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The Changing Face of U.S. Exploration

I recently heard a speech by the chairman of a large financial institution that provides funds to oil and gas companies drilling wells in the U.S.  The primary theme  of his talk was that “petroleum exploration is dead in the United States. We know  where all the oil is now, and the industry’s job is just to learn to get it out more  efficiently and profitably.”

As a geologist who’s spent a long career exploring for oil and natural gas, his  statement struck me as naively shortsighted.  I’d never considered that all our  nation’s oil fields might already have been discovered, and that nothing is left for  oil and gas explorers to do but pack up the maps and retire to their basements.

After all, within the last three years, two friends, Jim Musselman, president and  CEO of Caelus Energy in Dallas, and Bill Armstrong, president and CEO of Armstrong  Oil and Gas in Denver, have each discovered new oil fields that are the largest found  in the U.S. in 30 years.  Situated on Alaska’s North Slope, each of the fields is  expected to yield more than a billion barrels of oil, and both Jim and Bill say they  believe many more fields are waiting to be discovered in the state.  I’m certain  neither expect their new discoveries will be their last.

Both new fields were found by “conventional” methods:  i.e. utilizing inferred  models of geological “traps” where oil could be contained, then drilling vertical  wells to test their ideas.  For more than a century, oilmen and women have  employed a variety of geological theories, methods and technologies to explore for,  find and produce oil from the now?known fields around the world.
About a decade ago, the combined technologies of horizontal drilling and hydraulic  fracturing  (“fracing”)  made  possible  the  drilling  and  production  from  rock  formations previously known to contain hydrocarbons but thought to be too dense  or “tight” to yield them in commercial quantities.  Oil and natural gas produced  from this new resource base are known as the “unconventionals”.

Consequences  of  the  “unconventional  revolution”  have  been  profound.  The  technologies have opened vast areas of the U.S. and around the world as new  targets for drilling.  For the U.S., 2009 ended an annual decline in oil production  that dated back to 1971.  Since then, a steady annual increase in daily production  will allow the U.S. to reach or exceed 1971’s peak this year.  In doing so, the industry 
has employed thousands of new oilfield workers, decreased our reliance on foreign  and often adversarial countries to make up our petroleum shortfalls, decreased our  negative balance of trade deficits, and enhanced our nation’s security and influence  abroad.

For the oil industry, the unconventional revolution is changing the nature of the  business  from  exploration  to  exploitation.  In  the  past,  most  wells  and  field  discoveries were made by independent operators and small companies, who sold  their holdings to larger companies to develop and exploit.  Today, because “tight  rock” shales and fine?grained siltstones are more tabular in form and wider in  distribution  than  “conventional”  reservoirs,  finding  productive  zones  is  more  predictable, and thus is less risky than “wildcat” tests.  Greater predictability has  attracted billions of dollars to develop these “resource plays”, commonly by new  companies, venture capital firms and investment groups, for whom investors funds  are readily available.

In this new regime, the role of the independent geologist or small?time operator  has been greatly diminished.  Prices of oil and gas leases and expenses of horizontal  drilling, well completions, lease equipment and operations have all soared.  The  technical knowledge and expertise required to drill most wells today are well  beyond that of past generations of “mom and pop” operators.

As a result, conventional oil and gas exploration has been in a decline for the past  five years, with the number of exploratory wells down more than 60%.  Last year,  the  total  number  of  conventional  discoveries  was  the  lowest  since  1952.   Discoveries, once the backbone of reserve replacement, have failed to replace  production  for  the  past  eighteen  years.  Since  2014,  companies  have  cut  exploration  spending  by  47%,  or  close  to  $1  trillion,  with  many  companies  completely shutting down their exploratory drilling.

Bygone years when an exploration army of would?be J.R. Ewings was active may be  on the way to ultimate oblivion.  But so long as individuals with knowledge,  initiative, and burning desire to find new million?barrel fields are around, my bet is  that some will.  We anticipate that many new fields and producing areas will be  discovered by individuals conducting exploration activities.        

All Good Things Must Come to an End

The Proposed Liquidation of Five States Consolidated I, II & III, Ltd.

Investments in Five States Consolidated I, II & III, Ltd. (“Legacy Funds”) have been generating returns for investors for fifteen to thirty years. The average investor has received over three times his invested capital in distributions, for a weighted average Internal Rate of Return (“IRR”) of over 20% net to the investor. However, the assets making up these funds have depleted to the point that they can no longer carry the overhead needed to maintain the funds.
Lower oil and natural gas prices combined with normal depletion have resulted in the income from the Legacy Funds declining to a level that is close to break-even after overhead and debt service. For the majority of investors, the residual value is no longer material relative to their original investment, nor worth the cost and administrative “hassle” of owning the funds. Management is therefore proposing that the funds be liquidated.

Fund Life Cycle; Why Liquidate?

Oil and natural gas properties are depleting assets. It is the nature of an oil and gas fund to reach a point where declining volume combined with increasing operating expenses and overhead on a per barrel basis translates to diminished distributions. The high oil prices in the 2005 – 2014 period greatly extended the economic life of the Legacy Funds. The price decline since 2014 had the reverse effect, materially reducing the profitability and economic life of the funds.
Distributions have been minimal/non-existent for several years. Unless oil prices increase above $60 and remain there, or material capital investments are made in the form of property development through drilling/re-drilling, distributions will not increase/resume for several more years. The Legacy Funds are not financially viable enough to borrow enough money to make the potential capital investments in the future. Capital investments would require infusions of new equity.
Restructuring of the Legacy Funds would be required in any event. Reservoir depletion results in lower production volumes over time. The “fixed costs” of operating expenses and overhead increase both on an absolute basis and as a percentage per barrel produced. Expense items such as engineering, evaluating lease operating expenses and third-party operator charges, plugging expenses on abandoned wells, annual audits, tax returns and state filings are fixed charges and tend to increase over time.

Why Not a Legacy Funds Reconsolidation?

Late last year we discussed a “reconsolidation” plan. However, given the projected income after operating costs and overhead, the expense burden is still too heavy. Following a reconsolidation, forecast initial yield would still be nominal relative to the liquidation value of the funds. Liquidating the funds will maximize distributions to the investors, assuming current oil futures prices.
The good news is that there is still value in the properties that can be captured through liquidation. The net liquidation value is over $10 million after payment of all liabilities. In a liquidation value calculation, overhead costs are not included in the calculation of present value.

Proposal for Five States Energy Company to “Buy in” Investor Units

Five States Energy Company, LLC (“FSE”), the General Partner of the Legacy Funds, will make a cash offer to buy in the interests of all limited partners in the Legacy Funds. This would be a cash tender offer based on our calculated liquidation value using the same methodology on which we report each year. This valuation would not include any “burden” for fund level G&A/overhead on a “go forward basis”, or any implied sales costs such as sales commissions, etc. The investors would pay the “wrap up” costs of the individual partnerships (final audit and tax return).
Our logic is that FSE owns 25% of each fund. When combined with the direct ownership in the funds by the stockholders in FSE, the General Partner group owns over 50% of the total value of the Legacy Funds. Two-thirds of the limited partners on a “head count” own less than 10% of the total value of the Legacy Funds. This clearly results in an “overhead imbalance”.
FSE proposes to buy the producing properties from the Legacy Funds rather than conduct a third party sale. FSE has sufficient net worth and can absorb most of the fund overhead and costs through its current structure. Valuation of the producing properties will be calculated at a 9% net present value (PV9). This is about 11% higher than the industry standard 10% net present value (PV10). Proved non-producing assets (Behind Pipe, PDNP and PUDs) will be valued at PV9 and reduced by 50%, 50% and 70%, respectively (standard industry “risking”). The risking is less in some cases. We believe this is fair and equitable pricing for a portfolio of non-operated working interests. The costs associated with a public sale and the risk of a lower bid at auction will be avoided. The valuation will be audited by an independent third-party engineering firm.
This seems like a “fair” time in the oil price cycle to do this. During the life of the funds prices have ranged from $10 to $147 per barrel. Current wellhead prices are in the mid $60s and appear likely to stay in the $40 to $65 range for the next five to ten years. Wellhead prices are currently at the high end of that range. Having just had a major recovery from the $30/$40s, we feel that this is an appropriate time to liquidate the funds.

Optional Sale at Auction

Some investors have expressed concern with a conflict of interest in that FSE is the buyer in this transaction. If over twenty percent of those who do not accept the offer from FSE wish, we will carve out their share of the producing properties and sell them at auction on Energy Net, the largest on-line auction house for oil and gas properties. At auction these properties may receive a higher or lower value than FSE is offering. The amount received will be distributed to this subset of limited partners, less their share of the partnership wrap-up costs.
FSE may bid on these assets at auction. FSE would do so in a “blind” format, so that others in the auction could not see that FSE is bidding. If FSE is high bidder at a value lower than that offered prior to the auction, it will pay this lower price to the subset of investors choosing the auction, not the original offered price.

Why Not a Sale to FSEC Fund 2?

