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

The difference between conventional and many unconventional reservoirs is the degree of permeability of the sedimentary rock.  Many unconventional reservoirs are composed of shales.  Shales are even less permeable than carbonates.  Drilling oil and natural gas wells in shales was not economically viable until the development of horizontal drilling in the 1990s.  Horizontal drilling greatly increases the volume of the shale formation opened by the drill bit.  Hydraulic fracturing then increases the permeability of the exposed formation.

“Insiders Sound an Alarm”

On June 25^th a front page New York Times article titled “Insiders Sound an Alarm Amid Natural Gas Rush” written by Ian Urbina is an example of the disinformation and misleading reporting being presented by some with a predefined agenda.  Mr. Urbina has a long history of anti-energy industry pieces for the New York Times. In this article he cites emails and documents from unnamed “industry insiders” stating that natural gas shale plays are uneconomic at current prices, reserves are purposely inflated, and he suggests that these drilling programs are ponzi schemes, equating the shale plays to the dot.com bubble.

Natural Gas Shale Wells Are Uneconomic?

Many natural gas shale wells are uneconomic at current prices. It is necessary to receive more than $4 per mcf (thousand cubic feet) for natural gas to recover the cost of drilling the wells.  Prices are currently in the low $4 per mcf range.  However, the current low price is due to the increase in domestic natural gas production from unconventional natural gas development over the last ten years.  During that period unconventional gas has increased from insignificant levels to over 25% of the U.S. natural gas supply.

This additional supply from unconventional sources has driven natural gas prices down materially.  Five years ago, natural gas wellhead prices were $8 per mcf, with futures trading up to $12 per mcf.   These lower prices permeate the U.S. marketplace, helping to keep production costs of electricity down and providing further incentives to convert fleet vehicles to natural gas. Recognition of the potential for a dramatic natural gas price decrease due to the supply potential from unconventional development led Five States to sell its portfolio of natural gas properties in 2007 when the wellhead price was $8 per mcf.

The current industry consensus, as reflected in the futures price of natural gas on the New York Mercantile Exchange, is that over time the price of natural gas will increase.  As the initial shale wells deplete and production from them declines, the price of natural gas will rise.  At the point that it rises above replacement cost, the incentive to drill more wells will return.

Many companies are drilling these wells today because they have made a long-term commitment to this business on the expectation that prices will increase over time.  They have done this by investing in large leasehold positions.  These leases are typically for a three to five year term.  If production is not established within the primary term, the lease is lost.  Once production is established, the term of the lease is extended as long as production is maintained.  Many of the unconventional natural gas wells being drilled today are drilled to maintain these leases, with the intention of drilling additional wells when market prices warrant.

Shale Reserves Are Overstated?

There was a lot of skepticism within the industry a few years ago regarding the amount of gas that could be produced from unconventional reservoirs.  With natural gas from shale production now providing 25% of the U.S. supply, it is hard to argue with the significance of this resource.  The primary source of reserve information is the Energy Information Administration (EIA), which is a division of the U.S. Department of Energy.  Michael Schaal, director of the Office of Petroleum, Natural Gas and Biofuels of the EIA strongly disagrees with Mr. Urbina’s position.  http://www.eia.gov/pressroom/releases/pdf/shale_gas.pdf

Insiders Harbor Serious Doubts?

Mr. Urbina asserted in his New York Times article that many “insiders” in the natural gas industry harbor serious doubts about the long-term viability of the natural gas market. There are numerous rebuttals to the methodology and validity or bias of the “experts” cited by the author.  One is an expert witness for the coal industry.  Another is described as “a member of the advisory committee of the Federal Reserve Bank of Dallas”.  A spokesman for the Federal Reserve Bank of Dallas commented that the individual is an unpaid volunteer on a citizen committee.  If you would like more details, please contact me.

Five States’ Position

Our experience to date, and that of our peers, is that unconventional reservoirs are a huge energy resource for the United States.  EIA analysis confirms major domestic reserves from these resources.

