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Change in The Oil Industry and the Impact on Five States

The Oil Market

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.

Crude oil prices have basically fallen in half over the last twelve months. This translates to a decrease in Operating Cash Profit 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. 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.

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 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.

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.

PLS Denver Dealmakers Expo

Five States is planning to attend the PLS Denver Dealmakers Expo in Denver, CO beginning Tuesday, November 3, 2015.  Please email Thomas Edwards ( if you would like to set up a meeting during the event, or simply stop by our booth (#not assigned).  More information on the event can be found at the following link:

How Do We Know?

Our most frequently asked question the last several months can be summarized as “How Do We Know?” Some specific questions are, “How do we know:

  • When oil prices have bottomed?
  • When it is time to buy?
  • When the banks will force their non-compliant or insolvent borrowers to sell?
  • When it is time to “back up the truck” and buy “everything”?

We do not know the answers to these questions . . . we never do. We depend on the market to tell us when to close on individual transactions. As value investors, we know it is time to close on an individual transaction when it is priced at a level that we believe will generate our targeted rate of return.

I often state that we are “Benjamin Graham investors in oil and gas.” Graham is considered by many to be the “father of value investing”[1]. Graham’s thesis was that by performing fundamental analysis of the financial condition and financial performance of companies you can determine their true value. He believed that fundamental analysis differentiates investing from speculation. He posed that through fundamental analysis one can calculate the true value of a stock, and should only buy a stock at that calculated price or a lower price. Conversely, when a stock trades above its true value, one should sell.

As value investors in oil and gas assets, we perform a fundamental valuation of every asset we consider, using a process similar to that described by Graham. However, we use additional metrics that are unique to the oil and gas industry.

When buying producing oil and gas properties, we start with a list of what type of properties we want to own. This eliminates the need to perform superfluous work analyzing assets we do not want as part of our portfolio. We primarily target properties that have:

  • Long-lived reserves,
  • A high Proved Developed Producing (“PDP”) component in the valuation. We want the Proved Developed already Producing to be large compared to the potential production from additional development,
  • On-shore production,
  • Permian/Delaware Basin & Midcontinent production. This includes almost everything between the Rockies and the Mississippi River,
  • Solution-gas drive reservoirs,
  • Low lifting costs, and
  • Locations in the United States (no Canadian or Mexican assets).

We avoid projects with a high debt component in the capital structure. We are investing in a high operating leverage industry. It does not lend itself to high financial leverage.

In our analysis, we attempt to forecast the range of earnings an oil or gas property can generate in the future, much like a fundamental analyst tries to forecast the future earnings of a company. We also attempt to calculate likely outcomes under a range of scenarios and the probability of those outcomes. Scenarios include lower oil and gas prices, varying production levels and other variables discussed in this article. We calculate the price we are willing to pay based on our target rate of return applied to the forecast income. We avoid investments in which our analysis calculates that, in the low case, we can lose the majority or all of our invested capital.

Valuation Process

Future Production Volumes

The valuation of a producing property begins with a forecast of future production volumes. This forecast is based on historical rates of production which decline over time. Other data such as producing rate versus cumulative production help estimate the remaining reserves, as do measurements of bottom hole pressure and comparisons to nearby analogous well histories. The following is an example of the production curve of a property. The “squiggly” part of the graph is the actual production from the past. The smooth line on the right is the forecast future production.

Olivia Marie 32-5H


We use the forecast future production to calculate estimates of future revenue. We typically use the New York Mercantile Exchange (“NYMEX”) futures prices for West Texas Intermediate (“WTI”) crude oil to calculate the estimated revenue for oil produced each month in the future. For example, on July 27, 2015 the price for a barrel of oil sold in Cushing, OK in September 2015 was $47.39. The price for a barrel of oil to be sold in August 2016 was $53.17, and so on. We typically use the 48th month’s price as the estimated price for all months after the 48th month.

Crude Oil Futures


The term “differential” refers to the difference between the reference price (i.e., WTI) and a regional price (e.g., Williston, Midland, etc.). Bottlenecks in the transportation system and differences in quality account for the variance between prices. The Bakken has historically experienced a wide differential due to the lack of infrastructure and high production volume.

