The media has recently hopped on the possibility of a decline in oil prices due to the success of the new development in the United States. This has prompted three questions from Five States investors:
- Do we agree that there will be a correction in oil prices?
- How would a correction affect the Five States funds?
- What would the impact of a correction be on Five States Energy Capital Fund 2?
The oil market is already reflecting the expectation of lower prices in the future. Although the spot price of oil has remained fairly constant over the last year, the NYMEX prices for delivery in the future have declined to below $80 per barrel over the last five years (note that the forward curve has not been a statistically good predictor of realized prices in the future).
Spot and Future Oil Prices
The price of commodities (including oil) is quoted for delivery to a specific location at a point in time. The price for a barrel bought/sold/delivered today is called the “spot price.” Prices are also quoted and contracts traded for delivery in the future (referred to as “futures prices” and “futures contracts”).
Each day the market “clears” all volume offered for sale at the spot price. That is, every physical barrel offered for sale is sold and delivered. Ninety million barrels of oil are bought and sold worldwide daily. If supply increases relative to demand, prices fall. If demand increases relative to supply, prices rise. This equilibrium in the market is a function of daily deliverable supply and daily demand. Future expectations have nothing to do with this pricing at the moment the physical transaction occurs. This leads me to believe that speculators may affect the futures market, but they cannot affect the price of those 90 million barrels when they actually change hands each day. At this point, all transactions “cash settle” and the game is over.
The physical market prices can be manipulated to some degree by OPEC. To the extent OPEC producers are willing to withhold excess capacity from the market, they can reduce physical supply. OPEC (i.e., Saudi Arabia) can also increase production to decrease prices, as they did in the mid-1980s. Speculators buying oil to place in storage or selling oil out of storage can have a similar effect. However, the purchases or sales would have to be large and sustained to make a material difference in the trend of spot prices. Buying and storing crude oil for future delivery is an expensive way to speculate on oil prices. Although the ability of OPEC to manipulate world oil prices is given a lot of credence by some analysts, we believe this ability, especially over any significant time period, has been reduced by the shift in supply fundamentals.
There is almost always some surplus in deliverable capacity. While all of the oil delivered to the market on any day is sold, all of the oil that could be brought to market worldwide is not being produced. Small percentage changes in deliverable capacity can result in large fluctuations in price. During the 1990s, oil averaged about $20/barrel with lows below $10 and highs of over $30. Studies of that period concluded that a difference in daily deliverable capacity of ~2% to ~4% resulted in this volatility. It is possible that the increasing deliverable supply today could have similar results.
The US shale development boom is real. Results are exceeding many early industry expectations. Production is increasing at an accelerating rate throughout the US. The increases in production in Texas and North Dakota are staggering. There are many more large new shale plays on which development has barely begun.
US Crude Oil Production: Texas and North Dakota
Texas crude production is up 158% in the last five years;
North Dakota is now the second largest producing state
Source: US Energy Information Administration (EIA).
Production data through September 2013.
The technology used to develop shale reservoirs is also being applied very successfully to the redevelopment of conventional assets. Horizontal and vertical drilling, multi-stage hydraulic fracking and increased density drilling in low permeability conventional reservoirs are having excellent results.
Ban on US Export of Crude
Further distorting the market in US crude oil prices is the US ban on crude oil exports. Prior to the current development boom, West Texas Intermediate (“WTI”, the primary US reference oil) traded at a premium to Brent (the European reference oil). WTI is a superior quality crude. This trend has reversed because of increased supply in the US. The domestic supply has overwhelmed the existing midstream facilities (pipelines, storage facilities, etc.) and refining infrastructure, resulting in a domestic “glut” compared to world demand.
As US supply continues to increase, volatility of domestic crude oil prices will likely increase. This creates the potential for a domestic price correction, even if international prices remain at current levels. The ban on export of domestic crude could cause the pricing of US crude to behave like a domestic commodity on the downside. We could have a situation where wellhead prices fall when world prices fall because of international competition, but prices might not increase at the wellhead when world prices rise due to regional infrastructure constraints that would keep the US production from being sold outside of the regional market.
Energy Demand by Region
By 2040 Non-OECD demand will be
more than double that of OECD demand
Source: Exxon Mobil 2012 Energy Outlook.
