The decline in crude oil prices over the last six months has been dramatic. Since early summer, the spot price for crude oil traded on the New York Mercantile Exchange (“NYMEX”) has dropped from the $90 – $100 per barrel range, where it has been trading for the last several years, to about $70 per barrel at the end of November. Last week the posted price in the US was below $50 per barrel for Williston Basin (Bakken, North Dakota).
NYMEX Crude Oil Futures Prices
Two factors are causing the price of crude oil to fall. World supply is increasing due to the US oil boom, and world demand growth is slowing. It is classic economics. See my article, “Oil Fundamentals: Supply and Demand,” for a more detailed discussion of world supply and demand.
Regional Wellhead Price Differentials
The price decline in crude oil is further impacted in regions of the US where production volume has increased materially by what is referred to as price differential. Price differentials are the difference between a reference price, such as NYMEX, and the actual price paid at a field location or at the wellhead. Areas with off-take constraints or limited delivery infrastructure, such as the Bakken in North Dakota, can experience wellhead differential expansion (the price falling relative to the reference price) during periods of rapidly increasing production volume, infrastructure disruption or demand decline. See Tom Barnes’ article, “Price Differentials,” for a more detailed discussion of differentials.
Now for the $64 questions: “How Low Will Crude Prices Go and How Long Will the Correction Last?” The answers to these two questions are inversely related.
The decline in crude prices is a self-correcting situation. The lower the price of oil, the more oil is consumed. The lower the price, the slower the pace of new drilling, which accelerates the decline in deliverable supply. The faster the decline in deliverable supply, the sooner demand will outpace supply, resulting in higher prices. “The cure for low prices is low prices.”
In the short term, the “floor” for oil prices is very low. When midstream facilities are glutted, what happens to additional production? If every tank battery and pipeline is full, there is a physical constraint. In the short term, crude prices could fall below $60/barrel.
Unwinding of financial trades around the physical market can exacerbate a price decline. In 2008, we saw the price of oil drop below $40/barrel, falling $100 in 100 days. Paper traders exacerbate extremes when a trend reverses or breaks technical barriers. See Tom Costantino’s article, “Forward Curves, Markets & Trading Strategies,” for a detailed discussion.
Corrections of the magnitude experienced in 2008 are unsustainable. In a severe correction, “supply destruction” is almost immediate. The production from shale wells declines much more rapidly than conventional wells. Over 50% of the production from a shale well will be produced in the first two years after each well is completed. If drilling slows or stops, it will not take long for the new production developed in the past three years to decline materially.
When oil is in the $90+/barrel range development activity accelerates, ultimately increasing supply and depressing prices. When oil is below this level ($70s & below) development will slow, the rate of depletion will accelerate since new production is not being added, and demand will outpace supply, resulting in a price recovery. We expect the current correction and decline in new development will take six to twenty-four months to reverse.
In the intermediate and long term, we believe that the sustainable price of oil is in the $80 per barrel range. This covers the cost to continue shale development with an appropriate rate of return on capital. Without shale development, the oil market reverts to the late 20th Century position of dependence on OPEC. In our plans, we expect a trading range of $65 – $105. We do not expect to see long term oil prices above this range until the resumption of more normal worldwide economic growth.
Crude Oil Annual Trading Range
Near Term Impact on Five States Distributions
We have hedges in place on 88% of our proved producing properties at $90 per barrel for 2015. Hedges are in place on 42% at $87 per barrel for 2016. Having prices “locked in” will reduce the impact of lower prices over the next two years.
Our low leverage philosophy is defensive. Our properties have low production costs and we do not have a lot of debt. Low operating and financial leverage results in less downside volatility during periods of declining prices.
Midstream assets are not as sensitive to short-term price volatility. Revenue is in units of oil transported, not the price per barrel produced. Our midstream projects will still continue to operate, moving production that has already been developed even when drilling slows. Our pipelines and rail facility are the lowest cost transportation option currently available. We believe it would take a long-term drop below $70 to impact long-term economics of our pipelines.
We estimate net cash flow for Five States Consolidated I, II & III would decline by approximately 15% for 2015 compared to 2014 if NYMEX crude averages $70 per barrel. Net cash flow for 2016 could decrease an additional 25% in 2016 if NYMEX crude averages $70 per barrel.
