Tales from the Field: Swept Away in a Flood of ‘Opportunity’
By Thomas M. Kim, CTP, Managing Director, r2 advisors llc
Reposted with permissions from the September 2015 Journal of Corporate Renewal.
The current chapter on the energy industry would be incomplete without insights from the field. The energy boom and subsequent bust led to some fairly extreme situations caused by some of the unique facets of the energy industry, the locations in which the energy boom played out, and the characteristics of investments in the middle market. Many of these situations became severe because of factors unique to the industry, but in the main, the root cause of the difficulty appears to have been the failure of some to follow some basic business processes.
This article offers some hard lessons learned in the field that may be applied to future opportunities. Although based on actual situations, it is not intended as condemnation of specific companies or players. In recognition of that, the situations are described in intentionally vague terms to prevent identification of specific companies and individuals.
The energy industry is unique in some ways. First, the price of energy commodities depends entirely on the open market. Second, the industry is cloaked with an exaggerated notion that it is for insiders only. These factors, and others, help to create a sense that the energy industry is somehow special or unique. In reality, the industry shares common characteristics with all other industries. Although it definitely helps to have industry knowledge to be a successful long-term operator in the space, in many respects, a solid understanding of tried-and-true business best practices is of paramount importance.
There are some real characters in the energy industry. Stories abound of speculators and entrepreneurs who are known for taking outsized risks. The industry’s risk/reward equation can lead to headline-worthy returns when a speculative investment pays off. Even when the beneficiary unknowingly sits on a big find, their returns are eye-popping (think Jed Clampett of “The Beverly Hillbillies”).
One finds some very colorful people in the energy field who have interesting perspectives on life. One thing they all have in common is a strong belief in their ability to get rich quick in the energy industry. But some allow their businesses to go off of the rails because they lose focus on the core business. Sometimes their basic personalities make them susceptible to losing their focus as soon as the business produces any amount of money. However, most of the industry’s seasoned operators are much like consummate professionals found in any established industry, and the key performance indicators in the energy industry are similar to those found anywhere.
An Insular Industry
Another unique aspect of this industry is the personal connections among longtime players. The shared years in the business, coupled with navigating its ups and downs, creates a special bond among the players, much as it does in the construction and agriculture industries. Sometimes this familiarity creates long-term antagonism, but not always. Feelings of “being in the club” can be strong, and outsiders can face some special headwinds when trying to break in.
Like some other volatile industries, it is as much who one knows as what one knows. When professional investors get involved with closely held or family operations in any industry, they must anticipate the issues that will come up if the selling principals are no longer involved with the operation. If the principals leave on bad terms, they have a tremendous ability to impair the business, and legal remedies will be insufficient to cover the loss of value.
In one situation the author observed, the sellers committed quite a few breaches of legal agreements. In the end, however, the company was damaged, and it was the buyer who bore the brunt of the impact. This is a larger issue that covers the spectrum of acquisitions by professional investors of closely held businesses, but the impact is felt more strongly with concentration around one industry.
Williston, North Dakota, located in the northwest corner of the state, is the center of activity for the Bakken formation. The Bakken was discovered in the 1950s, but production was not feasible until recently, when fracking and enhanced drilling techniques were applied. By area, North Dakota is the 19th largest state in the nation. But with a population of around 700,000 (circa 2014), North Dakota ranks 47th in population density among the states. The 2010 census pegged Williston’s population at a little under 15,000, though the community had grown to nearly 21,000 in 2013, according to the Census Bureau. There is not a lot of infrastructure in northwestern North Dakota.
One important threat to businesses within the energy industry is the evolution from the “E” (exploration) to the “P” (production). Oil exploration had cycled through North Dakota a few times since the ‘50s, but it really started to boom in the early 2000s. When it did, there was a tremendous rush to drill, which created a huge demand for oilfield services in the form of heavy civil construction , very labor-intensive work requiring large groups of workers.
Then, the exploration companies would have transitioned to the production phase, which requires far fewer (and different types of) workers than the exploration phase. It just so happened that the transition from exploration to production occurred near the same time as the drop in the price of crude. This created a confluence of negative factors that made for great headlines about the devastating effects of the price decline. . Even without the oil price decline, there would eventually have been a large decrease in demand for construction services because the infrastructure would have been completed. However, the failure by many to anticipate the natural evolution from exploration to production was a major contributing factor that aggravated the fallout from the bust.
When times were good, all kinds of investors were clamoring for a target in the energy industry. Many chose to invest in “oilfield services,” a very broad term that covers everything from construction to more technical service like well-head installations. The problem is, oilfield services companies are almost entirely dependent on the demand for exploration, which in turn is dependent on the price of oil.
Many finance companies do not like to finance construction companies because the lender is paid as work is completed, and progress billing is inherently risky from a credit perspective. Construction companies typically are not great investment opportunities for equity investors either for many of the same reasons. But for whatever reason, when energy is involved, many investors sought out field services companies for acquisition. Many of these did not work out well because as soon as oil prices dropped, demand for oilfield services also declined.
