Managing Director | Scout Energy Partners
John Baschab is co-founder, manager of the General Partner, and member of the investment committee at Scout, a private energy investment manager established in 2011 in Dallas, Texas. The Scout strategy focuses on acquiring and operating mature producing assets in the contiguous United States, with $2.25 billion in assets under management across five funds. John is co-author of four books published by John Wiley & Sons, including Outperform: Inside the Investment Strategy of Billion Dollar Endowments (2010).
Founder & Managing Partner | Pearl Energy Investments
William J. Quinn is the founder and Managing Partner of Pearl Energy Investments. Prior to founding Pearl, Billy served as Managing Partner of Natural Gas Partners (NGP). On the investment side, he worked for Rainwater, Inc., Hicks, Muse, Tate and Furst, Inc., Bear Stearns & Co., and BT Securities Corporation. In addition to his investing activities, Billy serves as a guest lecturer on private equity investing at Stanford University’s Graduate School of Business and the Wharton School of the University of Pennsylvania. He also sits on the Wharton School Board of Overseers.
Chief Investment Officer, Head of Research, FEG
Greg Dowling is Chief Investment Officer and Head of Research at FEG. Greg joined FEG in 2004 and focuses on managing the day-to-day activities of the Research department. Greg chairs the Firm’s Investment Policy Committee, which approves all manager recommendations and provides oversight on strategic asset allocations and capital market assumptions. He also is a member of the firm’s Leadership Team and Risk Committee.
Greg Dowling (00:05):
Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG. This show spans global markets and institutional investments through conversations with some of the world's leading investment economic and philanthropic minds to provide insight on how institutional investors can survive and even thrive in the world of markets and finance. As we all stay home to do our part to flatten the curve, our current series, Dallas on Download highlights speakers who were originally going to be featured at our Dallas Investment Symposium that was canceled due to the coronavirus. This limited series will offer insights across a variety of asset classes and styles, including energy markets, credit markets, value investing, and biotech.
Greg Dowling (00:52):
Today, John Baschab from Scout Energy Partners and Billy Quinn from Pearl Energy are joining us on a podcast entitled "Death in the Oil Patch." All investors are facing the difficulties of navigating the uncertainty created by the coronavirus. If you thought it could not get any worse, well, energy investors are also dealing with the impact of a global price war. This has resulted in both a demand and a supply shock where only the strong will survive. We are going to attempt to strike the balance between providing content for both the energy novice and the energy veteran. But let's start with setting the table with some brief introductions. John, maybe a little background on yourself and Scout's strategy--your company--and what you do.
John Baschab (01:38):
Sure, Greg, thank you. And, of course, glad to be here. A little bit about Scout. Scout was established in 2009 and we raised our first institutional capital in 2011. We're now five funds in, and our strategy is different in the sense that we're interested in buying existing production and then try to do a good job managing them. So we're trying to enhance production where we can and make sure that we're doing a good job operating those assets and getting the best price that we can, and then taking the profits from that and distributing it to our investors in the form of distributions.
Greg Dowling (02:17):
Thanks, John. Billy, maybe a little background on yourself and also on Pearl. And maybe you can highlight how you are similar, but also how you are different than Scout.
Billy Quinn (02:28):
Yeah, sure. Again, like John said, thanks for having me, I really appreciate it. It' s a pleasure to join. Unfortunate that we have to do it by podcast and not in person, but this seems to be working out great for all of us. It's crazy how the world's adjusting. I'll start a little bit on my background and give you the abbreviated version. I started investing in the oil and gas business in late 1994 and was one of the managing partners at Natural Gas Partners for almost 20 years. I stepped down from there end of 2013. And then in 2015, I launched Pearl Energy Investments and we've been up and running for 5 years now. Two funds raised: a $500 million and a $600 million fund. Our primary strategy is backing great management teams in the energy business. And where it differs a little from John's, I would say half of our--if you broke our portfolio down, we're going to look like we're 80% E&P and 20% midstream.
Billy Quinn (03:25):
On the E&P side, we're going to be half conventional and half unconventional. And what that means... Of half the E&P, a lot of the types of assets that our companies buy will look a lot like what Scout does. It's acquisition exploitation, buying existing production, using modest leverage, and hedging. The other half of our E&P portfolio will be an unconventional--it's shale-oriented. Now, even with that, we like to think of the acquisition exploitation approach to shale, not lease and drill. Buying things that are primarily HBP with little drilling commitments, etc. So you're not on a clock. And then the other 20% of what we do is midstream. We have 2 midstream investments to date. So really I think the unconventional component and the midstream component are probably what differentiates us most.
Greg Dowling (04:23):
Hey, Billy, staying with you, what happened? We've had negative oil prices, I keep hearing we have no storage anywhere. Maybe for those novice investors who are more focused on the pandemic, what's gone on in the energy market?
