Tailwater Capital

Oil and Gas Make Renewables Green with Envy

Massive stimulus, in the amount of $400bn, has given the renewable energy movement a spark, but energy transition is challenged as inflationary pressures have brought investors back to oil and gas.

by Obey Martin Manayati, Private Equity International

The Inflation Reductiopn Act (IRA), signed in August after protracted on-again, off-again talks in Congress, threw a lifeline to the renewable-energy movement. “Everything just changed in the last six weeks in the US because the government put in place a $400 billion stimulus targeting renewables,” says Doug Kimmelman, founder and senior partner at Energy Capital Partners, one of the biggest investors in renewable assets in North America.

Most PE investors described the act as a gamechanger for the renewables sector. Highlights include an expansion of tax credits; bonuses for domestically manufactured equipment and for providers of renewable energy targeting lower-income areas; allowing tax credits to be transferable; and tax credits for newer technology such as battery storage.
Although renewables have benefited from government-pioneereid incentives, Kimmelman says, “we have never had stimulus anything closde to this size.”

Despite the mammoth IRA bill, renewable energy, the streategy du jour among many investors and limited partners, could have a tougher road aheand as investors fend off the impact of rising inflation and high interest rates.

To add to the complexity of the situation, the tight macroeconomic environment, alongside geopolitical tensions, is creating rare opportunities on the traditional side. Oil and gas private equity investors are seeing a resurgence as the rising price of gas – driven by the Russian invasion of Ukraine – has changed the equation for the sector, which has seen underinvestment for over a decade.

“This is our 25th year in business and the last time we saw opportunities with the same kind of risk-adjusted returns were back in the late 1990s or 2001,” says Wil VanLoh, founder an CEO of Quantum Energy Partners.

These forces are working in tandem to create what could be historic opportunities for energy PE investors, on both sides of the segment.  While traditional energy investors are looking for ways to cash in on the upheaval, those supporting the energy transition may have to tread lightly in a tougher environment.  Where it all plays out will determine which firms will lead the strategy in the future.

“Volatility is our friend”

“I don’ think institutions will ever invest in upstream [oil and gas exploration and production] private equity energy like they did 10 years ago, but some have back selectively with certain relationships that they have recapitalized with new money,” says Brent Burnett, Hamilton Lane’s managing director and global head of real assets.

PE energy dealflow in the US has been falling steadily in recent years, declining from around $78 billion in 2017 to around $33 billion year-to-date, as of June, according to data from PitchBook. This year’s deal count of 136 so far is also well below even last year’s, which tallied at 252 with about $42 billion of value, PitchBook says.

Alongside the fall in dealmaking is fundraising, which has also dried up in the sector.

But those numbers look to be turning a corner. Energy investors appear poised to take advantage of the macro situation, sources say. Recent large deals in the traditional sector include Kimmeridge-backed Sitio Royalties’ deal with Brigham Minerals worth $4.8 billion and EQT’s $5.2 billion purchase of the Quantum Energy Partners-backed partnership of Tug Hill and XcL Midstream, which operates gas assets. In addition, there has been a flurry of smaller transactions.

In July, the newly minted Vecino Energy Partners, with a goal to invest in the traditional energy space, secured an equity commitment of $200 million from EnCap Flatrock Midstream.

“There has been macroeconomic tailwinds that have, from a certain perspective, made the economics of investing in energy very attractive,” says Carlos Ulises Flores, a managing director of Eaton Partners, adding, “from the perspective of capital raising, we have seen limited partners coming back into the market.”

Ben Dell, Kimmeridge’s co-founder and managing partner, describes the uncertain macroeconomic environment as friendly to his oil investments. Kimmeridge has been active this year on the deal front with transactions such as the Desert Peak Minerals, DJ Basin and most recently the $4.8 billion Sitio Royalties deal.

“It doesn’t affect how we are investing per se, as we capitalize on volatility: it creates opportunities, and we are willing to put capital to work through the cycles. Volatility per se is probably our friend,” Dell says, describing the current environment as a replica of the 1999 to 2003 era of interest rates rises, triggering a recession.