As with all oil and gas investments, there is risk in reserve forecasts.  Risk in forecasting is a part of the analysis of any developing resource.  There is also risk in exploration, development and production, as well as risk in market pricing of the underlying commodities.

We have concluded that the unconventional oil and gas plays can provide attractive investments for our funds.  The exploration risk in many of these plays is materially smaller than in conventional exploration.  In many cases, the risk is closer to developmental drilling risk than exploration risk.

We have participated in nine Bakken wells in Five States Consolidated I, Ltd. on acreage held by both shallower and deeper production we have owned for about fifteen years. We have been very pleased with the results to date.   The Bakken is an unconventional oil play in North Dakota and Montana, developing oil wells in a major shale formation.  Some EIA estimates project that in a few years the Bakken will be providing up to twenty percent of the total U.S. oil supply.  We plan to continue participating in Bakken wells proposed on our existing acreage.

The development pace in the Bakken is so intense that many independents cannot fund their drilling obligations on wells being proposed on their acreage out of existing cash flow.  This is providing excellent opportunities for mezzanine funding.  We are pursuing several mezzanine and development opportunities in this play for Five States Energy Capital Fund 1.

We are also focusing on acquisitions and development opportunities in the first unconventional natural gas play in the U.S., the Barnett Shale in north Texas.  We stayed on the sidelines during the boom period in the Barnett Shale.  Now that the boom is waning and the development of the play is maturing, we expect to find acquisition opportunities based on attractive valuations.

As with all direct investing in oil and gas acquisition and development, the competition is fierce.  Thorough due diligence is a necessity.  Market volatility risk remains high.  This market volatility risk increases the need for proper structure when investing in high break even cost assets.  These risks can be managed through appropriate structure and the prudent use of hedging.  We believe the risk adjusted returns in this area are as attractive as any we have seen in the industry in the last eight years.  Unconventional plays should provide an attractive additional source of investment opportunities for Five States investors for the next decade.

The current Administration has firmly voted in favor of replacing America’s fleet of gasoline and diesel powered automobiles with all-electrics or hybrids.  Through speeches and legislation, the public is being encouraged to “buy electrics next time”. The Department of Energy’s forecast is that by 2020 there will be 100 million electric or hybrid cars in use, fully 40% of the U.S. registered vehicles.  Boone Pickens’ suggested option of converting existing trucks and buses to run on compressed natural gas (CNG), and building new vehicles to utilize this low-emission alternative, has gained little attention or traction in Washington.

The  marketing script for electric cars is appealing:  zero emissions, no more trips to the gas station, and government rebates and incentives to help lower the cost as drivers convert from gas-guzzling consumers to green-minded, electric-buzzing cruisers. However, before the public trades in their Ford pickups and Lexus sedans, they’ll need to learn patience and tolerance for inconvenience and higher costs.

Most of us are aware of the major disadvantages of electric cars or hybrids:

• Charging woes:  Electric powered vehicles require charging stations, and for people to travel long distances there needs to be a network of such stations located strategically.  Also, recharging of batteries often takes about 3 hours, which nowhere matches efficiency of a gas refuel.
• Traveling distance (Range):  The cars can travel only about 100 miles on average on a single charge.  However, evolving technologies will likely extend their ranges in future years.
• Lack of power:  In general, electric cars are still behind gas powered vehicles in their ability to accelerate and climb quickly.
• Overloaded batteries:  At the heart of electric automobiles are the car’s batteries.  With other car accessories such as radios, air conditioners, headlights and such in use, batteries drain quickly.
• They are expensive:  Batteries that power these cars are a costly issue.  Consider that the promising and long-lasting lithium-ion batteries cost about $10,000 each, they make these cars expensive.  And if the batteries last only about 4 years, they could add to the maintenance costs.
• They cause pollution:  While battery power has been regarded as basically clean, there are toxic elements within batteries which could spew toxic fumes.  Further, as is mentioned below, battery power may not be as eco-friendly as generally believed.  Also, because the car’s engines are powered by electricity, fossil fuels generate almost all of the energy.  This means that electric cars are simply exchanging pollution from tail pipes for pollution at another location, with the attendant loss of power via transmission lines from generating plants to recharging stations.
• They are heavy:  Batteries make vehicles heavy.  A battery pack of an average electric car can weigh up to 1,000 pounds.  This is a disadvantage because weight puts load on batteries and they drain out faster.

