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The Five Stages of Loss & Grief

In the last few issues of The Producer, I have discussed and illustrated the impact of the decline in oil prices on the value of producing properties. Also discussed was the fact that most producers who had what were previously considered “prime” debt levels drawn against their properties are now insolvent (their assets are not worth enough to pay off their debt).

The first question that is often asked is “How is this sustainable?” Unlike many businesses or assets, many oil companies (or producing properties) will continue to generate free cash flow before debt service. It’s like a business that sells its inventory at less than cost. As long as sales exceed the cost of operations, there is free cash flow . . . until they run out of inventory. In the case of an oil producer, enough free cash flow is generated to pay the overhead and the interest on the loan for a while . . . even though there is little likelihood that the debt will ever be fully repaid.

This results in a phenomenon we call “kicking the can.” Rather than dealing with the problem, the producer and/or the lender will often defer the problem as long as possible, in the hope that prices will return to former levels and they can avoid the pain of losing money.

In many cases, the operator or owner is not motivated to address the problem. Doing so could result in the loss of everything, including overhead payments (which includes his salary, club dues, car, expense account, etc.). The borrower has no motivation to solve the problem.

The lender is similarly conflicted. Energy bankers, at least the competent ones, have known what was coming for some time. But they were not motivated to solve the problem. They knew that directly addressing the problem by forcing borrowers into liquidation or foreclosure would result in losses for the banks, negatively impacting the banks’ earnings. . . and their bonuses. Kicking the can and hoping things would get better was much more attractive.

There was also a large degree of denial. “How could all those highly profitable prime loans go from grade A to subprime almost overnight?” It is emotionally unacceptable. Throughout 2015, most bankers were claiming that “their portfolio was solid, and they had only minimal problem loans.” But this was not true for most, if any.

In addition to the quantitative part of what is happening in the market for oil and natural gas properties, there is also a psychological part. It appears very similar to “The Five Stages of Loss & Grief” by Julie Axelrod:

1. Denial
2. Anger
3. Bargaining
4. Depression
5. Acceptance

At the beginning of the downturn, there was Denial. Producers claimed prices would recover quickly, they were adequately hedged so that it did not impact them, and some were misleading in how they presented their costs and expenses.

Then they became Angry. “How could the banker imply such a thing? How can I work my way out? How could the banker treat me like this after so many years as a great customer? Does he not understand?”

Bargaining became the next step. We saw a lot of this in the latter part of last year. Many deals we had reviewed prior to the price collapse started coming back around. “Well, you were willing to value it at $20 two years ago, how about $15 now (even though the current net present value is only $5). That would be a good deal!” We saw a long period of low transaction closings throughout the industry as sellers tried to bargain on unrealistic expectations.

We have finally begun to see Depression and Acceptance. This is evidenced by the increasing number of companies that are filing bankruptcy, and the increasing number of quality producing properties that are coming on the market.

Assessment of the Market Today

Quality of assets available is materially improving. We would like to own many more of the assets we are seeing. We have made more bids in the last few months than we did all of last year.

Velocity is accelerating. Many deals are coming in “ready to close” with realistic data packages, time lines and seller expectations. We are “weeding out” deals more quickly that are not of interest. I suspect we will review many more deals than the usual 300 +/- submittals we normally process in a year.

We are now seeing many deals that did not close last year. They are coming around again, but with more reasonable terms.

Some assets are starting to come out of bankruptcy. All the “hair is off,” so assets from bankruptcy almost always transact.

The market is rationalizing. We believe that the market valuation on producing properties is moving back to a net present value of 9% – 15% (at the asset level, without allocation for overhead, etc.). This is a significant improvement compared to net present value in the low to mid-single digits at the peak of the boom.

Most Proved Undeveloped assets (“PUDs”) have little or no value at current oil prices. The buyer still gets this potential upside, but pays little if anything for it. The assets that do have PUD value are really good.

Most submittals we are seeing are Working Interests (“WIs”) for sale. The Mezzanine opportunities (“Mezz”) are almost all first liens. The economics of buying working interests or making first lien loans are about the same:

  • The internal rate of return (IRR, or imputed real yield) is about the same for WI and Mezz
  • Payback is faster on Mezz loans than on WIs
  • Total return is higher on WIs than on Mezz
  • The Mezz loan has some preference compared to buying the WI, which reduces risk

We still prefer to own Working Interests. The higher total return and greater upside potential appeal to us. We will only make Mezzanine loans on assets we would like to own at the loan value. Then we are happy regardless of whether the loan pays off or we end up with the underlying collateral (the producing properties).

Some investors have expressed concerns about the long investment period since the closing of Fund 2, and the “drag” that the management fee can have on total returns. This is of concern to Five States management too. However, the primary issue is to not overpay for properties.

