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East Texas Geological Society Tech and Prospect Expo

Five States is planning to attend the East Texas Geological Society Tech and Prospect Expo in Tyler, TX beginning Tuesday, March 31, 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:

PLS Midland Dealmakers Expo

Five States is planning to attend the PLS Midland Dealmakers Expo in Midland, TX beginning Wednesday, March 25, 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:

2015 Energy Issues Outlook

Each year, JP Morgan writes a “deep dive” piece on energy. The report is a well-researched analysis that covers several specific topics. We find the report to be informative and useful as a basis for understanding current issues and forming opinions pertinent to our industry. This year’s topics include the history of energy development and the eventual transition to renewable energy, the impact of US shale oil on US energy independence and the latest trends in nuclear, wind, solar and energy/electricity storage. In this issue of The Producer, I offer a much condensed summary of the topics discussed in the JP Morgan report.

While the world has become twice as energy efficient over the last 50 years, global consumption of primary energy is three times higher than in 1965. The finite nature of fossil fuels, the increasing cost of extracting them and their environmental impacts are prompting the US and other countries to plan for greater reliance on renewable energy. What is on the horizon, and what factors will determine our energy future?

1. US energy independence in light of increasing domestic oil and gas production.

Rising US shale oil production makes US energy independence feasible by 2025. It has brought down the marginal cost of oil, and coincided with slowing oil demand for both cyclical and structural reasons.

Since 2006, the US has reduced its net oil imports from 60% of our supply to less than 30%, providing enormous savings to our nation’s economy and citizens. However, the ability of US producers to continue to ramp up production at the pace of the last decade will depend on several factors: robust industrial growth in the US and other countries, oil prices that provide adequate profit margins to producers, relaxing the ban on oil exports, and increasing light-oil refining capacity.

2. The rising cost of nuclear power.

Once thought of as a long-term bridge between fossil fuels and renewable energy, rapidly rising costs have slowed capacity additions outside of Asia. An analysis from France shows rapidly increasing capital and operational costs over the last decade. A prior assessment using data from the year 2000 estimated overall costs at $35 per megawatt-hour (MWh). The French audit report set out in 2012 to reassess historical costs of the fleet. The updated audit costs per MWh are 2.5x the original number.

In 1945, physicists predicted that nuclear breeders would be man’s ultimate energy source. A decade later, the chairman of the US Atomic Energy Commission predicted that energy produced by atomic reactors would be “too cheap to meter.” Today the picture is clear: the days of nuclear energy being a cheap way to add base load power are likely a thing of the past.

3. Wind power and the issue of questionable continued government subsidies.

US wind capacity was growing rapidly, and was ahead of the DOE’s “20% by 2030” plan until new capacity additions collapsed in 2013. A variety of factors make the next decade more uncertain for wind than the prior one.

Every year, Lawrence Berkeley National Laboratory publishes an annual wind study on the US, which gets 4% of its electricity from wind. There are factors which favor increased deployment of wind turbines: declining upfront capital costs, declining instances of involuntary wind power curtailment, and increasing transmission line deployment. However, those issues obscure the “elephant in the room”: continued reliance on subsidies to maintain capacity growth. Subsidies have been in place almost continuously since 1994. Whenever subsidy extension was unclear, capacity additions fell in the following year by 79%-90%. Without subsidies, it would probably be difficult to mobilize private sector capital for wind projects without cash grants, production tax credits, or investment tax credits.

4. Solar power in the US: An early look.

Analysts at Lawrence Berkeley National Laboratory now have enough critical mass to look at solar costs, capacity factors and growth potential. While costs have declined sharply, photovoltaic solar energy is starting from a very low base and relies heavily on continued subsidies and the continuing decline in module process costs.

Although sunlight has the highest theoretical potential of the earth’s renewable energy sources, its real-world limitations and costs have made its adoption slower than wind. The US gets just 0.2% of its energy from utility-scale and large commercial solar installations. Capacity forecasts from the Energy Information Administration and the Solar Energy Industries Association imply that solar’s contribution will rise only to 0.6%-0.9% of US electricity generation by 2016, which would still leave solar behind biomass.

5. Electricity storage.

Renewable energy intermittency can be mitigated by increased interconnectedness of electricity grids, or through advances in energy storage. The latest update from Sandia National Laboratories indicates that the going has been slow thus far, but there has been some progress in the lab.

