By Arthur N. Budge, Jr.

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.