Recently, other issues are emerging, further weakening the case for electrics:

A recent British study has determined that electric cars produce higher emission than gasoline-fueled cars.  The British study, which is the first analysis of the full lifetime emission of electric cars covering manufacturing, driving and disposal, undermines the case for tackling climate change by the rapid introduction of electric cars.  The study, commissioned by the Low Carbon Vehicle Partnership, which is jointly funded by the British government and the car industry, found that a mid-size electric car would produce 23.1 tons of CO2 over its lifetime, compared with 24 tons for a similar gasoline car.  Emissions from manufacturing electric cars result by utilization of materials such as lithium, copper and refined silicon, which require much energy to be processed.  Once the emissions from producing a replacement battery are factored in, the total CO2 from producing an electric car rises to 12.6 tons, compared with 5.6 tons for a gasoline powered car.

And will sufficient battery components be available anyway?  Several rare earth elements, including lanthanum, neodymium and dysprosium are used in products from high-capacity batteries to hybrid-electric vehicles.  China controls between 95 and 100 percent of the global market in these and other critical elements, and the United States is increasingly reliant on China as a supplier.  Will China always be willing to sell us as much of the rare earth elements as we need? Will we eventually have to buy all our batteries from China?

Utilities will need to upgrade equipment and services if a significant number of drivers choose to recharge their vehicles at homes and garages.  An important question is whether customers will opt to use their household current (120-volt) to charge their electric cars overnight, or will the homeowners be willing to ante up the roughly $2,000 to install a 240-volt line that will cut the recharging time to fewer hours.  In either case, the vehicle will be the largest discretionary load on the home, and utility bills will increase.

Another concern for utilities is that of local area overloads on transformers.  Transformers step down high-voltage power for residential electricity use.  Typically, in neighborhoods, one transformer serves three to six homes.  If there is overuse, it can lead to power outages.  In the case of needing to upgrade transformers to handle electric vehicle charging, who pays?  Likely, surcharges will be added to the monthly bill.

No doubt, in future months we’ll see an increasing number of television ads for electrics, and more electric and hybrid vehicles on our streets and roads. The question for each of us will be, “Do we really want one?”

The long-term outlook for oil and natural gas has been well understood for more than fifty years.  I remember my father talking about the shift in the world energy outlook in the late 1960s, when he chose to move from the oil division of Gulf to Gulf Minerals, the alternative energy group.  The story was the same then as it has been for the last five decades; U.S. production is on the decline and imports will continue to increase and the vast majority of reserves are in politically risky or unstable regions such as the Middle East, North Africa and Russia.  Therefore we face perpetual rising energy costs.

Crude Oil Market Changes

But today West Texas Intermediate crude oil is trading at a discount to all other world oil!  This is an historical “first”.  Since inception, public contracts for North Sea Brent (the primary international benchmark oil price) have traded at a discount to West Texas Intermediate (WTI) crude oil.  WTI is a high quality crude, and has the geographical advantage of being produced in the largest consuming market in the world, thus avoiding significant transportation costs.  WTI is now trading at as much as a 10% discount to other major world oil markets.

