to invest overseas has been increasingly drawn to this thesis, but it is still relatively nascent."

Kerogen might be described as the exception to the rule. Set up by former executives from J.P. Morgan's Asia energy and natural resources team who subsequently moved to Indonesia's Ancora Capital, the firm is nearing a final close on its debut fund of $1.5 billion. Its first two investments - drilling company AJ Lucas, which has exposure to European shale gas, and sub-Saharan Africa oil specialist NewAge - clearly represent assets and geographies that are of strategic importance to China. Kerogen has a strategic alliance with China National Offshore Oil Corp. (CNOOC) and is targeting a 3x return on its investments.

Several other regional private equity firms are bulking up their sector expertise, including RRJ Capital, a Singapore-based firm set up by Richard Ong, formerly of Hopu Investment Management. The firm already has something to show for its efforts, committing $485 million earlier this month to a liquefied natural gas (LNG) processing and export project operated by US firm Cheniere Energy. RRJ has also backed Frach Tech Holdings, which supplies pumping equipment to the US oil and gas industry.

Temasek invested alongside the private equity firm in each of these deals, while Korea Gas Corp. has agreed to buy from the Cheniere project.

Growing exposure

According to Lorna Chen, a partner at Shearman & Sterling in Hong Kong, Asian exposure to global oil and gas and mining assets may be far greater than the numbers suggest. Many participants are aware of the political ramifications of their investments in natural resources and so operate below the radar. Rather than making direct investments in companies, these investors participate in co-investment structures that place additional corporate layers in between themselves and the assets. These co-investment structures resemble a standard private equity arrangement in that the LPs are passive investors, relying on the GP to carry out due diligence and manage the asset.

"It's a smart way of doing it because certain government-backed entities might be seen as representative of the country itself, and there are sensitivities about China, for example, buying natural resources around the world," Chen says. "These partnership structures are also very flexible in terms of raising money on a deal-by-deal basis, which is useful in large-scale natural resources projects."

The NOCs are not so secretive and a quick glance at outbound investments by the Chinese oil majors offers a clear picture of wider acquisition strategies. In the last few years, CNOOC, China National Petroleum Corp, China Petroleum and Chemical Corp. and Sinochem Corp. have targeted emerging basins in the former Soviet Union, Africa and South America, as well as unconventional assets - oil sands, shale oil and coal seam gas - in North America and Australia.

Kerogen invests with one eye on potential exits to these companies or their regional counterparts. "Energy security is increasingly a driver for many Asian NOCs and from an early stage our team has been involved in advising them on their investment strategies," says Cheng. "As a result, we believe we have a solid understanding of the strategic, commercial, operational and financial drivers influencing many of the decisions."

Energy-focused GPs from North America admit that they don't think of Asia specifically when making energy investments because demand patterns are more of a macroeconomic issue - if commodity prices rise, investors will benefit regardless of the principal drivers. However, there are two PE poster children for upstream deals in emerging basins: Kosmos Energy, a West Africa-focused oil producer backed by The Blackstone Group and Warburg Pincus, which completed a $594 million IPO in May 2011; and Cobalt Energy, a company created by Goldman Sachs, Riverstone and The Carlyle Group that has interests in the Gulf of Mexico and Africa, and raised $850 million when it went public in 2009.

Established energy investors note that there is tendency to become preoccupied with the few winners and forget the many losers. Upstream development involves a number of factors over which the GP only has so much control, particularly political risk, availability of infrastructure, and geological surprises and the impact these have on the cost of services.

"Investments in the midstream and power generation sectors tend not to be as risky as upstream because they are typically supported by contracts with creditworthy counterparties," says Lucius Taylor, vice president at ArcLight, a US-based GP that invests in assets across the energy sector. "In upstream transactions, the equity is invested in drilling wells and the results depend on whether they produce what you expect, the cost to complete them and commodity prices, none of which are easily controlled. It is more volatile, so one tends to seek much higher returns to compensate for the risk."

