The universe functions in cycles. Stars are born and die, providing the material for the birth of new stars and planets. Galaxies and solar systems revolve in their cosmic dance. Current theory holds that the universe began with a massive explosion of energy, and will continue to expand for millions of eons, at which point it will begin to collapse on itself in the ultimate cycle of existence as we understand it.

Here on earth, we live in a world of cycles. Night follows day. We rise, are active, tire and then sleep. Spring follows winter. Each generation is born, lives and dies, begetting another generation to follow the same cycle. Cycles of temperate and harsh weather are recorded throughout history. Periods of famine and periods of plenty have been the norm throughout human existence, documented as far back as Joseph’s prophecy to Pharaoh of “seven years of plenty followed by seven years of famine.” Archaeological records throughout the history of man show that this cycle was often the key driver of the birth and death of civilizations.

Many cycles that exist in nature and in human activity are long in comparison to the human life span. Currently geological theory believes that we live in an Ice Age, and that we are now in the Third Interglacial stage. Yet few of us are stocking up for the end of this interglacial stage and the resumption of the Ice Age. The longer the cycles, the more we perceive them as changes from “normal”. If we grew up under a certain set of circumstances, we consider them the norm and any change from that to be the exception. We thought my grandmother, who was a Depression orphan, was peculiar in her hoarding habits, always having two freezers full of food (in addition to the kitchen refrigerator, a cellar full of home-canned food and a garden) and saving used aluminum foil and jelly jars. But the Depression was her “norm”, and our time of plenty was an anomaly.

In our modern times, we have shielded ourselves from many of the impacts of natural cycles. We produce and store so much food that in industrial societies we no longer face the specter of famine. In many areas, we no longer even “suffer” the inconvenience of the seasonality of our favorite foods, shipping them half-way across the world so we can have fresh berries on our cereal every day. But the natural cycles are still functioning in the background, applying their pressure to various portions of the economy.

Financial cycles mirror natural cycles in many ways. In early civilization, agriculture was the primary industry. Times of plenty resulted in low prices of goods and higher standards of living. Hard times resulted in periods of economic contraction. As we all learned in school, the Great Depression was initially ignited by overexpansion of the agricultural sector followed by a great drought.

Financial cycles continue. The information technology boom of the last thirty years has apparently eliminated the inventory cycle, which was the most regular cause of business expansion and contraction. However, it did not eliminate the financial cycle, as we have so painfully learned over the last five years.

The current financial cycle began in 1981, when Paul Volcker, then Chairman of the Federal Reserve, decided to break the inflation cycle of the 1970s by raising interest rates. Treasury yields peaked at over 21%. President Reagan introduced a series of new policies targeted at cutting government spending offset by lower marginal tax rates to counter the contractive effect of reduced government spending. The higher interest rates squelched the inflation, and the lower marginal tax rates stimulated the economy, but the spending cuts were never achieved. The decline in inflation translated into declining interest rates, which set off a price/earnings expansion cycle in both financial assets and real property values that lasted 25 years.

Declining interest rates resulted in a rise in the value of all income producing assets. If one could no longer get 20% interest on their government bonds, then they would consider paying more for stocks, bonds or real estate, thus driving up the price of those assets and driving down the yields. With the Federal Reserve continually lowering interest rates, the economy grew and we were able to ignore the time bomb we had created in the actually unsound social entitlements that Congress continued to expand. We now hear some pundits speak of the current situation as “the end of . . .” (fill in the blank depending on the political leaning of the speaker), requiring drastic measures (personally, I think a little pragmatic reassessment of our expectations would go a long way to resolving these issues). Asset values escalated beyond sustainable fundamentals. The sub-prime collapse is often credited with causing the boom, but in reality it was the inevitable end of a 25 year expansion that had been manipulated to last beyond all reason. Asset values were materially overinflated. A correction was past due.