A sale of the properties to FSEC Fund 2 is not contemplated because FSE would be the recipient of the bulk of the sale proceeds. This could be misconstrued if oil prices were to move significantly in either direction.


It is bittersweet to shut down our funds that have performed so well for decades. We are proud of our record of a weighted average 20% IRR and over 3:1 cash on cash returns. But we believe liquidation is the optimal decision for our partners, and we are pleased that we can liquidate the funds with a nice final cash distribution.
The liquidation of our fifteen to thirty-year-old funds does not imply withdrawal by FSE from the market place. Five States plans to continue offering production investment funds in the future. To a large extent we “stayed out” when the market was valuing assets on “$100 per barrel oil”. Now that oil and natural gas prices are back to levels we consider reasonable, we are aggressively pursuing acquisitions again.
We believe the market for investing in producing properties is the best we have seen since our major liquidity event in 2006/2007. We are working on placing the remainder of the FSEC Fund 2 capital now and plan to launch FSEC Fund 3 this summer.

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Déjà Vu All Over Again (Again)

Those who have read my articles over the last 25 years know my favorite Yogi Berra quote: “It’s déjà vu all over again.” This is such an apropos description of the oil business I can’t resist continuing to use it frequently.  In this article, I will discuss how the oil and gas industry went from boom to bust and how Five States as a value investor intends to take advantage of the opportunities the bust has created.

The oil and natural gas industry is very cyclical. Oil and natural gas supply and demand are very price inelastic[1].  This results in small changes in supply or demand having a material impact on wellhead prices.  Drilling projects require large capital investments with long cycle time between commitment and deployment.

Producing oil and natural gas properties[2] have a lot of operating leverage[3].  During periods of expansion, “Wall Street types” want to “teach” oil producers “financial engineering” (financial leverage, i.e. using more debt).  This increases total leverage, further increasing fixed costs, thereby increasing risk and volatility.  The combination of these factors results in a recurring pattern of boom and bust.

Today we see the cyclical pattern playing out again. Too much oil production has resulted in lower oil prices.  The oil patch is in the middle of a financial wash-out due to lower wellhead prices combined with too much debt.  The U.S. is once again the world’s largest oil producer, providing the increased supplies that caused oil and gas prices to fall.  Capital investment in new development (outside of shale) is slowing around the world.

These cycle changes are normal for this industry that has enabled the creation of our modern economy. Consensus is that the U.S. will remain the world’s marginal oil producer for the next decade or longer[4]. The U.S. can currently produce as much oil as the world economy demands, but only at high prices.

By the most optimistic forecasts, solar, wind and other renewables will not have a major impact on world oil or natural gas demand for at least a decade or longer. Neither will electric cars.  The most impactful change is the shift from coal to natural gas as the primary fuel used to generate electricity (natural gas now exceeds coal and will continue to take market share from coal[5]).  For the next twenty years, world demand for oil and natural gas will continue to increase, depleting the lowest cost shale formations which over time will result in rising prices.

World Supply and Demand and Future Oil Prices

Oil trades in a world market. Oil prices are a function of world-wide supply and demand. Despite increased U.S. production, if world demand grows faster than world supply the price of oil will increase.  Almost all major forecasts predict increased demand for oil over the next decade.[6]

Future prices for natural gas are less clear. Natural gas is the most logical fuel to transition the world away from coal as the world’s primary energy commodity.  It provides the most environmental benefit per dollar invested (more than solar or wind).  However, U.S. reserves are so plentiful that it may take a long time for the price of natural gas to increase materially.

The U.S. shale boom resulted in a huge reversal in oil and gas supply trends. The development of unconventional resources (production from shale formations) resulted in a renaissance in oil and natural gas development in the U.S.  These new U.S. shale deposits account for more than 80% of total world shale oil reserves.  By comparison, the Energy Information Administration (EIA) estimates total world conventional proven oil reserves to be 1.7 trillion barrels, and unconventional reserves to be 5 trillion barrels.  The U.S. now has over half of the proven world oil reserves.  However, much of these reserves are only economically viable at prices over $60 per barrel.

Increased supply from shale production has resulted in lower world oil prices and the belief that the U.S. can become energy independent. But the EIA, in its Annual Energy Report 2017[7], projects U.S. shale oil production in the U.S. will peak in the next decade. The peak may be reached as early as three to five years from now, or it could take ten years or longer.  Given that 80% of the world shale reserves are in the U.S., it is likely world shale production will peak near the same time as U.S. production. Unlike oil, the unconventional natural gas supply in the U.S. is expected to last for decades without any impact on the ability to develop new supplies.

Prohibiting exports would not make any difference. In fact, allowing free trade in oil and natural gas should result in slightly lower world prices. With a near “unlimited” supply, natural gas prices will be determined by the marginal cost to produce natural gas relative to demand, and thus should remain around current levels.  The U.S. will remain a net importer of oil for the foreseeable future, but should become a major net exporter of natural gas.

According to the EIA we have plenty of oil and natural gas. The key questions from an investor standpoint are “at what price?” and “for how long?”  Maintaining the supply of unconventional crude oil will require higher prices[8].  A widely accepted estimate is that crude oil needs to be above $60 per barrel to sustain current production volume.  Recently we have seen improving statistics on a cost per barrel (oil) basis and cost per mcf (gas) basis.  But as the best shale oil reserves are depleted, the sustainable wellhead price per barrel must increase to support the development of lesser quality reserves.  Over time, the trend will revert to upward pressure on oil prices.


Value Investing Defined

Motley Fool defines value investing as “investing in assets trading at prices below their Intrinsic Value. Value investors, therefore, are essentially buying assets at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their Intrinsic Value.

To better understand value investing, investors should understand a few related terms:

  • Intrinsic Value: An estimate of an asset’s worth. Importantly, intrinsic value differs from an asset’s Market Price in that it represents the calculated present value of the underlying income stream.
  • Market Price: The price at which an asset is trading at any given time in the asset’s market. Value investors hope market price volatility will occasionally drive an asset’s market price irrationally below its Intrinsic Value, thus creating a value investing opportunity.”[9]

Five States applies this logic to investing in proved, producing oil and natural gas properties. However, there is one caveat to the Motley Fool definition.  If oil and natural gas properties can be purchased for their Intrinsic Value, an investor can earn the implied rate of return as current income over time from owning the asset.  The investor does not have to sell the asset at a Market Price exceeding the Intrinsic Value to make a profit.

The Intrinsic Value of a property is calculated using traditional fundamental analysis.  Engineering forecasts on the future production volume from a developed field are prepared.  Forecasts of production volume on mature, proved developed fields tend to be very accurate in a portfolio context.  Future oil and natural gas price forecasts and production expenses are then used to calculate our forecast of Present Value[10] of projected future income.  A standard reference discount rate is 10%+/- (before the impact of G&A and any debt leverage).  This is referred to in the industry as the PV10 value (PV for present value, 10 for the 10% discount rate).

A buyer may adjust the discount rate up or down depending on his subjective assessment of risk and quality of the producing properties. The likelihood of more income than forecast over the long-term from future development that is not included in the projected income may also be a factor in using a lower discount rate.  If the Market Price of a property is at or below the Present Value of future projected income (the price that generates our target rate of return), a value investor will buy it.  If not, they would pass.  Most of the time during the last decade, the Market Price of producing properties has been higher than the Intrinsic Value.  Over the last three years, this trend has reversed.

Value Investing requires discipline, and results in very few exciting transactions. It tends to be a slow return process.  An investor must wait to invest when the Market Value is greater than the Intrinsic Value.  It can be like a day of fishing where they don’t bite very often.  You get frustrated, but over time you catch enough to get you to keep putting your line back in the water!

I find Value Investing the most logical way to deploy capital in the oil and gas sector.  But it requires patience, discipline, and can be counterintuitive in execution.  The best time to buy often does not feel right. Intrinsic Value often equals or exceeds Market Price following a decline in the overall sector, when investors are hurting from overpaying when the Market Price was higher than Intrinsic Value.  Market momentum does not matter in Value Investing.

Over the last several decades, most Value Investing has been in the form of private equity.  In the public markets, the most successful investors were executing growth strategies that benefited from declining interest rates through price/earnings expansion[11].  Since the early 1980s, investors have been willing to pay ever higher prices, in essence accepting ever lower yields, for stocks and bonds.

Private equity investors using value strategies have been able to compete in part by capturing the Liquidity Premium[12] inherent in illiquid assets.  They could then arbitrage the difference between the private and public market valuations on exit, by buying in the private market and selling in the public market.  Examples of the Liquidity Premium are easiest to see in real estate and oil and gas.  Real Estate Investment Trusts (REITs) and energy Master Limited Partnerships (MLPs) have traded at 1.5 to 2.5 the private market value of the underlying assets.  This has always seemed like a huge premium for liquidity to me.  With interest rates bottoming, the arbitrage potential has become less available.  However, the liquidity premium can still be captured through new investments in oil and gas properties.