Revenue forecasts are adjusted for the impact of field differentials. Differentials change over time, so understanding the impact of this potential volatility is another variable in our valuation equation. We receive a “field price” for our production at the wellhead that may be higher or lower than WTI. This results in basis differential risk that we are usually unable to control or mitigate.

Differentials Map

Source: Coquest Daily Report 7/28/2015


Using the NYMEX contracts described above, when we buy a producing property we hedge a portion of the production for the next three to five years. The hedge is an actual physical forward sales contract for delivery of 1,000 barrels of WTI delivered to Cushing, OK on the expiration date. Using hedges reduce the price volatility risk in new investments.

Operating Expenses

Producing properties have several categories of operating expenses. Fixed costs include lease overhead and pumpers (i.e., field employees). Variable costs include electricity/fuel, subsurface maintenance and repair, surface equipment and repair, wastewater disposal, and production taxes. In the single well example below, fixed annual operating costs total $36,000 per year. Variable costs total $30 per barrel. These costs as well as severance and ad valorem taxes are subtracted from revenue to give us the property level cash flow. As illustrated below, the economic limit of the property is the point where property level cash flow is negative. At this point, the well should be shut in and possibly plugged and abandoned.

Economic limit of a property


We calculate the value of a producing property by applying an appropriate discount rate to the expected cash flow to calculate. This is the net present value of the projected future production. At this point we have estimated value of the PDP portion of the property.

In many cases, there are believed to be proved undeveloped reserves[2] on the property (i.e., PUD or Proved Undeveloped). Depending on the risk in developing this potential, we may attribute some value to these undeveloped reserves. We estimate the timing and capital costs to develop the new reserves. Then, we calculate the expected cash flow and net present value as we did with the PDP reserves. But these reserves are less certain, so we then “risk” the calculated present value by reducing it by as little as 20% or as much as 90%. We then add the risk adjusted valuation of the undeveloped reserves to the valuation of the PDP to calculate the value of the property.  If we believe we can buy the property at this price, we should achieve our risk adjusted return if the base case scenario proves to be reality. This is how the market tells us when to buy.

Contract Closing

If we are successful in identifying an asset that meets our valuation parameters we will attempt to get it under contract. We will structure our investments in direct purchases, preferred or “mezzanine” investments or high interest rate loans on any of these types of assets.

We then enter into the closing process. This includes review of the leases (title review), review of all existing contracts and operating agreements, physical inspections and any other documentation related to the structure of the deal.

Various Oil & Gas Segments

The previous example was for the purchase of producing properties. We actively pursue investments in four basic subsets of the oil and gas industry:

  • Oil Properties– properties that primarily produce crude oil
  • Gas Properties – properties that primarily produce natural gas
  • Midstream – assets such as pipelines, storage, and processing facilities
  • Service – well workover and maintenance, waste disposal & transportation other than pipeline

We invest in direct purchases, preferred or “mezzanine” investments or high interest rate loans on any of these types of assets. Investments in assets other than producing properties are based on underlying production fundamentals. We perform a valuation analysis on midstream and service assets similar to what we do on producing properties. The economic life in midstream and service assets is a function of the economic life of the underlying production they service, so much of the skill set required to perform this analysis overlaps with production assets. The legal and contract work is also related.


I often joke that investing in oil and gas is like riding a roller coaster blindfolded. You cannot really see where you are going, but you know there will be big highs and lows, and as long as you do not get thrown out of the car you will have a great ride. The inherent returns in oil and gas are high, due to a large part because of the volatility. Over the last thirty years we have “had a great ride” being well compensated for accepting volatility of the ride. We avoid “getting thrown out of the car” by managing our risks. We use our fundamental analysis to determine the appropriate levels of debt and non-producing exposure as we make new investments. As long as we avoid too much debt and too much exposure to non-producing assets we can structure our portfolio to generate positive cash flow through the inevitable downturns, and be positioned to profit in the upturns.

We are also asked what area we like today: oil, natural gas or midstream? Right now I like gas. But that tends to have little to do with what we will actually buy. Opinion is not the driver. By sticking to our disciplined fundamental analysis, the market tells us which sector is being priced the most attractively on a risk/reward basis. The market will also tell us when not to buy.