An old adage is that the profit is made when you buy. That is, the profit is determined by buying at the right price. Because of material re-pricing of oil and gas assets, any acquisitions that we could have made (but did not) in the couple of years following the closing of Fund 2 would be underperforming today. I am proud of our adherence to our disciplined methodology, “keeping most of our powder dry” for the opportunities that are now presenting themselves.

The returns from investing in producing properties in today’s pricing environment are sufficient to cover the overhead we incurred before we begin generating our target yield. If we buy properties at a price that will generate the lower end of our target return, the return to the investors should exceed the priority return without a major recovery in oil and gas prices.

I have commented in several previous articles about the conditions that make for great value investing:

  • Low oil and natural gas prices
  • High discount rates on valuing future oil and natural gas income streams
  • Unpopularity of the oil and gas sector

When Good Wells Go Bad

Like people, oil and natural gas wells have productive lives—they are born, decline over a period of time, then are put to rest. Also like people, the length of their lives can be affected by a variety of circumstances, both physical and economic. Ultimately, however, all wells reach their economic limit and can no longer be profitably maintained. They are then “plugged and abandoned.”

Of course, many wells drilled with high hopes turn out to be “dry holes.” In some of these, anticipated reservoir rocks are not present, are filled with salt water, or are too dense to allow passage of fluids through their pore spaces or fractures. Soon after the well reaches its targeted depth, such wells are filled with mud and cement and are sealed.

Wells that are deemed potentially productive are “completed,” a process in which protective steel pipe (known as “casing”) is cemented in place to prevent the hole from collapsing—safely protecting fresh water zones behind steel and cement and isolating gases and fluids contained in the various layers of rock. Perforating the pipe opposite the targeted formation allows oil to flow into the well bore where it can be brought to the surface and sold.
When wells are new, oil and gas entrapped in rocks nearest the wellbore are the first to enter, and production rates are high. As oil and gas are produced and reservoir pressures decline, fluids must move greater distances to reach the wellbore. Initial production rates may decline rapidly, sometimes as much as 90% in the first year, depending on the characteristics of the fluids and their host rocks.

Generally, after several years, production rates stabilize at lower values and future well performance becomes more predictable. All wells will continue to decline, but the rate of decline may be so gradual that the well may continue to yield low volumes for many years or even decades. Low rate wells, commonly known as “strippers” because they strip the remaining oil and gas from the ground, typically produce less than 15 barrels per day. Although they produce only about 10% of the total US oil output, stripper wells comprise 80% of the total number of US wells. At the end of 2015, there were around 380,000 domestic strippers, down by 19% from 2008. However, strippers still surpassed “non-strippers,” which totaled about 90,000 at the end of last year. These stripper wells are an important component of the economy as they employ thousands of oil field workers, support most of the well service sector, and each month provide income to several hundred thousand mineral and royalty owners.

Much of the imputed value of marginal production is in its “tail”—the long period of time after a well’s flush production has passed, its decline rate has leveled and, hopefully, the well has recovered its cost of drilling and operation. At such point, operational expenses are generally low and settled, and the operator can typically expect the well to continue to generate profits for many years. However, a sudden and significant decrease in oil prices or an increase in operating expenses will shorten the well’s economic life and truncate its projected future net revenue.

Five States and our investment partners are not totally immune from these problems. We own interests in many producing properties that are at or near their economic limit. We routinely review all our properties to “keep our garden weeded,” eliminating unprofitable properties that have little potential future value, but continuing to hold those that may prove more valuable in the years ahead.

As a well reaches the end of its economic life, operational expenses eventually overtake profits and the owner’s previous asset becomes a potential liability. The margin between profit and loss can be excruciatingly thin and is almost exclusively determined by daily oil prices.

Consider the situation in which the expenses of a well’s maintenance is equivalent to $40 per barrel (i.e. $40 oil is required for the well’s owner to “break even” each month). If the price increases to $45, the owner makes a profit of $5 per barrel; at $35 per barrel he loses $5. In other words, an owner of marginal properties must be willing to place a bet each day: continue operations with the expectation (or hope) that prices will eventually move higher, sell as soon as possible, or plug and abandon immediately.

Alas, such a decision is not a simple one. If he sells or plugs his wells, and prices suddenly turn upward, he has lost the opportunity to participate in what could be a bonanza. Because operating expenses are fairly independent of oil prices, small fluctuations in prices can result in significant leverage on profits. Every dollar above break-even drops directly to the bottom line. If prices suddenly plummet, as they did last year, an owner’s pain increases as he must “feed the kitty” for an indeterminate period.