Billy Quinn (04:37):
Look, I'd frame this by saying first, 2019 was not a great year for the energy business. When you look at what happened from the end of 2018 to the end of 2019, the rig count fell from 1100 to below 800. The capital markets were nonexistent. The business as a whole didn't feel good. When you look back historically, it wasn't a good year for the business results in the field. When you look at a lot of the shale companies--fewer locations, more issues drilling these shale wells with communication between wells, which many people expected, not all. The business as a whole had this real fog over it and the capital markets were gone, so it wasn't a great business to be in, despite oil averaging $57 in 2019.
Billy Quinn (05:28):
What's going on now though... I think going into 2020, the market was balanced. You remember, in mid-January, prices were up in the low $60s. There was the skirmish with Iran. Oil and demand were pretty much in balance. Right around that time was the inflection point where the skirmish ended and we were all realizing the impacts of oil demand in China, from their experience with COVID-19. So when I look at what's going on now, it's purely demand-driven, it's purely the pandemic. People like to talk about the Saudis and the Russians because it makes good headlines and story writing and it's great to gossip about. And sure there are issues between those countries and ours, but the real answer is they were having to contemplate cutting production to begin with because oil was off 1.5 to 3 million barrels a day in China. So we went from being in balance to out of balance and over-supplied.
Billy Quinn (06:25):
And then where we sit today, we've never seen this before. We've gone from a 100 million barrel a day market demand-wise down to 70. That's huge. This will... When we look at charts, you look at everything, this just stands out. In the past, if you saw... In 08-09 when we went through the financial crisis, you saw demand drop 1.5 To 2 million barrels a day and for a very short period of time. So, like I said, we've never dealt with these issues before. And in our opinion, it's purely pandemic-driven.
Greg Dowling (06:58):
John, with that backdrop, what are you doing to help preserve value in your assets?
John Baschab (07:03):
Sure. I'd love to come to that. And just to emphasize things that Billy just mentioned--the route that got us here. I think even though a lot of attention has been paid to the miracle of a doubling of U.S. production, primarily out of tight oil, out of the shales in the Permian and in the Bakken and primarily demand--not withstanding the drop Billy mentioned in '08-'09 timeframe--demand for crude oil globally has gone up by about 1.3 million barrels per day per year for decades now. And much of the satisfaction of that demand over the past few years was really coming from increases in U.S. production. If you look at global production over the past 5 or 6 years, the increases have been almost exclusively a U.S. phenomenon.
John Baschab (07:50):
And the increases in the U.S. have been almost exclusively, a tight oil phenomenon. There have been increases coming from the Permian and increases coming from the Bakken and other tight-oil sources. And so it was truly a remarkable thing that the U.S. had become the swing producer and the satisfier of incremental demand. And what we were seeing in January, just to go back to Billy's comments, was that that shale revolution was starting to slow down. And it was starting to slow down in my view, because a) well productivity stats were starting to flatten the amount of production that you could get from an incremental well drilled on a per foot basis was starting to flatten. And so we'd gotten through the experience curve effects, and some of the other things that had made the shale revolution so profound.
John Baschab (08:36):
And then number two, there was a lack of capital in the industry. In the downturn in '15 and '16, there was an immense amount of capital that came in from a whole host of sources to help support, augment, and increase all the things that were going on in the shale business and in new development of crude oil resources in the U.S. In January--and really in Q4 of last year in 2019--we weren't seeing that. So prices being lower for crude oil, a lack of new debt or equity, capital availability for continuing to develop those resources, and a flattening of effectiveness in the drilling programs were combining, in my view, to lead to probably an orderly market clearing process for the industry. For a long time, production continued and outpaced demand increases despite low prices. Uneconomic things were happening.
John Baschab (09:34):
So it was our view that the market would start to clear probably by the end of 2020, and we were going to have a very orderly process where there was either consolidation in the shales or a diminution of drilling and a decrease overall of development based on all those factors. But it would be a very orderly process. What's happened now between the things with a supply shock from OPEC failing to agree a few months ago and then now, of course, with the COVID-19 pandemic, I think is probably going to be a chaotic market clearing process. And so the range of potential outcomes over the coming months looks different than what it looked like in January, which would have been banks reviewing their portfolios, consolidation, lots of mergers and acquisitions, achieving scale, going to a manufacturing mode in the Permian, things like that.
John Baschab (10:27):
Now it's much harder to guess how things will play out because the values of these firms have been diminished immensely by what's happened. And so it's harder to guess how M&A will play out. As well as the lenders that might force action or other groups that might be acquirers and consolidators of assets have got their hands full. The market dynamic and market clearing feels the same, but the things that might happen and the conditions that are being experienced are really dramatically different over the past six weeks. It's been really something to absorb. As far as what a producer--what we would do, or really any producer would be thinking about in this environment, first thing that you'd be interested in, of course, is just making sure that you've gotten yourself to the least cost to produce a given barrel of crude or a given cubic foot of gas.