Some are surprised that we have not made many new investments since the price crash at the end of last year. It takes time for those incurring huge losses to process changes of this magnitude, something akin to the five stages of grief.[3] Late last year the mentality was denial and anger, with the consensus that “this cannot be happening and it cannot last.” By the late first quarter we saw many bargaining for the terms and pricing they believed were available before the crash, hoping that they could somehow turn back the clock. We are now beginning to see depression and acceptance, which is translating into acceptance by sellers and others seeking capital of the new reality.

We believe this is an excellent time for making new investments in oil and gas. We are in the low end of the cycle, and long-term upside potential exists. This is probably the best oil and gas investment market we have seen in over a decade. Downturns are always the best investing environment for value investors like Five States.

As discussed in my Producer article last quarter, pretty much every independent in the industry that was using 50% debt in their capital structure is in a difficult position. Debt levels in the oil and gas industry reached all-time highs before the crash.  The need for capital to restructure the excessive debt will be great over the next few years. We are well positioned to provide that capital to private independents. We do not know when the bottom will occur, or which segments will be the best. But by sticking to our disciplined value investing methodology, we expect to continue to make solid investments during the current trough of our industry’s roller coaster ride that will justly reward our investors for the risks taken.

[1] “Benjamin Graham.” Wikipedia: The Free Encyclopedia. Wikimedia Foundation, Inc. 27 June 2015. Web. 5 August 2015.

[2] Proved Non-Producing (‘PDNP”) or Proved Undeveloped (“PUD”) reserves.

30-Year Anniversary Events

Five States is celebrating our 30th year in business! We gratefully acknowledge the confidence and support of the many financial advisors, investors, business associates, employees, and friends who have been a part of our success and growth through the years.

Many of the company’s current activities are “business as usual”: reviewing investment submittals, analyzing and evaluating prospective projects, making lease inspections, and visiting construction and development sites. This year we are making special efforts to initiate new industry contacts, strengthen existing relationships with current investors and advisors, increase our visibility by sponsoring more industry events, and provide opportunities for staff members to be featured speakers at professional and trade association meetings.

To that end, Five States recently hosted a three-day investor field trip to Midland. Fourteen individuals attended, including five from Five States and nine guests representing seven investment groups from around the country.

A brief reception at the Doubletree Hilton kicked off the first evening, followed by dinner at the nearby Wall Street Café. On the morning of the second day, an orientation at the Permian Basin Petroleum Museum introduced the group to the Permian Basin’s geology and oil industry history. Everyone had the opportunity for up-close inspections of a drilling rig, pumping units, and other types of production equipment.

Following lunch, the group visited facilities of the Advantage Pipeline System, an 87-mile pipeline from Pecos to Crane, Texas, in which Five States’ Fund 1 has a substantial investment. The facility includes oil truck off-loading facilities, storage tanks, and pipeline pump stations. The Advantage Pipeline System currently gathers and transports more than 70,000 barrels of oil per day, delivering them into the Longhorn System that moves oil from West Texas to refineries on the Texas Gulf coast.

That evening, Five States hosted a celebratory anniversary reception at the Petroleum Club of Midland for our guests, as well as many of Midland’s independent oil men and women. Investors had a great opportunity to meet with and ask questions of knowledgeable and experienced professionals.

After breakfast on the third day, we visited a rail terminal which handles tank cars transporting oil produced nearby, as well as open-top rail cars that bring in frac sand used in wells to hydraulically fracture dense, oil-bearing rock formations. Guests expressed appreciation for the visit and said that they had learned much about field operations during their brief time in Midland.

Five States will continue to work throughout this year to expand our network of business associates and to uncover opportunities that can provide lucrative results to our investors in the months and years ahead.

Capital Rationing

Last quarter my article in The Producer focused on Cost of Capital. This quarter I will address the impact of Capital Rationing on the market for direct oil and gas investments. Capital Rationing is a reflection of limited capital in an industry segment. Following the collapse in crude oil prices, capital in the oil and gas sector is now more disciplined, providing a greatly improved investment environment for Five States.