Lower prices will decrease operating cash flows from the production components of the portfolio in FSEC Fund 1. However, the hedges in place will mitigate much of the negative impact over the next couple of years. Prolonged lower prices could slow the pace of further drilling on our development projects. This could affect the development schedules for the OSR-Halliday, as well as the Waggoner Ranch. Lower oil revenues could also impact our mezzanine loan with Diversified Resources and their ability to stay current on the 12% coupon.
The two largest investments in Fund 1, Great Northern Midstream and Advantage Pipeline, should continue to perform at or above current levels in 2015. Advantage Pipeline is still projected to begin making cash distributions in early 2015. We expect larger distributions from Great Northern Midstream in 2015. The increased distributions from our midstream assets, along with our hedges, should offset much of the negative impact from the decline in oil prices.
Five State Investment Strategy
We have made only one investment for FSEC Fund 2 to date. This is the Tenawa natural gas processing plant. Falling crude oil prices have impacted this project. The decline in crude prices has reduced the value of the extracted natural gas liquids, particularly propane, and while still a profitable project, we have reduced our projected profit on this project by roughly 50% – 60%. Going into the winter it is difficult to estimate the demand pull on propane and hence the extent of any upward pressure on price. We still have 80% of the capital of Fund 2 uncommitted, so we have plenty of capital available to take advantage of new opportunities.
In the 20th Century, the greatest risk in oil and gas investing was unsystematic risk. The primary risk was drilling a dry hole. Today, the primary risk is systematic, or market risk. Shale development projects are almost always productive. Wellhead price volatility is now the greatest risk. The NYMEX price must remain over $60 per barrel for many of the shale projects to be profitable and encourage additional drilling.
As we have stated over the past few years, we are cautious about new oil investments based at $90 per barrel, typically investing in a mezzanine or preferred structure. We believe $70 – $85 per barrel is the “fair value” for the NYMEX reference price. When the price for crude oil is below $80 per barrel, we become more aggressive seekers of producing properties.
We are excited about developing opportunities. We believe lower prices will renew acquisition opportunities, which remain part of our investment strategy. If good assets are revalued based on current prices, they can be acquired at lower prices and performance on new investments will be more attractive.
Eroding bank borrowing bases of independents should create demand for equity. As oil prices fall, the collateral value of producing properties declines, reducing the amount banks will advance. The last few years we have seen some banks underwriting loans very aggressively. This trend should reverse, reducing the amount of bank capital and providing more opportunities for private equity.
Independent producers that need more capital to continue development will look either to mezzanine investors like Five States or sell assets. This may take time to develop. Collateral revaluations typically take place twice a year. Much of the reduction in bank collateral value is not because assets are bad. In many cases lenders loaned too much on good assets because they were assuming higher prices.
Our business development team is actively approaching community and regional banks, updating them on our interest in providing capital to their customers who no longer have sufficient borrowing capacity under their primary banking lines. Lower oil prices should also put pressure on banks and investors holding underperforming natural gas assets to sell some of these assets.
Another primary reason for the increase in producing property prices over the last five years was an overall industry “land rush” during the shale boom. Many acquirers of producing properties were trying to gain control of the potential shale acreage, paying an inflated price for the existing production in order to acquire the shale drilling rights. This type of competition will no longer be bidding up producing properties.
We will continue to actively solicit midstream investments. The energy renaissance is still in its early stages, and it will probably take twenty years to develop the new infrastructure needed.
We like new oil investments at $80 per barrel or lower. Lower prices should result in lower development costs, improving the long-term economics of the redevelopment underway on our legacy holdings.
We are in a defensive position on oil prices with respect to our legacy portfolios. But the price drop is not without negatives. If prices remain at this level, we will realize lower income for the production not hedged. We have been using prices in the $80s in our forecasts and valuations for 2017 and beyond for the last three years.
As Warren Buffet said, “Be fearful when others are greedy and greedy when others are fearful.” Lower oil prices provide a much better environment for value investors like Five States to place new capital. These lower prices provide the best environment for placing new capital we have seen in over a decade.