“We had a recession in 2001-02, oil demand didn’t go down and we had no supply response. As a result, we then got into a multi-year bull cycle in energy, and I think we are setting up the same way directionally,” Dell says.

Since 2014, oil prices dipped to an especially low level, weeding out a host of energy PE investors, leaving a handful of experienced players. Quantum Energy, for example, is in the market raising its eighth fund targeting $4.5 billion.

Although describing traditional energy as “the biggest bright spot in terms of where return opportunity exists,” VanLoh says many traditional energy firms have had some challenging years, making it tough to raise capital because of their impaired track records.

“If you were to put an oil and gas project today next to a wind and solar project with current prices for capital, your oil and gas project is going to generate three to five times higher return than a wind or solar project,” VanLoh says.

“While a lot of capital has been raised for renewable, I do think that institutional investors are pretty suspicious of the return profiles or the deals that they are looking at,” he adds. For his firm, VanLoh says a majority of capital is flowing into traditional oil and gas and midstream space.

Investors step on the gas

Beside oil, natural gas, which is often touted as a bridge to the energy transition, has become more attractive as demand surges around the world, with valuations in this sector rising.

The midstream energy sector has also recovered from the lows of the pandemic shutdown, Riverstone’s partner and co-head of private equity Baran Tekkora says, citing a recent example of Riverstone’s $3.55 billion sale of Lucid Energy to Targa.

Adds Jason Downie, co-founder and managing partner at Tailwater Capital: “Even in this macroeconomic environment, we think natural gas is an easy opportunity.” As the world grapples with the squeezed liquid natural gas supply, Downie says the US has the capacity to support its allies with exported natural gas and provide them with a fuel source to counterbalance geopolitical risks, opening up more opportunities for investment.

“If we can make this a global goal – to take coal-fired power generation and replace it with natural gas – it can have a huge decarbonization impact, and it’s a very easy technology switch,” he says.

Jason Thomas, Carlyle managing director and head of global research, also sees a longer future in gas in solving energy problems. “The investment in gas as a transition fuel has certainly increased and I think people recognize that the expected returns in that sector are very high, whereas a year or two years ago, people might say, ‘Why would I invest in gas? It’s going to be obsolete in five years.’”

Gone is the thrill of the drill

There’s also been a shift in the strategic approach to investing in traditional energy. In the past, investors were heavily focused on growth opportunities involving upstream exploration and production, a strategy that was eventually undermined by crashing prices and diminishing returns. More recently, investors are looking for more established companies with predictable cash flows that can generate performance and increase distributions to LPs.

“Pre-covid, most companies were focused on growth and that was very capital intensive. However, in recent years, much of the industry has adopted a new business model that is focused on return of capital with responsible capital expenditures,” says Tekkora.

And for Downie, it’s all about returning cash to investors: “Higher prices traditionally meant more volumes, but today that is different – what we have seen is that higher prices mean more return of cash flow to investors and not necessarily more drilling.”

Carlyle’s Thomas says the divestment approach that was adopted by those against traditional energy has “actually been self-defeating, not only in terms of economic security or economic growth, but also just purely in terms of carbon emissions.”

In written responses, Warburg Pincus managing director Roy Ben-Dor says in today’s environment, patience is a key investment strategy. “As growth investors, we have the unique ability to be patient, spending years developing a thesis, canvassing assets and ultimately partnering with strong entrepreneurial teams that have real impact.”

Having it both ways

The choice in the energy sector doesn’t have to be either/or, as many firms are investing in both traditional and renewable energy. This is being spurred on by government stimulus, including the IRA, as well as changing consumer preferences.

Big PE firms are fundraising record amounts targeting the renewable space. These include Brookfield Asset Management, which this year closed its $15 billion Brookfield Global Transition Fund, and TPG, which closed its $7.3 billion TPG Rise Climate Fund. In addition, Blackstone has since 2019 invested approximately $16 billion in projects that are aimed at energy transition.

Earlier this year, Blackstone announced it is planning to deploy $100 billion firmwide in the renewables space in the next decade.

