Citi Scouts U.S. Fracking Investments for Foreign Clients

Foreign investors with exceptionally deep pockets and a lot of patience are using private-banking channels to buy their way into the U.S. fracking industry.

These buyers, with net worths in excess of $25 million, are vying to acquire expensive land surface and mineral rights through co-investment funds that shield their identity.

Citigroup's private bank, for example, is scouting out exploration and production opportunities in Colorado, Kansas and the Bakken region, which includes parts of Montana and North Dakota. The drop in oil prices has forced oil mineral rights in those areas downward by 50% in recent months, attracting bargain-shoppers.

Citi has at least one transaction in the works, and it has gathered client commitments from at least three continents including Asia, the Middle East and Latin America, said Dan O'Donnell, global head of real estate and private equity at Citi Private Bank.

"We are partnering with an experienced operator that would do the drilling and fracking, but I can't say anything more than that, as the deal is still open," he said in a phone interview from his office in Boston.

This activity is the latest example of how funds established under private banks can mimic the kind of risk-taking and investing synonymous with nonbank private-equity firms and hedge funds.

Any number of Citi's investors may capitalize a deal, with each agreeing to varying degrees of exposure. The pool of their funds can grant them a strong advantage over a lone bidder.

O'Donnell declined to elaborate on other pending deals, citing ongoing discussions, but he described North American energy, along with distressed European real estate, as his top investment play for 2015.

The market to buy and sell these royalties has slimmed since oil prices fell last year. The rights are typically highly sought, as they pay handsome dividends when production is strong. In Colorado, rights beneficiaries were fighting to preserve their payment streams even before the global glut cut into local production. Owners there have urged the state legislature to approve compensation worth hundreds of millions of dollars in payouts in areas where local municipalities have passed fracking bans. Owners say their livelihoods depend on the payments.

"It's painful," said Michael Baker, vice president of business development at Energy Net, an online auction house for U.S. mineral rights, referring to the current market.

Baker has not seen foreign investors showing interest, but it is also difficult to know who is really behind every deal. The biggest buyers are backed by private equity, he said.

Natural Gas Partners, which manages $7.3 billion in energy-related funds, is possibly the highest profile such firm in mineral rights, according to industry executives. Private-equity giant Carlyle Group has a minority interest in the Irving, Texas, company, with a 47.5% ownership. Other dedicated mineral rights bidders include Black Stone Mineral Co. in Houston (unrelated to the Blackstone Group) and Noble Royalties in Dallas.

In December, Basa Resources, a privately held firm, bought Chevron's operated interests in the 140,000-acre East Texas Oil Field. The $34 million deal was the largest in Energy Net's auction history, according to Baker, who is hopeful that the dealmaking will resume from its current lull. Owners who have grown accustomed to luxury lifestyles will have to liquidate eventually, he said. He hopes "eventually" comes sooner, not later.

Dick Sadler, head of oil and gas at Bank of America's acquired wealth management unit U.S. Trust, is advising his clients to hold out. Selling into the discounted market will lose his clients millions of dollars, even though high premiums are attached to mineral rights for their long-term potential returns. Deals cost often eight to ten times annual cash flow production per site, according to Sadler.

For clients interested in buying, rather than selling, Sadler described the transactions as prohibitively expensive. "We have clients who try to buy them, but you have to be willing to significantly overpay."

Many clients are afraid the production halts will disrupt the royalty payments for which they depend. The fearful include university foundations, retired oil company executives and beneficiaries of oil dividends. "Boy, are we having a lot of those discussions right now," he said.

The impact of the global glut on U.S. shale may still be in its infancy, but analysts are optimistic about the industry's long-term payout, meaning the mineral rights are likely a strong bet, if the land bears fruit.

Energy experts last week expressed optimism that the collapse in oil prices may be nearing bottoms, but production strains are showing no sign of reprieve for mineral rights beneficiaries. Energy services company Baker Hughes reported that overall U.S. drilling activity fell in January by as much as 20% compared with last year. In the single week ending Feb. 6, U.S. drillers idled 83 rigs. Another 84 rigs were shuttered last week.

Deal bonuses on lease contracts and working interest contracts are also plummeting. Average bonus payments have fallen from several thousand dollars per acre to below one thousand dollars per acre, according to Sadler. U.S. Trust may complete 30% fewer leases this year, versus a thousand leases a year from just a few years ago, he said.

In North Dakota, drilling activity has declined 50% since last fall, and in Texas, drilling permit applications fell in January since last September. Those halts will result in a faster than expected decline in shale production, commodities experts at J.P. Morgan Securities believe, even as the U.S. Energy Information Administration estimates national oil output will be the strongest ever this year.