Even though a well is producing at a loss, the owner likely realizes that it still represents a potential asset. Even after most reservoir pressure has been depleted and his production has declined to the economic limit, as much as 85% of the original oil in place (“OOIP”) still remains in the reservoir. Could a portion of the remainder be recovered by other means (e.g., water-flooding or the like)? Equipping his wells for such processes is time consuming and expensive, and may ultimately prove unsuccessful in the long run. If he is not well financed, where would he get the required investment capital?

The owner also knows that there may be other zones, perhaps deeper, that could be later drilled and exploited on his leased acreage. Is it worthwhile holding the leases by production until he can find companies who would finance the expenses of exploration and development, and provide additional value to him?

Even if he decides to plug and abandon his wells in order to eliminate expenses, or the state’s regulatory agencies require him to do so, he is not out of the woods. The expense of plugging and abandoning a well is likely to be greater than the value of recovered equipment (i.e., the “salvage value”). The owner may have to borrow funds from a bank or other source just to stanch his losses.

If he has already borrowed from a bank to drill new wells or fund operations, his problems are exacerbated. His loans may be collateralized by hedges placed during a time when oil prices were higher. Their value may be burning off monthly, making his collateral worth less than his loan, and leaving him unable to make principal and/or interest payments.

This is the situation of many individuals and companies in the oil business today: underwater, cash strapped, frustrated and scared. It is a common and unfortunate malady that seemingly occurs about every 10 years or so in our industry.

The News is So Bad!

I have received a number of calls recently with a common theme; “The News is So Bad!” This statement is usually followed by:

  • “I read that the price of oil/gas will never recover”;
  • “The drilling industry is collapsing”;
  • “I read that the collapse of the oil/gas industry may go on for decades”; or
  • “How can we make money if oil/gas prices don’t recover?”

For value investors, this is as good as the environment gets for making new investments!

The Boom

The boom in oil and gas was driven by several factors. The first was growth in world demand. Despite slowing growth in energy demand in the developed economies (the US, European Union and Japan) primarily due to more efficient use of energy, world demand continued to grow over the last decade. Total energy demand from the emerging economies (China, India and others) is now greater than from the developed economies. The rate of growth in demand by the emerging economies has slowed in the past few years, but world energy demand continues to increase every year.

World Oil Demand

The increase in energy demand resulted in higher prices, which led to the development of unconventional oil and gas development. The method of development is not what is unconventional. Hydraulic fracturing has been used throughout the world since the 1950s. The unconventional part is developing shale formations, which is not economically viable when oil is less than $40 – $50 per barrel. When oil was over $80 per barrel, there was a “gold rush mentality” in the industry, with attempts made to develop almost anything that would produce.

The development was very successful. The majority of the new production developed was in the US. Domestic oil production increased by two-thirds over the last decade, from six million barrels per day to over 10 million barrels per day. Last year, the US was the world’s largest oil producer. But this led to excess deliverable supply and a price collapse.

US Oil Production

Too Much Debt

The boom and subsequent collapse were fueled by a combination of success in drilling and too much debt. The location of the shale formations is well understood and documented, so few dry holes were drilled. This led to the perception that drilling shale wells was not risky, so greater levels of debt were used to capitalize the development than was historically normal.

Oil Price and Unexpected Market Tightness

Debt and Leverage Have Increased Sharply in the Energy Sector

Since interest rates were low, the addition of low interest debt to the capital structure of oil companies became common. The “cost of money” to develop or buy oil properties decreased tremendously.

Historically, good quality proved producing oil properties were valued at a 10% – 15% discount rate. That is, the value of the estimated future income stream is valued at a price that would generate a 10% – 15% net yield over the life of the well.

Low cost debt resulted in the discount rate declining into the 6% – 8% range, increasing the market value of these wells by two to three times or more. And these yields were being calculated on assumed future oil prices continuing at record levels.

Record Prices and Production Volume

Until late 2014, oil was selling for record prices, ranging from $80 – $140 per barrel. The consensus view was that oil would continue to sell for $80 – $100 per barrel. It was assumed it would “spike” above that range during periods of international instability, and that any declines below that range would be short-lived.

By late 2014, world production began to increase to a level greater than world consumption, as demand growth began to slow. Inventories reached historic highs, and prices collapsed. US production has peaked, and is expected to decrease by 700,000 barrels per day this year.

When Do We Buy?

I am often asked “How do we call the bottom?” The answer is, we can not. I have no idea if the bottom was last quarter or if the price of oil will decline again later this year.

However, it is time to buy. We are clearly in the bottom quartile of the cycle. Oil prices are low and discount rates are high. There is “a lot of money on the sidelines,” but most of it is focused on public companies and assets over $100 million.

We believe that over half the oil and gas companies in the US are insolvent. The values of producing properties have decreased by over 80% in the last two years. Many of the transactions will be liquidations of companies. We expect more assets to change hands than in the 1990s.