John Baschab (11:21):
And so I think a real focus on costs has been something that we've had as well as, I'm sure, the entire industry. The costs that you've got, many of them aren't things that you can necessarily control. When I look at big costs for a producer of our nature--mature assets that have been around for awhile--your big costs are things like labor, chemicals, energy, and transport. And so, of course, we're doing a review of those. I believe that most firms were probably already pretty lean coming out of the 2015 and 2016 downturn. The move up in oil prices was pretty moderate in '17 and '18. It gave people more room to do things that were interesting and to develop assets, but I didn't sense that anyone felt particularly flush in that environment. And so a thing that seems different to me this time around versus '15 and '16, when there was a wave of cost-cutting, is that maybe there's less room to maneuver. The other thing that does feel different though, is maybe there's more productive conversations to be had with your midstream partners than in the previous environment, because we are facing diminishing supply in that environment. If you were a midstream or a transport company in 2015 and 2016, you were still looking at ever-increasing volumes out of the basins that you were transporting from. And now, I think, as a producer, you're having to work with your midstream partners to generate economics that reduce the amount that you consider shedding-in.
Greg Dowling (12:51):
Hey, Billy, being that you own some midstream assets, maybe you can talk about midstream and also just storage. We hear the stories that we're out. We're completely out of storage here in the U.S. and around the world and there's tankers floating from Saudi Arabia. What's the real story? What's it like from a practical standpoint?
Billy Quinn (13:11):
Yeah. I'll start with, when you're going into mid-March, you do the simple math and you start hearing that demand is going to be off globally 20 to 30 million barrels a day and there's anywhere from 1.8 to 2.1-2.2 billion barrels of availability, what's going to happen? Where are we going to put all this oil? Because we've only got 60 to 90 days of real storage. There was a lot of talk of that mid-March with we--with all our portfolio companies. We were on it then to figure out what are we going to do if it comes to a point where we see this continuing and there is a real storage issue? What are we going to shut-in? Which wells, which timing are we going to shut-in or curtail, etc.?
Billy Quinn (13:51):
So there was a lot of prep in the business. We were talking about this on the ground level in the industry mid- to late March, not two to three weeks ago. So I think a lot of people were prepared for it. I think as time has moved on and prices have fallen, you've had what markets should do. Markets are behaving the right way. People talk about the Saudis and the Russians cutting big now. They were going to do that anyway. They had no place to put the oil after a certain period of time, so they were going to make those cuts. Just like in the U.S., particularly if you go to the Permian Basin, there has been massive curtailment and shut-ins of production. I think it's way more than what you're reading in the newspaper every day. So I think the storage issue--depending on how long the demand at this level lasts--the storage issue has been, for all intents and purposes, resolved.
Billy Quinn (14:41):
Anecdotally, we've got two companies--I was on the phone with one yesterday--where their midstream service provider was actually calling them, begging them to supply more barrels to them in June and July. And I think what's happened is, what the media is not talking about and most people aren't picking up is with prices at $15 to $25--forget the -$30, -$40, because that doesn't last very long--but even $15 to $25, there's a lot of oil in this country that just doesn't make sense to produce. So you have a lot of producers shutting-in more than what we were expecting. So I think the storage issue--running out of storage--has pretty much resolved itself, and it's resolved itself through curtailments and shut-ins.
Greg Dowling (15:24):
When you say shutting-in production, how easy is that? For those that aren't as familiar, is it as easy as turning off the faucet handle? And maybe you could contrast that between conventional and unconventional.
Billy Quinn (15:37):
Yeah. I was going to say, that's the big difference. For a lot of conventional wells--and even in the conventional wells, they differ by basin and reservoir what you can purely shut-in or not. But I would say, if you had to generalize, most of the older longer-lived oil wells you can reasonably shut-in for a period of time and feel comfortable. In fact, a lot of those wells have been shut-in and brought back online historically. So from the conventional perspective, you don't worry about it as much. And John may differ in opinion on that. On the shale, that's a trickier question. And it's a trickier question because you can shut those wells in for two, three, maybe even four months and bring them back online. They're generally speaking, going to perform like they were before, but if you keep them shut in for 9, 10, or 12 months, there are question marks because people just haven't done that.
Billy Quinn (16:33):
So nobody knows how those are gonna respond. And remember, these are really expensive wells that companies have spent $7 to $10 million per well drilling over the last 2 to 3 years. Making a decision to shut those in is much more complicated. So the preference on the shale wells is to actually curtail. And so what we've seen in our portfolio is the companies have gone through and they've said, "What are older shale wells that the economic value's lower? Can we shut those in and feel okay that if we lose it, it's not that much. In exchange for... We'll shut the old ones in, but the newer wells we'll curtail." So we'll take it from producing--a 2000 barrel a day well, we'll flow it at 500, 600, or 700 barrels a day. So it keeps the fluid moving through the wellbore.
