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“Déjà Vu All Over Again” – The Market for Oil and Gas Assets

What a difference a year makes! At this time last year, oil was around $60 per barrel, and we thought we had taken a beating. When oil fell from $85 to $60 per barrel, the present value of the future production fell in half. Little did we know that, in 2015, we would see the wellhead price of oil fall another 50% and the value of producing properties fall even further.

The story was similar for midstream assets (i.e., pipelines). Although most midstream assets are still generating strong earnings, the value of many midstream assets fell by a factor of three or more. The dramatic drop in value occurred as the market began to believe oil prices will not recover significantly and domestic volumes will continue to decline.

We first discussed the likelihood of a decline in oil prices in my article “A Correction in Oil Prices?” in the fourth quarter 2013 issue of The Producer. Due to our concern, we took a defensive position in our investing activity over the last several years. Despite our caution, overall results from investments made during the boom have been disappointing.

The oil and gas industry is in in a devastating down-turn, but our financial condition remains healthy. Five States Energy Capital Fund 1 and Fund 2 have no debt. The managing entities of the various funds are also solvent, and have only operating liabilities. All of our entities remain solvent and have healthy balance sheets.

Our “legacy funds” (Five States Consolidated I, Ltd. Five States Consolidated II, Ltd. and Five States Consolidated III, Ltd. ) generated the majority of the cash distributions investors have been receiving over the last decade. These returns were from investments made primarily in the 1990s, and have already generated over 3:1 returns and an IRR of ~20% over the last 25 years. However, we now need to be cautious and increase the strength of the balance sheets of the legacy funds. We incurred conservative levels of debt over the last cycle to participate in development opportunities on properties owned by those funds. We now believe it is conservative to accelerate paying down our bank lines on these funds. The cash distributions for these funds will be suspended for the next two to four quarters.

Expected results from Five States Energy Capital Fund 1 have deteriorated with the collapse of oil prices. We have stayed within our targeted risk band, which will allow us to operate through the downturn. We now expect Fund 1 will have full capital recovery with a low single digit return over the life of the investment. If prices stay this low for an extended period, we may incur a small loss.

Such forecasts are materially lower than we were estimating a year ago. The biggest negative was the decline in value in our two pipeline assets. Great Northern Midstream was sold this month. While we made a profit, it was not nearly the result we expected a year ago. The decision to sell was primarily driven by the risk of North Dakota Bakken production, the majority of which is not profitable below $60/barrel. The owners of GNM unanimously agreed it was better to recover our capital than to continue to own this risk. This quarter, we are distributing proceeds from the Great Northern sale. After this quarter, Fund 1 distributions will be materially lower

Many in the industry are faring far worse. More than 250,000 jobs have been lost in the energy sector. Most oil and gas companies that had what was considered conservative debt levels in 2014 are now insolvent. More than 40 oil companies filed for bankruptcy protection in 2015. Some analysts are predicting that half the companies in the industry will fail in 2016.

Five States is well positioned to take advantage of the downturn. We plan to pursue acquisition of producing oil and natural gas working interests through the downturn. More than 65% of the capital committed to Five States Energy Capital Fund 2 has not been deployed. We anticipate opening Five States Energy Capital Fund 3 mid-year, as soon as the majority of Fund 2 has been committed to new investments.

Buy Low

I am often asked why we want to buy oil or natural gas properties now if wellhead prices are low and are not expected to recover in the near term. As value investors, we adhere to the old adage, “buy low, sell high.”

The current situation is much like it was when we started Five States in 1985:

Low Wellhead Prices – wellhead prices of crude oil and natural gas are down two-thirds over the last 18 months. When prices are low, there is less room for them to fall.

In order to continue producing the 92 million barrels humanity is consuming each day, new reserves have to be developed. The marginal replacement cost of oil is in the $60 per barrel range. If the price remains below $60, natural depletion will result in declining production, supply will decrease and prices will increase.

 “But what about the Saudis and Iran?” Saudi Arabia, Iran and others have materially lower production costs than the US, Russia or Venezuela. But Middle Eastern producers do not have the capacity to supply world demand alone. Conventional production has peaked. Without renewed development of the more expensive North American production from sources such as shale, world supply will decline.