The cause of this reversal is a significant increase in oil produced in the central U.S. and in central Canada. Canadian tar sands and Bakken Shale production have overwhelmed the transportation and storage infrastructure in the central U.S.  Oil inventories at Cushing, Oklahoma are at historic highs (Cushing is the market location for oil produced in central North America).  Other factors contributing to this reversal are (1) North Sea Brent production is in irreversible decline, (2) global demand increased by the second largest annual amount (2.75 mm barrels/day) in the last 30 years, with all but 0.5 mm barrels/day from non OECD nations, and (3) a transportation bottleneck developed from Cushing to coastal refiners.  This huge spread in oil prices will easily pay for the needed infrastructure, the construction of which will eliminate the spread by enabling physical arbitrage.

The Bakken was not considered a “viable play” ten years ago, and was not considered part of the U.S. reserve base. The United States Geological Survey (the USGS, a part of the U.S. Department of Interior) is now estimating that the Bakken Shale in the U.S. and southern Canada may be the largest oil field in North America.  Some analysts are speculating that it is larger than the Saudi Arabian oil fields. 

But it is expensive.  The estimated fully allocated cost of Bakken production ranges from $60 to $80 per barrel.  If prices remain high, development of shale formation will continue throughout the world.  As more experience is gained, costs will fall.  Five States production partnerships own interests in a number of Bakken wells.  The Partnerships own shallow production in North Dakota, and therefore the rights to participate in deeper Bakken wells on our leases when they were proposed.  We have been very pleased with the results to date and intend to continue to participate in future wells when they are proposed.  We are also pursuing Bakken opportunities through Five States Energy Capital Fund 1, providing financing to smaller independents being overrun by drilling programs of larger E&P companies.

Natural Gas Market Changes

Estimates regarding the recoverable natural gas reserves in North America have been “turned on their heads”.  In 1979, President Carter championed the Natural Gas Policy Act, which prohibited new use of natural gas as a boiler fuel because it was such a scarce and unique commodity.  Natural gas is now so plentiful that it has been the primary (and almost only) new base fuel used for electrical generation over the last decade.

The primary change in the market over the past 30 years has been higher natural gas prices.  This has been followed by increased investment in drilling and research and development in recovery technology.  This resulted in the development of recovery technology for extracting oil and natural gas from shale formations.   This supply increase will soon be partially offset by accelerated Gulf of Mexico declines due to cessation of Gulf of Mexico drilling. 

The oil and gas industry has always recognized that shale formations contained hydrocarbons.  However, prior to the last decade, it was not economically practical to produce oil and natural gas from extremely low permeability shale formations.  As oil and natural gas prices rose, new investment was made in new technologies for recovering oil and gas from these formations.  Horizontal drilling and multi-stage hydraulic fracturing have opened the flood gates. 

The results have been staggering.  The outlook for North American natural gas is now one of sustainable long-term supply, rather than one of perpetual decline.  Owners of Liquefied Natural Gas (LNG) terminals that were developed to import natural gas to the U.S. are studying the feasibility of reversing these facilities to allow for the export of U.S. natural gas.  

The increased supply has driven prices lower.  The spot price for natural gas today is half of what it was in 2007 when we sold all of the natural gas properties owned by Five States production partnerships.  The recession also contributed to lower natural gas prices as electricity demand eroded.  The market currently expects natural gas prices to rise over the next few years as the economy recovers, but futures prices are still one-third lower than the highs of 2008.

Financial Sector Changes

The response of government regulators has been most surprising to me during the recession.  Historically, whenever there has been a major correction in any of the real property sectors of the economy regulators have required banks and institutions to promptly recognize the erosion in their collateral base (“mark the assets to market”) and take appropriate action to restore the required loan to value ratios in their portfolios.

This time has been different.  Regulators recognize that requiring financial institutions to liquidate assets such as real estate and natural gas properties into the weak economy would result in further erosion of prices.  Instead, the decision has been made to let the institutions continue to carry these non-complying assets on their books, in essence pushing the pain off into the future, hoping that things will get better or that the day of reckoning will come under the next politician’s watch.  So far, it has worked.  Markets have been fairly stable.

