“Certainty”
By Arthur N. Budge, Jr.
We held the twenty-fifth anniversary Annual Members Meeting of Five States Energy Co. in mid-April (the meeting of the owners of the general partner entity). I began my presentation with a discussion of the high level of macro uncertainty in making investments today.
Oil and gas prices remain extremely volatile. Over the past twenty-four months, the price of crude oil reached almost $150 per barrel and has been less than $40 per barrel.
The Energy Information Administration (a part of the U.S. Department of Energy) recently published their outlook for crude oil prices for the next two years. I am sure a great deal of heavy analytics went into telling us that they are confident oil prices will range somewhere between $40 and $200 per barrel over the next two years!
We also discussed uncertainty generated by the lack of availability of capital on “Main Street” and the depressive effect this is having on financing cycle time in the general market on business transactions. I have heard many in both real estate and energy financing refer to it as “like swimming in molasses”.
The reactionary behavior by the Federal Government in directing capital allocation in the private sector over the last two years is causing severe mispricing of capital. Washington is choosing the beneficiaries, rather than allowing the efficient rationing of capital through free market pricing mechanisms. The government is effectively providing free capital to the companies that are actually at the root of the problem and transferring the risk and cost to the general economy (the rest of us). The dislocations and mispricing are resulting in a surplus of low risk capital and a shortage of risk capital. This is resulting in a lot of what we call “kick the can” by many financial institutions. They are deferring dealing with problem investments hoping things will get better. This has the adverse effect of keeping them from making productive new loans because they are focused on their risks and problem assets. We believe this translates into a macro environment of NO GROWTH, but provides EXCELLENT VALUATIONS for asset acquisitions.
As we have discussed many times in the past, we consider ourselves classic value investors. A value investor is one who determines the value of an asset and buys only when the market price is below that value. We determine value by estimating future income and calculating the price that we can pay for that asset to achieve our target return. Value investing is often “out of synch” with market valuations. It often looks contrarian, but is actually based on a discipline of sticking to our assessment of value based on fundamentals. When we invest, we are depending on the future income generated by the investment as our source of return, not on selling the asset to someone else for a higher price later. The current environment is very attractive for value investing. But we are working in a period of high global uncertainty.
In a time of uncertainty, you need to have good people you trust around you. As you know, Jim Gibbs, Don Malouf and I have been partners for twenty-five years. We have been through the good, the bad and the ugly together. Our behavior under various conditions does not surprise each other.
We also have a team of professionals managing Five States who have been with us for a long time. Sixty percent of our employees have been with us for over five years. Thirty percent have been with us for over ten years. Many of the shorter tenure employees are in positions that were newly created due to our growth at the time they were hired. The average oil and gas industry experience of our employees is over twenty years. On average, seven years of those twenty years have been with Five States. Our employees have spent one-third of their career with us.
I receive many questions about the new additions to our management team and the impact that is having on our culture. Richard Harrison joined us in 2007 as CFO, and we entered into a joint venture with Mike Tonti last year. To us, these are not new relationships.
Richard and I have known each other and done business together for twenty-three years. I met Richard at a colleague’s wedding in 1986. Immediately thereafter, I began doing contract financial work for a private equity fund in which Richard was a principal. A few years later the Harrison family began investing with Five States. In the 1990s, I led a group of investors in a specialty finance company investment managed by Richard. The investment did not fare as we had hoped. Wall Street flooded the sub-prime market with inexpensive capital. New competitors drove the entire industry to negative margins. Rather than follow the industry and continue to write bad loans, Richard developed a dissolution plan that substantially saved our investment. To ensure it was successfully implemented, Richard remained at the helm long after his own position was wiped out. A few years later, Richard assisted us in detailed analysis and management of a west coast technology investment in which we were involved, including the sale of a significant portion of our investment to a venture capital firm. In 2007, when I needed help with the completion of the business plan for Five States Energy Capital, I turned to Richard. At that point we had twenty years of business experience together, and I knew I could depend on him. Upon completion of the business plan, Richard joined us on a full-time basis.
Richard and I were involved in Indian Princesses with our daughters fourteen years ago when our girls were five years old. Indian Princesses was a program sponsored by the YMCA where fathers and daughters participated in outdoor/camping programs. Mike Tonti and his daughter were also in our tribe.
Mike and I spent many hours around the campfire discussing the general condition ofTexasbusiness. Texas was coming out of the real asset price crash we experienced in the late 1980s, but value investing in income producing real property (real estate and oil and gas) was still out of favor. During that period, Mike began investing in Five States production income partnerships. Shortly after that, I needed to refinance Five States Energy’s structural debt at a time when the credit market was very tight for oil and gas. I explained the situation and the collateral to Mike around the camp fire. Mike commented that it sounded like a good investment with a much higher yield than he was earning on his bond portfolio, and that he would be interested in buying some of it. I sent him the memorandum on Monday, and he bought all of the available debentures the following Friday. Oil prices fell below $10 per barrel. Mike reviewed the condition of Five States with me, determined the debt was secure, and we weathered the storm.
Ten years ago Mike and I began an ongoing discussion of the real estate bubble, and how we could work together to capitalize on the opportunities that would emerge when the bubble burst (we were a little early!). Prior to last year, the Tonti family had been in the real estate rental business for 50 years, operating in seven Sunbelt markets, but had never had outside investors. Two years ago Mike and I began serious discussions on a joint venture. Mike’s primary concern with bringing in outside investors was what he calls “alignment”. He wanted to make sure that the investors and the manager’s interests were in synch; that one group was not benefiting at the expense of the other. It was the same issue that was core to the formation of Five States when I began working with Jim and Don in 1985.
We have an old saying inTexasthat it is easier to stay focused “when you know who’s watching your back”. The analogy is to a gunfight in the old west, and not having to worry about someone sneaking up behind you because your partner was watching out behind you. Knowing whom we are investing with is a key to our success dealing in private equity. Even more important is whom we are working with on the inside.
Five States is an organization where I am surrounded with people I trust. They are very close to family relationships. We have been through good times and bad times together, and I know what I can expect from each one of them. When we’re working in difficult situations I know my back is covered. This allows me to stay focused on executing our business plans and taking advantage of the opportunities that are available to us. In these uncertain times, I have certainty in my colleagues. I know how we will work as a team to take advantage of the emerging opportunities. I sleep well at night because I know our house is in order.