Value Investing in the Oil Patch

The Market Price of producing oil & natural gas properties is a function of three factors:

  • Expected Future Price of oil and natural gas and expenses
  • Discount Rate on which the Present Value of properties is being calculated
  • Sentiment, manifest in Availability of Capital and Supply of Producing Properties for sale

Future Prices are currently much lower than they were forecast to be a few years ago. This has resulted in a decline in the value of proved producing properties of two-thirds to seventy-five percent[13].  A property that would have sold for $1 million or more in 2014 has a present value today of $250,000 – $350,000, and can be purchased to generate first year free cash flow of over 10%.

Discount Rates currently used by the market when calculating the Present Value of properties are “reverting to the mean.”  When properties could be financed with debt at 4% to 8% interest, competitors were using discount rates of 8% or lower.  Now that “cheap leverage” is no longer available, discount rates are reverting to the long-term range of 8% to 15%.

Sentiment is more negative than it has been since the late 1990s. The discipline of Capital Rationing[14] has returned to the oil and gas industry. Capital Rationing reflects a limit of capital available to a business relative to the amount of investment opportunities they have that are projected to generate a return higher than their cost of capital.  Capital rationing has historically been the norm for the oil and gas industry. An oil company almost always has more investments it projects to be profitable than it has access to cash with which to drill those prospects.

During the boom oil companies could get all the funding they wanted for almost any project. Many projects that were funded are not profitable at current wellhead prices.  Most new acquisitions made toward the end of the boom when oil prices were higher will never achieve payback of the investment.  Many oil companies are now in a debt or liquidity squeeze. Debt levels that three years ago looked conservative have proven to be excessive. Capital investments in oil and gas are now more disciplined, providing a greatly improved environment for deploying new capital. This is providing both an increased supply of assets available for purchase and an improved environment for companies like Five States who are making new oil and natural gas investments.


2018 is starting to feel a lot like the 1990s:

  • Oil & natural gas properties can be purchased on attractive valuations based on today’s wellhead prices.
  • Intermediate to long-term expectations are for higher oil prices. But the Market Price of producing properties today does not reflect material increases in oil prices over the next decade.
  • Capital rationing is creating a greater supply of mature properties than has been available for purchase in over ten years.

This sets up a great fundamental investing opportunity:

  • Market Values are once more aligning with Intrinsic Value. Producing properties can be bought at the most attractive value available in over a decade.
  • Current Yields on producing properties are extremely attractive compared to stocks, bonds or real estate. Yields on newly acquired mature producing properties can be expected to exceed rates currently available from junk bonds with much better “collateral coverage”.

This provides an ideal Value Investing opportunity.  New investments will provide an attractive yield to cover the “time value” of owning properties.  At the same time, an investor has a “free option” on the upside potential in oil prices. Under this scenario, the timing of the inevitable increase in prices is unimportant.  An investor can collect an attractive yield each year while waiting for the price increase.

The key to success will be accumulating good quality, long-lived production at or below Intrinsic Value and managing and administering those assets efficiently. This is the basic strategy Five States executed in our first twenty years.  It really is like déjà vu all over again (again)!

[1] Inelastic is an economic term used to describe the situation in which the quantity demanded or supplied of a good or service is unaffected when the price of that good or service changes. Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.

[2] Producing oil and natural gas properties are defined in this article as oil and gas wells that have been drilled, completed, and on production for several years. This provides historical production and operating expense data for forecasts of future income.

[3] Operating Leverage describes businesses or assets with a high fixed cost structure. Businesses with high operating leverage cannot reduce their costs when prices for their product fall. This results in a rapid erosion of their profit.



[6] Energy Information Administration (EIA) International Energy Outlook 2017, page 35

[7] Energy Information Administration (EIA) Annual Energy Outlook 2017, page 43

[8] Energy Information Administration (EIA) International Energy Outlook 2017, page 13

[9]  I substituted “asset” for “stock”.

[10] Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

[11] Price/earnings expansion defined

[12] Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects.


The decline in the value of properties is discussed in my 3rd quarter 2015 article in The Producer.

[14] Capital Rationing in the Oil and Gas Industry is discussed in detail in my 1st quarter 2015 article in The Producer of the same name.

Rules of the Road

This year begins the thirty-third year of business for Five States Energy Company. Some of our early investors have been participating with us almost as long, and continue to join us in new offerings of partnerships and funds.

When Don Malouf, Arthur Budge, Jr. and I organized Five States in 1985, we agreed to be guided by several principles for the business to which we have attempted to adhere through the years. With Don’s passing, we reflect back on these tenets with renewed commitment to continue the company as we believe he would have wished.

Plan for the future with a long-term investment outlook.

From the inception of Five States, our primary goal has been to accrete wealth for ourselves, our families and our investors through the acquisition of high-quality, long life, income-producing oil and natural gas properties to be held for income generation.  We manage the business conservatively, with an investment horizon of years or decades, rather than months.

Put the interests of our investors ahead of our own.

We’ve built our business on the concept that we’re successful only if our clients and investors are. To date most of our investments are structured as “back in after payout”, i.e. investors receive 100% of invested capital before Five States receives promotional benefit. The result is that Five States and investors have common objectives from the start: to recover investment capital as soon as possible, so that payout occurs quickly. Everyone benefits from low overhead and expenses charged against revenue.

Maintain significant ownership of the company.

Ownership in Five States is the principal personal asset of the Managers. Managers own a large percentage of the company, and have personally invested in every investment opportunity offered by the company since 1985. We “eat our own cooking”, and believe our investments and those of our clients and investors to be successful and profitable.

Manage the business with integrity, with quality business partners.

Integrity of the people we deal with, including employees, brokers, business associates, clients and investors, is of upmost importance to us. Prior to entering into a financial transaction of any kind, we strive to know as much as possible about the record and reputation of the persons with whom we’re to work. It’s usually the first step in our analysis of any proposed project.

Provide timely transparency in company and investment affairs.

We’d like our investors to be as knowledgeable and informed about their investments as possible. We try to make our offering documents, quarterly and annual reports, and correspondence comprehensive and clear, and we welcome questions about the company or investments at any time.

Enjoy the ride.

At the inception, Don, Arthur and I believed that a well-run oil and gas company, committed to long term objectives of acquiring and managing high-quality oil and gas properties, could be an interesting and fun experience. It has been!  Although Arthur and I will greatly miss Don, neither Arthur nor I have thoughts of doing anything other than continuing to enjoy our activities, our loyal employees and a host of wonderful financial advisors, family offices, and individual investors that have made running Five States such an enjoyable venture.

America’s Shale Oil and the Changing Geopolitical Landscape

Rarely do I read a book that is sufficiently interesting and provocative that I keep it on the shelf for further reference. One such book that has been so influential for me is The Clash of Civilizations and the Remaking of World Order, (1996) by Samuel P. Huntington, a political scientist at Harvard. His thesis was that people’s cultural and religious identities would be the primary source of conflict in the post-Cold War world.  Huntington argued that future wars would be fought not between countries, but between cultures, and that Islamic extremism would become the biggest threat to world peace.

For me the book provided a framework for understanding and interpreting relationships of world cultures as they were at the time, and suggested scenarios of future world politics, economies and events. It’s been interesting to consider events as they’ve occurred throughout the past two decades and consider how their likely causes aligned with Huntington’s forecasts.

I recently added another such book to my shelf: The Accidental Superpower, (2014) by Peter Zeihan. Its author, an international strategist, explores the thesis that the new U.S. abundance of shale oil is creating a new paradigm of worldwide geopolitical structure.

At the end of World War II, the U.S. stood alone in the world as the one great superpower. However, unlike victors in previous wars, the U.S. did not demand tribute from the defeated countries or move to permanently occupy and subjugate them. To the contrary, as set forth in the Bretton Woods Agreement, we established the principal of worldwide free trade, opened our markets to imports of foreign goods without tariffs or prescriptive restrictions, and set our navy to be the guarantors of worldwide deep-water shipping. In so doing, we protected shipping lanes to ensure the movement of the emerging supply of crude oil and refined products that our growing economy would need in the years ahead. The overall result has produced the longest period of generally peaceful relations among all neighboring countries, especially those of the European Union.

The U.S. and other countries have prospered during the past seven decades, and the U.S. has been assured a continuing supply of imported crude oil. However, the cost to the U.S. to be the world’s de facto policeman has been a drain on our economy and treasury. It was inevitable that we would need to reduce funding to our navy and its related facilities and services at some time.

Production of shale oil is providing the opportunity and rationale for the U.S. to trim its sails. The Domestic Energy Producers Alliance (“DEPA”) recently announced that the U.S. is now “officially energy independent”. The U.S. hit the “energy independence” milestone of zero net waterborne oil imports this year, as U.S. crude exports surged to a record 2 million barrels per day. The necessity of the U.S. to maintain its expensive navy may be largely obviated. As our navy is downsized, other countries may pick up the burden of the control of shipping lanes. Most of the increases will be by countries for their own border security and protection of export markets. But they will also become a threatening competitor to the U.S.