Greg Dowling (17:19):
John, any comments on Billy in terms of shutting down or shutting-in production. And then I also wanted to ask you about hedging. I think a lot of people just think, "Well, hedging's easy, right? You're either hedged or you're not," and there's a lot more nuance to that. So maybe add to Billy's comment and then talk about hedging your book.
John Baschab (17:37):
Well, on the shutting-in front, just to expand on Billy's point about conventional assets. We're primarily a producer with conventional assets that are well into their lifespan. And so, Greg, you're differentiating between the decision to shut-in versus just the actual technical act of doing it. As Billy mentioned, the technical act of doing it is relatively simple. For us, the decision is fairly complex, relative to just what it takes to turn a valve and turn off production. The decision to shut a well in boils down to that well's marginal economic contribution to your income and to your returns. But there are a lot of caveats that go along with that because you may have other things besides just purely the marginal economics of that well that affect it. You might have volume commitments on a pipeline for transport or to a firm to make sure that you want to hit, you're going to want to hit your marginal commitment for volumes.
John Baschab (18:41):
You've got lease agreements that may require you to produce in order to preserve access to that lease or preserve a mineral lease. And you may have fixed cost absorption that you're thinking about on that well, and you may decide to continue to produce from a well as opposed to shutting it in even for a short period of time, even though that that well is uneconomic and hedges factor into that--we'll come to that in a moment. But I'd say the decision to do it is fairly complicated and involves a lot of departments within a firm. You've got to consult with land. You've got to consult with your marketing group and think about your volume commitments. And then you've got to consult with engineering. I think all producers--it's more true for an unconventional well, but even for a conventional well we worry about what the production will be, should you return that well. And so the amount of effort that goes into the decision is considerable.
John Baschab (19:32):
Hedging is a topic that probably superficially seems simple, but turns out to be a fairly complex decision. I'd say it's similar to the conversation about shutting-in a well. Shutting-in a well is relatively simple. The decision to do it is fairly complex. I think hedging probably gets misunderstood for a variety of reasons. The purpose of our hedging program is several things. One is its intent is to preserve some value in the assets in the near term, at least, and also to smooth cash flows. The amount of money that you'll receive for your crude oil and your other products in a given month can vary pretty widely. A hedging program that looks out over a period of months or quarters or years will have the effect of making more predictable and smoothing out the cash flows that you've got so that you can more carefully match your cash flows to the business with the expenses that also tend to be more smooth than, than the revenue side.
John Baschab (20:35):
The decision to hedge for a given producer is probably much more specific to the nature of their production than someone from outside the business might guess, because it has a lot to do--each well has got its own individual marginal economics. We talked about that when we talked about shutting them in. And so how much hedging you need to do for that? Well it might depend on what you see its marginal economics to be. And the value preservation of a given hedge for a well will also depend on that well's decline rates. If you've got a well with a shallow decline that has substantial portions of its future value, 5 or 10 years out, that's going to be more difficult to hedge that far out than to hedge in the near term. And so the amount of value that you're actually able to preserve through hedging will vary a lot depending on the nature of the production and its declines.
John Baschab (21:30):
Other aspects of hedging that I think get overlooked sometimes is there are sub-products that you hedge. Oil and gas companies... Crude oil and natural gas are commodities, but the way that you get paid for them differs wildly depending on where that product is, what it costs to produce it, the specific quality of the crude oil produced. And in many cases, you've also got byproducts--natural gas, liquids like ISO butane or propane or pentane--that are coming out of a production stream that also have to be sold separately and have their own separate markets and have their own separate pricing and their own separate liquidity for those products. And so that may influence the tenor that you can hedge and the volume that you can hedge. And just a last thought on hedging. Hedging is important part of value preservation and income smoothing, but you also don't want to have too many hedges because the unhedged portion of your production is the portion that will help you carry those rising costs in a rising price environment. So I think about the unhedged portion as being your hedge to hedge against increased costs.
Greg Dowling (22:43):
John, I like that. You sound like a consultant. "Basically, it depends."
John Baschab (22:48):
Greg Dowling (22:49):
Billy, your model is mainly backing management teams, and the small nimble management team supported by private equity is responsible for much of the shale revolution. But now we have all of these issues and we hear about new terms like "smash-co," where small management teams or small companies are being smashed together to get more scale. What is the energy world, especially in the Permian, look like over the next 5 to 10 years? Is integrated oil just gonna mow everybody down or are we still going to have these small, nimble entrepreneurial teams out there?
Billy Quinn (23:30):
You know, we are in a very entrepreneurial business. So despite what everybody's talking about, I have a hard time seeing the popping up of newer management teams, entrepreneurial teams going out there, that's not going to disappear. It has been greatly reduced and will reduce further in the coming years because of the available capital to new teams, but it's an entrepreneurial business, so I still think we're going to see new teams out there. The bigger question mark on some of this is what's left to lease that makes any economic sense? So the business opportunity in the Permian--in certain parts of the Permian anyway--may not be available for some of these teams.
Billy Quinn (24:14):
From a more macro perspective, I think there's definitely going to be consolidation and there will be consolidation into the best hands, the most efficient hands. You know, the majors will be involved. They'll do some things out there. But to me it feels like there will be some larger independents who combine and form even bigger independents. You'll have overall consolidation, but it's not going to be all the majors gobbled up and we're going to wake up and the Midland Basin and Delaware Basin are entirely owned by Exxon and Chevron in the next two, three, four years. But I think it's key. We emphasize management teams and we see with our companies how critical it is that the teams who operate efficiently... And that's getting drilling costs down low. And they're on top of all the details of their business. Keeping G&A low, which is critical. Those are the teams that thrive and succeed in these types of markets.
Billy Quinn (25:09):
You know, you mentioned the "smash-co," and I think smash-co's are done in private equity generally for one of two reasons, and they're pretty simple--and it's mostly the first. It's usually you have a couple of teams in an area and one team is performing really well and doing the things I just mentioned from an execution perspective and another team or two are mediocre and the way our business is and has been for the last five years, being mediocre is going backwards. You have to be top-tier and provide the top level of execution to actually make money in this business. So private equity firms, we all realize that, and we say, "We've got three teams in this one area and one's doing great. Two are doing average to below-average. We got to put them together. You're going to get rid of G&A and you're going to have the best management team with all of the assets.
Billy Quinn (26:01):
Occasionally--and I've heard a little bit of it going on in this market--where you have two really good teams in the market and just because of scale efficiency, challenging times, the overhead, the G&A burden is real, and you just put two teams together because you can't afford two when you can have one and one set of G&A. So there may be some of that. If oil prices stay in the $20 to $30 range for the next 12 months and we're having a similar conversation today. We had a second wave of COVID and everything gets shut down again and prices stay low. I think you'll see a lot of good teams get kicked to the side because you just got to get even more efficient. But to this point, I think it's really performance-driven.
Greg Dowling (26:51):
Hey John, you have a slightly different model. What do you need to do? Is it just...? You can't really combine teams because you don't really have a team approach. Is it really just squeezing G&A and getting costs down? Is that easier for you to do? Harder for you to do?
John Baschab (27:05):
The effect of talent in this business on outcome is really remarkable. And I think as Billy mentioned, in his part of the oil and gas business, the entrepreneurial requirements and entrepreneurial acumen that is needed to develop new assets is an incredibly important part of how the outcomes will work. And similarly, in our business where we're managing things that are older and further down the road in their development, in their life cycle as a producing asset, talent is, is similarly important. If you think about, for instance, our effective market cap in the firm and the ratio of that to employees, it would put us in the upper reaches of the ratio market cap to employees of the Fortune 500. What that implies to me is that talent and acumen and technical expertise and experience really matter in these affairs and are one of the most important tools that you can bring to bear, whether you're trying to develop new assets like Pearl is, or effectively manage older assets like we are. So talent really matters, ironically enough, in a commodity business.
John Baschab (28:31):
As far as the things that we can do, the levers that we can pull, I alluded to them earlier. It's really about trying to be efficient in your labor. We're visiting every well every day. You're trying to... Is there a way to be effective and efficient in the routes that you're driving? Is there a way to make a truck that you've got last another year? Is there a way to work with the vendors that you're dealing with and share some of the savings that you might come up with? Thinking through the partnerships. So we would talk to people that we do business with and ask them, "What are the things that we could do that would help you in your own business? If we gave you more predictability about the things that we'll do, would that help you lower your costs? And can we share those things in some way?"
John Baschab (29:29):
I mentioned working with our midstream partners in order to share our plans with them. If we're faced with maybe say shutting-in volumes, and--as Billy alluded to a moment ago--that midstream partner would like those volumes for their own reasons that we might not know, then maybe there's some shared economics that can be generated so that both parties get a win. When you're shutting things in or curtailing production, that's no good for anyone involved, so you're always trying to find ways to keep producing and make sure that everyone can get some of the economics. So those are the types of things that we're doing. As I mentioned, probably for most producers, it's more difficult on this round because I don't think that there was necessarily a lot of overspending going on in the industry from--starting in 2015 and 2016 when we saw this first round of price shocks. But it's a very robust and entrepreneurial industry and a very creative industry, and one that is accustomed to swings, even violent ones like this, and so I've got good hope that all the firms that are facing this are going to be able to do well across all those categories of expense reduction.
Greg Dowling (30:48):
What's the lending environment like? There's so much debt on a lot of these companies and wells. How are lenders reacting during this time?