Most electricity is used when generated and not stored. Storage facilities are equal to just 2% of installed global generating capacity, and most can only store minutes to a few hours of supply. The most common approach is pumped storage: pump water uphill into a naturally-occurring or man-made reservoir at night when electricity prices and demand are lower, and discharge the water downhill to spin a turbine during the day when prices and demand are higher. According to the Electric Power Research Institute, pumped storage accounts for 99% of all electricity stored around the world.

Other methods of energy storage include compressed air, thermal storage, batteries, hydrogen storage, and flywheels. All may have potential use in specific instances, but large scale storage is still more of a concept than reality.

Dallas Dealmakers Expo

Five States is planning to attend the PLS Dallas Dealmakers Expo in Dallas, TX beginning Tuesday, January 27, 2015.  Please email Thomas Edwards ( if you would like to set up a meeting during the event, or simply stop by our booth (#405).  More information on the event can be found at the following link:

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

Crude Oil: A Market Perspective

The decline in crude oil prices over the last six months has been dramatic. Since early summer, the spot price for crude oil traded on the New York Mercantile Exchange (“NYMEX”) has dropped from the $90 – $100 per barrel range, where it has been trading for the last several years, to about $70 per barrel at the end of November. Last week the posted price in the US was below $50 per barrel for Williston Basin (Bakken, North Dakota).

NYMEX Crude Oil Futures Prices
(January 2015) 

Graphic courtesy of

Two factors are causing the price of crude oil to fall. World supply is increasing due to the US oil boom, and world demand growth is slowing. It is classic economics. See my article, “Oil Fundamentals: Supply and Demand,” for a more detailed discussion of world supply and demand.

Regional Wellhead Price Differentials

The price decline in crude oil is further impacted in regions of the US where production volume has increased materially by what is referred to as price differential. Price differentials are the difference between a reference price, such as NYMEX, and the actual price paid at a field location or at the wellhead. Areas with off-take constraints or limited delivery infrastructure, such as the Bakken in North Dakota, can experience wellhead differential expansion (the price falling relative to the reference price) during periods of rapidly increasing production volume, infrastructure disruption or demand decline. See Tom Barnes’ article, “Price Differentials,” for a more detailed discussion of differentials.


Now for the $64 questions: “How Low Will Crude Prices Go and How Long Will the Correction Last?” The answers to these two questions are inversely related.

The decline in crude prices is a self-correcting situation. The lower the price of oil, the more oil is consumed. The lower the price, the slower the pace of new drilling, which accelerates the decline in deliverable supply. The faster the decline in deliverable supply, the sooner demand will outpace supply, resulting in higher prices. “The cure for low prices is low prices.”

In the short term, the “floor” for oil prices is very low. When midstream facilities are glutted, what happens to additional production? If every tank battery and pipeline is full, there is a physical constraint. In the short term, crude prices could fall below $60/barrel.

Unwinding of financial trades around the physical market can exacerbate a price decline. In 2008, we saw the price of oil drop below $40/barrel, falling $100 in 100 days. Paper traders exacerbate extremes when a trend reverses or breaks technical barriers. See Tom Costantino’s article, “Forward Curves, Markets & Trading Strategies,” for a detailed discussion.

Corrections of the magnitude experienced in 2008 are unsustainable. In a severe correction, “supply destruction” is almost immediate. The production from shale wells declines much more rapidly than conventional wells. Over 50% of the production from a shale well will be produced in the first two years after each well is completed. If drilling slows or stops, it will not take long for the new production developed in the past three years to decline materially.

When oil is in the $90+/barrel range development activity accelerates, ultimately increasing supply and depressing prices. When oil is below this level ($70s & below) development will slow, the rate of depletion will accelerate since new production is not being added, and demand will outpace supply, resulting in a price recovery. We expect the current correction and decline in new development will take six to twenty-four months to reverse.

In the intermediate and long term, we believe that the sustainable price of oil is in the $80 per barrel range. This covers the cost to continue shale development with an appropriate rate of return on capital. Without shale development, the oil market reverts to the late 20th Century position of dependence on OPEC. In our plans, we expect a trading range of $65 – $105. We do not expect to see long term oil prices above this range until the resumption of more normal worldwide economic growth.