But stabilizing markets of overleveraged underperforming assets at artificially high prices has a drastic impact on the economy.  Banks will not make as many new loans for development as they would in a normal environment while their balance sheet is loaded with nonconforming assets.  Businesses and investors are more cautious about investing in new projects, fearing the risk of overpaying in the artificially inflated market, recognizing that the risk of further correction in value is possible.  Compounding the reluctance to deploy funds is the infinite liquidity for financial institutions provided by the Federal Reserve.  These artificially low and unsustainable interest rates are resulting in asset inflation as capital flows out of traditional liquid instruments and bonds in search of yield.

Conclusion

Prices are the primary driver in both the oil and natural gas sector.  Throughout the late 1980s and 1990s, oil and natural gas were produced and sold at prices below sustained replacement cost.  Consumers responded to these prices by consuming at an unsustainable rate.  Investors shunned new investments in oil and natural gas exploration and production, research in new recovery technology and research and development in alternative and renewable energy. 

Today, higher prices are stimulating investment in all of these areas.  New development opportunities in oil and natural gas development have resulted in tremendous increases in domestic investment activity.  Unlike production acquisitions, investment in these relatively low risk developmental activities is difficult for institutional financial investors to comprehend, but is extremely attractive when properly exploited by industry professionals.  This has been the brightest spot for new investments for Five States production partnerships and Five States Energy Capital Fund 1.  We expect to expand our activity in these areas during the next few years.  We also anticipate increased investment in natural gas assets, both in the form of mezzanine investments and asset purchases for Five States Energy Capital Fund 1. 

We continue to expect high energy prices over the long-term.  In this new environment, we also expect continued high volatility.  We are excited by the new opportunities that these changes are providing in domestic, on-shore U.S. development and production, and believe that our disciplined, value based investment strategy will continue to provide quality investments in the energy sector for ourselves and our partners.

Recent political events and natural disasters throughout the world have caused considerable loss of life and property to millions, and continuing anguish and uncertainty about the future to their families and friends.  It seems that each day delivers a new crisis that captures our attention and sows the seeds of concern about an outcome that could significantly alter our lives.

Each unsettling event has been reflected in the financial and commodity markets that have responded with increased volatility and rising prices.  Oil futures have continued their pattern of reacting in spades to volatility, recently peaking to prices not experienced since August 2008. Gasoline prices have risen in near lockstep, reflecting oil price increases almost immediately. Frequently asked questions are, “How much higher can it go?”, and “What can I do about it?”

A new book entitled $20 per Gallon:  How the Inevitable Rise in the Price of Gasoline Will Change Our Lives for the Better by Christopher Steiner explores the questions.  With the premise that gasoline prices may ultimately reach $20 per gallon, the author offers scenarios of public responses that could occur at various price levels on the way up. Rather than decrying the changes that will come at considerable social and economic cost, Steiner envisions a future where human ingenuity will spur greater efficiency and less waste. 

He points out that the United States imports 67% of its oil, but that only 40% is used for transportation fuels.  The rest is used to make, fortify and shape almost everything in our lives.  With every penny that gasoline moves up, so does the price of most other commodities and items we consume.  The mounting cost of gas will dictate cultural changes, housing changes, civic changes, education changes. Each increase in the price will bring new pain that will force us to adapt.  Our lives will transform on innumerable fronts as a gallon of gasoline goes from $4 to $6 to $8 and beyond.

We’ve already experienced the first volley of high gasoline prices.  During 2008, a year when gas prices touched historical highs, Americans drove 100 billion fewer miles than they did the year before.  That’s the first such decrease in thirty years, and easily dwarfs the driving decreases during the 1970s oil embargo.  Now, with gasoline prices of $4 looming just over the horizon, we should expect an increase in the popularity of smaller cars, closer to home vacations, and fewer miles driven. Long distance auto travel to far-away destinations for many may become only a dream.