Cost of Capital is the price, expressed as a percentage that a company must pay for capital. Think of it as a weighted-average of the cost of debt and equity. For example, if debt costs 4% and equity 10%, and the optimal mix was 60% debt and 40% equity, then the Cost of Capital would be 6.4% (i.e., 4% * 60% + 10% * 40% = 6.4%).

This percentage is then used to value new investments. Financial theory assumes that a company will undertake any investment that will generate a risk-adjusted return greater than its Cost of Capital. Capital Market Theory assumes that companies that follow this discipline can raise unlimited capital (one of several unrealistic assumptions).

Most of the time though, there are limits on the capital available to a company. Capital Rationing is a term used to describe when companies are subject to this limiting factor. Capital Rationing is defined as “the act of placing restrictions on the amount of new investments or projects undertaken by a company . . . by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.”1

Capital Rationing in the Oil and Gas Industry

Oil and gas companies have historically been subject to Capital Rationing. The oil and gas industry is extremely capital intensive. Most companies invest more capital on an ongoing basis than they generate from operations. This also applies to the industry as a whole. Most years the industry consumes more capital for new development than it generates in oil and gas income.

The additional funding is made up by the capital markets through bank loans, bond sales, stock sales or by direct investments in individual projects. Rarely does the industry have access to enough capital to fund all of the possible exploration and development projects. Companies have to prioritize, resulting in the less attractive projects not getting done.

Since the “Great Recession,” Capital Rationing has not been the norm for the oil and gas industry. The lust for income-producing assets, combined with the notion that the oil and gas business was no longer risky due to the statistical certainty of success in most shale plays, led to a huge increase in capital available to the industry.

Over the last eight years, total debt in the oil and gas sector has increased materially. Since 2002, total corporate bonds outstanding has increased over fourfold.

Debt and Leverage Increase in Energy Sector

 Debt and Leverage in Energy Sector

There has also been significant growth in bank loans to oil companies with $1.6 trillion in syndicated loans as of 2014, up from $600 billion in 2006. (BIS Quarterly Review, March 2015). Total capital raised by the major oil and gas private equity funds has increased over tenfold, from $3 billion in 2001 to over $30 billion in 2014.

 Energy Private Equity Fund Growth: 2001-2004

Energy Private Equity Fund Growth

Source:  Sage Road Capital presentation to IPAA Private Capital Conference, January 2015

In addition to the growth in debt outstanding and private equity capital growth is record stock issuance by upstream producers in Q1 2015 amounting to $10.8 billion.

 Upstream Equity Issuances by Quarter
($ in billions)

Upstream Equity Issuances by Quarter


Source: Tudor Pickering Holt & Co. presentation at DUG Bakken/Niobrara, April 2015

The confidence during the recent investment frenzy was fueled by the belief by many that oil prices could not fall below a certain level. The rationale of some was that the Middle Eastern sheiks needed a certain wellhead price to support their populace. Others reasoned that since the new North American oil plays were so expensive, prices had to stay at a level that made those projects profitable. But none of this has proven correct. Only two factors determine the daily wellhead price of oil: supply and demand. The oil supply increased and oil demand growth slowed.

Higher prices over the last decade stimulated the development of new oil supply. During this same period, worldwide economic expansion slowed. The difference between a tight oil supply, which results in high prices, and a surplus, which causes prices to tumble, is only a few percentage points.

Many companies are now in a debt or liquidity squeeze. Debt levels that just a year ago looked conservative are now proving to be too much. The following is an example of the “meltdown” of the financial condition of a hypothetical oil company.

Prior to the decline in oil prices, the hypothetical company on the following page looked healthy:

Operating Statement
Revenue (net of differentials & Severance Taxes) $85 100%
Lease Operating Expenses & Overhead 29 34%
Operating Profit     $56 66%
Interest Expense assuming line fully drawn 4% 7 9%
Cash Flow from Operations minus Interest Expense $49 57%
Operating Profit Margin (Operating Profit/Revenue) 66%
Interest Coverage 7.6 x
Value as multiple of Operating Profit 5.5 x $308  
Senior Borrowing Base        
Max Loan Amount based on an Advance Rate of 60% $185  
Capital Structure
Senior Debt $185 60%
  Mezz Needed      0    0%
  Total Debt $185 60%
Equity     $123 40%
Total Assets $308 100%