Although demand growth has plateaued in the US and Western Europe, world demand is continuing to grow. Consumption has not declined. Only the rate of growth has slowed.

Oil prices will recover. The question is when, and how much. We are assuming in our evaluation of new producing properties that prices remain low for four to five years, average in the $50s in the intermediate term and $60+ in the long-term. Through hedges, we will “lock-in” the oil and gas prices on the majority of our new acquisitions for the first four to five years to minimize income volatility as we recover the majority of our investment from the early current income. Hedging will ensure investor payback and a profit if a price recovery takes longer than we forecast.

High Discount Rates – the Cost of Capital for the oil and gas sector is increasing. We believe the discount rate for valuing producing properties is once again in the 9% – 12% range.

During the recent boom, the market underestimated the systematic risk[1] inherent in owning producing properties. Many incorrectly assumed that because new oil and natural gas production from shale is expensive to develop, wellhead prices would not fall below the cost to develop it. Compounding this error, many lenders failed to recognize the increased risk inherent in the higher operating leverage caused by the much greater drilling costs. They continued to loan money using conventional loan to value metrics, which have proven to be too high. Wellhead prices have fallen materially below the capital cost to profitably drill and complete the new unconventional wells. Looking forward, investors will require an additional risk premium in their cost of capital to compensate for this additional risk.

Junk bonds and inflated stock and MLP valuations provided Five States’ competitors with “cheap currency”, allowing them to pay more for oil and gas assets than Five States would as a cash buyer. Public companies and MLPs financed the drilling boom with “cheap debt” or raised cash at inappropriately high stock prices, allowing public companies and MLPs to spend more than true value to develop new reserves.

We recognize that there are “hundreds of billions of dollars waiting on the sidelines.” But the majority of those dollars are with hedge funds and large institutional investors. Many are recognizing their lack of the skill sets necessary to evaluate individual producing properties. With many of the smaller oil and gas companies insolvent, restructuring is not an option. The opportunity for Five States will be to buy real property interests in producing oil and gas properties, a skill many financial firms lack.

Some ask, “How will you get the good deals?” The reality is, there are no “steals”. This is a very competitive market, and it is always competitive. Buying producing properties was as hard in 1998 when oil was below $10 per barrel as it was during the boom. The reason the 1990s acquisitions look so good in hindsight is that we “bought low”. Today, discount rates are much more normal, so new acquisitions are good value and can generate high cash yields at current prices. We can earn a good current yield from owning the production without needing prices to recover to pre-crash levels. This is an excellent scenario for long-term value investors.

We Buy “Oil in Ground”

The majority of the focus in the media is on the spot price of oil. However, we are not buying barrels of oil to sell in all at once. We are buying producing oil and natural gas properties that we will produce over time. There is an inherent return imbedded in owning these assets.

We Get “Paid to Hold”

Financial theory is based on the assumption that money has “time value”; that a dollar in hand today is worth more than a dollar received in the future. It is similar to investing in income producing real estate. If you buy a house for $100,000, make $10,000 a year for five years then sell it for $100,000, you earn a 10% return without the value of the house or the rent increasing. The same concept applies in buying producing oil and gas properties when discount rates are in the double digits.

Greatest Value Investment Opportunity in Decades

We believe the ongoing collapse of the oil and natural gas industry represents the greatest value investment opportunity we have seen in decades. However, prices for future delivery of oil and natural gas are higher than current wellhead prices, reflecting the market expectation of some recovery over the next few years. The collapse in prices might last longer than we expect, so we will use futures contracts (hedges) to mitigate the price risk during the period when we are recovering our capital, “locking in” the price on much of our production during the payback period. That way the majority of our risk will be the rate of return realized, not whether we will recover our capital from the investment.

The upside potential in buying properties at current prices is huge. A recovery to $60 per barrel could easily double or triple the income from and value of producing properties. As prices rise, not only does the price per barrel increase, but total economically recoverable reserves also increase.