Because of many “accidental” factors, including such fortuitous items as relative isolation, friendly countries along our borders, and a broad network of navigable rivers for the transport of raw materials from the interior areas to port centers for manufacturing and/or export, the U.S. is more favorably situated to remain the world’s dominant superpower.

The book is really three: a survey of the resources and geography of the U.S. that have made possible our growth and achievements thus far; the evolution of shale oil and the dominating influence it has and will continue to have; and a discussion of the geography and population of various countries around the world – factors that will determine the probable winners and losers in the next several decades.

The Accidental Superpower is an interesting read for almost everyone, especially those of us intrigued by the geopolitics of the oil and natural gas industry. At a minimum, it is an affirming reflection of how fortunate we are to live in a country with such abundant resources and favorable geography.


Five States Legacy Fund

We have been attempting to wind-down and liquidate Five States Energy Capital Fund 1, LLC (“Fund 1”) this year. Until the last few weeks we thought we were on schedule to do so. However, for reasons discussed in this article, we do not expect to be able to do so until next year.

We plan to propose in 2018 that the producing properties owned by Fund 1 be contributed to Five States Legacy Fund, LLC (“Legacy”), a new entity, in exchange for units in that entity.  We plan to simultaneously propose the consolidation of the three Five States legacy partnerships, Five States Consolidated I, Ltd., Five States Consolidated II, Ltd. and Five States Consolidated III, Ltd. (“Cons 1, 2 & 3”) into Legacy. We are targeting the consolidation to occur effective December 31, 2018.

We originally anticipated completing the consolidation by December 31, 2017. However, issues involving Fund 1 require it to exist into 2018.  Consolidating Cons 1, 2 & 3 into Legacy in 2017 then adding Fund 1 assets the next year does not make sense economically or administratively.

Fund 1 Liquidation

The Rule 144 holding period (six months from the acquisition date) for the Plains All American units (NYSE: PAA) received from the sale of Advantage Pipeline has lapsed.  However, we were informed in late October by PAA counsel that, although the PAA stock is marketable, they will not transfer shares without the Rule 144 “legend” until April 2018, the twelve-month anniversary of the Advantage sale.  We anticipate distributing the PAA stock to Fund 1 investors as soon as the legend is removed in April 2018 or shortly thereafter.

We also learned in late October that the Great Northern Midstream (“GNM”) lawsuit, which involves the distribution of the remaining escrowed sales proceeds, will likely not settle before year-end.  Therefore Fund 1 will not receive the remaining cash or final K-1 from GNM until 2018.

Following the PAA distribution, the remaining assets of Fund 1 will be cash and receivables, and an interest in North Permian Well Service (“NPWS”).  This asset is currently “on the market”.

All net cash and proceeds from the various sales will be distributed to the Members. If consolidation is approved, producing properties in Fund 1 will be contributed to Legacy.

Investors who choose to stay will receive a pro rata share in Legacy.  Those who wish to liquidate will be paid their pro rata share in cash.

Cons 1, 2 & 3 “Reconsolidation”

This proposed consolidation is the same process used when we formed Five States Consolidated I, Ltd. in 2000, Five States Consolidated II, Ltd. in 2005 and Five States Consolidated III, Ltd. in 2009.  Continued depletion has reduced the production volume from the partnerships over the last decade. The retrenchment in oil price over the last several years has reduced the cash flow from each partnership.  General and administrative costs are consuming a material part of the cash flow from each partnership.

Cash Tender Option

The remaining value to some investors in the various funds is small after twenty or more years of distributions and depletion. We recognize that some investors may elect the “tender” purely from a “size” perspective.  Others may no longer wish to participate in oil and gas investments.

Investors who do not wish to participate in the consolidation will have the opportunity to “tender” their interests for sale for cash at the time of consolidation. The valuation for the tender will be the same as the values used in the consolidation.

If necessary, we will raise capital through the sale of units in Legacy to generate cash to pay to exiting investors who choose to tender. Management plans to participate for its pro rata share in any additional funds raised.

Consolidation Logic

The producing properties that are owned by the four entities are the type of assets we continue to target for new investment. We believe a “restructure” that results in a financially stronger entity is advantageous to all involved.  We estimate attractive quarterly distributions relative to the liquidation value of the assets following the consolidation.  We also believe there is significant potential for increased returns from continued development of these assets and from the possibility of higher oil and natural gas prices over the long-term.

Investors in any of the four entities who do not wish to participate in the consolidation will be offered a cash liquidation option. For those who elect the cash option, we believe that the lack of transaction fees and the appropriate risking of undeveloped reserves results in an attractive exit.

For regulatory purposes[1], Legacy must be composed only of working interests. Legacy will not include any securities such as notes receivable or LLC interests.

Benefits to forming Legacy include:

  • Continue to hold high-quality long-lived properties for Income and Appreciation. We would resume quarterly distributions to all investors.
  • Decreased general and administrative costs. The savings are primarily attributable to a material reduction in the combined professional fees (tax returns and audits).
  • Enhanced property diversification. As properties in the partnerships deplete, the remaining value of each partnership becomes concentrated in a smaller number of properties. Consolidating the partnerships will increase the well, field and geographic diversification, providing the partners with diversification closer to that of the original partnerships.
  • Low Average Debt Ratio. The debt ratio of Legacy following the consolidation is estimated at about 30% – 35% of the value of the properties. A senior debt ratio of 50% is considered normal.
  • Improved operational decision-making. Consolidation allows us to make prudent capital expenditures to enhance the long-term value of partnership assets, without as much concern for the impact on quarterly distributions. This mitigates the predicament of being hindered from making large capital expenditures when warranted because the size of a partnership has decreased.
  • Improved administrative efficiency. Several properties are owned by more than one entity. Consolidation will increase administrative efficiency.

Valuation Methodology for Consolidation

The price proposed for the consolidation will be the present value of the producing properties owned by each entity using current oil and gas price assumptions and a 10% discount factor, increased or reduced by outstanding debt, hedge positions and working capital. There are no imputed transaction costs or fees.  Each entity will be allocated a pro rata share of Legacy based on these values.

For example, if a fund is valued at $200 and the total value of all entities is $1,000, then the investors in that entity would be allocated 20% of Legacy.  The valuation of the properties in each entity will be audited by an independent engineering firm.  Details on valuation will be distributed upon completion of the audit.


Legacy will have debt in its capital structure. The debt of the partnerships participating in the consolidation will be assumed by Legacy. In addition, Legacy may borrow funds to acquire additional properties in the future. The total debt of Legacy is estimated to be in the range of 30% of total asset value.


Legacy will assume the existing hedge positions of the four participating entities. The hedge positions are included in the economic analysis.  The settlement value at the time of closing will be “netted” from the allocation value.

Consolidation Process

Investors and financial advisors will receive a Private Placement Memorandum for Five States Legacy Fund, LLC.  They will also receive a schedule of their pro rata share of the calculated value of their interests in the entities being consolidated. Investors will be asked to vote for the consolidation.  They will also be asked to indicate whether they will participate in the consolidation or liquidate.

Following are approximate dates anticipated in the consolidation process:

June 2018                 Private Placement Memorandums distributed

August 2018             Ballots from all investors due back to Five States

December 2018        Effective date of consolidation


Five States senior management continues to believe that high quality domestic oil and natural gas properties are an attractive long-term component to a diversified portfolio. Jim and I plan to continue operating Five States into the foreseeable future for ourselves, our families and our investors who share our expectations and investment philosophy.  We believe that we are on the cusp of a very good period for making new oil and gas investments.

As with previous major corrections in the oil and natural gas markets, the rationalization of value has taken years. We are seeing credit tightening by many banks, tighter regulation of oil and gas loans by the OCC and bankruptcy of competitors.  We are also seeing capital rationing returning to the oil and gas markets, resulting in more conventional properties coming on the market than we have seen in a decade.  These are the conditions that are best for value investors like Five States.

Continuing to hold the portfolio of high quality long-lived assets through Legacy is consistent with that philosophy.  This proposal provides a good option for all investors.  Those who share our philosophy and expectations can continue to participate in owning these assets. For those who do not share our philosophy and expectations or who no longer wish to be invested in this sector, this proposal will provide a liquidity option over the next year.

The economic benefits of forming Legacy to “holders” include reduced overhead, no “dead deal cost” and strong understanding of the undeveloped reserve potential in a long-lived portfolio of producing properties.  For those choosing the cash tender option, there will be no commissions or fees burdening the sale, and the valuation includes appropriate risking (good value) of the undeveloped reserves and avoids the risk of discounted valuation on the sale of the small working interests.

We hope you will join us by endorsing this proposal as we work through 2018. Please call me at (214) 560-2569 with questions or comments.

Is the World Facing “Peak Demand” Rather Than “Peak Supply”?

For at least 100 years the world has been anticipating the “rapid exhaustion” of crude oil supplies. Will we continue to be as concerned in future years as we have in the past?