In the background to this drama, and influencing the boom and the bust, was the evolution of the energy market. Prior to 1970, the world oil market was effectively controlled by the United States (history students will recall that the Japanese attack on Pearl Harbor was in retaliation for the Roosevelt Administration’s blockade of Japan’s oil supply in Indonesia). During that period, the Texas Railroad Commission was successfully manipulating the deliverable oil supply to maintain a constant oil price. In the early 1970s, the leaders of the OPEC countries (Saudi Arabia, et. al.) realized that the United States no longer had the production capacity to control world oil prices, but that OPEC functioning as a cartel could. With the Arab Oil Embargo of 1971, OPEC set off the resumption of the boom/bust energy cycle that began in the early years of the industrial revolution, which was only briefly interrupted by the success of the United States in manipulating the world market in the early 20th century.

Energy cycles are long. The last two have been particularly extreme. The 1970s/early 1980s boom resulted in the development of excess deliverable supply, resulting in a fifteen year bust that lasted from the early 1980s through the 1990s, when oil and natural gas sold at prices below replacement cost. As the excess deliverable supply was consumed, the current growth cycle in the energy industry began. The consensus of many pundits was that “this is the end, we are running out and oil and natural gas prices can only go to the moon.”

The length of the bust impacted investor and government behavior during that portion of the cycle. The low energy prices contributed materially to the economic stimulation of declining interest rates during the 1990s. Little money was invested in energy conservation. Despite the lessons of the oil embargoes, gas guzzlers once again became the vehicle of choice. Little capital was invested in new oil and gas exploration and recovery technology. The trend was one of rising demand in the face of falling supply.

By the early part of the last decade, the excess deliverable supply was used up, as the existing producing properties followed their natural decline and consumption continued to increase. As expectations of higher oil and gas prices resumed, capital returned to the energy sector. Focus on conservation returned. Research and development into ways to consume energy more efficiently once again came into focus. New technology developed over the last two decades was applied to exploration and recovery. The results have been stunning.

Natural gas closed below $2.50/mmbtu last week – a price level not seen on a sustained basis since 2002. Natural gas prices peaked at over $10 in 2008. The current collapse is due to the success of the development of shale reservoirs, which has turned expectations for the U.S. natural gas supply on its head. It is now estimated that the U.S. have as much as 100 years of reserves based on current projections of future demand. Five years ago projects were under way to import liquefied natural gas into the U.S. Now the cycle has reversed and several projects are underway with the goal of exporting U.S. and Canadian natural gas.

The same technologies that are used to develop shale gas formations are also being successfully applied to shale oil formations. Ten years ago, Five States scoffed at a U.S. Geological Survey estimate that the Bakken Shale formation in North Dakota, Montana and southern Canada might be the largest oil field in North America. [sentence omitted from original article]

This is a paradoxical time for us in our planning. Oil and natural gas markets are moving in opposite directions for the first time. Oil is booming while natural gas is crashing. We are grateful that we sold our gas properties in 2007 and are in a position to once again accumulate natural gas properties when the market presents opportunities. We continue to actively solicit natural gas acquisition opportunities. Depressed markets are often the best environment for making great value acquisitions. However, failure of regulators to enforce traditional discipline on over-extended banks continues to allow them to keep non-conforming producing natural gas off the market, “waiting for the market to recover”.

As Jim discussed in his article “The Froth is on the Punkin’,” it feels like boom times in the oil business. There is an atmosphere of frenzy around several of the major oil plays. Articles are being published rationalizing why it is different, and why oil prices cannot fall. We are bullish on oil over the intermediate to long term. But one concern is that the pace of development could result in short-term periods of excess deliverable oil supply resulting in unforeseen corrections in oil prices. The investment structure of Five States Energy Capital, LLC allows us to continue to participate in high quality acquisition and development projects, but to do so in a preferred position. With the customer (the producer/borrower) in the “first loss” position, and our crude oil production hedging program limiting short-term price exposure, Five States can remain active in the oil sector without exposing investor capital to the risk of material loss in the event of a short-term price collapse.