Proved Undeveloped Reserves (PUDs) or the “undeveloped locations” on the majority of domestic properties have little net present value at current prices. But if prices recover into the $50 – $60 range, the value of the undeveloped locations on many properties become profitable to develop, adding material value.

As Yogi Berra said, “It’s like déjà vu all over again!” In many ways, this is a repeat of the late 1980s-90s. We can acquire producing properties at attractive values while prices are low. These new investments will generate an attractive current yield at the prices we can currently “lock-in”. While we are enjoying the attractive yield, we can wait for the appreciation that will come with an inevitable price recovery. With values and yields this attractive, it almost does not matter when the price recovery occurs!

What Happened in 2015?

As the oil industry stumbles into 2016, everyone is asking the same questions:

  • Why did oil and natural gas prices fall so far and so fast in 2015?
  • Did anyone see the collapse coming? Did anyone forecast it?
  • Were OPEC or non-OPEC countries or groups to blame? Were individuals?
  • How long will current conditions last? Will prices recover?
  • Could prices go lower from here? Is there a floor?
  • What will happen to my oil and gas investments? Could I lose all my money?
  • What factors would have to change for prices to rise?
  • What’s the long-term outlook for the industry? Is this the time to be selling petroleum interests, standing pat or loading up?

Of course, no one has answers to all the questions, but in this article we will present the facts as we know them and share thoughts about where the future may take us from here.

The most likely explanation of the recent drop in prices was that oil traders suddenly recognized that the world is awash in oil and is likely to remain so for several years. Cited are full-to-overflowing storage tanks in Cushing, Oklahoma, and oil loaded tanker ships idling on oceans and docked in harbors throughout the world, just waiting to offload millions of barrels to refineries and power plants. Price-bears note that oilfields in Iraq were back to producing almost 4.5 million (MM) barrels of oil per day (“bopd”) in November of 2015, and that Iran has resumed production and announced intentions to increase to 3MM bopd in the near future when sanctions are lifted. On a statistical basis, global inventories built by 2.0 MM bopd in the second and third quarters of 2015. These are the largest inventory builds since the fourth quarter of 2008. The EIA forecast that global inventory builds started to decline in the fourth quarter of 2015 to 1.4 MM bopd and will average only 0.6 MM bopd in 2016.

The possibility of a continuing worldwide oil glut is a concern to producers. In previous times, when oil markets became sated, OPEC, led by oil behemoth Saudi Arabia, acted as the world’s swing producer, cutting back production in order to maintain price stability. This time Saudi is showing no indications of slowing production anytime soon, and in fact is working to produce more. They are attempting to regain their market share at the expense of high cost producers, including US shale drillers. US production appears to have peaked in May of 2015 at 9.4 MM bopd.

Everyone is waiting for the other guy to flinch on production. Until someone does, the price of oil is likely to remain low. Although the Saudi production cost is less than $10 per barrel, social welfare programs take the all-in cost to $100 per barrel. The Saudis are beginning to utilize their cash reserves and have even discussed monetizing a part of Saudi Aramco through a public offering.

A second factor influencing prices is investor perception of future supply and demand. Because there are limited substitutes for oil, a relatively small perceived or actual shortage/surplus in the worldwide balance of supply and demand can cause wide price swings. A relatively small quantity of surplus barrels in the system is interpreted by the public as unlimited supply, and prices fall. A few barrels temporarily unavailable for immediate needs can create panic. Markets react as if the world will soon run out of oil, and prices soar. The tail wags the dog: the price of a few barrels can establish the price of millions. The pendulum can and does swing rapidly and widely in both directions.

Little more than a year ago, US producers were on a roll. Wells were being proposed and drilled in record time, production was increasing, and the US was reducing its unfavorable balance of payments gap. In November 2014, oil closed at $91.16. As US storage capacity disappeared and OPEC stood firm on production quotas, prices fell: to $53.27 in December 2014, and further to $34.66 in December 2015, a collapse of 62% in only 13 months.