Operating profit was 66% of revenue and debt was 60% of Total Asset Value. This resulted in strong coverage ratios. But over the last year, the decline in oil prices resulted in the following changes:

  • Oil Price declined from $85 to $55, a decline of 35%. So Revenue declined 35%.
  • Lease Operating Expenses and Overhead remained constant at $29.
    • Therefore, Operating Profit declined 54%. The decline in Operating Profit is 50% greater than the decline in oil prices and revenue.
  • Asset Value is estimated at 5.5 times Operating Profit. Asset Value decreased by 54%, the same as the decline in Operating Profit.
  • Borrowing Base remains 60% of Asset Value. But since Operating Profit and Asset Value decreased by 54%, the Borrowing Base will decline by 54%.

When expressed in dollars rather than percentages, the negative impact of the financial leverage is devastating. (See table below). The Borrowing Base has declined from $185 to $86, a decrease of $99. The value of Total Assets has declined from $308 to $143, a decrease of $165. The outstanding debt of $185 is now greater than the revised Value of $143. This hypothetical company is now bankrupt.

Before the decline in Oil Prices Redetermination after the decline in Oil Prices % Change
New Price Change
Operating Statement
Revenue (net of differentials & Severance Taxes) $85 $55 ($30) -35%
Lease Operating Expenses & Overhead 29 29    
Operating Profit     $56 $26 ($30) -54%
Interest Expense assuming line fully drawn 4% 7 7  
Cash Flow from Operations minus Interest Expense $49 $19 ($30) -62%
Operating Profit Margin (Operating Profit/Revenue) 66% 47% -28%
Interest Coverage 7.6 x 3.5 x -54%
Value as multiple of Operating Profit 5.5 x $308 $143 ($165) -54%
Senior Borrowing Base            
Max Loan Amount based on an Advance Rate of 60% $185 $86 ($99) -54%
Capital Structure
Senior Debt $185 $185
Equity (Deficit)     $123 ($42) ($165) -134%
Total Assets $308 $143 ($165) -54%


If the company has hedges, the hedges might keep the company afloat for a year or two. But the impact is clear. If prices remain at this level, companies that had debt levels considered normal a year ago will have problems. Those that are not bankrupt become non-conforming or non-complying with their loan covenants, resulting in a primary source of their funding “drying up”.

Most independents had sold their production forward (hedged), locking in higher prices. But, most only sold forward for a year or so. Without a major correction in oil prices, a growing group of companies that are out of compliance with their borrowing covenants will become insolvent. We have seen companies where hedges were 25% or more of the tangible net worth. As those hedges roll off and the profit is used, that translates to shrinking total assets.

Even some large public companies are being impacted. For example, this month we saw two packages of properties totaling $1 billion in value for sale by a public company that is financially solid. Clearly management is taking capital rationing seriously.

During the boom both public and private companies were keeping assets that they traditionally would have sold. Public companies were keeping non-core and non-operated properties. Many of these properties were “mature annuities” with little or no development prospect. Because their cost of capital was low, they could hold these assets to try and slow the rate of decline in their reported reserves (total “barrels in the ground”).

Compounding this move to divestiture, many companies are reducing staff, so they no longer have the resources to administer these assets. There will likely be a move to selling off midstream assets such as gathering systems (pipelines) and storage facilities to free up capital for their core investments.

During the boom the industry had access to what appeared to be “unlimited” cheap capital. Now capital is limited and more expensive. This creates improved opportunity for Five States. We like “boring, no-growth” annuities.

In addition to the increase in public offerings, our business development team is hearing a different story from commercial banks and private companies than they did this time last year. Borrowing bases are eroding, and banks are beginning to put pressure on borrowers to take the necessary steps to bring their loans back into compliance. Some lenders are looking for ways to “play kick the can” by softening covenants and inflating forecast price decks. But these “tricks” only delay the inevitable. Without a material increase in oil prices, a major restructuring of the oil and gas sector will be necessary. This is about as good as it gets for making new investments in oil and gas!

The Oil Glut

Global oil prices are now near five-year lows. US producers are feeling the pain; they are not alone. Low oil and natural gas prices are causing companies and governments throughout the world to reexamine their budgets, rethink their priorities and, in some cases, make major policy decisions based on the possibility that significantly higher prices may be a long time coming, if ever.