Some PE firms are dialing back on investing in fossil fuels under pressure from LPs and widespread ESG concerns. But for some, even though they are investing in both traditional energy and renewable energy, it is hydrocarbons that have carried the day with more attractive returns this year.

“We don’t try to force money into oil and gas or try to force money into wind or solar. What we do is to look for good returns and good teams. Because of that, the vast majority of our capital, probably a little over 80 percent, has gone into the traditional oil and gas and midstream space,” VanLoh says.

A major concern for those involved in the energy transition are high costs, both from the inflationary environment and supply-chain dislocation, which is driving up costs of developing new projects. However, investors in the space remain upbeat, in part because they believe the energy transition represents an almost inevitable, long-term trend.

“I think the opportunity for investors in renewable energy is better now than it’s been at any point in the last decade,” says Sandbrook partner and co-founder Alfredo Marti.

“If you think about investments in renewable energy, wind and solar generation for example, those are sectors where all the investment goes in upfront, but then once the assets are built, there are no feedstock costs and you barely have any [operating expenses]. So you’re left with a stream of revenue, which unless locked contractually, it is pretty well correlated with inflation.”

As the energy transition accelerates, there will be strong demand for midstream infrastructure that is environmentally progressive and reduces carbon footprint, Riverstone’s Tekkora says.

“Likewise, much of that midstream infrastructure can and will be repurposed for the energy transition,” he says, giving the example of International-Matex Tank Terminals (IMTT), based in New Orleans, which is focused on both traditional energy and decarbonization products. Riverstone acquired IMTT, an operator of 19 terminals in the US and Canada, in 2020 from Macquarie Infrastructure Corporation for $2.68 billion.

Recently, IMTT announced that it is building additional tanks, pipeline and dock infrastructure at its Geismar, Louisiana marine terminal to handle renewable feedstocks and renewable products such as renewable diesel and biodiesel.

Valuations are high, so “you really have to believe in that growth story or else you are at risk of paying some very high prices on assets that may not materialize,” Burnett says.

To protect their margins, investors like Sandbrook Partners are more focused on inflation protection and on more sophisticated portfolios of contracts designed to capture the upside of the market. For example, these investors prefer shorter contracts, says Alfredo Marti.

“There was so much capital going into building renewable energy projects to the point that the utilities and other buyers were in a very favorable position,” he explains. “Those contracts therefore became very favorable to those buyers. As a result, prices were low and there was generally no inflation indexation. The owners of the generation were committing themselves to sell that power at a relatively low flat price for 15 to 20 years.”

Overall, Eaton Partners’ Flores says renewables have a favorable time factor on their side: “We do see that the trend on the renewable side is less affected versus other forms of energy investment especially in the private market. The reason being that investors have recommended that this trend will continue over the next 10, 20 to 30 years.”

Supply-chain pain

Supply-chain dislocation adds pressure to renewables as most of the components used for solar and wind production are imported. In some instances, this has slowed down the pace of development of new assets. “There is a real risk that companies may not be able to build as much as they want to because they cannot get sufficient equipment such as turbines, cranes, installation vessels,” Marti says.

As a result, some firms are investing in companies that build those components. “Within the renewable power sector, we have shifted our focus from owning megawatts of solar and wind to investments we believe have a higher return potential in developing battery storage and investing in companies that provide critical services and equipment needed to build renewable generation,” says David Foley, global head of Blackstone Energy Partners.

Blackstone made a $500 million investment in Array Technologies, an Albuquerque, New Mexico-based manufacturer of utility-scale solar technology.

The US is energy independent relative to hydrocarbons, says Quantum’s VanLoh, but not when it comes to renewables. “If we don’t make sure that we onshore those supply chains by bringing back the mining to North America, bring back the refining capacity for all those key mineral inputs and manufacturing capacity to make wind turbines, solar panels and batteries, the energy independence we have today is going to go away over the next decade,” he says.

(This has been corrected to reflect that Blackstone’s $100 billion commitment in the renewables space is firmwide, not just on one platform. -Ed)

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