Oil-bears recognize that US oil producers, through horizontal drilling and multi-stage hydraulic fracturing, have unlocked the secrets of obtaining oil and natural gas from the world’s bountiful shale reservoirs. The bears believe now that the genie is out of the bottle, the world’s oil producers will acquire and utilize them, and oil will no longer be a scarce commodity.

A third factor that may lead to disastrous consequences for many companies is the extensive use of borrowed capital. The disadvantage of America’s high-tech shale-play is its high cost. Competition for prospective oil and gas leases has been frenetic. Drilling and completion expenses are high. In their rush to exploit leases before they expire and to “prove up” as much of their potential reserves as possible, aggressive companies have been drilling as fast as they can, typically borrowing as much as banks and private investors would allow.

Collateral to secure the loans has often been producing assets, hedged by futures contracts purchased to assure deliveries at specified prices. Over time, higher price contracts have been expiring and new contracts are at much lower prices. The result is that many bank loans are now in non-performance status and are likely to be called for repayment in 2016. By some estimates, as many as one-half of existing E&P companies, especially the newer, highly leveraged shale drillers, will be out of business by the end of the year.

Prices may be further weakened by increased usage of renewable energy. But despite the growth over the last few years, wind and solar account for only 2 ½% of US energy supply. Further production and efficiency increases are expected, but most authorities do not believe renewables can or will substantially replace oil and natural gas based transportation fuels within the next decade or so.

Facts for the oil-bulls’ case can be equally persuasive as for the bears’. Oil and natural gas are commodities, and at the fundamental core, prices are ultimately determined by supply and demand. Energy is essential to the economies and well-being of all countries. The more energy one has, or can get and use, the stronger, healthier and more viable is its economy. The US, with only 6% of the world’s population, uses almost 22% of the world’s annual energy production, but is able to generate 22% of world’s nominal economic output. We are an immensely successful nation specifically because we have great natural resources, and have learned to use them effectively.

The world requires about 94 MM bopd. Annual demand is increasing about 1.1%, or 1 MM bopd. Worldwide spare capacity is now only about 2 MM bopd above daily production, down from about 8 MM bopd only a decade ago. The International Energy Agency (IEA) projects that by 2020 the world will need another 6 million bopd, outstripping the spare capacity of OPEC. In other words, demand has been increasing while spare capacity has been decreasing. The decreased margin of safety increases price volatility.

With world population continuing to increase, and with the citizenry of developing countries demanding more goods, services, and access to better transportation, the question is whether enough oil and natural gas will continue to be available to meet future demand. Exxon estimates that global population will grow from 7 billion in 2010 to 9 billion by 2040. Even if the per person consumption of energy stayed the same, energy demand would increase by 28%.

US production of shale oil is currently 4 MM bopd. Unlike production from conventional sandstones and limestone reservoirs, which typically have longer lives and slower decline rates, production from shale reservoirs have steep decline rates (up to 90% in the first year) and shorter lives. The result is that production from shale oil fields must be increased or maintained by continued, active drilling programs. If wells are not being drilled, production declines rapidly.

When oil prices began their decline in November 2014, drillers began taking rigs out of service and laying off employees. From a high of 1,931 working rigs in November of 2014, the number has plummeted to fewer than 700. US shale oil production has already declined by more than 500,000 bopd. Projections are that it will have declined by 1 MM bopd by mid-2016. In other words, without drilling as many or more wells than were drilled in 2014, US production will continue to decline rapidly.

Of course, the real wild card in the supply/demand picture is the possibility of turbulent disruptions in any of the world’s major oil producing areas, particularly in the Middle East or the Former Soviet Union. The loss of sustained production in one or another of those hot spots would immediately and dramatically drive prices skyward. The effects of such disruptions are to no country’s best interest, but it is not out of the realm of speculation.

For the present, we at Five States believe that opportunities to acquire quality producing properties may soon be among the best in our careers. A recent article in the Dallas Morning News cited a prediction that half the oil companies now in business would declare bankruptcy and/or go out of business in 2016. Many of their assets and producing properties will be sold at prices much below their value at year-end 2014.