In July of last year, oil was trading above $100 per barrel. Since January of 2015, the average price has been less than $50. The new technology of horizontal drilling combined with multiple stage hydraulic fracturing has unlocked literally billions of barrels of oil from tight reservoir rocks. Since 2005, US oil production has been increasing at an astonishing rate. The US is now the second largest producer in the world, close behind Saudi Arabia. “This is a historic turning point,” historian Daniel Yergin said. “The defining force now in world oil is the growth of US production.”

The result has been the development of a worldwide oil glut that has hammered commodity prices. Here in the US, lower prices have idled half the fleet of drilling rigs, necessitated the layoffs of thousands of workers, and are wreaking havoc among the independent oil and gas operators who depend on operating cash flow to fund their businesses. Around the world, the glut is creating some significant geo-political ripples.

As was recently pointed out in a talk by Ken Hersh, chairman of Natural Gas Partners, the world is suddenly shifting from one of energy scarcity to one of energy abundance. “It’s a world in which the economics of scarcity, whose rules are determined by producers, are being replaced by those of consumers, who are benefitting from lower prices,” Hersh said.

For American motorists, the price-drop is providing a windfall. The average price of a gallon of gas is more than a dollar lower than it was a year ago, a huge savings to consumers who are putting much of it straight back into the economy, buying clothes, electronics, restaurant meals and other items they might not otherwise splurge on.

Worldwide, lower prices could imperil the economies of petro-states such as Venezuela, Iran and Russia. Analysts believe OPEC, whose 12 members account for around one-third of the world’s oil supply, is trying to drive some US shale producers out of business. Saudi Arabia, which effectively leads the cartel, has so much wealth it can handle significant losses, but for countries whose economies rely heavily on high oil prices, the outlook is much bleaker.

The West now has more leverage over rogue petro-states. Until the US made the accommodative agreement with Iran over Iran’s nuclear program, Iran could no longer rely on high oil prices to soften the impact of economic sanctions. For a time, the US had an opportunity to make a favorable deal. Similarly, Russia now has more reason to pull back on its aggression toward its neighbors, and even to make sales of natural gas to China, which it might not have previously considered. Whether Mr. Putin ultimately accedes to the pressure to lessen his belligerency toward Ukraine is still to be determined.

Venezuela is in even worse financial straits. Inflation is a staggering 60%, and currency controls have generated scarcity of basic needs. In the past, President Nicolas Maduro, and his predecessor, Hugo Chavez, hid the perilous state of Venezuela’s finances behind populist policies funded by vast oil revenues. Now political upheaval is a real possibility.

The US benefits in other ways by its new largess. Oil imports are, and have historically been, the largest component of our foreign trade deficit. Every barrel produced domestically replaces one otherwise imported. Since 2005, when production of shale oil began coming on the market in significant volumes, the US has reduced its dependence on oil imports from 72% to 16%, an amazing accomplishment.

The US has spent billions of dollars in military support to protect oil transport ships in hazardous areas, and to provide military equipment and personnel to those countries considered critical to a continued secure supply. With less dependence on imports, the need for a continued high level of support might be reduced.

Further, with increasing supplies, the US dollar becomes stronger, and our government’s hand is strengthened in negotiations with foreign governments. We have the opportunity to regain our reputation as a stable and reliable partner to our friends and allies, and to be less required to deal with unfriendly regimes merely because we need to purchase their oil.

NAPE Pittsburgh

Five States is planning to attend the NAPE Pittsburgh in Pittsburgh, PA beginning Wednesday, April 15, 2015.  Please email Thomas Edwards ( if you would like to set up a meeting during the event.  More information on the event can be found at the following link:

Member(s) of the Five States team scheduled to be in attendance: Thomas Edwards and Jeff Davis

PLS Denver Dealmakers Expo

Five States is planning to attend the PLS Denver Dealmakers Expo in Denver, CO beginning Tuesday, April 07, 2015.  Please email Thomas Edwards ( if you would like to set up a meeting during the event, or simply stop by our booth (#not assigned).  More information on the event can be found at the following link: