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Private Equity Player: Capital Seeking Inflation Hedge in Energy

The public capital markets have turned to energy in a big way this year -- this despite general economic turmoil and low commodity prices. Wil VanLoh, CEO of Houston-based private equity firm Quantum Energy Partners thinks natural resources are seen by investors as an inflation hedge.

"I think there was a lot of concern at the beginning of the year that there could be a lot of stress in the energy space, that a lot of companies with the lower commodity prices could get some real pressure to sell assets because of either being over levered or needing to generate cash flow to preserve their resource plays and drill. But...we've had a very, very robust public capital market, very receptive to energy in particular, probably more so than most other industries."

VanLoh said the exploration and production sector has seen about 20 companies issue debt this year and another 20 or so that have issued equity, "which is really quite extraordinary.

"I think a lot of people are starting to get very nervous about inflation, and interest in the energy space and commodities in general and specifically energy commodities, I think, has really flashed on everybody's radar significantly. The energy space has attracted a pretty good chunk of the activity that's taken place in the public capital markets."

While VanLoh and Quantum would rather see the industry relying on private equity, the firm is finding investment opportunities, which is a good thing as Quantum just closed its $2.5 billion Energy Partners V fund. However, putting capital to work in the natural gas patch right now is a bit challenging, VanLoh said.

The upstream acquisition market is pretty slow because of a large bid-ask spread between buyers and sellers due to wide swings in commodity prices, he said. And many drilling prospects are uneconomic with gas at $3-5. Since oil prices have held up better, Quantum is looking at more oil-focused plays, VanLoh said. On the gas side, though, unconventional resource plays are attractive if one is selective, he said.

"I think most people in the industry will tell you [with a gas price of] something south of $6-6.50 a lot of these plays start becoming very challenged economically," he said. "Costs can go down some, and drilling costs have come down depending on where you are in the country, anywhere from 20 to 40% since the peak. But even given that, I think a lot of these plays are still very challenged at gas prices below $6 to $6.50."

While a tremendous amount of gas has been found in shale plays over just the last year or so, VanLoh noted that this was in an environment of $8-14 gas prices. "The real question is what's going to happen to gas production in the U.S. now that the rig count has been cut in half," he said.

Not all rigs have stopped drilling, and the ones that continue are creating midstream opportunities as new wells must be connected to gathering systems, processing and pipelines.

"Resource plays are a macro trend that's driving the growth in the upstream industry, but they're also driving tremendous need for infrastructure buildout in the midstream industry," VanLoh noted. Gas resource plays often lie in areas with existing infrastructure that was built to accommodate conventional production, but what's in the ground can't handle the pressure from the wells being brought on stream today, he said. Additionally, processing capacity is often required.

"If you just look over the last five years, the amount of capital that the midstream industry is spending basically on new build infrastructure has gone up approximately 500% so you've seen a huge, huge jump," he said.

Gas storage is another area where capital has been finding a home.

"We're spending a lot of time on storage right now," VanLoh said. "It's probably one of our most active areas. I think clearly in the lower to middle part of the Gulf Coast you clearly have conditions that you could call adequate to overbuilt. But really getting downstream of the bottlenecks is what's key in storage."

The Rocky Mountain region is one production area where there hasn't been a lot of storage development, VanLoh noted. Resource plays with growing output in the region offer opportunities for storage facilities that can connect with multiple pipeline outlets, ideally three to five, VanLoh said.

Besides pipeline flexibility, it's operational flexibility that makes storage investments attractive, particularly with the increasing demand from gas-fired power generators for intraday swing services. For this reason the storage projects Quantum is looking at are all high-deliverability, multi-cycle projects, VanLoh said.

"A lot of money is flowing from the public standpoint into [energy] companies. Certainly, us private equity guys were hoping that wouldn't be the case," he said. "But energy is massively capital-intensive. Because it's so capital-intensive, every year you've got to have access to significant capital. This year ended up being a pretty good year from a public markets side. We'll see what next year holds."

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