The Permian Basin remains ripe for another round of consolidation—including some mergers of equals—but new opportunities are emerging for private equity, and some may specifically favor the smaller, more nimble producers in those portfolios.
Hart Energy queried top private equity firms invested in the Permian about what’s next for the most prolific shale play in the U.S. This interview with Douglas Prieto, CEO at Tailwater E&P, is the final exclusive interview featured in a three-part series, including Permian Thriving on Small Deals, Says Pearl Energy and PE Navigates a Tale of ‘Haves and Have Nots’ in Permian.
This interview was edited for clarity and length.
Deon Daugherty: What is the state of the private equity cycle for Permian investment?
Douglas Prieto: We are in a unique phase in the private equity cycle for Permian investment. Fundraising has continued to lag historical levels, but there has been some recent capital formation and there are now quite a few teams looking for assets.
At the same time, teams with assets have been more focused on developing into a company that can generate consistent free cash flow and be attractive to a strategic buyer. When coupled with lower oil prices with a relatively flat five-year strip and a more recent degradation in the front end of the natural gas strip, few private equity-sponsored companies with assets are looking to exit in this environment and publics have been slower to sell non-core assets because of the focus on inventory depth.
This has resulted in notably fewer marketed processes of scale in the Permian recently, although that could change as we head into year-end if prices can hold in the mid-sixties. If OPEC+ floods the market with incremental barrels and prices drop into the $50s, that will likely have a chilling effect on transaction levels unless a company has a catalyst that forces them to transact. The price of oil has essentially been flat for 20 years and if it had just kept up with [the Consumer Price Index] over that time period, oil would be closer to $100 on an inflation adjusted basis. We’ll likely need higher prices to stimulate transaction activity.
DD: What will PE investment in the Permian look like during the next 12-18 months? Are there new barriers to entry? How might concern about a lack of available Tier I acreage impact the ability of portfolio companies to reload?
DP: We anticipate compelling opportunities for Permian investment as capital intensity has continued to increase with manufacturing style cube development, longer laterals and larger fracs with higher intensity, despite all the efficiency gains that have occurred.
We have been active in providing non-operated capital to operating partners to help them develop their assets in a more capital efficient manner and explore emerging benches, while we participate in the entirety of the cube development to moderate risk. In addition, we have steadily been deploying capital into minerals and royalties.
We have seen increased barriers to entry in operated assets, as we estimate approximately 21% of Tier 1 Permian inventory has been consolidated over the past two years, which is staggering. And on recent quarterly conference calls for Exxon, ConocoPhillips and Chevron, who all have scale and cost of capital advantages, indicate that they are focused on continuing to consolidate in the Permian.
We typically see non-core assets sales in the wake of industry consolidation, but consolidators have been slower to sell assets because of the inventory length concerns. We believe that PE will play a critical role in continuing to expand the edges of the basin with innovative technologies (we call this aerial expansion of inventory) and testing new deeper zones in existing fairways (vertical expansion of inventory).
We believe that the ingenuity and grit of those in industry coupled with modern technologies will allow the Permian to continue to re-invent itself, just as it has so many times in the past. So many forget that the Permian was once deemed the largest uneconomic field in the world before the advent of fracture stimulation and horizontal drilling.
DD: How do you view asset valuations in the Permian?
DP: Valuations in marketed processes have been strong, though they are measured against a lower strip price which provides some upside in the event prices rebound in the future. We continue to find ways to create win-win transactions for both buyer and seller in bi-lateral, off-market discussions where transaction counterparties can collaborate to identify the most important value drivers for each.
DD: In your view, how much runway exists in the Permian? Where is the next opportunity set?
DP: Based upon what we know today, we believe there is approximately nine years of remaining Tier 1 inventory in the Permian, which represents approximately 101,300 Tier 1 locations at a pace of approximately 11,300 wells per year, which is in line with historical activity levels. However, that does not factor in all the work that is being done to identify additional emerging zones and targets in existing fairways and to expand the edges of the basin. As an example, we see at least five new benches being actively targeted in parts of the Delaware Basin and three in the Midland Basin. With time, we expect many of those benches to become primary targets that can help expand the runway of inventory life, in addition to aerial expansion that occurs.