Our biggest concern is the continued efforts of government to thwart the cycles. Some steps taken in the Troubled Asset Relief Program (TARP), signed into law by President Bush, stopped the collapse. But the shoring up of overinflated markets left excessive loans on the books of many financial institutions, resulting in the “investment bubble” in real estate and in other sectors never fully correcting. The financial reform bills passed by the Democratic controlled House from 2008 to 2010 avoided key issues, and left those most responsible unaccountable and further entrenched “too big to fail”. The current Republican controlled House has done nothing to address these issues and there has been no leadership in this area from the White House. The excesses that led to the debacle are as bad as ever. Not only do we have gridlock in Washington, but we have gridlock in several key sectors of the financial system. We do not believe this is sustainable. It is a scary time.

Fear and uncertainty often provide the best investment opportunities. As fear is priced into investment sectors, valuations become more attractive. The technological advances in the domestic oil and natural gas industry are providing very attractive new long-term investment opportunities. We continue to believe income-producing real assets are one of the few investment areas where we can generate strong current income while protecting our capital from the erosion of damaging fiscal and monetary policy. We often comment that our primary responsibility is to recognize reality and manage our investment risks accordingly. Recognizing and managing to the reality of the current situation is critical to investment success as these cycles continue.

Clearly, these are boom times in the oil and natural gas business. Individuals and companies are scrambling to glean as many dollars as possible before the party is over. As a lawyer friend is fond of saying, “When it’s raining oatmeal, get out your bowls.”

By almost any measure, activity throughout the country is barreling along at a frenzied pace. According to the Baker Hughes rig count of January 20, 2012, the number of drilling rigs exploring for oil and gas in the United States was 2008, up 296 from this time last year, and up 1520 from the all-time low of 488 in April of 1999. Construction and deployment of new rigs is constrained only by the lack of skilled men and women to operate them. Operators drilling horizontal wells in the new resource plays are finding they often must wait months before equipment is available while prices of fracing crews and other services are increasing as much as 30% each year.

Universities that have traditionally provided the industry with graduates educated in geology, geophysics and petroleum engineering report that classes in these courses are now filled to overflowing, some with waiting lists. New graduates are receiving multiple job offers with starting salaries that seem astoundingly high to us oldsters.

As discussed in previous articles in The Producer, the confluence of new drilling and completion technologies has opened vast areas of the world to the development of petroleum reserves that before were either not known or not recognized as profitably exploitable. In a world whose population strives for improved living standards, hydrocarbons are seen as efficient and reliable contributors to total energy supply.

The combined factors of growing energy demands, declining world oil production, robust current prices, U.S. dollar weakness, anemic investment alternatives and significant cash reserves being held by institutions and investors make investment commitments to energy appealing at this time. As a result, the boom is on.

Since its earliest beginnings, the oil industry has witnessed periods of active expansion generally followed by declines or actual busts. There have been three major ones during my professional life spanning more than a half-century.

Looking forward, we can only surmise what the future will bring. Barring the possibility of a worldwide industrial collapse, nuclear war, or some other natural or man-made catastrophe, it appears that sufficient quantities of hydrocarbons exist and can be produced throughout the world to solve many of humanity’s major problems. Here in the U.S., it is reasonable to assume that the current level of activity in the oil patch can continue for years to come.

Nevertheless, we at Five States are acutely aware that when the music stops, we need to be seated. We spend much boardroom time attempting to look ahead, discussing protective strategies for preserving our gains while at the same time evaluating developing opportunities. For that reason, we have removed much of the risk of future price declines by selling forward much of our future production and locking in attractive prices near current highs, submitting funding proposals to reputable and successful sources, and financing only those projects backed by high-quality collateral.

For the first time in our history, the greatest threat to the industry may not be lack of customers, limited resource base, technological knowledge, equipment shortages, technical difficulties, or capital limitations, but simply governmental policies that are so stridently anti-development, anti-business, and anti-competitive that they impede the ability of businesses to succeed. What a shame it would be for the U.S. to have all the ingredients necessary to produce but lack the will of lawmakers to let it happen.

Here’s wishing you a very happy, healthy and prosperous 2012!