John Baschab (30:57):
Well, I think they're doing a very good job in making sure that they understand the position of the assets that they've underwritten and their portfolio. The redetermination season happens... There are two redeterminations typically on energy loans every year, one in the fall and one in the spring. There were already concerns about the energy business in Q4 of last year, so there's a lot of scrutiny going to loans in this April, May, June redetermination season, but it seems to me just industry-wide to be more a continuation of a lot of the conversations that were already happening late last year from lenders where they were trying to make sure that they firmly understand the collateral that backs the loans, that they understand what management teams have in mind and what actions they're taking. Some of the questions you're asking about. "How, how are you hedging?How are you thinking about keeping your costs in line? How are you thinking about shedding-in production? What will that do to the reserves that are the collateral for the commitment that we've given you?"
John Baschab (32:06):
I think most of the conversations happening across the board are productive. The lenders behave in a lot of ways, I think, as an equity holder would. That is, they really want to understand the assets, they give some credit to how a management team is thinking about things, and they really don't necessarily paint their entire portfolio with the same brush. They really get into the details and understand a lot of the qualitative pieces even of a producer's business in order to help them understand what their risks are. And then they work in a very productive way to help them achieve their goals for risk reduction and for making sure they understand the collateral. But helping the producers also achieve their goals of focusing on productions, focusing on their business, and focusing on managing their costs during this time.
Greg Dowling (33:06):
Hey, Billy, I wanted to ask you a slightly different question. I like when John mentioned all the different byproducts that come out. It's not just oil. You can get gas and you can get different types of gas and even oil is very different. I think some people think that you put a hole in the ground and you get gasoline, and that's the only thing that ever comes out and it's all the same and it's fungible, and that's not true at all. Your dad spent a lot of time in the airline industry. That's one of the businesses that is impacted by energy. What are all the different pros and cons of low energy prices? Are there some businesses and some people that are benefiting from $20 oil?
Billy Quinn (33:53):
Some, but few. In normal circumstances, there is a whole list of industries that you would look at and say, "Great, $20 oil is better for them," the airline industry being front and center of that. But for the airline industry, how much do you really benefit with $20 oil when you're putting 60%, 70%, 80% of your fleet out in the desert, not using them, and the planes that you are running have 5 people on them. So I think they'd rather have $70 oil and full planes. And I think you'd find that with most industries right now, that they'd trade having $60 oil for normal demand times, because this is... What we're going through today is something that nobody is unscathed. Everybody, every business has issues. There are few that benefit from this, but they're the very few. We've looked at this like, "Who really materially benefits from what's going on today?" And there aren't many.
Greg Dowling (34:52):
Is it possible to...? I mean, you're absolutely right, if there's no demand with airlines, it doesn't matter what jet fuel is. Are there any benefits that we might get a kind of a supercharge recovery if people start getting on planes because they can store certain fuels that once we get going that it would be more of a coiled spring? Or does it even matter?
Billy Quinn (35:17):
I don't think it matters. And I think it's hard. What you're storing today... Remember what we started talking about is storage is going to be pretty full coming out of this. And we'll have sustained prices and they may not be as low as $20 to $30, but they may be in the $35 to $45 range for some period of time coming out of this until we work off this storage overhang. And timing of this is, as you said earlier, so uncertain because we don't really know when demand's going to respond. I think that the businesses we're talking about--the airline business in particular and cruise ships--I think they are more concerned about do people come back and buy their product and how quickly does that happen than they are about a number of elements of their cost structures today. Because they just have real demand issues.
Greg Dowling (36:05):
That makes complete sense. I might finish with two questions, and I'll ask each of you this question: what's the opportunity set going forward? So we titled this "Death in the Oil Patch" and for many there will be death in the oil patch, but is there opportunity? And how do you underwrite that opportunity when the future is so uncertain? How are you all putting new money to work? Is this a good time? Put on your sales hat, tell us why this might be a good time to invest. And then I also want to ask, what is the impact of ESG divestment? We see a lot of this. Is that going to permanently push down the amount of capital to invest in energy? And what does that do?
John Baschab (36:46):
From our standpoint, the opportunity set looks very good. If you just look at the facts on the ground, energy prices are as low as--are at historical lows. You asked the question about the banks. I do think that there will be some firms that need to exit their assets in under some stress because they can't find agreement with their lenders, or just because the economics have turned so violently on them in their production that they need to go through a process--either quasi-bankruptcy or an actual bankruptcy--in order to reset things so that those assets can be produced economically. And I think that stands to reason. Regardless of what a manager would say about the opportunity set, you can just look at pricing and look at the amount of lending that's gone on and see that that will probably force a lot of action in energy.