“Peak Oil”, the idea that global oil production would soon reach a maximum and then begin to decline, attracted a significant number of believers in the 1900s and early 2000s. The concept of Peak Oil developed from a theory put forth by American geoscientist M. King Hubbert in 1956. Based on overall reserve estimates and the pattern and history of field discoveries in the United States, Hubbert created a composite, mega-decline curve that predicted U.S. crude oil production would peak in the 1965-1970 time period, then continue to decline to ultimate depletion of the resource base.

And U.S. oil production did reach a peak, a little later than the original Hubbert curve predicted. But with the discovery of North Slope oil in Alaska in 1968, production began to increase again. It now appears that Hubbert’s approach predicts a profile for conventional oil production in a defined geographic area, under specified technological and oil pricing conditions.

In 2008, “unconventionals” happened. The combined technologies of horizontal drilling and hydraulic fracturing (“fracing”), when applied in shale and tight sand reservoirs, unlocked billions of barrels of oil and natural gas that had never been producible before.  Suddenly, hydrocarbon production in the U.S. began to increase. With rising crude production, the U.S. stopped soaking up the world’s excess oil supply.

Instead of cutting back crude production to balance the market, Saudi Arabia increased production to protect its market share. The result was a global glut of crude and liquids, along with a truly major price collapse.  Today you’re more likely to hear people talk about a possible worldwide peak in oil demand than a peak in oil production. One oilman quips, “The world keeps not running out of oil.”

But the principal arguments of Peak Oil haven’t changed much. Proponents of a production maximum point out that the worldwide discovery of giant and supergiant oilfields peaked in the 1960s and has been falling off sharply since then.  As more and more of those giant oilfields go into decline, they say, world crude production inevitably will decline as well.

Also, recent international exploration results haven’t been pretty. “Oil discoveries declined to 2.4 billion barrels in 2016, compared with an average of 9 billion barrels per year over the past 15 years,” the International Energy Agency (IEA) reported in its Annual Outlook.

“Meanwhile, the volume of conventional resources sanctioned for development last year fell to 4.7 billion barrels, 30 percent lower than the previous year, as the number of projects that received a final investment decision dropped to the lowest level since the 1940s,” according to the IEA.

One of the most consistent statistical trends through many years has been that worldwide oil demand growth has been about one million barrels per day each year. Even with a substantial increase in the development and consumption of renewables, the trend of increasing oil demand is likely to continue.  Most of the world’s developing countries have few alternatives but hydrocarbons to provide the transportation and electrical generation fuels to build their economies.

When people ask “How much oil is there?”, the answer must always be “At what price?” Exploration and development of natural resources are ultimately determined by anticipated future product prices, and even small changes in their direction can strongly influence development decisions.

If You Don’t Have an Oil Well

When I was a boy growing up in West Texas in the 1960s, there was a frequent television commercial for the Western Company[1].  The ad concluded with a beautiful young woman in roughneck overalls and a hard hat hanging off the side of a drilling rig, speaking the famous tag line:

“If you don’t have an oil well, get one! You’ll love doing business with Western!”

Although I don’t attribute my desire to own oil and natural gas production to Eddie Chiles, I still believe that owning producing properties is an outstanding portfolio component.

At Five States we were excited in early July to close our first investment in several years in a group of producing oil properties for FSEC Fund 2. Based on recent calls from investors, I decided to cover some “whys” in my article this quarter:

  • Why Own Direct Oil & Gas Interests?
  • Why Is It Taking So Long to Deploy New Funds?
  • Why Is It Worth the Wait?


The primary reasons to own producing oil and natural gas properties in a portfolio include:

  • Current Return – producing properties provide return through current cash income, unlike many other asset classes where the investment must be liquidated to realize the majority of the return.
  • Inflation Hedge – increasing energy prices have been a core component to price inflation over the last fifty years.











  • Attractive Total Return – producing properties have priced at a net present value of engineered future cash flow in a range between 8% – 12% (unleveraged) for much of the last thirty years.
  • Why Not Oil & Gas Stocks
    • Low Correlation – the return from producing properties has a low correlation to financial assets. The following correlation coefficients are calculated on the changes in oil and natural gas prices to the other asset classes.






    • Liquidity Premium[2] – some advocate that owning energy stocks to invest in oil and gas entails a high liquidity cost. Sabine Royalty Trust (“Sabine”) is a mature oil and gas royalty trust. Following is a comparison of the Market Cap of Sabine compared to the Net Present Value (“NPV”) of its oil and gas holdings calculated at a 10% discount rate[5]. The liquidity premium; the difference between the Market Cap and the PV10%[6] value of the PDP Sabine owns is currently almost 4.5x. This is over twice the average liquidity premium in the 1980s and 1990s. This is a huge cost if the investor plans to make a long-term investment in oil and gas for income. Oil and gas “flow through” vehicles such as Royalty Trusts and MLPs[3] (much like REITs[4], except that they invest in oil and gas) accumulate properties in a publicly traded investment vehicle and distribute the income to investors. These are the “purest plays”, as the assets consist almost entirely of oil and gas production.



The market for direct oil and natural gas properties has been in a state of flux since the crash in oil prices. As discussed in my fourth quarter 2016 article in The Producer, the 50% drop in oil corresponded to a 75% drop in the PV10% value for producing properties. The Proved Non-Producing and Proved Undeveloped (“PDNP” and “PUDs”) declined as much or became worthless.

The typical first lien loan advance rate on an oil and gas production loan is around 60% of PV10%. Therefore, without making aggressive assumptions about price recovery, most loans have been “underwater” by historical underwriting standards. The decline in oil prices from $85 per barrel to $45 per barrel resulted in an average decline in loan value of 80%, so the net present value of the collateral for most production loans fell below the loan amount.










Lenders have been holding onto underperforming loans, hoping for a partial recovery. Throughout the last ten quarters, many analysts have been calling for a quick recovery back to $60 per barrel. A recovery of oil prices back to $60 per barrel would have resulted in a doubling from the value at $45 per barrel. This has not happened, and the properties have continued to deplete.

Many of the properties that have been on the market are making their third or fourth round now without closing. However, many sales are now being forced by the lenders and banking regulators, or are coming out of bankruptcy. We believe we are now beginning to see financial discipline return to the market.


The asset in which we invest is “used up” daily as it is produced. This has several unique characteristics:

  • Depleting assets generate more cash flow than the real return. For example, a property that generates cash of 15% on cost for the first year after purchase is only generating a real return of 8%. The other 7% is depletion (return of capital). Often all of this cash flow does not make it to the lender, but instead is consumed by the operator in overhead.
  • The depletion erodes the value of the asset. In the preceding example (all else being equal), the value of the property decreased by 7%.

Depletion reflects the amount of oil that is produced each year, which decreases the total remaining. It appears we are approaching a point where lenders are much less willing to tolerate the annual reduction of their collateral while hoping for things to get better.


I have received calls from investors asking “What have you been doing?” The calls come mostly from “new investors” (those who have been investing with us for less than ten years). We have been busy. A year in which we close multiple investments looks a lot like a year in which we don’t close any.  In a typical year, we process 250 to 300 submittals (any investment opportunity that gets recorded in our log).  Submittals are generated through attendance at trade shows, referrals and direct solicitations.

Submittals receive a preliminary screening by the Preliminary Investment Committee (“PIC”).   The PIC is four senior members of the Investment Committee who review new submittals in a preliminary “triage” to determine if it might be a “fit” for Five States.  About a third of submittals make it through PIC and receive some level of additional research and due diligence.  About half of those that make it through PIC get deep analysis, consisting primarily of engineering, geologic and financial review.  Of those, about two-thirds are rejected, and we attempt to close about one-third. So in a good year, we hope to close only about 4% of transactions initially screened.


I am also asked, “Why aren’t you closing deals?” The answer is, the deals we have wanted either aren’t closing, or are pricing too high.

I was discussing new investments with a successful real estate promoter recently. I asked how he could continue to invest all the funds he was raising, when the price of income producing properties continued to rise, resulting in the project yield continuing to decrease.  His response was “my investors make the decision to ‘buy the market’ when they invest with me.  It is not my place to decide if the market is pricing correctly.  My job is to place the money entrusted to me as efficiently as possible.”

The real estate promoter’s rationale doesn’t work for me in directing Five States. Perhaps it is satisfactory for real estate (since they don’t deplete), but I don’t think it is for direct investments in oil and gas properties.  Investors do not have the insight or access to information to understand how the market is pricing assets.  Based on significant research and analysis, we believe we have a much better handle on this.

I think the most valuable service we provide to our investors is the deals we don’t do. Many deals we analyzed we passed on closed.  The question is whether the buyer made a good investment.  Over the past few years, most who closed would have to say “no”.  But we still have “dry powder” to invest when the market values assets attractively.

Despite adhering to our discipline, Five States’ returns on new investments over the last ten years have been disappointing. The decline in oil and natural gas prices from the +/- $80 per barrel range resulted in material decline in the value of producing properties. Also, the degree of slow-down resulted in a decrease in the valuation of pipelines and other midstream assets. We saw bids for Great Northern and Advantage both drop by one-half to two-thirds from the time we received initial bids until closing.