At $6 per gallon, the increased comparable price of jet fuel will raise ticket prices of air travel to levels that will exceed the budgets of all but the most affluent passengers.  We’ve already seen airlines raising prices, reducing flights and services, and retiring planes. We could next expect mergers and consolidations, and finally financial failures and bankruptcies of all but a few carriers.

At higher prices, fuel costs will curtail the quantities of truck delivered commodities and manufactured goods to stores, and make long auto commutes too expensive for most workers.  Big-box stores, filled with goods produced in China and elsewhere, could disappear as the cost of distributive transportation makes products unavailable or non-competitive.  Manufacturing in the U.S. will revive, as quality locally produced goods replace those now made overseas.  

The author suggests that we may eventually live in a society more like the past than the present. People will leave their mini-mansions in distant suburbs and re-urbanize the cities, living together more densely in energy efficient, high-rise condos and apartments. Those with yards will have gardens in which they raise their own fruits and vegetables.  Fewer of us will own cars, and we’ll travel more on subways and surface rail. We’ll own more bikes and walk much more than today.  Now-vacant buildings and storefront shops will reopen, serving local residents.  With fewer large cars and trucks on the roads, our air should be cleaner, people leaner and healthier.

Steiner’s scenarios are interesting to ponder. With his underlying premise that the price of crude oil and its many derivative products may rise over time, perhaps to levels that seem almost unimaginable now, the outcomes may truly come to pass. During my own career as a petroleum geologist, spanning fifty years, the price of oil has risen 3500% from $3 to $105 per barrel, and gasoline 2000%, from 18 cents to $3.60 per gallon.  It’s not difficult for me to believe that with trends projected into the future, the price of gasoline could ultimately reach $20.

U.S. housing starts reported a higher-than-expected increase in January which is a positive sign for the housing market to begin the year.  Total housing starts jumped 14.6% from December levels to a seasonally-adjusted annual rate of 596,000 units in January. 

Monthly housing starts is a typical media driven headline with little to no meaning as the coincidence that a bunch of buildings started during a particular month or period of time reflects weather, labor, commodities, debt pricing, when you need to deliver the product and the start of large projects. Building permits represent the real trend or pipeline of units which we will see in the near future (1 to 2 years) as the permit process takes anywhere from 120 days (for single family) to three years (west and east coast multifamily).  Annual housing starts peaked in January 2005 at 2.068 million starts. We are thus still 73.8% off the peak levels. Single-family starts are 77.3% below peak levels. Construction jobs represent 25% of this recession’s job losses forcing many housing workers to leave the industry until the U.S. absorbs the excess housing units. Eventually equilibrium will be met, and the demand will again exceed supply.  At that point prices will rise for existing housing as well as workers as the industry attempts to bring workers back into housing production to meet demand.

Look for lots of headlines about housing as an indicator that the economy is recovering.  In reality, housing will most likely be a lagging indicator due to record overbuilding during the boom. In the meantime, we will continue to look for properties positioned to benefit from a rebound.  This will first occur within particular submarkets (cities such as Austin) until eventually enough submarkets recover to see a stable national housing market and a recovery underway.

How long will this take? No one really knows but we peaked in 2005(in home ownership and starts) with the dramatic drop in deliveries in 2008, 2009, and 2010, see the chart below. 

Annual Housing Starts (1978-2010)

We do not seek to pick the bottom, but to invest along the curve if the opportunity hits our investment criteria.  The dollar cost averaging approach to investing in housing following a cyclical overbuilding will allow the investor to average in on a cost basis and capitalization return. For example a rising capitalization rate market over three years from 7% to 8% to 9% would leave an investor with a 8% average return and basis. The investor benefits from earlier acquisitions which have locked in lower debt rates while still participating in higher capitalization purchases/debt later. The opposite is true if we face deflation, so laddering is tactically the best method to address interest rate risk. The value investing timing is based on the overbuilt housing industry recovering over time at a rate relative to both its submarket and the overall national economy. Nonsystematic risk events will interrupt the rate of recover/timing but ultimately equilibrium will be reached.  We continue to believe this is a good time to invest in housing.