John Baschab (37:50):
And we think that one of the big predictors... I mentioned talent matters in this business. Manager acumen has a significant contributor to the outcomes in a given asset, but the commodity price matters too. And so a meaningful part of the outcome and the kind of assets that we buy is going to be derived from the assumptions that underwriting that you made about what commodity prices will be. And when commodity prices are low today and expected to be low in the future that seems like a pretty decent place to be buying the assets, because you've got built-in pessimism both today and tomorrow about what the prices will be, and that should, therefore, leave more room for upside surprises from price, and reduce the amount of downside surprises in price. And so I think a combination of prices being low and a fair amount of turnover in assets due to prices being low creates a great opportunity over the coming probably one to three years to buy the kind of assets that we are interested in.
John Baschab (39:05):
One thing that was interesting in the 2015 and 2016 downturn that we saw was that it took a while for that to manifest. No surprise, the things that might delay the action here are firms. Number one, they've got hedges--we talked about that--and that gives them some near-term both value and cash flow protections that would allow them to continue on even if the barrels they're producing are uneconomic. Number two, if you were going to sell an oil and gas asset, you asked us a lot about cost reductions. You'd like to get your costs to what their new levels are going to be and make that provable to a buyer before you went to sell that asset so that you can maximize the value you're going to receive. And those kinds of things take a while to do. And then thirdly, if action gets forced either by a lack of capital, or by lenders, or some combination of those--just purely running out of cash in some cases--that's going to take a while to eventuate.
John Baschab (40:06):
And so what we saw in 2015 and 2016 is that there was a period of two to three years where we were buying assets that were the result of low prices in 2015 and 2016. These things can take a little while. This won't necessarily be something that's sudden. So when I look at the things that we'll be doing, I expect that to probably be things that are happening in say Q3 and Q4 of this year. I do think, probably, that the action will be compressed this time relative to 2015 and 2016, because there is less both equity and debt capital in the market. So I think it'll probably be even more of a buyer's market this time. And I think that maybe the action will be a little more violent and a little more compressed, but even that said, that's probably something that takes 9 to 18 months to play out, as opposed to the 18 to 36 months we saw in this last downturn.
Greg Dowling (41:04):
Thanks, John. Billy, what's the opportunity set look like for you?
Billy Quinn (41:09):
Yeah. We're really excited about the opportunity. And that's not without caution. Obviously there are a lot of issues and considerations investing in a market like this, but I think what it starts with when we look at our existing portfolio and where those teams are and what it takes to survive and thrive in a market like this, we feel like our portfolio is set up well. And it starts with low leverage and very well-hedged. And I think what we'll see over the next 12 months is that the companies that have modest to low leverage and they're very well hedged, they will have the flexibility to take advantage of market opportunities. It's going to be tough. The next 12 to 24 months, there's so much unpredictability for anybody to look out and have any precision in what they're forecasting price-wise what happens. It's a difficult market for that because there are so many unknowns, but I think if you look out 24 to 48 months, you feel better about what's going to happen.
Billy Quinn (42:10):
For us, I think it starts with not only having well-capitalized teams and looking at the right assets and the distress in the market, but it's also where do we think prices can go. Reflecting back on what we talked about as we started this podcast, pricing... John mentioned that conventional and shale, about 50-50 production in North America--it's actually skewed up a little more. The U.S. produces 12-12.5 million barrels a day and about 4 of that comes from a conventional--4 to 4.5--and 8 comes from unconventional.
Billy Quinn (42:47):
And what most people don't appreciate is not only are we shutting-in, curtailing production, which will create issues in bringing that back online, the natural declines in these wells, in the shale wells, is 30 to 40% a year. So with no new drilling activity--we've seen the rate count go from 800 down to 400 and it's dropping quickly. I think we'll see a rig count in the 200 range in the coming month or two. So with shut-ins, curtailments, and no new drilling, it's going to take a couple of years, but I really think we will have potentially a supply issue, which will lead to a more promising price outlook. But that's going to be 2 to 5 years out, it's not going to happen in the next 12 to 24 months. So given that backdrop, if you can look out and get comfortable that you're setting businesses up and making acquisitions and building businesses over a 4, 5, or 6-year period, you feel like this is a great market. That's kind of our thought and our process in how we're approaching the current market. And we're excited about it.
Greg Dowling (43:52):
So last question is just ESG. You guys think of this at all? Are solar panels a competition for nat gas, for power plants? Are investors wanting to invest in carbons?
Billy Quinn (44:03):
Yeah. I'll start with ESG isn't going away, and I think it's a good thing. I think every business--it doesn't matter whether you're a producer of hydrocarbons or a consumer of hydrocarbons--we should all be looking at ways to do things better. So I don't think that's going away, with certain components of ESG. I think that the question marks will be... I've said this for a long time: we're not getting rid of oil, we're not getting rid of gas. The whole thought of going all solar and wind, it's just not practical. It's not going to happen. So when I hear people talk about it, I half-laugh, because we need everything. We need oil, we need gas, we need solar, and we need wind. We need all the power sources. Where population growth has been over the last 30 to 40 years and where it's going in the next 30 to 40 years, we need everything. And I think that will continue.