Although disappointed in our results, we are proud that we did not incur a major loss of capital. We have always said that we underwrite to a low double-digit return, where expected outcome can range from 0% to 20%. We always believed that targeting a higher return increased our risk of material loss of capital. FSEC Fund 1 final results are anticipated to be in the -5% to 4% range. This is disappointing, but given the severity of the crash in the oil market, I am pleased that our discipline resulted in our ability to return the majority of our investors’ capital.


I still consider producing oil and natural gas properties a cornerstone of my portfolio.   I make all of my investments in this sector through Five States.  The value investing philosophy embraced by Five States is the only way I believe one can maintain a significant allocation to this sector without taking material risk of loss of capital.  And I trust the integrity of the Five States investment team to continue to adhere to a strict value investing discipline.

I like to compare oil and gas investing to riding a roller coaster blindfolded. As long as you don’t get thrown out of the car, you should have a good ride.  The average returns from long-term oil and gas investing are strong.  But the volatility is high.  In order to “stay in the car” for the long-term, a disciplined investing methodology is required.

We believe the market for producing properties is finally entering the stage in the cycle where value investors can find attractive purchases. We continue to believe Five States is one of the best options available to those who wish to have an allocation to direct oil and gas.


[1] The Western Company was a major oil services firm, primarily in acidizing, fracturing and cementing, run by Texas icon Eddie Chiles, famous throughout the region for his “What are you mad about today, Eddie” political radio spots and as co-owner of the Texas Rangers baseball team. At its peak, the Western Company had over 5,000 employees and annual worldwide revenues of over $500 million. It was liquidated through sales to other major service companies in the 1990s.

[2] Liquidity Premium – the explanation for a difference between two types of financial securities (e.g. stocks) that have all the same qualities except liquidity.

[3] MLPs – Master Limited Partnerships

[4] REITs – Real Estate Investment Trusts

[5] Source – Sabine Royalty Trust 12/31/2016 Form 10-K

Changing Expectations

What a year! This time last year, I thought Mr. Trump was in the race to provide a media shill to allow the “real Republican candidates to debate the real issues.” After the primaries I thought a Republican victory over the Clinton machine was impossible. Equally surprising to me was the Republican dominance in Congressional and state races.

Closer to home for Five States, we have seen a strong recovery in oil prices. The spot price for WTI crude is in the low $50s per barrel, up from the high $20s – low $30s this time last year. This translates to a doubling or more of well-level cash flow. Natural Gas and Natural Gas Liquids (“NGLs”) have also rallied strongly.

The U.S. has resumed exporting crude oil for the first time since the 1970s. The first export shipment of Liquefied Natural Gas (“LNG”) from the U.S. was in February 2016. The U.S. Department of Energy forecast the U.S. becoming a net exporter of oil and natural gas in their 2017 report by 2026.[1]

Over the last decade, the U.S. has reduced its per capita output of noxious pollutants and CO2 more than any major nation in the world. The primary reason for this decrease has not been renewables, but the conversion from coal to natural gas as our primary electricity source fuel, combined with energy efficiency.

The expectations for the oil and gas industry from recent political and economic changes are intertwined. Increased U.S. oil and natural gas supplies have resulted in lower world energy prices. Reduced regulatory overreach should result in continued development of these supplies. Continuing the transition from coal to natural gas should continue the decrease of U.S. emission levels and contribute to increased U.S. economic competitiveness. The U.S. petrochemical industry is undergoing massive expansion.

The U.S. is once again a major world energy supplier. Through U.S. exports of oil, natural gas and natural gas liquids, the U.S. is now the “swing producer”[2], to the detriment of the ability of the Middle East and Russia to increase world prices through manipulation of supply.

Prices and Price Volatility

The decline in world oil and North American natural gas prices is a direct result of the “Shale Revolution” in the U.S. Over the last decade, the world oil price declined from the $80-$100+ per barrel range to the current ±$50, after recovering from a drop to the high $20s in 2016. North American natural gas prices declined from $8-$12+ per mmbtu to the current ±$3 per mmbtu.

Banning Fracing

The threat of banning hydraulic fracing was the biggest energy wildcard in the 2016 election. Hydraulic fracing has been used to complete the majority of domestic oil and gas wells in the U.S. since World War II. Over a million wells have been fraced in the U.S. in the last 70 years, with no documented impact on fresh water aquifers or other adverse ecological impact from the fracing process.

Hydraulic fracing combined with horizontal drilling has resulted in a huge increase in recoverable oil and natural gas reserves in the U.S. Shale development led to a reversal of the U.S. trend of increasing oil imports. Ten years ago we were importing two-thirds of our oil from places that don’t like us. The world oil market was dominated by OPEC[3], a cartel that manipulated supply to achieve higher energy prices.

Banning fracing would have shut down shale development. Domestic production would have declined to pre-2005 levels in a few years. This would have given OPEC the ability to once again manipulate world oil prices and would have strangled the North American supply of natural gas. Higher prices for oil and natural gas would have returned us to dependency on Middle East supplies. Perhaps the threat by Ms. Clinton to ban fracing was election posturing, but that threat is now “off the table.” This should help keep U.S. supply healthy, with average oil prices below $70 per barrel and natural gas prices below $5 per mmbtu for the foreseeable future.

 Conversion from Coal to Natural Gas

A decade ago the U.S. was using a lot more coal to generate electricity. The drop in natural gas prices from an expected level of ±$10 per mmbtu to $2-$4 has been the primary driver in the switch from coal to natural gas over the last decade. This has resulted in lower electrical costs, with the side benefit of the U.S. reducing its output of noxious pollutants and CO2 more than any other industrialized country in the world.[4]

Regulatory Overreach

Throughout the U.S., regulation of business has exploded over the last decade. The notion that having every business in the country filling out forms and everyone being audited by various regulators is insane. If that worked, we could eliminate crime through regulating it.

I have read more than once “if they’re not doing anything wrong, why do they object to increased regulation?” The reason is that complying with regulation is costly. When regulation is ineffective it is wasteful. When regulatory overreach is used to execute policy that is not approved by Congress, it is politically predatory.

Five States supports appropriate regulation of extractive industries. However, the outgoing administration was using the bureaucracy to obstruct the fossil fuel industry in ways that Congress never authorized. The injunction against Dakota Access and the cancellation of Keystone XL have been very costly to the U.S. oil and gas industry. Judging by the media, one would think there are no pipelines in North and South Dakota. In reality, there are tens of thousands of miles already in place, moving crude and natural gas in the most environmentally friendly and cost efficient manner.

These policies have materially adversely affected Five States. Blocking Keystone and Dakota access has resulted in North Dakota crude being moved by truck and rail. Our North Dakota oil production has sold for $12-$25 per barrel below national averages over the last five years because of the obstruction of pipeline development. The huge negative differential was the primary reason we sold Great Northern Midstream last year, as we believe the Bakken in North Dakota is not economic even if average U.S. oil prices return to $60 per barrel.[5] Unwarranted delays in obtaining the lake crossing permit for Great Northern Midstream cost as much as $50-$100 million in the sales price. Regulatory delay has been a major drag on many other Five States investments over the last eight years. A change in federal policy in this area should be beneficial to the oil and gas industry and Five States.

Consensus on the “New Normal”

In a recent Deloitte survey [6], 84% of industry participants believe oil prices will be in the $40-$80 per barrel range in 2017, with 73% expecting prices to be in the $60-$100 per barrel range in 2020. This is a much “tighter” range of expectations than in recent years.

Disparity in assessment of value between buyers and sellers makes it difficult to get transactions done. When there is a wide difference among buyers, sellers and lenders on price forecasts, there is a wide disparity in valuation. When there is consensus it is much easier for transactions to close.

Last year, when the price of crude crashed into the $20s and $30s, almost no transactions closed. Buyers were not willing to bet on higher prices soon, and sellers and lenders were not willing to sell on valuations that would have resulted in devastating losses, being willing to take the risk that prices would recover. Now with prices at what the majority consider the “new normal,” things are beginning to move again.

Bids and Competition

We submitted more bids on producing properties in the last six months than we did in the past several years. We have been high bidder on several property packages (although none have closed yet) and have been close on others. We feel like “we’re in the hunt again.”

During 2016, we saw a number of changes in the oil and gas upstream financial market. Several of our peers failed, financially unable to make it through the period of volatility and no transactions. Several middle market and community banks are exiting the market. We also believe many of the remaining banks will be stricter in their lending, providing more opportunities for “mid-risk” investors like Five States.

New Transaction Team Member

The biggest competitive issue was the shutdown of the oil and gas finance group of GE. This provides two great things for Five States. The first is the elimination of the largest non-op working interest owner in the U.S. from the pool of competition.