You have often heard the old adage that the best place to find oil is in an oil field, and the Permian continues to highlight the truth of that statement as new technologies allow additional benches to be identified and targeted. Hopefully recovery factors can be increased as well. However, some emerging targets will require higher commodity prices to see development.
DD: As you consider the best place to deploy capital, where does the Permian rank and why?
DP: We believe that the Permian represents our best opportunity for capital deployment in our non-operated and royalties strategies because of the strong single well economics and reservoir quality, which implies the lowest breakeven prices of any play in the Lower 48 and means that there will likely be economic drilling activity in almost every commodity price environment.
We have seen meaningful drilling activity this year that has outpaced our expectations on our large, diversified Permian non-operated footprint that we purchased last year. Since closing, we have approved over 160 new drill AFEs [authorizations for expenditure] with a weighted average single well IRR of 109%. We also see the Permian as a great place to invest in infrastructure to move produced volumes to liquidity points and prevent bottlenecks.
For instance, our producer’s midstream team is in the process of building much needed gas infrastructure in Lea County, New Mexico, to assist operators in one of the most prolific parts of the Permian with gas gathering, treating, processing and flow assurance. The team is also working to enable operators to move volumes to markets not subject to Waha basis volatility and enhance netbacks. The combination of robust economics, cube development scale and emerging target optionality in the Permian creates a significant investable total addressable market from our perspective.
Having said that, we still put an emphasis on capital deployment in the core of the Eagle Ford, Williston, D-J and Haynesville for all our strategies as well. Operational expertise, track record, single well economics, reservoir quality and team integrity are all top of mind when considering a partner.
DD: How is the divestment cycle from late 2023-2024 consolidation playing out?
DP: The divestment cycle has been slower than many expected in terms of marketed processes for upstream assets in the Permian. Operators have quietly divested or farmed out some smaller assets, but many are holding onto inventory that would have been sold in a prior cycle because of inventory concerns. We have also seen some upstream companies sell midstream infrastructure or non-Permian inventory as a way to hit divestment targets. If we have sustained lower commodity prices, that could change and more assets could be sold.
DD: What do you expect for further consolidation in the Permian?
DP: I think we’ll see another round of consolidation as indicated in recent conference calls, and I do believe we’ll see some mergers of equals. I also think that will be followed by a period of non-core asset sales that will provide opportunities for private equity for two main reasons: (1) if we have sustained lower prices for 12 to 18 months, some inventory should likely be sold rather than sit at the back of a large company’s drilling schedule receiving no investor credit and (2) we are starting to see some cost creep in the operational structure of larger companies, meaning certain assets are actually better situated in the hands of smaller, more nimble operators.
DD: How challenging is it to complete deals in the Permian? Where are the pain points, and what gets a deal across the finish line?
DP: Marketed processes for assets of scale in the Permian have fierce competition that often favor the publics who have a lower cost of capital and may be able to use equity as a currency. We have seen value in more fragmented assets, creating joint ventures and off market, bi-lateral negotiations around non-operated assets of scale. In any transaction, the ability to identify and provide solutions to address key considerations of a seller, outside of purchase price, including surety of close without the risk of trying to re-trade once under PSA [production sharing agreement], flexibility, transparency and commerciality in document negotiation, along with transactional speed, can help to build a strong dialogue and assist with overcoming uncertainty in deal making.
DD: How does PE look at the pure-play versus diversified producer? Is one better than the other?
DP: Team and inventory quality, free cash flow generation, operational excellence, margins, single well economics, flow assurance and limited volatility in basis differentials are all things that may be more important than whether an operator is a pure-play versus diversified. There will always be periods in which investors may have a narrative around whether basin diversification or concentration is better, but quality of the business is more important than a transitional market theme in our view.