Observing how North American firms active in the oil sector were created, we can derive conclusions that will help us make our investment thesis.
It is a sum of factors that will yield success for exploration capital investments.
1. Ramification
What the general public doesn’t know is that a significant amount of hydrocarbons is pumped out of the subsurface by privately-held firms (in North America). This is unique to North America given its strong capital markets and easiness of acquiring mineral rights. Most firms were created in the 20th century when there was no talk about energy transition and oil&gas developments were quite common. However, as reserves inevitably deplete, many (or most) tend to get sold to larger firms, and in general publicly-traded companies, in a process called “consolidation”.
Ramification is the opposite of consolidation where a central entity (like an investment fund) creates many small entities. The fund acts as a coordinator for its firms, providing them with bespoke capital financing solutions and technical consultancy (especially geoscience and reservoir engineering), while maintaining partial ownership in them, with the rest being held by the local entrepreneurs who will take care of the business.
The listing of oil&gas firms on public markets is clearly no longer a solution, given the fact that society does not appreciate this particular sector, which has resulted in undervaluations.
2. Many small assets instead of a few very large ones
An example from the former Soviet Union states: after its breakup, the top US firms (and some European) went to invest there and got participations in very high-profile projects, unquestionably world-class assets (like Arkutun-Dagi – Chaivo – Odoptu fields, Tengiz, Kashagan, and many others). While these have major reserves, it is possible to create the same monetary value by adding many smaller assets to a company’s (or a fund’s) portfolio. In general, the largest firms have thresholds below which they will not proceed with the development of an oil&gas accumulation. This represents a niche opportunity, especially when facing a rapid depletion of global reserves.
3. Relationship with host governments and inter-government cooperation
This is a delicate subject, since no business can happen without the approval of the rulers in the jurisdiction where we intend to carry out exploration.
It is paramount that we maintain good relationships with governments and present them with satisfactory plans that will address:
- The extent of expected exploration (the more the better)
- Bespoke financing options and establishing fast capital access channels to international partners
- No shady business clauses
In a simplified statement, exploration capital firms can and will arrange the financing of projects (and will keep those financing channels open) as long as the host governments abide by the contract rules and don’t hinder operations. Capital is always deployed in steps and not all at once. To make money in the oil&gas sector one has to either export the extracted products (in exchange of foreign currency), or use the extracted products to develop the internal economy (which, again, requires foreign trade). Exploration capital funds should not invest in countries unwilling to participate in foreign exchanges, since this is viewed as a kind of lack of collateral (whereby the collateral is the development of the national economy).
4. Privacy, flexibility, reduced costs and quick deployment of capital
As opposed to publicly-listed explorers, private firms follow minimal rules. They can speed up project implementation and have the right of discretionary contract awarding. They don’t need to waste time with needless reporting and a very high level of secrecy regarding internal funds will be kept at all times. From a legal point of view, investment funds (and their portfolio companies) have an obligation to pay royalties and taxes on what they produce and deliver returns to shareholders. Anything in between is classified and auditing will be prohibited, unless explicitly required by law.
5. Outstanding financial metrics
Unknown to the general public is that exploration projects have some of the highest IRR/ROI/MOIC indicators, as well as the fastest payback/breakeven time. An exploration project usually takes 1-2 years, with the selling process (exit) included that would be 2-3 years maximum, which is the fastest scheme. Almost all funds are closed-ended and they take up to 10-15 years to disburse their profits to shareholders.