The second benefit of the GE shutdown is the addition of Mike DePriest to the Five States team. Mike was a Managing Director with GE Energy Financial Services for almost 20 years. He started as Head of the Portfolio group, and then moved into an origination role. Mike closed almost $1 billion of transactions for GE. These deals were very similar to the deals that Five States wants to close. Mike is a petroleum engineer and has over 35 years of experience. After spending seven months in another division of GE, Mike decided he wanted back into oil and gas. We have known each other for a long time, and have often talked of working together. Mike joined Five States as Executive Vice President and Chief Acquisitions Officer in late-November. It’s always great when you get to hire “a ringer”!

Valuing Properties

Many have asked with the recent rally in oil and gas prices if we “missed the bottom.” Not at all. The market is composed of two parts: expectations of future oil and gas prices and expenses, and the discount rates at which the market values those assets.

Forward prices for commodities are quoted publicly every day for most major commodities. For example, the price of a barrel of oil to be delivered in April is different from May. In calculating estimated future income from properties, we assume a different price for each month. Over the last year, although the spot price has increased, futures prices have remained in the mid-$50s.

When we buy properties, we “lock in” the majority of the price for the first three to five years through forward sales (“hedges”). Because we lock in the price in the early years, volatility in the short-term price has little impact on our returns.

Equally important in valuing properties is the discount rate with which we value the estimated future income stream. We could buy everything on the market every day if we would just lower the required discount rate (pay more for the property). To understand this concept, which of the following would give you a better return: buying a property assuming $45 per barrel at a 10% discount rate, or $50 per barrel at a 30% discount rate? The answer is the present value calculates the same.

High quality producing properties are a unique asset class. Most of the return from owning these assets is in the form of current income, they have historically been a good inflation hedge, and they have historically had a low to negative correlation to financial markets. Volatility is higher than in many other classes, but long-term returns have historically more than compensated for the volatility.

Expectations for 2017

We believe that this is a great time to be acquiring interests in producing properties. The industry is in the middle of a huge upheaval, and the values of producing properties are about half of what they were three years ago, while the rate of return per new dollar invested has improved (values are lower and yields are higher). The oil and gas industry is deleveraging, both operationally and with less debt. This bodes well for disciplined value investors. We are surprised that we have not closed any new acquisitions, but we are pleased with the increased volume of good assets we are seeing. We are also very pleased to have Mike on board leading our acquisition team. With the rationalization of the market around more consistent future expectations of oil and gas prices, we are expecting the changes to be good for Five States investors.

[1] U.S. Energy Information Administration

[2] Swing producer is a supplier or a close oligopolistic group of suppliers of any commodity, controlling its global deposits and possessing large spare production capacity. A swing producer is able to increase or decrease commodity supply at minimal additional internal cost, and thus able to influence prices and balance the markets, providing downside protection in the short to middle term. Examples of swing producers include Saudi Arabia[1] in oil, Russia in potash fertilizers,[2] and, historically, the De Beers Company in diamonds.[3]

[3] OPEC – Organization of Petroleum Exporting Countries

[4] Source: World Bank, Carbon Dioxide Information Analysis Center, Environmental Sciences Division, Oak Ridge National Laboratory, Tennessee, United States.

[5] WTI reference price of $60 per barrel – $12 differential = $48; this is below the total cost to continue Bakken development

[6] Deloitte Center for Energy Solutions, 2016 oil and gas industry survey

What a Difference a Year Makes!

2017 opened with a much brighter outlook for the petroleum industry and the future for America’s energy security than did 2016.

At year-end 2015 the U.S. oil industry was in a funk. In the last seven months of 2015, oil prices declined 38 percent, from more than $60 per barrel in June to $37 by the end of December. During the year, the U.S. active rig count declined 61 percent, from 1,811 to 698, as contractors withdrew many of their rigs from service, stacked them in service yards, and released thousands of workers who had been required for drilling and completion operations.

Vocal public demonstrations against fracing were more frequent and strident. The practice of fracing was being charged for many alleged offences, including earthquakes, use of poisonous substances in frac fluids, and pollution of groundwater resources. Demonstrations were often actively initiated and/or supported by politicians, TV personalities, Hollywood starlets, press pundits and other public figures. Several communities and states passed laws restricting or banning fracing outright. Among those in the industry there was concern that without the ability to employ fracing, U.S. oil production would begin a rapid decline that would put it back on the downward slope that had existed in the U.S. from 1985 to 2006, before America’s Shale Revolution got underway.

Significantly, within the industry, an oppressive sense of angst was prevalent, as the EPA and other government agencies continued to expand and enforce policies of an anti-industry administration. Many wondered if a national “frac-ban” would be pursued which, if enacted, would likely end the Shale Revolution in the U.S., and with it, the opportunity to drill for and produce more than 95 percent of our nation’s proven petroleum reserves.

Looking back to 2005, there had been widespread concern that the U.S. was “running out of oil,” and the U.S. faced the unpleasant probability that it would need to continue increasing oil and natural gas imports required to fuel our vehicles and sustain our economy.

2017 opened to a very different scene. Oil prices had risen during 2016, closing the year at $53.72 per barrel. Most of the wells being drilled in the U.S. are in “resource plays”: oil shale or tight sandstone reservoirs that are expensive to drill and complete, and generally require oil prices above $50 per barrel to be economic. Some stacked rigs were now being put back into service.

Amazingly, during 2016 several of the largest oil fields ever discovered in the U.S. were announced. In August, Apache announced its discovery of the Alpine High field in Reeves County, Texas. The U.S. Geological Survey estimates that it could contain the equivalent of 20 billion barrels of oil, in an area largely written off as low-potential by previous workers.

In September, Armstrong Oil of Denver and the Spanish company Repsol announced that an often-overlooked rock formation on Alaska’s North Slope may hold a 120,000 barrels per day secret. Experts say it could be one of the largest oil discoveries in Alaska, holding upwards of three billion barrels of oil.

Then, in November, Caelus Energy, a privately owned and financed company in Dallas, announced its most recent discovery in Smith Bay on Alaska’s North Slope. Located about 60 miles southeast of Barrow and 160 miles west-northwest of Prudhoe Bay and the Trans-Alaska Pipeline, preliminary evaluation of the field indicates possible recovery of 2.4 billion barrels of oil. Caelus believes that the expanded area may contain upwards of 10 billion barrels of oil.

These new discoveries point to what experts say is a shifting reality for American energy producers … one in which deeply ingrained worries about a dwindling oil supply have become almost moot. “We will never run out of oil,” said Bernard Weinstein, associate director of the Maguire Energy Institute at Southern Methodist University.

Election Year Choices

On the threshold of the November elections, we are being assailed by both major presidential candidates with charges and counter-charges, uninformed rhetoric and strident babble. Neither candidate appears willing or able to discuss energy matters with reason, nor almost any other major issue.

The creativity and ingenuity of American geoscientists and engineers have led the world in unlocking the secrets of tapping underground vaults of energy. The technology of horizontal drilling combined with the 60-year-old technology of hydraulic fracturing (“fracking”) have been almost miraculous in creating riches that were unknown or untapped before. The individuals and companies that manage the drilling, extraction, and refining of the products have actually created real wealth, not just printed paper funny-money or redistributed currency that is already in circulation. In the process they have also created hundreds of thousands of high paying new jobs, putting millions of dollars in the pockets of workers and their families.

America’s abundant and available natural resources have provided us with energy that is effective and economical, giving us energy security and a competitive advantage in the global marketplace. They are riches that should be managed and maximized to the benefit of our nation. They can be shipped to other countries, bringing balance to our trade deficit and offering secure supplies to our friends. Locking them up will make us more dependent on foreign countries which are hostile toward our interests, thereby hurting our allies and our balance of payments.

There is just cause for celebration by all Americans! Abundant oil and natural gas supplies are also providing reliable supplies of gas-generated electricity for homes and businesses, lower gasoline prices at the pump with no worries about restricted quantities, and no fears that shortages will contribute inflationary pressures on the economy.

Yet almost throughout the entire “shale revolution” of the last decade, the oil and gas industry has been pulling its load uphill, against an administration that has done its best to hamper, cripple and ultimately decimate the creative and productive forces that provide bountiful benefits to its citizens. What it could not do through Congress, it has tried to do through executive mandates, the EPA, the Corp of Engineers, and a host of other governmental agencies. Its tactics have been to deny or delay permits, issue injunctions, and slow or stop industry activities in any way possible, occasionally acting against existing laws, regulations and policies.

The veto against construction of the Keystone Pipeline was one of the first of many administrative blows against the industry. Not only did it deny the operators drilling Bakken wells in the prolific Williston Basin of Montana and North Dakota a safe and economic method of moving their oil to market, it served to alienate our closest neighbor and trading partner, Canada, by slamming shut a means of getting its heavy oil to our refineries on the Gulf Coast.

The recent attempt of sabotage was to halt construction of the multi-billion dollar 1,172-mile Dakota Pipeline that runs from the North Dakota Bakken region to connecting pipelines in Illinois. It had previously been granted approval by all governmental agencies and was more than half completed when it was interrupted. Fortunately, a federal judge ultimately lifted the injunction and construction resumed. Meanwhile, the delay wasted millions of investors’ dollars.