OECD – Organization for Economic Co-operation and
Development (34 countries).
We do not know if there will be a correction in oil prices, but the possibility of a near-term correction is high enough that we are defensive. Calling the timing of a crude oil price correction is impossible, and a price correction may not happen. It is possible that growth in world demand will stay in equilibrium with growth in world supply, and prices will remain stable, or that world demand will increase relative to growth in world supply and prices will once again increase. Most of the new oil investments we are considering are mezzanine structured, which adds additional safety against a near-term price decline. If there is a correction in the price of crude oil, we expect that it will be short-lived, maybe six months to two years.
Valuations & Distributions from Existing Funds
In the short-run, the impact of an oil price correction on distributions would be small, primarily due to our high level of hedges. We have the majority of our production hedged for the next two years, locking in current prices on the majority of our production.
Since 2007 distributions have remained fairly constant. This is because the decline in oil and natural gas prices has been in the futures market, but not in the spot market. The impact of price volatility on distributions has also been reduced by our hedges.
The most material impact will continue to be on the calculation of net present value. As reported over the last several years, the calculated net present value of our producing properties has decreased as futures prices have decreased. Further decline in futures prices would cause this trend to continue, even if wellhead prices and distributions remain constant.
Impact of a Decline in Prices on FSEC Fund 2 (the new fund)
A correction in oil prices at this time could actually be very beneficial to FSEC Fund 2. Lower prices have three positive features in our analysis of new investments:
- Forecast future income is lower, resulting in lower valuations of potential new investments. This can result in better values (“buy low . . . “).
- Competition for oilfield services decreases, decreasing future expenses, further improving future results.
- Expectations of those with whom the Fund will do business decrease, resulting in less euphoria and less competition for individual assets.
For the last few years, demand for oil and gas investments has been very strong. It has almost appeared that investors could do nothing but win in this sector, despite the erosion in oil futures prices.
Largely masking much of the decline in futures prices has been the decline in discount rates used in calculating the net present value of oil and gas properties. This decline in discount rates has loosely followed the decline in interest rates.
Producing properties are depleting assets. In a flat price model, they calculate as a declining annuity.
The increasing prices over the last decade have somewhat masked depletion, causing forecasted cash flow from producing properties to calculate as a perpetuity. Combined with the expectation of continued development of new reserves, many properties have calculated as appreciating assets rather than depleting assets.
Declining prices can cause a reversal in forecasts of new development. Declining prices will slow the pace of development in some shale plays. If interest rates rise, discount rates used to value producing properties could also rise, resulting in further declines in the calculated present value of producing properties. This would materially amplify the decline in calculated net present value during a correction in oil prices.
We have seen the exuberance in the market play out in oil and gas public equities. E&P companies that have focused on acquiring acreage in “hot” plays in order to grow reserves are experiencing strong valuations in the marketplace. These strong valuations in the public market have resulted in a dramatic increase in new public offerings. In 2013 $65 billion was raised in 494 equity offerings compared to 8 offerings in 2012, totaling $1.4 billion. We believe this level of activity is indirectly contributing to higher valuations of proved properties. If oil prices decline, this trend could reverse and the prices of properties could come more in line with our valuation.
Energy Sector: Public Equity Offerings by Year
(Includes Initial Public Offerings and Secondaries)
Data Source: Bloomberg
Operating leverage in domestic oil production has increased materially. The break-even for full cost recovery in most shale plays now averages over $50 per barrel and over $5.00 per mmbtu for natural gas. Break-even is higher in the most mature plays such as the Barnett Shale in North Texas (gas @ $5+) and the Bakken Shale in North Dakota (oil @ $60+). These are wellhead prices, not NYMEX. Wellhead prices are typically 5-10% below NYMEX.
Shale production also has a much steeper decline rate than conventional production. This increases risk in present value calculations much like operating leverage.
