My Energy Investment Thesis #2: Unconventional Oil and Gas
Thesis #2: Unconventional Oil and Gas
My father was born in the West Texas oilfields. Eventually, his family relocated to Houston since it effectively became the oil & gas capital of the world. Instead of heading back to West Texas to continue the good work built by his father, he decided to become a software engineer and ended up building a technology company servicing the large oil & gas empires that built its fortunes on top of the Permian Basin. And then West Texas closed for business as oil prices went into the dark ages. The July 1983 cover of Texas Monthly read: “So long, it was fun while it lasted.” Even in the '90s when I headed off to university in the great oasis in Austin, many of my friends from West Texas would talk about the drought and how they were never going back. The dark ages lasted for 30 years... and then...
BOOM! Fracking + horizontal drilling unleashed a resurgence that put the Permain Basin back on the map. The sheer number of resources in 'unconventional' was believed to be so large that the US could rival Saudi Arabia as the largest producer of oil and gas. This created a black swan moment that even caught great investors off guard turning the largest private equity buyout at its time into a disaster.
When I landed back in Houston in 2010, the oil and gas industry was radically changing forever as access to vast amounts of the resource became unlocked. A few big things started to play out as a result.
First and foremost, keep in mind that the unconventional business is primarily a US Onshore phenomenon driven by private property rights. Property rights as we know it in the US does not exist to the same degree in most parts of the world. While the unconventional revolution could be a global one, it has primarily been a US play. And in the US, Houston is the unconventional headquarters. If you wanted to be successful in extracting this resource, you needed to be Houston (for those in DFW, I love it too, let's meet at Javier's to discuss a re-write to explain how you fit in).
In the early 2010s, the world was still licking its wounds from the cleantech investment implosion. There was no Paris Agreement. Governments and societies were not organized at this time around a clean message. While not popular with the up and coming generation, the oil & gas business was still an industry that investors could raise money behind. Petroleum engineering degrees started to rise again. And it seemed at the time that the unconventional business alone would take over the world.
What did this mean as an investor?
It meant that the unconventional business and technologies being developed to make it more competitive was the huge growth opportunity in one of the largest industries in the world. It also meant that Houston was the best place to be as an investor, not only for unconventional technologies but also for conventional. The leaders and experts of the unconventional extraction of natural resources were based in Houston. And the large IOC's, NOC's, and service companies that did not have a presence in Houston established offices here during the earlier part of the decade as a result. Simply put, Houston became a good place to be an investor if interested in taking advantage of this new industry within an industry— and for entrepreneurs in this unconventional oil and gas industry, it was the only place to be.
Unlike most technologies, which are designed to reduce cost, fracking and horizontal drilling were more expensive than other extraction methods. While it increased the amount of oil and gas available, digital and new technologies became even more critical to lowering the cost of unconventional methods in the oil and gas industry in order to compete with the more traditional methods. Unfortunately, at the time, oil prices were soaring and cost reductions brought about by digital methods were not a priority. Getting into the best land positions, extracting as fast as possible, and ensuring continuity of service providers were the priorities.
In conclusion, almost a decade ago, we believed that the unconventional business, while not the only opportunity in energy, was the unicorn to chase and you needed to be in Houston to capitalize on it. We also believed that technology (software) and the great generational crew change (millennials that are technology-dependent) were critical components to unlock the investment value. At the same time, we knew that venture capital, a model that works well with software companies in most industries, had yet to prove out in this industry and thus we needed to walk carefully into the dark.
What did we learn?
Energy independence, once a campaign slogan, became a reality. The US is now the largest producer of oil and gas in the world. At the same time, however, and in spite of these advances in availability and technology, the industry is struggling to make money doing it. The price of oil remains low — and must remain low in order to remain competitive. The industry paradigm shift has taken place and will remain a key component in how companies allocate capital (including technology investments). As a result, many of the leading unconventional producers are struggling to manage debt, cash, long-term profitability, and reputation.
When your largest customers are not making money, they will not pay a lot for services. And technology is a subset of services (and valued in a similar fashion). As a result, we have seen very few unconventional focused startups succeed at the level required for early-stage venture capital expectations to make sense for the associated risk. I will write more about the crew change and software in another post since these factors also come into play here. And it also why we are seeing a new type of fund emerge.
While the market fundamentals of the unconventional business itself are questionable today and there are many technology startup dead bodies lining the energy corridor (in which I am writing this memo), there are new factors playing out creating more risk as an investor:
- Governments (Legal Drivers): are starting to rally around driving a cleaner and more sustainable approach to energy supply especially as more research suggests that there may be environmental problems with current methodologies which will drive more scrutiny and possibly more regulations.
- Public (Social Drivers): our future generation and their belief in living and working in a cleaner world is rippling throughout society. We are seeing this play out in real-time both at the highest levels as well as at the most tactical levels. When I was graduating from university, very few of my colleagues wanted to work in oil & gas because it was a financial decision. It was during low oil prices and the technology industry was booming. Today, our future generation is not going into energy (except new energies) for social reasons. I have been tracking this for the past decade and it is not getting better. We are also seeing the number of petroleum engineering graduates fall off a cliff. It is logical to argue that the lower oil prices are also a factor here; however, the societal trends show a more disturbing pattern.
The irrational exuberance that I had in 2010 is gone: There are questionable market fundamentals, stronger government interaction (& possible future even inevitable regulations), societal pressures, and a difficult fundraising environment. Even if an investor can raise money today for unconventional technologies, will they be able to raise more when needed even if generating returns? I will write a separate post on this.
However, my gut tells me to not ignore this space especially as I ponder Milton Friedman's wisdom, Warren Buffet's advice (but really hard to follow), and the fact that there is only a handful of us that understand this space. The question is whether prices have fallen below these technologies' long-term value.
The industry needs technology that can help lower costs and make these processes more sustainable if we believe that energy demand is going up. There is also substantial pressure from society as a whole — and soon to be from regulatory bodies— to reduce emissions. I'll write more about this later. Many companies have made promises to the market to reduce their carbon footprint. While these advances are incredible and have a great deal of potential, new technologies are critical to making this happen.
As I ponder the ebbs and flows of the investment proposition into unconventional technology to support the great Permian Basin, it reminds me of Jack Ingram's song, Great Divide, and how while we may come and go, West Texas will live on forever:
"They still listen to high school football
On the radio in West Texas
The lights still shine bright
Every Friday Night
And you can drive 90 miles an hour
Down the highway straight through Sisco
The cops are at the ball game, its gettin' tight
And the sky gets wider and wider
You disappear like the day
Into the Great Divide you fade away
Its another world all together
In the middle of God's country
Smells like money, smells like shit, yea it smells like hell
But when the cattle's all together
And the pump-jacks all are movin'
And the cotton's all in bloom
And it smells like nothin' else
And the sky gets wider and wider
Just like a brand new day
Out in the Great Divide you fade away
Its the land of my people
Dreamers come out here to find a bigger piece of sky
Its all the winners and all the losers
Real good people, just like you and I
Yea but nothin's really changed much
As you drive down I-20...
...And everybody's dirty
Man, their all just a bunch of gamblers
And some got rich, but their gamblers still"
Read the next part of my thesis — about the energy transition — and let's discuss if you still believe that afterward.