The National Petroleum Council (“NPC”) is a federally chartered and privately funded advisory committee, established in 1946 by President Harry S. Truman. Its sole purpose is to advise, inform and make recommendations to the Secretary of Energy with respect to any matter relating to oil and natural gas. NCP membership of approximately 200 persons is selected and appointed by the Secretary of Energy. Individual members serve without compensation as representatives of their industry and the nation as a whole, not as representatives of their particular companies. The goal in selection of members is to assure a well-balanced representation from all segments of the oil and gas industry, including individuals from academic, financial, research, and public interest organizations and institutions.

The advice of the NPC is transmitted to the Secretary of Energy in the form of NPC-approved reports that are provided to the government as a public service. The cost of providing this advisory service is borne by voluntary contributions from NPC members. The NPC conducts studies in response to specific requests by the Secretary. Since its formation in 1946, the NPC has prepared over 200 reports, which deal with virtually every aspect of oil and gas operations. As a member of the NPC for almost a decade, I have witnessed the many hours of detailed and exhausting work required to complete each report requested by the active Secretary.

At our meeting in late September, the NPC approved the draft of the 2011 report entitled “Prudent Development: Realizing the Potential of North America’s Abundant Natural Gas and Oil Resources.”

In his 2009 letter asking the NPC to conduct this study, the Secretary of Energy requested the assessment concentrate on two tasks: (1) develop an up-to-date understanding of the potential natural gas and oil supply opportunities in North America, and (2) examine the contribution natural gas could make in a transition to a lower carbon fuel mix.

The study developed four conclusions about natural gas and oil with the intent that these findings will help guide the nation’s future policy decisions.

• First, the potential supply of North American natural gas is far bigger than was thought even a few years ago. As late as 2007, it was thought that the United States would become increasingly dependent on imported liquefied natural gas, owing to what appeared to be a constrained domestic supply. It is now understood that the natural gas resource base is enormous, and its development is potentially transformative for the American economy, energy security and the environment. These newly discovered resources have the potential to meeting even the highest projections of demand and amount to over 100 years of supply at today’s consumption rates.
• Second, and perhaps surprising to many, America’s oil resources are also proving to be much larger than previously thought. The North American oil and natural gas resource base offers substantial supply for decades to come and could help the United States reduce, but not eliminate, its need for and resulting cost of oil imported from outside of North America. Thanks to advances in the application of technology, North America has a massive, economically accessible oil resource base, which includes huge quantities of unconventional gas such as shale gas.
• Third, America needs these natural gas and oil resources even as efficiency reduces energy demand and alternatives become more economically available on a large scale. Even presuming the United States uses energy much more efficiently, diversifies its energy mix and transitions to a low carbon fuel mix, Americans will need natural gas and oil for much of their energy requirements for the foreseeable future. Moreover, the natural gas and oil industry is vital to the U.S. economy, generating millions of high-paying jobs and providing tax revenues to federal, state and local governments. Every additional unit of energy produced domestically reduces foreign imports and our balance of payments deficit.
• Fourth, recognize the impact of natural gas and oil dependence on environmentally responsible development. In order to actualize the benefits of these larger natural gas and oil resources, safe, responsible and environmentally acceptable production and delivery must be ensured in all circumstances.

It is hoped that the conclusions of the NPC’s report will ameliorate the opinions of the current administration in Washington, which still holds to the view that natural gas is simply a “bridge” fuel to a future dominated by subsidized wind, solar and ethanol. In the meantime, it is comforting to know the U.S. has the resources to continue to provide clean, abundant and cheap energy to U.S. consumers—provided our oil and natural gas companies are not impeded by governmental actions engendered by a hostile business atmosphere.

Dallas, Texas – August 29, 2011 – Five States Energy Capital, LLC (“FSEC”), which provides Independent Capital for Independent Producers^®, is pleased to announce the closing of $85 million in financing for a Bakken Shale Producer (“Client”) on August 18, 2011 to further develop its Bakken assets and acquire additional working interests in the trend.  The financing agreement consists of a $25 million senior credit facility, $50 million junior credit facility and $10 million acquisition facility.