West Texas Intermediate Crude Oil Breakeven Price
for 15% After-Tax Return by Play
Source: Copano Energy Presentation (data per Credit Suisse
Small/Mid Cap E&Ps research report released April 10, 2012)
Volatility of actual wellhead prices from reference prices such as NYMEX tends to increase as the various plays mature because the increasing physical supply swamps existing infrastructure. As the pipelines and storage facilities “fill up”, the price buyers are willing to pay goes down. For example, Bakken crude is extremely high quality, but Bakken crude is currently trading about $12/bbl below NYMEX at the wellhead. This differential has been as high as $25/bbl in the last few years. In the near-term, this trend of higher and more volatile differentials will likely manifest in newer plays as supply overwhelms existing regional infrastructure and markets. A good example of this is the Great Northern Midstream opportunity. The opportunity was created by the huge increase in Bakken production in North Dakota. New development like Great Northern Midstream will reduce these problems in the intermediate term. We expect to see other opportunities like Great Northern Midstream as the various plays develop around the country.
I suspect financial leverage (debt) is also increasing. Succumbing to the push for growth in loans, commercial banks have lowered risking of the valuation of Proved Undeveloped (“PUD”) reserves. It appears that oil and gas bank credit is as loose as it has been since 1982, and this is likely resulting in increased financial leverage on top of the increased operating leverage.
The impact of the reversal of investor sentiment in oil and gas is huge. The risk attributed in valuing new development has decreased, resulting in higher valuations. In many of the oil acquisitions we underwrite, the winning bidder is valuing oil PUDs as if they are producing. Their illogic is that since there is little dry hole risk, there is no PUD risk. But costs have increased materially, and Estimated Ultimate Recovery (“EUR”) is not well documented in many plays. The increased leverage in the sector will magnify negative errors in the PUD value calculations in the event of a crude oil correction.
The combination of factors discussed above has reduced the calculated net present value of Proved Producing reserves. The reduction is due to three factors:
- Lower forecast cash flow from the Proved Developed Producing portion
- Shortening of the economic life of the Proved Developed Producing portion (the lower prices result in the properties reaching economic limit sooner)
- Delaying and reducing (and in some cases eliminating) the present value of Proved Non-producing (PDNP & PUD; Proved Developed Non-producing and Proved Undeveloped)
With the high degree of inherent leverage and misunderstanding by many market participants of true downside risk, the potential for a material correction in the value of domestic producing properties is high. Corrections in the oil and gas market are rarely forecast. If one occurs now, it should provide some excellent investment opportunities. Most of the new oil investments we are considering are mezzanine structured, which adds additional safety against a near-term price decline.
- 1. Do we agree that there will be a correction in oil prices?
Yes, we believe the potential for a correction in crude oil prices exists, especially domestically. We are managing the funds defensively in case a correction occurs.
Our “expected case” is for oil prices to average at or near current levels, increasing over the long-term. We expect a correction would be short-lived (six months to two years).
- How would a correction affect the Five States funds?
We believe that the distributions would remain fairly constant for a couple of years. A correction longer than two years would have a material impact on distributions.
Calculated valuations would be affected in the short-term.
- What would the impact of a correction be on FSEC Fund 2?
We believe the impact would be favorable, because we should be able to invest the Fund capital more advantageously.
Over the last decade, domestic producing properties have been in the strongest bull market I have seen in my career. Consensus expectations have not been this uniform since the early 1990s. The current bull market is driven by high oil prices, low discount rates and positive investor sentiment. This is an 180? reversal since our entry into the acquisition of producing properties in 1985. The one certainty in finance is that when fundamentals change, things change. The reversal of any of these three core fundamentals in any industry would be sufficient to reverse valuation in any industry.
Sometimes I feel that investing in the oil and gas sector is like riding a roller coaster blindfolded. There will be lots of unexpected ups and downs, but as long as we do not get thrown out of the cart we will have a great ride! I will close with an example of how wrong consensus expectations can be. The following was widely circulated in the late 1990s:
“Oil prices have fallen below $12 a barrel for basic grades, a level at which it is hard for even efficient companies to produce, refine and distribute oil profitably as gasoline, heating oil and jet fuel.
“And prices are likely to remain low. The once powerful Organization of Petroleum Exporting Countries, the 11-nation OPEC cartel that ruled the oil world in the 1970s, lacks the will or ability to control oil supplies these days. On Thursday, OPEC ministers at their winter meeting in Vienna, Austria, failed to agree on even a slight production cutback to ease the current oil glut. That signals continued low prices through this winter.”
LA Times, “If Exxon, Mobil Merge, Would Biggest Be Best?” November 27, 1998, http://articles.latimes.com/1998/nov/27/news/mn-48263