Allaying upstream concerns

There are several ways to minimize this risk. A number of US private equity firms stick to geographies with which they are familiar, principally onshore and offshore North American basins. There is often a reluctance to enter OECD member countries because of less certainty over legal and regulatory structures.

The approach advocated by Kerogen and Standard Chartered Private Equity (SCPE) among others is to avoid early-stage assets more suited to venture capital investors, where the historical average for exploratory success is around 10%. Instead, they focus on companies that have already discovered reserves and require additional capital to develop them. This might be an emerging shale player that has acquired assets and is in the process of running tests and drilling initial wells.

The capital commitment might be no more than $150 million, well below the threshold for NOCs but within the range of a $1 billion private equity fund. Co-investors are often brought in to provide further funds as the asset is developed. "There is generally more alpha to be captured in taking assets up the development curve than in acquiring stable producing assets which by definition tend to be more exposed to beta," Cheng adds.

Finally - and this is common to all energy-focused PE players, regardless of their particular targets - risk is reduced by backing management teams with which the GP is familiar. First Reserve's track record in Asia is a prime example. Its first investment in the region, Australia's Whitehaven Coal, came through a company called AMCI Capital. Two executives who spun out from AMCI then introduced the private equity firm to its next portfolio company in the country, mining services provider Calibre Global.

It was a similar process with KrisEnergy, a Southeast Asia-focused oil and gas exploration and development player that First Reserve acquired for $500 million in 2009. The team behind KrisEnergy had previously set up Pearl Energy under exactly the same business plan and the company went on to list in Singapore. The founders exited in 2008, selling to Abu Dhabi sovereign investor Mubadala, which beat First Reserve to the deal.

"When we wanted to start KrisEnergy, we went to people who had made money from Pearl or missed out on making money from it. First Reserve was in the latter category," says Richard Lorentz, the company's business development director. "They knew our business plan and they knew us. We went from initial contact in March 2009 to agreeing a deal structure within a couple of months."

Long-term gains

The benefits of familiarity with management are also felt long after the ink has dried on the contract. Operating upstream oil and gas assets requires rapid decision-making based on updates concerning the performance of different wells. Ultimately, private equity investors in control positions must pass judgment on the commercial viability of an asset: Do you stick and put in more capital, or twist and move on to something else?

"You want a management team capable of making decisions because you can't spend all your time at the asset itself," says ArcLight's Taylor. "You are constantly trying to replace or increase reserves, which requires more drilling and acquisitions, which can be a very time intensive decision making process."

An investment in a start-up or early-stage oil and gas company is also an investment in the management team's ability to acquire assets in a particular geography. In addition to geological expertise, this requires a network of relationships with local governments, regulators and other operators that takes years to construct. It is no coincidence that the founders of many independent developers globally have previously served as senior regional executives for the oil majors.

KrisEnergy has been around for two-and-a-half years, during which time it has built up a portfolio of 14 exploration licenses covering Vietnam, Cambodia, Thailand and Indonesia. Given that tender and bidding processes in Southeast Asia can last 1-2 years alone, the company believes it has made rapid progress. It puts this down to the management team's long experience in the region.

"In general industrial sectors, we can manage our investments and bring in consultants if needed, but for oil and gas and mining, dedicated expertise is required," says Alastair Morrison, co-global head of SCPE. Natural resources is Standard Chartered Bank's single largest sector globally and it has considerable experience in areas such as reserve-based lending, but SCPE recently hired an executive with a natural resources background from the industry in order to provide technical expertise and assess investment opportunities.

Morrison adds that it would be difficult to function without people on the ground in the relevant geographies. He cites Nigeria, where SCPE has made an onshore gas investment, as an example. "Local knowledge is vital. There is one state that you wouldn't enter without a flak jacket, but two states down, it's fine for a guy like me to drive around in a jeep. You also know which state governors you can do business with."