The businesses nearer to the core of the industry probably represent a better long-term opportunity. Production is described in terms of proximity to the source of the commodity and the customer. Upstream represents the source. Downstream represents the end user. Midstream represents the transportation function. Sticking to businesses within each functional group, and keeping to those groups that more closely align with an investor’s experience, can go a long way toward an objective assessment of the opportunity. Oilfield services businesses are more like a construction business than an energy business. It just so happens that their customers are in the energy business.
Location, Location, Location
The end of an oil boom can have a drastic impact on real estate as well. During the most recent boom, investors were everywhere looking to buy real estate so they could build apartments, hotels, restaurants, and other amenities to support the rapidly growing population. It seemed obvious to outsiders that there was a great investment opportunity in real estate. After spending time with some real estate professionals in the Bakken in early 2015, however, it was apparent that the hungry investors had not been listening to the local real estate community and had not looked around at the vast expanses of land available for development.
Local brokers were pretty clear that they had seen this type of frenzied demand before (and they feel confident they will again). But when one can see nothing but raw land for 360 degrees, one begins to wonder how a prudent investor could select a site that would be “perfect” for development. There is just too much from which to choose. A major flaw in investor diligence seems to have been that too few principals went to the area to investigate. On a drive from Minot to Williston—about the same distance as Wilmington, Delaware, to New York City—one sees too many green-field opportunities to count.
The isolated issues that existed in Williston did not translate into broader opportunities for real estate investors across the region. Once the demand was gone, so was any interest in residential or commercial development in the area. The author’s firm was involved with a failed development project in a small town nearly 100 miles from Williston . Standing in the center of the small town, it’s difficult to imagine how long it will take before that project is feasible commercially, but it must be measured in decades. Even then, it may still be subject to big cycles. Another energy boom will open up interest in any number of towns within a reasonable radius around Williston.
Real estate industry players who evaluate projects day-in and day-out probably did not see many opportunities in the Bakken relative to opportunities elsewhere—and there were plenty to choose from circa 2012. The rapid increase in demand in North Dakota may have been enticing, but many could anticipate a decline that would create a steady-state demand well below the peak. The existing real estate infrastructure probably was adequate for that level of demand, and the peak demand should have been satisfied with temporary, rather than permanent, solutions. Even the providers of temporary housing (man camps) are moving on—their occupancy rates have dropped drastically, and it is no longer feasible to keep camps in operation in North Dakota.
The energy industry is not unique when it comes to the business knowledge required to succeed. It does, however, require a very firm understanding of the impact that commodity prices have on the entire spectrum of companies operating within the industry. Also, just because a service is provided to the energy industry does not make the company providing it part of that industry. Most believe an energy industry company has a tremendous upside that balances the tremendous risk involved. For example, an oil production company takes a huge gamble on its investment in physical assets and strategy. When the bet pays off, the returns are enormous. That seems to be balanced. But investing in a construction company that does a portion of its work for the oil industry seems unbalanced. Real estate investments as tangents to the energy boom, in undeveloped areas, seem likewise very unbalanced in terms of risks and rewards.
Any investor or operator considering an investment in the next boom would do well to spend a great deal of time in the local area. It’s hard to imagine that any principal who visited the Williston area and spent time with the locals would have been as bullish as the herd appeared to be. It would be critically important to get information from as many local sources as possible before considering an investment.
Also, diligence should be performed by people who can blend in a little. The hype surrounding the Bakken boom made it too easy for every seller to want to get into the game, and they could see the buyers coming from miles away. In that environment, it was too easy for the buyers to be set up as patsies by the sellers as a group. While this is not to suggest that there was a conspiracy to fleece the buyers, many of the selling entrepreneurs saw a unique opportunity to take advantage of out-of-towners who were unfamiliar with the local climate. It appears that some of the normal cautious behavior one would expect of sophisticated buyers was abandoned for fear of missing a golden opportunity. This ended up costing some investors.
Hindsight is perfect, but it is difficult to make progress when looking into the rear-view mirror. Such trite clichés roll out whenever there is a major adverse change in an industry. Experts clamor for understanding and the players vow to learn from and not repeat the experience. With the recent rapid collapse in the price of crude oil, the exploration and production industry has taken a major hit.
It is always time to remain objective and to take the time to consider a 360-degree view around the target before jumping in, no matter how attractive an opportunity appears to be on the surface. There are a number of investors who considered investments in the Bakken, decided against making any outlays for reasons that include the factors outlined in this article, and are money ahead because they didn’t lose focus on business fundamentals.
Thomas M. Kim, CTP, JD, MBA
Mr. Kim is the founder and Managing Director of r2 advisors llc, a Denver-based financial advisory and turnaround consulting firm. His advisory practice revolves around businesses that are facing financial or operational distress.
For more on the TMA visit their website at: https://www.turnaround.org/