After assessing several financing strategies and proposals, FSEC was selected by the Client as its preferred partner partly due to FSEC’s own experience in the participation of drilling oil and gas wells in the Bakken the past 6 years.  The Client expects to participate in the drilling of an additional 50 Bakken wells in the next 18-months in Williams and McKenzie Counties, North Dakota.

“We are very excited to enter into this financing agreement.” said Five States Energy Capital, LLC President and CEO, Arthur N. Budge, Jr.  “We have been active in the Bakken for several years, and we continue to search for ways to participate in the development of oil and gas assets in the trend.  We expect this partnership to be mutually successful for several years as we partner to further develop these assets.”

About Five States Energy Capital, LLC

FSEC was established in 2007 to provide customized capital solutions to independent producers located throughout Texas, New Mexico, the Mid-Continent and the Rockies. Combined with its affiliate, Five States Energy Company, LLC, Five States manages more than $250 million in oil and gas investments.

For more information contact:

James B. Griffis • Vice President – Business Development • jgriffis@fivestates.com
Dallas Office: 4925 Greenville Avenue, Suite 1220 • Dallas • Texas • (214) 560-2573
Midland Office: 500 West Texas, Suite 1170 • Midland • Texas • 79701 • (432) 269-9929

In the first quarter 2011 edition of The Producer, I wrote about recent “Game Changers” in the oil and gas industry, discussing the impacts of the development of unconventional oil and natural gas reservoirs and of the resulting new production on domestic and international energy markets.  Recently some media channels have reported what appears to be a populist backlash against the development of these resources.  On further analysis, much of this appears to be orchestrated by special interest groups including environmentalists, and those with vested interests in “alternative energy” and the coal industry.  The attacks come in two forms; environmental and economic.

The primary environmental claim is that hydraulic fracturing can damage drinking water sources.  Recently, EPA (Environmental Protection Agency) Administrator Lisa Jackson testified before Congress that she is not aware of any proven cases where hydraulic fracturing has contaminated ground water.  There are no documented cases of this occurring in the sixty year history of the use of hydraulic fracturing to stimulate oil and natural gas wells.  There are cases where poor well drilling practices have allowed produced gas to seep into nearby water wells, but this is not due to hydraulic fracturing.  The formations being fraced are thousands of feet (8,000’ below the surface in the case of the Barnett Shale) below the freshwater zones and are separated from the freshwater zones by multiple layers of impervious rock.  The physical energy in the fracing process is not sufficient to cause the damage claimed.

The second argument is that these resources are not economically viable.  Following is a discussion of our assessment of the economic viability of unconventional oil and natural gas, and some of the fallacies or misleading statements in recent news articles.

Conventional Reserves

To understand unconventional reserves, it is necessary to define conventional reserves.  All conventional oil and gas reservoirs are formations of porous rock which are in some manner “capped” (trapped) by a non-porous layer of rock.  Most conventional reservoirs are made up of sandstone or carbonates such as limestone or dolomite.  Sandstone reservoirs were formed by the layering of eroded sand and silt over millions of years.  Carbonate reservoirs were formed over millions of years by the precipitation of minerals out of sea water.  Collectively sandstone, limestone and their variants (mudstone, siltstone, clays, dolomites and shales) make up sedimentary rocks.

Sedimentary rocks have different degrees of porosity and permeability.  Porosity is the space between the grains of sediment.   The more porous the rock, the more gas or liquids it can hold.  Permeability is the degree to which the pores in the rock are connected.  If the pores are well connected (higher permeability), then gas or liquids can move through the sedimentary rock and the natural cementing materials that “hold” the rock grains together, allowing for production.  In very “tight” or low permeability rocks such as shale, the oil and gas do not readily flow through the rock, even under great pressure.

Porosity – space between the grains of sediment.                   Permeability – connections between pores

Rocks in which the pores are not well connected may not be sufficiently permeable without artificial stimulus.  Some conventional formations, such as certain dolomites, could not be economically produced until the development of hydraulic fracturing.  Hydraulic fracturing is used to increase the permeability of the reservoir rock.  This process was introduced in the west Texas oil fields about sixty years ago.

Unconventional Reserves