Crude Oil Annual Trading Range 

West Texas Intermediate Spot Price, Cushing, Oklahoma Note: 2014 numbers are through Nov. 24, 2014 (Source: EIA)

West Texas Intermediate Spot Price, Cushing, Oklahoma
Note: 2014 numbers are through Nov. 24, 2014 (Source: EIA)

Near Term Impact on Five States Distributions

We have hedges in place on 88% of our proved producing properties at $90 per barrel for 2015. Hedges are in place on 42% at $87 per barrel for 2016. Having prices “locked in” will reduce the impact of lower prices over the next two years.

Our low leverage philosophy is defensive. Our properties have low production costs and we do not have a lot of debt. Low operating and financial leverage results in less downside volatility during periods of declining prices.

Midstream assets are not as sensitive to short-term price volatility. Revenue is in units of oil transported, not the price per barrel produced. Our midstream projects will still continue to operate, moving production that has already been developed even when drilling slows. Our pipelines and rail facility are the lowest cost transportation option currently available. We believe it would take a long-term drop below $70 to impact long-term economics of our pipelines.

We estimate net cash flow for Five States Consolidated I, II & III would decline by approximately 15% for 2015 compared to 2014 if NYMEX crude averages $70 per barrel. Net cash flow for 2016 could decrease an additional 25% in 2016 if NYMEX crude averages $70 per barrel.

Lower prices will decrease operating cash flows from the production components of the portfolio in FSEC Fund 1. However, the hedges in place will mitigate much of the negative impact over the next couple of years. Prolonged lower prices could slow the pace of further drilling on our development projects. This could affect the development schedules for the OSR-Halliday, as well as the Waggoner Ranch. Lower oil revenues could also impact our mezzanine loan with Diversified Resources and their ability to stay current on the 12% coupon.

The two largest investments in Fund 1, Great Northern Midstream and Advantage Pipeline, should continue to perform at or above current levels in 2015. Advantage Pipeline is still projected to begin making cash distributions in early 2015. We expect larger distributions from Great Northern Midstream in 2015. The increased distributions from our midstream assets, along with our hedges, should offset much of the negative impact from the decline in oil prices.

Five State Investment Strategy

We have made only one investment for FSEC Fund 2 to date. This is the Tenawa natural gas processing plant. Falling crude oil prices have impacted this project. The decline in crude prices has reduced the value of the extracted natural gas liquids, particularly propane, and while still a profitable project, we have reduced our projected profit on this project by roughly 50% – 60%. Going into the winter it is difficult to estimate the demand pull on propane and hence the extent of any upward pressure on price. We still have 80% of the capital of Fund 2 uncommitted, so we have plenty of capital available to take advantage of new opportunities.

In the 20th Century, the greatest risk in oil and gas investing was unsystematic risk. The primary risk was drilling a dry hole. Today, the primary risk is systematic, or market risk. Shale development projects are almost always productive. Wellhead price volatility is now the greatest risk. The NYMEX price must remain over $60 per barrel for many of the shale projects to be profitable and encourage additional drilling.

As we have stated over the past few years, we are cautious about new oil investments based at $90 per barrel, typically investing in a mezzanine or preferred structure. We believe $70 – $85 per barrel is the “fair value” for the NYMEX reference price. When the price for crude oil is below $80 per barrel, we become more aggressive seekers of producing properties.

New Opportunities

We are excited about developing opportunities. We believe lower prices will renew acquisition opportunities, which remain part of our investment strategy. If good assets are revalued based on current prices, they can be acquired at lower prices and performance on new investments will be more attractive.

Eroding bank borrowing bases of independents should create demand for equity. As oil prices fall, the collateral value of producing properties declines, reducing the amount banks will advance. The last few years we have seen some banks underwriting loans very aggressively. This trend should reverse, reducing the amount of bank capital and providing more opportunities for private equity.

Independent producers that need more capital to continue development will look either to mezzanine investors like Five States or sell assets. This may take time to develop. Collateral revaluations typically take place twice a year. Much of the reduction in bank collateral value is not because assets are bad. In many cases lenders loaned too much on good assets because they were assuming higher prices.

Our business development team is actively approaching community and regional banks, updating them on our interest in providing capital to their customers who no longer have sufficient borrowing capacity under their primary banking lines. Lower oil prices should also put pressure on banks and investors holding underperforming natural gas assets to sell some of these assets.

Another primary reason for the increase in producing property prices over the last five years was an overall industry “land rush” during the shale boom. Many acquirers of producing properties were trying to gain control of the potential shale acreage, paying an inflated price for the existing production in order to acquire the shale drilling rights. This type of competition will no longer be bidding up producing properties.