Judy and I celebrated our New Year’s Eve in Cairo, on a tour of Egypt and Jordan sponsored by the Metropolitan Museum of Art. The trip had been on our “bucket list” for many years, and the opportunity to see it through the eyes of MET guides made it even more irresistible.

Of course we shared the amazement that every visitor experiences on seeing the structures and monuments of these ancient lands for the first time, and we were almost overwhelmed by the immensity of the scale of time, space and history that our tour encompassed.  We expected that our books and cassettes would have better prepared us for what we’d see, but they fell far short of actuality.

However compelling as the old sights were for us, as we traveled we became increasingly conscious of events unfolding in the eastern Mediterranean Sea that may change the fortunes and politics of the surrounding region for decades to come.  Only recently announced, a huge new natural gas field, the Leviathan, was discovered in June 2010 by Noble Energy Inc., an Israeli company, and several other international players.  The Leviathan is situated 81 miles west of Haifa in the Levant Basin, a rich hydrocarbon area and one of the world’s largest offshore gas finds of the past decade.  The discovery well was drilled to a depth of 16,900 feet, where it encountered field reserves estimated to be as much as 16 trillion cubic feet (tcf) of natural gas.  A deeper extension of the well could penetrate a formation estimated to contain 9 tcf.  In addition, the Leviathan gas field may contain 4.2 billion barrels of oil. The field is located 29 miles southwest of another large gas reserve, the Tamar gas field, which was discovered in 2009 and is also operated by Noble Energy Inc.

Israel is almost completely reliant on imported oil, producing less than 4,000 barrels of oil per day (bopd) of its 250,000 bopd demand.  If the Leviathan pans out, it could produce enough oil to satisfy Israel’s requirements for two decades. In addition, potential reserves of natural gas could make Israel a net natural gas exporter for the first time ever.  Discussions are in progress for a major pipeline to be laid across the floor of the Mediterranean to deliver natural gas into Italy for further distribution.  Conceivably, sales could also be made into Egypt, Jordan and other nearby countries. In any event, the discoveries dramatically change the geo-political framework of the area.   

As presently configured, the Levant Basin is triangular-shaped, lying just offshore of Israel and Lebanon, and perhaps extending as far north as Syria. The United States Geological Service (USGS) estimates that 122 tcf of undiscovered, recoverable natural gas may be contained in the Levant Basin province.  This compares favorably with the USGS natural gas estimates of 85 tcf in the SW Wyoming province, 73 tcf in Alaska’s National Petroleum Reserve, 70 tcf in the Appalachian Basin, and 70 tcf in the Western Gulf Basin province of Texas and Louisiana.  It will take much more exploration and drilling to ultimately determine if the estimates are reasonable.

Such immense reserves could conceivably be a boon for the entire eastern Mediterranean region, producing much needed energy to neighboring countries and revenue to the working and royalty interest owners.  As can be expected however, it will take time to determine how revenue is to be allocated.  Israeli officials are already suggesting that now that the fields have been discovered, terms of dividing the income between investors and the government may be re- determined.  Furthermore, although Israel claims exclusive rights to the basin, Lebanon, Syria and perhaps other countries in the area can be expected to demand a share.  It will take time to negotiate terms.  Meanwhile, new field discoveries in the Levant basin can be anticipated. 

Although in the past Egypt and Israel have cooperated on a few joint petroleum ventures in the Sinai, history has not been on the side of peaceful negotiations among neighboring countries for cooperative ventures or wealth sharing.  Nevertheless, the recent discoveries in the Levant Basin offer exciting new possibilities for discussions of potential projects that would benefit all the peoples and governments of the region.  What a great New Year’s present for the world that would be!