What’s the Deal?

The answer to the original question is, we will make money by owning income-producing assets. Producing properties are at a value that generates a double digit current yield based on current wellhead prices. Little, if any, value is being paid for future development potential.

We will be using forward sales (“hedges”) to lock in the price of the majority of our production for four years. This ensures that if we are early and prices are lower over the next few years, we will have “locked in” the double digit yield over this period, and be almost certain we have made a profitable investment.

By using hedges, we are giving up the potential to earn superior returns in the short-term. I like this trade. It allows us to accumulate high-quality, long-lived assets, which will earn a very attractive current yield while we wait for an intermediate-term recovery in oil prices which we believe is inevitable.

Good News – Bad News

The US Energy Information Agency (“EIA”) recently announced that production from wells drilled since the start of 2014 made up 48 percent of total US crude oil production in 2015. With the increased use of hydraulically fractured horizontal wells, new production as a percentage of total US production has more than doubled from 22%in 2007, according to the EIA. These are startling facts.

Crude oil production from hydraulically fractured wells now makes up the majority of oil produced in the United States. As of 2015, 51% of crude oil produced in the US came from wells targeting tight oil formations, most significantly the Eagle Ford and Permian Basin in Texas, and the Bakken and Three Forks formations of Montana and North Dakota.

Crude Oil Production

Consider what the combined technologies of hydraulically fracturing and horizontal drilling has meant to our country. Without them, if the average annual rate of US production in 2007 had continued to decline at the same rate it had during the past decade, US average daily production would now be at about 4.3 million barrels of oil per day (“bopd”), rather than 9.4 million as it was in 2015. We would now be importing 75%of our oil supply.

The benefits of increased oil production have been significant. Analysts and politicians agree that decreased reliance on foreign crude in the past few years has allowed the US to be more flexible in its foreign policy and given the US more global heft.

The US is now much less reliant on oil from the Mideast and elsewhere. Think of what that means, not just to our trade-account deficit, but to the reduced necessity of deploying many of our young men and women in the military to protect oil transportation routes.

Literally billions of dollars have poured into the hands of individuals, companies, and state and federal treasuries as a result of new production. Hundreds of thousands of land and mineral owners, many of whom live in areas that previously produced little or no oil or natural gas, now receive monthly royalty checks. That’s the good news.

US Oil Production and Imports

The bad news is that US crude oil production is falling in response to the collapse in oil prices that started in mid-2014. Output is now poised to drop below 9 million bopd—700,000 bopd off its April 2015 peak—and the rate of decline is accelerating, perhaps losing at least another 750,000 bopd by year end, a total drop of 16% in 18 months. That raises all-important questions of how low will US production go, and how much will oil prices need to rise to reverse those declines?

Rig Count by Drilling Direction

Of course, because the decline rate of production from horizontal wells is so high—as much as 90% from year to year—it takes a minimum of about 1,000 active drilling rigs to sustain the current rate of production. However, the total number of active rigs in the United States continues to fall. At the end of March, the number of oil-oriented rigs had fallen to 372, down 15 from the previous week, and down over 1,200 from the recent peak of October 2014. Further reductions are anticipated.

Oil Rigs in Operation

Producers fear they may never again experience the robust oil prices they enjoyed during the 2010-2015 period. The few oil-producing nations with spare production capacities, primarily Saudi Arabia, Iran, Iraq and, to a lesser degree, Russia, have demonstrated that, by maintaining high production levels, they can drive prices lower, and keep them there for extended periods. The effect has been to enable them to maintain their market share, and to make oil from US horizontal drillers non-competitive. For almost all the world’s oil exporters, today’s low prices are unsustainable over the longer term, but today they are successfully damping out aggressive drilling in the US.

At $40 per barrel, and with today’s drilling and completion costs, there are only a few spots in the major US shale plays where it makes economic sense to drill and produce more oil. For there to be a meaningful response from producers, prices must not only be higher than $55 per barrel, but producers must believe that it will stay at that level long enough to recover their investment and make a profit, and hopefully, continue to increase. Even though this is far below the $100 per barrel price of the shale heydays, many producers can make this work, especially if they have undrilled locations on leases held by currently producing wells. Progressively higher prices will bring on additional production. Estimated stable prices of $70 to $80 per barrel are required to put most of the US rig fleet back to work.

The bad news for U.S producers is that shale has so fundamentally changed the oil market that the word “recovery” is no longer relevant. That is because oil prices are now range bound, locked into a bracket which is capped at the high end, and with a floor at the low end. Above $55 per barrel, US production starts to increase, the oil market builds supply, and prices respond by going down. Based on recent experience, a price floor appears to be some number below $35 per barrel.