Diversification challenges

The challenges of assimilating to a variety of different operating conditions mean that relatively few private equity firms can operate effectively in multiple geographies. Discount the global firms that have considerable resources at their disposal, and most investors struggle to achieve operational excellence across more than two basins.

This explains the differing perceptions of where the major opportunities lie for private equity. Convincing cases can be made for deepwater exploration (taking advantage of new technologies in seismic imaging and remote operations), North American natural gas (leveraging the multiple arbitrage created by US LNG prices that are one fifth of global rates), European shale (less developed than in North America but full of potential) and emerging basins in non-OECD countries. Executing strategies, however, relies on recruiting people with capabilities in particular areas.
For all the interest that Asian private equity firms have shown in oil and gas, the vast majority are still in the process of building up their expertise.

"I have been approached by a plethora of private equity firms with an appetite to explore the water and stick a toe in oil and gas," says KrisEnergy's Lorentz. "A major reason for this is oil prices above $100 per barrel, but this has also generated a lot of competition. The environment has become increasingly difficult in the last 2-3 years: If you start out now with a pile of money and a blank sheet of paper, you might struggle."

SIDEBAR: Energy by numbers - The rise of Asia

Emerging Asian demand is the dominant energy theme of the past 10 years. The resources required by the likes of China and India to fuel rapid economic growth have sent commodities prices to record highs and seen major exporters reap massive windfalls. The rise of mineral-rich Western Australia alone is testament to the power of this theme.

In terms of oil and gas, China attracts the most attention, as its national oil companies (NOC) pursue assets in the former Soviet Union, Africa and South America, often engaging in government-to-government oil-for-loans transactions. China's oil demand is a significant factor on its own - its share of global demand is expected to reach 15.5% in 2035 from 10.5% in 2010, with imports likely to double to 12.9 million barrels per day - but non-OECD Asia is equally important.

That group of nations imported 16.3 million barrels of oil per day in 2009; by 2035 it will be 30 million, according to the International Energy Agency (IEA). A more recent trend is an increasing appetite for alternative energy assets such as oil sands, shale-based gas and coal seam gas to complement conventional reserves.

"When you look at the OECD nations, there will never be growth in oil demand at this point. We are also discovering ways of producing liquidity using horizontal drilling and fracking [hydraulic fracturing], which will increase oil and gas output," says Jonathan Farber, co-founder and managing director of US-based private equity firm Lime Rock Partners. "Consider long-term demand for oil and gas without Asian demand and it's a pretty barren scenario."

Led by NOCs from China, Korea and Thailand, outbound oil and gas acquisitions in Asia Pacific reached $46.1 billion in 2011, up from just $12.5 billion five years ago, according to Thomson Reuters.

While private equity accounts for a tiny part of global M&A in the sector, up until the global financial crisis, fund sizes were increasing. First Reserve's 2007-2008 vintage fund came to $12 billion, $4.2 billion more than the previous vehicle, while Riverstone saw its fund size more than double to $10 billion over the two periods.

For 2008, Preqin has records of final closes by 20 vehicles with a significant focus on energy (excluding cleantech) raising a total of $13.2 billion. This fell to $1.7 billion from five funds in 2011. With several of the global buyout firms - for whom the energy sector is a rich source of large-ticket transactions - looking to raise large funds for the first time since the financial crisis, investor interest is likely to increase.

Asia is still very much a poor relation of the US in terms of energy fundraising. Between 2008 and 2012, 28 US-based funds attracted capital commitments of $24.7 billion. In Europe it was just $1.9 billion, while the rest of the world - dominated by Asia - accounted for 13 funds and $4.9 billion.

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• Topics
• Industrials
• Infrastructure
• Expansion
• energy
• Commodities
• Asia
• China
• Kerogen Capital
• Warburg Pincus Asia
• First Reserve Corp
• Standard Chartered Private Equity
• RRJ Capital