Time Value of Money

Financial theory is based on the assumption that money has “time value”; that a dollar in hand today is worth more than a dollar received in the future. For example, if you have a dollar today and use it to buy a CD paying 2%, the CD will be worth $1.02 in a year. Stated conversely, the present value of $1.02 to be received a year in the future is worth $1.00 today if the interest rate (the “discount rate”) is 2%.

The concept of a discount rate is used to value the projected future income from producing properties. The discount rate is the expected rate of return. A buyer calculates the expected yield into the price they are willing to pay for a producing property.

In the following example, I have assumed our target return (a discount rate) of 10%. If we expect to receive $5,400 in income over the next three years, we are willing to pay $4,508 for the property. We would earn $892 in profit ($5,400 of income on a $4,508 investment) which calculates to a 10% return, without prices increasing.

Present Value of a 3 Year Annuity


Barrels Produced Income/ Barrel Income Received Present Value @ 10%
1 100 $         20 $    2,000 $    1,818
2 90 $         20 $    1,800 $    1,488
3 80 $         20 $    1,600 $    1,202
Total $   5,400 $   4,508

Beyond the Storm, Bright Horizons

Over the last five years, oil production in the US increased by over 4.5 million barrels of oil per day (“bopd”) to almost 10 million bopd.  The US now rivals Saudi Arabia for the position of largest oil producer in the world.  This 4.5 million bopd increase is about a 5% increase in world supply.  Increased world supply combined with slowing demand due to the worldwide economic slowdown resulted in a collapse in the price of oil.

Oil Price and US Production Volume

Crude oil prices have basically fallen in half over the last twelve months.  This translates to a decrease in Operating Cash Profit[1] for most producing properties in the US of 65% to 85%.  If low prices are assumed to continue into the future calculated present value of producing properties have fallen by a comparable magnitude.

Declining Operating Margin Per Barrel

The majority of the new oil production is from shale formations.  Shale production (both for oil and natural gas) differs from conventional production in two ways.  The cost to drill and complete shale wells per barrel of oil or per MMBtu[2] of natural gas recovered is much higher.  The higher capital cost per well requires an oil price of $40 to $60+ per barrel or a natural gas price of $3 to $5 per MMBtu to generate a profit on a new well.

The second difference is that production from shales and very low permeability reservoirs has a different decline profile than production from conventional sand and carbonate reservoirs.  Shale wells produce half the volume they will ever produce in about 18 to 24 months, compared to about five years for more conventional wells.  If shale development ceased, the 4.5 million bopd of new oil production developed in the US in the last five years would fall in half in less than two years.  The extraction/development process must be continuous.  Otherwise, production will rapidly decline.

There is an old adage in the oil industry.  Low prices are the cure for low prices.  Oil selling at +/-$45/bbl and natural gas at +/-$2.50/MMBtu are lower than the average long-term replacement cost.  As new shale production depletes, prices will recover.  We estimate that oil prices must be $65+/bbl and natural gas prices must be $4.00+/MMBtu over the intermediate term to maintain current production levels in the US.

We do not know when prices will begin to recover.  It may be as early as later this year, or it may take two to four years.  Because of the rapid decline rate of the new US production, we do not believe it will take over five years for a recovery in oil prices.  Natural gas could take longer.

The Oil and Gas Industry

The collapse in oil prices has resulted in a material slow-down in drilling and development.  This slow-down is already resulting in a decline in domestic production.  It is also resulting in a dismantling of the infrastructure to develop new production, particularly in the drilling and completion sector.

US Crude Oil Production and Rigs

The decline in Operating Cash Profit is having a devastating impact on the financial condition of many independent producers.  Many companies that had a debt level that was considered “bank prime” this time last year are now insolvent.  Others that have debt but are still solvent are severely constrained in their operating and development activities.

Many companies will require major restructuring.  Some will fail and their assets will be liquidated.  Some companies with a “healthy balance sheet” will sell mature producing assets to free up cash for their higher return development projects.