We will continue to actively solicit midstream investments. The energy renaissance is still in its early stages, and it will probably take twenty years to develop the new infrastructure needed.


We like new oil investments at $80 per barrel or lower. Lower prices should result in lower development costs, improving the long-term economics of the redevelopment underway on our legacy holdings.

We are in a defensive position on oil prices with respect to our legacy portfolios. But the price drop is not without negatives. If prices remain at this level, we will realize lower income for the production not hedged. We have been using prices in the $80s in our forecasts and valuations for 2017 and beyond for the last three years.

Oil Fundamentals: Supply & Demand

As with all commodities, the price of oil is determined by supply and demand. People often think that oil is “special” because we are “running out,” and do not understand how prices can fall. But like all commodities, the daily price of oil is determined by daily demand and deliverable supply. When supply is tight or demand increases, the price increases. When supply exceeds demand, the price declines.

Until five years ago, it was widely believed (much like in the 1970s), that the price would keep rising forever, until oil became too expensive to use as a fuel. But the US “Energy Renaissance” has reversed that trend.

World Supply Growth

World oil supply is growing at a rate unforeseen just five years ago. The source of this new supply is the US Energy Renaissance. New sources of oil are being developed from “tight formations”, primarily in Texas and North Dakota.

US Oil Production

US Oil Production

US Oil Production (Texas & North Dakota)

US Oil Production (Texas and North Dakota)

The long-term decline in world-wide oil production has reversed, but the oil produced from the Shale Revolution has a high price tag. The cost to develop shale oil is +/-$50/barrel—over twice the price of crude in the late 20th Century.

The idea of imminent “Peak Oil,” widely accepted early in the last decade, has been proven incorrect. See Jeff Davis’ article, “Great Expectations: Revisiting Peak Oil,” for a detailed discussion. At the end of the 20th Century it was believed that US production would continue to decline, while consumption would continue to increase as the economy grew. Although the rate of consumption per unit of economic growth was expected to decrease due to conservation, alternatives and renewables, it was believed that total demand would still continue to grow. The scenario of increasing demand coupled with decreasing supply would ultimately result in a Malthusian scenario where oil prices would continue a long-term increase with prices dictated by the market manipulation of the OPEC cartel.

World GDP vs. Petroleum Demand

World GDP Change vs Petroleum Demand Change

Source: World Bank for GDP, EIA for Petroleum Demand


World Petroleum Demand OECD vs. Non-OECD

World Petroleum Demand OECD vs Non-OECD

Organisation for Economic Co-operation and Development (“OECD”); Source: EIA


The Energy Renaissance in the United States has been phenomenally successful. The US is on its way to once again being the largest oil producer in the world. This past summer US production exceeded Saudi Arabia production.

The application of horizontal drilling to develop previously uneconomic shale reservoirs is achieving the more optimistic expectations of a few years ago. Adding to the growth in supply is the recent reversal of strategy by OPEC kingpin Saudi Arabia. Saudi Arabia is now increasing production to defend market share rather than curtailing production to manipulate the world price of crude oil. See Seth Phillips’ article, “OPEC in the Modern Era,” for an overview.

Higher crude oil prices provided the funding for technological advancement, which reversed the trend of declining supply. We now know that there is a lot more oil and natural gas to recover than we thought in the 20th Century, but this supply is only available at a higher cost. See Gary Stone’s article, “Shale Revolution,” in this issue for a detailed discussion.

Demand Growth Slowing

While supply continues to increase, the rate of growth in energy demand is slowing. Technology and conservation have slowed the rate of growth in energy consumption per unit of economic growth. Energy demand is highly correlated to economic growth. The Great Recession further curtailed energy demand growth.

But the industrialization of the emerging economies (primarily China and India) is more than offsetting conservation and efficiency in the industrialized economy. This trend is expected to continue for several more decades.

Growth in Oil Demand, 2014-2040

In recent years, supply has been growing faster than demand. The oil market has been anticipating a future price decline for the last several years. The primary reasons that prices had remained in the $90 – $100 per barrel range were supply disruption in Africa and the Middle East and sanctions on Iran and Russia.

As with any commodity, when supply is growing faster than demand, price declines. But high prices are the cure for high prices, and vice versa. The new US production has a very rapid depletion rate. The development cost is over $50 per barrel in many of these plays, so oil needs to be over $60 per barrel to provide a profit and cover operating costs and taxes.