The presidential election will have a big impact on the future direction of fracking regulations. At a March debate in Flint, Michigan, Secretary Hillary Clinton gleefully stated: “By the time we get through all of my conditions I do not think there will be many places in America where fracking will continue to take place.” In contrast, Donald Trump agrees with the courts and says fracking should be regulated by the states.

Realize that the attacks against hydraulic fracturing are not really about fracking. They are a covert way to halt domestic oil and natural gas development, as more than 95 percent of the wells drilled in America today use the technology. America’s new era of energy abundance is the direct result of horizontal drilling and hydraulic fracturing. Ban fracking, and you’ve essentially banned U.S. Energy Independence.

How We Purchase Oil and Gas Properties

Financial theory is based on the assumption that money has Time Value.  The idea is that a dollar available to you today is worth more than a dollar available to you later.  The mechanics are fairly simple:

  • Borrowers will pay interest to get money now and repay it later.
  • Lenders will be paid to give up money now and be repaid later.

Time Value (Discounted Cash Flow) calculations are used to determine the cost or reward. Following the financial crash of 2008, the concept that money has “Time Value” has been somewhat turned on its head. The Federal Reserve has maintained what has become a 0% interest rate policy since the crash, which effectively makes borrowing to the most “prime” borrowers free, and lenders not being paid for providing capital.


Since 1981, declining interest rates contributed to inflation in the stock market and real estate. As interest rates fell, investors “bid up” the value of income streams.

Compounding this inflation has been an increasing amount of debt used in the capital structure of many investments and companies. Almost all real estate transactions were financed with at least 80% debt. When markets began correcting in 2008 (that is, values of assets began falling) it became clear that real estate values could decline by 20% or more. Given that 20% equity in real estate was considered “strong” the prospect of real asset values falling by more than 20% was catastrophic. It would have led to most real estate loans being greater than the underlying collateral value. This would have led to the insolvency of many financial institutions, as well as material collapses in the value of pension and insurance company portfolios. Similar collapse was faced by many companies with high levels of debt in their capital structure.

Ben Bernanke, the chairman of the Federal Reserve (“The Fed) at the time, took what was probably the only rational course by materially increasing liquidity in the system and materially decreasing interest rates. This resulted in a rapid re-inflation of property and other asset values, thus ending the crisis.

However, as often happens at the end of a long-term cyclical trend, the Fed (likely encouraged by the Treasury Department), has kept this policy in place ever since. For the Fed, it is like a “free lunch, increasing asset values at no cost (although it came with no underlying fundamental growth).  An additional bonus from the perspective of the nation’s largest borrower (the U.S. government) is that it dropped the cost of borrowing materially, which was attractive during a period of rapidly expanding deficits.

During this current cycle, the Fed appears to have altered its priorities. Rather than the historical mandate of maintaining price stability, many of the governors are focused on maintaining the growth of investment markets.  They appear to have accepted the idea that forcing investors to take more risk in order to earn yield was the way to do it.

The perversion in all of this is that those who contributed to the collapse in 2008 prospered from this new policy, while those who “did the right thing,” particularly those who had saved and not over-borrowed, bore the brunt. Wall Street and the big banks prospered.  Retirees and others living on savings could no longer earn any return on their savings without materially increasing their risk exposure. John Mauldin published an excellent article on this topic on October 9, 2016.

Valuing Investments – the Financial Theory

If you studied this in college, skip this section.

The concept of Time Value of Money is extended into valuing equity investments.  As in the case of a borrower and a lender, investors give up money today by investing it in exchange for the expectation of receiving one or more payments totaling a greater amount in the future.  Valuing the uncertain future returns is performed using the concept of Discounted Cash Flow (cash flow being the investment returns paid to the investor).

The value of the Discounted Cash Flow is the Present Value.  If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment.

Financial academia has stated Present Value of an equal and the Net Present Value of unequal payments over time in algebraic terms as follows, Net is added to present value to reflect the change in the math to include the payment of the initial investment in the formula.











Looks complicated, doesn’t it! But it is not. I will attempt to restate this in plain English in the next section.

Valuing Investments – the Financial Theory

Here is a plain English explanation of Discounted Cash Flow. If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment. Based on the estimated amount and timing of Future Earnings, the Present Value of those earnings can be calculated using the assumed Rate of Return required by an investor.

Following is an example:

Investor’s required Rate of Return (i.e., Discount Rate)                                               10%

Future Value(i.e., Payment from Investment to be received 1 year from today)     $110

Present Value of Investment Today                                                                                 $100

If the investor invests $100 today, and actually receives his investment of $100 back in a year plus $10 in profit, he will have made 10% on his money ($100 * 10% = $10 + $100 = $110).

To calculate Net Present Value (that is, to calculate the value of an uneven series of payments over time), you do this calculation for each payment to be received over time and add them together. All financial analysis programs and spreadsheets perform this function.

This simple arithmetic is the basis of financial theory, and it is what all of the Greek formulas and algebra above say. This calculation underlies almost every investment evaluation I have ever seen.  All of the financial terms used to describe the components – Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flow and a number of others – describe an attempt to solve for one of the three variables based on assumptions about the other two.

Determining The Discount Rate

Financial theory then attempts to explain how the Discount Rate should be determined. Broadly stated, the discount rate should be as follows:

Discount Rate = Risk-free Rate + Inflation Rate + a Risk Premium

For example if the Risk-free Time Rate is 4%, the Inflation Rate is 1% and the Risk Premium is 5%, the Discount Rate used to value the future stream of earnings would be 10%.  The calculated Net Present Value is the amount that would result in the return from the investment equating to a 10% yield.

Example in Oil Properties

We use Discounted Cash Flow to value oil properties. To calculate future cash flow we estimate future production volume, make an assumption on future prices by year, and subtract our estimates of future expenses per year.  We then calculate the present value of each income payment expected to be received using an appropriate Discount Rate.

Fifteen years ago, the Discount Rate used to value mature, fully developed producing properties was around 12%. Backing into the Discount Rate calculation above, we can calculate the Risk Premium as follows:

Risk Premium = Discount Rate – Risk-free Rate – Inflation Rate

So if the:

  • Discount Rate = 12%
  • Risk-free Rate = 6%
  • Inflation Rate =  2%

then the Risk Premium must have been 4% (12% – 6% – 2% = 4%).

It is easy to see how applying this logic led some during the energy boom to decrease their Discount Rate in valuing oil and gas properties into the single digits. If the:

  • Risk-free Rate = 0%
  • Inflation Rate =  0%
  • Risk Premium = 6%

a Discount Rate of 6% is calculated. (0% + 0% + 6% = 6 %).

If an investor buys properties using a 6% discount rate, and borrows 60% of the money to make the purchase at 2%, he can then generate a 12% Return on Equity.


Looks pretty good in an environment of 0% interest rates.  But there is a flaw in this “relative return” logic.

What Happened to the Oil & Gas Industry?

During the last decade many of our competitors decreased their discount rates into the single digits. In order to maintain high yields, they borrowed money at low interest rates to achieve yields on equity higher than the return from the producing properties.  As I discussed in the prior two issues of The Producer, this combination proved deadly.  As oil prices dropped in half, cash flow from producing properties decreased by 75% or more.

Most producing properties continued to generate positive cash flow before debt service.  But this is partly because some of the investment is being liquidated every day.  However, if oil prices over the next five years average lower than $80-$100 per barrel, which is now widely accepted, many properties will never generate enough cash flow to pay off the debt.

The error made by many investors over the last ten years was assuming that oil prices would remain high.  Some argued that “Peak Oil” would result in decreasing supplies outside the U.S.  Others argued that the high cost of shale development would create a “floor” for oil prices, and that prices could not fall below the floor.

But oil and natural gas are commodities.  They do not behave any different than any other commodity.  When supply is tight or decreasing and demand is constant, prices rise.  When demand is constant or decreasing and supply is increasing, prices fall.

Absolute Return

“Absolute return is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period of time. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.”


We are Absolute Return investors at Five States.  We believe that the appropriate unleveraged return for owning producing properties is in the 9%-12% range.  We therefore use this metric regardless of changes in the risk-free rate. We believe that this is the only way to be a rational value investor in this crazy economy.  As the market for oil and natural gas prices continues to rationalize, we are once again high bidder in some cases.  Frustratingly, in several recent asset sales in which we were the high bidder, the sales have not closed.

Patience is the most difficult virtue in value investing.  But in strange times like these, sticking to fundamental discipline is the only investment methodology that makes since.  We believe strongly that financial markets will rationalize, and that oil and gas markets already are doing so. We continue to review hundreds of assets each year for possible acquisition by our funds.  We saw a large number of assets that we are interested in owning over the last three months.  We have been high bidder on several of these assets, but the sellers are still holding out for more.  So they have not sold. As the market rationalizes, market prices for producing properties are approaching our fundamental valuations.  Our peers who are long-term investors, with whom we “compare notes”, are holding the same valuation metrics.  As the market continues to rationalize, we expect to be able to make the best acquisitions of producing properties we have made in over a decade.