Billy Quinn (44:54):
I think the biggest question mark on the heavy push towards some of the renewables is making sure those projects actually make economic sense. To-date, a lot of those projects have been subsidized by tax incentives. And we saw at the end of 2019, the solar and wind extension of the tax credits come up in Congress. And it was a difficult process. Solar, for all intents and purposes, got shut down and wind got extended another year or two, but it was a challenge to get that. And that was in December. Now, with our government effectively printing money and borrowing trillions of dollars or more to support a PPP and state and municipal governments, how are we going to pay for it? And I think, going forward, that's probably one area where you see the tax subsidies fall. And then the curve ball on all this--solar, what is the relationship with China like? Because 60% of the solar panels that we use here in the country are all manufactured over there. So that's another curve ball, impossible to predict. It's hard for me to see how the tax incentives to those businesses continue much longer given what's gone on in the last 3 months.
Greg Dowling (46:10):
John, any comments on that?
John Baschab (46:11):
Sure. Maybe similarly, ESG is a very important matter to investors that we talk to. It's regular topic in conversation. I think the conversations around carbon and emissions associated with oil and gas output or production get a lot of the attention, but I think it's really important to note that ESG encompasses a substantial number of your practices. It's how do you make decisions within the firm? Transparency, governance, labor practices, and things like that that are also extremely critical and things that you want to do in a way that's consistent with the culture that you're trying to create in your firm and with your obligations to your investors and to other stakeholders in your business. And so I wouldn't want a conversation about ESG to ignore those things because we think they're very important and it's something we spend a lot of time documenting and implementing.
John Baschab (47:09):
Another misconception around ESG, with regard at least to production, that we talk about sometimes with people is that oil and gas firms are subject to an immense regulatory regime at nearly every governmental level--federal, municipal, state, and on. And an immense amount of in the way that you produce--in every aspect of your operations in development of an asset.
John Baschab (47:37):
And so I would want someone not familiar with the industry to understand very well that this is a highly regulated endeavor and one where immense amounts of time and effort and resources are spent doing things in a way that complies with a significant body of regulation that's intended to enforce some of the things that ESG is about. When I talk to people who have concerns about the oil and gas production piece of ESG considerations, I'd echo what Billy says here. If you just look at the statistics, this is a world highly reliant on hydrocarbon energy. I came to the oil and gas business through the alternative energy business, and so I've spent a lot of time looking at this and thinking about this. Even today, 85% of the world's energy consumption comes from hydrocarbon sources. I mean, it's surprising. There's even a considerable amount of coal still in the world's energy mix.
John Baschab (48:38):
And the world needs to be trying to make careful decisions about the balance between availability, abundance, and costs of energy in society. It's very difficult to go from an 85% reliance on hydrocarbon sources of energy in any rapid fashion. Billy mentioned that and I would concur. It's difficult to do quickly. It's very clear that there is a strong correlation between GDP per capita in a country and the quality of life of the citizens of that country. It's also--GDP per capita is extremely highly correlated with energy intensity per capita. And so there is a really strong relationship between available and inexpensive energy and the quality of life for a person in the world. So available inexpensive energy is going to be important in the future.
John Baschab (49:36):
If institutional investors abandon the upstream sector, my view is that that will not be helpful for some of the goals of ESG. Or maybe said differently, the presence of high-quality investors and thoughtful capital in the energy business produces more responsible, more compliant, and more ESG-friendly outcomes by producers. The barrels--the oil and gas will be produced. I've just mentioned what demand looks like both now and in the future. Those things will be produced by someone. The best outcome from an ESG standpoint is the presence of engaged, high quality, thoughtful investors who have ESG concerns, because that produces the best probability of those ESG concerns getting reflected through into the operations and decision-making of those producers. So I encourage institutional investors who have ESG considerations to embrace the industry, because it has the highest probability of actually generating the outcomes that they're interested in.
John Baschab (50:40):
I also think that the energy industry--we talked a lot earlier about how entrepreneurial it is. And you can see that in some of the accomplishments that Pearl has had. The entrepreneurial spirit in the energy industry is also a great place where the developments that will come to replace our energy mix in the future. Billy said we, the world, is going to need all sources of energy, and for those things to be as inexpensive, abundant, and as available as they can possibly be, because that has a high impact on global quality of life. A lot of the innovations that will help produce that outcome are going to come from the energy business because it is entrepreneurial. And because it has a significant amount of talent and understands how to think about the development and provision of energy sources. Continued engagement by the institutional investing community in this sector will also produce--has a higher probability of producing that outcome as well.
Greg Dowling (51:42):
Hey guys, that was fantastic. Thank you both for your time. I enjoyed it, I think our listeners will too. If you are interested in more information on the topic, please go to our website where we will have a list of relevant FEG publications. And don't forget to subscribe to our event communications at www.feg.com/subscribe so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client. Therefore, nobody should consider these FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views or opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of their respective firms or of FEG.
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