In the last few issues of The Producer, I have discussed and illustrated the impact of the decline in oil prices on the value of producing properties. Also discussed was the fact that most producers who had what were previously considered “prime” debt levels drawn against their properties are now insolvent (their assets are not worth enough to pay off their debt).
The first question that is often asked is “How is this sustainable?” Unlike many businesses or assets, many oil companies (or producing properties) will continue to generate free cash flow before debt service. It’s like a business that sells its inventory at less than cost. As long as sales exceed the cost of operations, there is free cash flow . . . until they run out of inventory. In the case of an oil producer, enough free cash flow is generated to pay the overhead and the interest on the loan for a while . . . even though there is little likelihood that the debt will ever be fully repaid.
This results in a phenomenon we call “kicking the can.” Rather than dealing with the problem, the producer and/or the lender will often defer the problem as long as possible, in the hope that prices will return to former levels and they can avoid the pain of losing money.
In many cases, the operator or owner is not motivated to address the problem. Doing so could result in the loss of everything, including overhead payments (which includes his salary, club dues, car, expense account, etc.). The borrower has no motivation to solve the problem.
The lender is similarly conflicted. Energy bankers, at least the competent ones, have known what was coming for some time. But they were not motivated to solve the problem. They knew that directly addressing the problem by forcing borrowers into liquidation or foreclosure would result in losses for the banks, negatively impacting the banks’ earnings. . . and their bonuses. Kicking the can and hoping things would get better was much more attractive.
There was also a large degree of denial. “How could all those highly profitable prime loans go from grade A to subprime almost overnight?” It is emotionally unacceptable. Throughout 2015, most bankers were claiming that “their portfolio was solid, and they had only minimal problem loans.” But this was not true for most, if any.
In addition to the quantitative part of what is happening in the market for oil and natural gas properties, there is also a psychological part. It appears very similar to “The Five Stages of Loss & Grief” by Julie Axelrod:
At the beginning of the downturn, there was Denial. Producers claimed prices would recover quickly, they were adequately hedged so that it did not impact them, and some were misleading in how they presented their costs and expenses.
Then they became Angry. “How could the banker imply such a thing? How can I work my way out? How could the banker treat me like this after so many years as a great customer? Does he not understand?”
Bargaining became the next step. We saw a lot of this in the latter part of last year. Many deals we had reviewed prior to the price collapse started coming back around. “Well, you were willing to value it at $20 two years ago, how about $15 now (even though the current net present value is only $5). That would be a good deal!” We saw a long period of low transaction closings throughout the industry as sellers tried to bargain on unrealistic expectations.
We have finally begun to see Depression and Acceptance. This is evidenced by the increasing number of companies that are filing bankruptcy, and the increasing number of quality producing properties that are coming on the market.
Assessment of the Market Today
Quality of assets available is materially improving. We would like to own many more of the assets we are seeing. We have made more bids in the last few months than we did all of last year.
Velocity is accelerating. Many deals are coming in “ready to close” with realistic data packages, time lines and seller expectations. We are “weeding out” deals more quickly that are not of interest. I suspect we will review many more deals than the usual 300 +/- submittals we normally process in a year.
We are now seeing many deals that did not close last year. They are coming around again, but with more reasonable terms.
Some assets are starting to come out of bankruptcy. All the “hair is off,” so assets from bankruptcy almost always transact.
The market is rationalizing. We believe that the market valuation on producing properties is moving back to a net present value of 9% – 15% (at the asset level, without allocation for overhead, etc.). This is a significant improvement compared to net present value in the low to mid-single digits at the peak of the boom.
Most Proved Undeveloped assets (“PUDs”) have little or no value at current oil prices. The buyer still gets this potential upside, but pays little if anything for it. The assets that do have PUD value are really good.
Most submittals we are seeing are Working Interests (“WIs”) for sale. The Mezzanine opportunities (“Mezz”) are almost all first liens. The economics of buying working interests or making first lien loans are about the same:
- The internal rate of return (IRR, or imputed real yield) is about the same for WI and Mezz
- Payback is faster on Mezz loans than on WIs
- Total return is higher on WIs than on Mezz
- The Mezz loan has some preference compared to buying the WI, which reduces risk
We still prefer to own Working Interests. The higher total return and greater upside potential appeal to us. We will only make Mezzanine loans on assets we would like to own at the loan value. Then we are happy regardless of whether the loan pays off or we end up with the underlying collateral (the producing properties).
Some investors have expressed concerns about the long investment period since the closing of Fund 2, and the “drag” that the management fee can have on total returns. This is of concern to Five States management too. However, the primary issue is to not overpay for properties.
An old adage is that the profit is made when you buy. That is, the profit is determined by buying at the right price. Because of material re-pricing of oil and gas assets, any acquisitions that we could have made (but did not) in the couple of years following the closing of Fund 2 would be underperforming today. I am proud of our adherence to our disciplined methodology, “keeping most of our powder dry” for the opportunities that are now presenting themselves.
The returns from investing in producing properties in today’s pricing environment are sufficient to cover the overhead we incurred before we begin generating our target yield. If we buy properties at a price that will generate the lower end of our target return, the return to the investors should exceed the priority return without a major recovery in oil and gas prices.
I have commented in several previous articles about the conditions that make for great value investing:
- Low oil and natural gas prices
- High discount rates on valuing future oil and natural gas income streams
- Unpopularity of the oil and gas sector
Until recently, I thought we would experience the first two in this cycle, but not the third. The sentiment in the financial media now seems to be shifting to pessimistic. As Mr. Buffet says “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” We appear to be entering that once-in-a-generation period when oil and natural gas assets can be purchased on double digit current yields based on the assumption of continued lower oil and gas prices. If you believe that oil and natural gas will remain the primary fuel sources for the next couple of decades, the timing is about as good as it gets for making new investments!