Transaction activity in the oil and gas industry was at the lowest level in a decade in 2015.  However, we have seen more high quality, long-lived, fully developed conventional producing properties (the type we seek) for sale this year than in a long time.  These have mostly been large packages being sold by public companies.  These assets are mature and have limited additional drilling potential.  When money was easy and cheap, public companies were holding these assets to maintain reserves and earn the spread between their low interest rates and the return from owning production.  But with capital tight, public companies no longer want to hold these long-lived annuities. They want to free up their capital for growth investments.

The tsunami of oil and gas properties we expect to result from the insolvent companies has not yet hit the market.  Earlier in the year, many were hoping things would get better soon.  The expectation was that oil prices would settle at around $60+ per barrel.  At that level the damage was not nearly as severe, and many could have worked their way out through restructuring.

Many producers had hedges that locked in higher prices through 2015.  As we approach the end of 2015 most of these hedges have settled and these companies and their creditors are facing the prospect of $45 per barrel oil in 2016.

Note in the chart above that most properties generate Operating Cash Profit at $45/bbl even though they are insolvent.  Insolvent producers still have cash flow, but are selling their reserves at a price that will not fully repay their debt.

We expected to see a lot more properties for sale in 2015.  But insolvent operators have every reason to delay.  Sale or liquidation today results in nothing to the insolvent operator. If operations continue, everyone still gets another paycheck and hope that things will get better.

Lenders are trying to defer the realization of losses.  Perhaps bonuses are calculated on the year end value of the portfolio.  Or perhaps the objective is to raise a new fund before fully reporting the decline in the old fund.  I suspect some do not yet recognize the degree of damage to their portfolios.  “Word on the street” is that regulators and auditors will be “turning up the heat” at the end of the year.  It is the typical “kick the can” mentality in a real property downturn.

The consensus in the industry is that this is a cyclical downturn.  Prices are expected to correct over time and development of shale reserves is expected to resume.

Five States

Five States is not immune to this downturn.  Our Operating Cash Profit from producing properties is down commensurate with the industry.

We remain in a healthy financial condition.  Our debt level on our legacy funds (Consolidated I, II and III) is very low compared to the industry norm.  The Energy Capital Funds have no debt.  We also have a higher percentage of hedges and our hedges are over a longer period, than most independents.  These two differences have provided us greater financial strength than many to weather this downturn.

The legacy partnerships remain cash flow positive and bank compliant.   We are accelerating the rate of bank principal pay-down for the legacy partnerships in case prices drop further in 2016 or 2017.

Few of the development opportunities for our producing properties are profitable at $45 oil.  We sold what we considered our weakest Bakken properties in Consolidated I last year.  There are a very large number of Bakken development opportunities which we expect will be developed when oil prices warrant.  We were planning to do significant development on the SE Adair in Consolidated III.  We believe that oil prices need to be in the $60/bbl range to support Bakken development and the SE Adair redevelopment.

Five States Consolidated I, II & III have returned multiples on the money invested in cash distributions, and they still have residual value.  These partnerships contain good quality, long-life producing assets that are profitable at current prices.

Five States Energy Capital Fund 1 is fully invested and has no debt.    The decline in oil and gas Operating Cash Profit has been offset by increased income from its midstream investments.  All of the producing properties are cash flow positive at current prices.  We have profitably “harvested” some of the portfolio.  We recognized major loss reserves against our materially underperforming investments at year-end last year.

The midstream investments (e.g., pipelines) are earning record profits.  We expect volumes to decrease and competition to increase over the next several years.  The range of possible outcomes is much wider than we anticipated a year ago.

Five States Energy Capital Fund 2 has made two investments.  Approximately 70% of the fund capital is undeployed.  We expect to invest the majority of the undeployed capital in production acquisitions and production financing in which the fund will earn a double digit current return and a participation in the assets financed.

Capitalizing on the Downturn

We are seeing more conventional producing properties on the market than we have in a long time.   The economics on which assets are being valued reflect current lower oil and natural gas prices.  The discount rates on which properties are being valued appear to be increasing, returning to historical norms that we consider appropriate valuations.

