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Private-equity firms fueled the US shale revolution with $125 billion. Now they face a reckoning of epic proportions as the oil market melts down.

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  • The US shale revolution that propelled the country to energy dominance was backed in large part by private-equity firms. 
  • Now, many of those firms may be at risk as the price of oil reaches 20-year lows and fuel demand evaporates.
  • Small to midsize firms that specialize in oil and gas will have trouble raising funds in the future, while larger firms with diverse portfolios will be shielded, according to nearly a dozen experts.
  • That puts the future expansion of America's oil and gas industry into uncertain territory. 
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Extracting oil from a shale formation is not like puncturing a pressurized juice box with a straw. It's much harder. 

After digging down a mile or so, you have to turn the drill horizontal and drill for thousands of feet more, fire something called a perforating gun, and then pump in pressurized liquid that cracks the rock open, allowing oil and gas to seep out. 

This process, which gave rise to America's oil revolution, is expensive — far more expensive than methods used by many OPEC countries, which allows them to keep pumping even when oil prices are low.

And it's been financed, in large part, by private equity.

Over the last decade, private equity has helped propel the US to energy dominance. Firms dedicated to oil and gas have pumped $125 billion into North American ventures since 2008, according to data from Private Equity International (PEI), helping the US become a net exporter of petroleum.

oil and gas industry capital raised

But now PE funding is at risk of drying up, according to nearly a dozen experts Business Insider reached for this story. 

As oil prices plunge to 20-year lows, some oil-and-gas-dedicated PE firms may have no choice but to shutter their doors as their portfolio companies go bankrupt or struggle to yield returns, the experts said. 

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The coronavirus pandemic made a bad situation worse

The problems for energy private equity didn't start with the coronavirus pandemic, said Greig Aitken, director of M&A at the consulting firm Wood Mackenzie and Kent Willetts, a managing director at the law firm Alvarez & Marsal. 

"What we saw going into this oil crash was that oil and gas markets were already very capital constrained," Willetts said. "Lenders were pulling back from the sector." 

Investors started losing confidence in the sector after the last price crash, which sent the cost of Brent crude from more than $100 a barrel in 2014 to under $30 a barrel in 2016, sources said. 

Then in 2018, the market wobbled again, Aitken said.

And so for the last two years, portfolio companies have struggled to achieve successful exits, he said, in part because energy giants have been shy to acquire more assets with so much market uncertainty. In fact, 2018 was the slowest year on record for global upstream M&A, he said. 

As a result, private-equity firms have had to hold onto their companies for far longer than the three to five years or so that's typical before a sale. 

"That's problematic for [private equity firms] because they want to invest as little capital in them as possible," Aitken said.   

But if the state of private equity was bad going into this year, the pandemic-fueled collapse of oil markets — which at times saw prices for certain futures contracts sink to the negative double-digits — has only made it worse.  

"It's a very dire situation," Willetts said. 

Chesapeake energy gas well

More than 500 American exploration and production companies could go bankrupt if US crude oil remains at $20 a barrel, CNN reported. That number more than doubles if oil is at $10 a barrel. 

And for some of the biggest companies, it's no longer a hypothetical.

Whiting Petroleum and Diamond Offshore Drilling filed for bankruptcy earlier this month, and on Wednesday Reuters reported that Chesapeake Energy is preparing to potentially follow suit. 

Read more: Layoffs, dividend cuts, and budget reductions: We're tracking how 18 oil giants from Equinor to Exxon are responding to the historic oil price meltdown

The downturn could wipe out some small and midsize funds

Small or midsize private-equity firms that specialize in backing oil and gas companies are most vulnerable to the collapsing oil markets, several sources said. 

Those include outfits like EnCap Investments, Riverstone Holdings, and Lime Rock, which have collectively raised more than $55 billion for the oil and gas industry since 2008, according to PEI. 

"Some of them are going to be in real trouble," Aitken said. "There's no way around that. They're going to have a lot of losses in their businesses."

10 leargest oil and gas fund maners

These firms won't exactly go bankrupt, Aitken said, but they may have trouble fundraising as investors suffer poor returns and look to place bets in more reliable industries.

"There could be some question whether limited partners ultimately produce capital when it's called upon," said Michael Freeman, a partner at Haynes and Boone. "It certainly makes it much harder on the road to raise capital." 

Lime Rock and Quantum Energy Partners declined to comment on the record. 

In a statement, Riverstone said it has expanded its investments over the past decade to areas outside of oil and gas, including renewable energy, such as wind, solar, and biomass, where "demand is very strong and accelerating."

"We are also hearing from investors looking to take advantage of the market dislocation in the form of a special situations fund," said the firm, which has raised about $20 billion for oil and gas specific funds since 2008, per PEI. "So while it is true that there are parts of the energy business that will be difficult in the short to medium term, we continue to see interest in others."

Whiting Petroleum

Energy private equity deploys strategies to stay afloat

Other energy-focused firms also have a broader reach than oil and gas including EnCap, the top fund by oil and gas fundraising, per PEI. 

According to a person familiar with the matter, the firm is in the market to raise a fund devoted to renewable-energy projects including energy storage, wind, and solar.

At the same time, EnCap has $5 billion to $6 billion in so-called dry powder — unspent investor dollars that it can use to acquire new assets — meaning the firm doesn't necessarily need to fundraise for oil and gas investments for some time, the source said.

And timing is key, several of the experts said. Investors will be better off if they can afford to hold onto their assets for a few more years before selling them off, Freeman said. 

"To an extent, private-equity firms have the ability to be patient," Freeman said. "You might just see them sit and try to wait things out a little bit." 

But, he added: "A lot of these companies that PE firms hold are already marginally distressed. They're looking at a difficult scenario." 

oil rig

Larger private-equity firms can weather the storm

Larger private-equity firms, on the other hand, are more sheltered from the meltdown of oil prices, according to Brent Shultz, another partner at Haynes and Boone. 

"Maybe they have one fund that's struggling that maybe like an energy opportunities fund, but they may have 15 or 20 other funds that do other types of investing," Brent Shultz, a partner at Haynes and Boone, said. 

But even the giants may decide to move away from oil and gas in the future or focus their investments in midstream or downstream companies — which transport, store, and refine oil — as they are more likely to survive a downturn, according to other attorneys.

Oil and gas assets soon to be on sale

The upside for oil-and-gas private equity is that if these firms have money to spend they could see steep returns if they play their cards right. 

To avoid bankruptcy, oil companies may eventually sell off assets for cheap, Aitken said. Private-equity firms could then gobble them up and sell them once prices bounce back, which analysts estimate could be sometime next year. 

"There probably will be some new capital allocated," Aitken said. "There always seems to be a few buyers around who go, 'Well, now we're at the bottom, so now is the time to invest.' But I don't think that's going to be massively widespread because of the issues that have been around for the last couple of years." 

Plus, downturn aside, there are enduring issues in the sector, Aitken says, related to the transition from fossil fuels to renewable energy, which "puts a cloud over the longer-term future of oil and gas."

"Looking at things through an ESG lens, there will probably be less capital allocated to the sector," he said. "The combination of that with where we are right now today — the real short term problems — I think there will be a drop off overall in funds."

SEE ALSO: Private-equity firms are scrambling to save portfolio companies by calling in money from investors and rewriting worst-case scenarios

SEE ALSO: Private equity bet billions on live entertainment in 2019. Here's how the coronavirus has turned that investment thesis on its head.

SEE ALSO: Lansdowne Partners' high-flying clean energy fund got slammed in March, but its oil-focused fund is up for the year despite plummeting crude prices

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