The investment thesis is:

  • Value production based on these low oil & gas prices
  • Lock in the oil and gas price on the production for 3 to 5 years
  • Use a low level of debt in the acquisition – less than 40% of the purchase price

This structure should generate a good current return from the day the investment is made.  The combination of large hedges and low debt levels result in a high certainty of payback even if prices do not increase.

We cannot call the timing, but the fundamentals are clear.  We are in the buying part of the investment cycle.  Wellhead prices are down, and there is fear in the oil and gas market.  This is very much like the first two decades of Five States.  We believe this is “the best of times” for long term value investors. 

[1] Operating Cash Profit is Net Revenue less Operating Expenses and Property Level Taxes.  It does not include recovery of the capital investment to drill and complete the well.

Riding the Cycles

No one needs to inform west Texas citizens that the oil and natural gas industry is currently in a slump. All one has to do is drive from Midland to Odessa and count the number of drilling rigs standing idle in storage yards, or pick up a copy of Midland’s The Daily Observer to read about oilfield layoffs, diminished company profits, and numerous mergers and acquisitions.

Anyone who has lived in the Permian Basin for more than a decade has experienced the effects of major downturns. Old-timers who can remember the days in the 1950s and 1960s when $3 per barrel oil and 18¢ per MCF natural gas were the norm have lived through five major price collapses. Most of us who have been around the business for any length of time have learned to accept periodic industry retrenchments as normal, and have developed something of a bunker mentality about dealing with them.

Cyclical downturns can actually be the “Best of Times” or the “Worst of Times” for oilmen and their investors. They are created when oil and natural gas prices decline rapidly, usually unexpectedly, and remain low for an extended period. The first major decline since $3 oil started its upward run in 1973 occurred in 1985, when the benchmark price of a barrel of West Texas Intermediate crude oil dropped 62.4%, from $30.81 to $11.57. The resulting jolt was sufficient to create havoc in the oil fields, bankrupt companies, and ultimately contribute to toppling major banks in Dallas, Houston, Oklahoma City, Denver, Chicago and elsewhere that carried large positions of oil and gas debt in their loan portfolios.

Five States was chartered in 1985 in the midst of the wrenching price decline of that year. As prices withered, banks initially began calling in oil loans of borrowers who were in default on debt covenants. Within months, as their debt to asset ratios continued to worsen, the banks began calling in loans from their “good” customers who were still current with scheduled repayments and still compliant on their covenants. Some of these borrowers, unable to raise funds from alternative sources, lost their properties and sometimes their companies in the melee.

Billions of dollars of oil and gas equipment, producing properties, royalties and minerals, oil field service companies and operating companies were thrown on the market, available to anyone who had enough money and courage to bid on them. For some individuals, it was the end of the line. For others it was the beginning.

In such times, the difference between losing a company or starting one is often the availability of or access to capital. Although Five States had only modest assets and a small bank account at the time, we had the experience to recognize that good value properties were on the bargain table. We also had little overhead and no debt. The only missing ingredient was cash. We began knocking on doors as far from the oil patch as possible, hoping to find investors who would listen to our story. A few did, most noteably fee-only financial advisors.  Five States’ upward cycle had begun.

Although oil prices began to recover the following year, it took more than a decade for confidence in the industry to be fully restored, for new banks and capital sources to become well established, the glut of producing properties to finally be settled in new hands.

For most young companies, and those aspiring to grow rapidly through acquisitions and the drill bit, institutional capital and bank debt are essential elements in their development. Serious problems can and do arise when, in the flurry of their activity and achievement, a drop in commodity prices slashes revenue, debt becomes unmanageable, and the companies fail.

In recent years, the commodities futures markets have come to be utilized much more widely and effectively to lock in forward prices, protect collateral and reduce risks of commodity losses. Even so, companies who carry high debt loads, especially over longer periods, always face the possibility of catastrophic losses.

Five States has always been a conservative player. Our focus on investing in long-life legacy oil properties that generate strong operating margins provides us a stable financial foundation.  With excellent financial partners willing to provide capital when needed, a knowledgeable and experienced staff, relatively low debt ratios, an envious track record, and a reputation for competence and integrity, we believe that we are again moving into a new cycle of attractive acquisitions, growth and success.