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Mezzanine Deal to Drive More Drilling, More Oil and Gas Production

Five States Partners with Diversified Resources, Inc.; First Foray into Appalachian Basin in Five States’ History

DALLAS, TX (July 17, 2013) – Five States Energy Capital, LLC, a private-equity investment group, today announced two oil and gas transactions. The first deal, a $15.8 million mezzanine loan to Diversified Resources, Inc., will provide growth capital for the privately held oil and natural gas company. In the second deal, the two companies will acquire shallow, conventional assets for future development from Trans Energy, Inc. (OTCBB: TENG) for an undisclosed amount.

Five States’ financial commitment to Diversified Resources will allow the exploration-stage company to reduce its debt while continuing to build its presence and develop shallow, conventional producing assets in the Appalachian Basin. The two companies have also partnered to acquire approximately 250 wells in West Virginia from Trans Energy, Inc. (OTCBB: TENG), representing Five States’ first expansion into the basin in the company’s history.

“Conventional wells continue to play a key role in our country’s energy mix. While chasing the next homerun might be appealing, there are a lot of singles out there,” said Five States Energy President and CEO, Arthur Budge, Jr. “This partnership allows us to diversify our investors’ assets with a de-risked deal while giving Diversified Resources more liquidity to make additional acquisitions.”

With a long history of oil and gas exploration and production, the Appalachian Basin continues to offer long-life reserves and low drilling risk, making mezzanine financing an attractive option for Five States, its investors and Diversified Resources.

“Our partnership with Five States closely aligns with our long-term growth strategy. We’ll continue to acquire additional assets and increase production through operational improvements and drilling,” said Rusty Hutson, President and Co-owner of Diversified.

As Five States launches its 29th fund, the firm will continue to acquire conventional producing properties.

About Five States

Founded in 1985, Five States is a private equity investment group based in Dallas, Texas. With roots in the acquisition and financing of conventional oil and gas resources throughout the U.S., the company focuses on long-term, income-generating opportunities for its investors. Established in 2007, Five States Energy Capital, LLC provides customized capital solutions to independent producers located throughout Texas, New Mexico, the Mid-Continent and the Rockies. Combined with its affiliate, Five States Energy Company, LLC, Five States manages more than $250 million in oil and gas investments.

About Diversified Resources, Inc.

Founded in 2001, Diversified Resources, Inc. is a privately held oil and natural gas company based in Birmingham, Ala. With a focus on developing and operating conventional oil and natural gas assets in the Appalachian Basin, the company operates approximately 900 wells in Ohio and West Virginia with gross production of 5,000 Mcf/da and 100 barrels per day.

 

Will the US Achieve Energy Independence?

I am frequently asked if America can, or will, ever again be energy self-sufficient. The question is more complex than it seems.

For many of those who ask, the question is really about American’s ever-increasing level of oil imports. “Are we likely to develop sufficient production capacity in the US such that we no longer need to import oil from foreign countries?”

Prior to the Arab Embargo of 1973, the US was essentially energy independent. We had sufficient oil production for our own requirements and enough to sell abroad. We were a creditor nation and enjoyed a secure domestic supply, price stability and a favorable balance of trade. However, when our domestic oil demand outstripped production capacity in the early 1970s, the US was forced to buy oil from other countries, some of whom are unstable and/or unfriendly to the US Imports have increased as our population and per-capita usage increased and domestic production decreased.

The lowest level of US production in recent years occurred in 2008, when only 6.7 million barrels per day were produced. Since that time, thanks to the benefits of horizontal drilling and multi-stage hydraulic frac treatments, more than 1.1 million barrels per day have been added, most from shale and tight rock formations in both old and new producing basins. According to the US Energy Information Administration (EIA), the US in 2011 exported more petroleum products, on an annual basis than it imported for the first time since 1949. The increase in foreign purchases of distillate fuel contributed the most to the United States becoming a net exporter of petroleum products. American refiners still imported large amounts of crude oil, some of which is refined and exported as petroleum products, including gasoline.

Admittedly, projections of future production growth are dependent upon many factors and range from 1.5 to 4.0 million additional daily barrels by 2015. This would result in a possible daily total of 9 to 12 million barrels. This is well below our total US petroleum requirements, but constitutes a very beneficial step in reducing our trade deficit.

After 2015, the favorable gap between production and exports is expected to grow, as imports continue to wane. The gap could grow even faster if tight oil plays pan out better than expected. But just because the domestic energy industry is ramping up does not mean the US can stop importing foreign oil tomorrow. Most horizontal wells have steep decline rates, meaning that to increase annual production volumes, new wells must not only overcome declines of existing wells, but add even more new volumes to daily rates. Moreover, it may be unwise to completely eliminate imports from some sources. Each day, the US imports about 2 million barrels from Canada and 1 million barrels from Mexico, two of our most valued and reliable trading partners. To stop deliveries from them could damage relationships and leave us more vulnerable to a catastrophic interruption of supply in our country.

Of course, petroleum is only one segment of the energy budget of the US, comprising about 37% of the total. Of that, about 72% is used in transportation, with most of the remainder allocated to industry, and minor percentages to residential and commercial heating, and electric power generation. At 25% of the energy budget, natural gas is the second most utilized source, divided almost equally among industry, residential and commercial heating, and electric power generation. At 21%, coal is used almost exclusively for electric power generation, as is nuclear (8%) and renewables (9%).

The US is blessed with such an abundance of energy resources that we can logically export some. If total energy is considered, the US is over 70% self-sufficient today. With the world’s largest deposits of coal, estimated by some to be an 800-year supply at current rates of consumption, we are already shipping millions of tons to Europe and Asia. Current and anticipated future development of shale resources is adding natural gas supply in such quantities that prices have been driven down, and natural gas is displacing coal as a cleaner alternative to generating electric power. Even with heavy restrictions on building new refineries or expanding existing ones, we’re still able to export some refined products. Numerous applications to export liquefied natural gas (LNG) overseas are awaiting approval, and more are in the process of being filed. Sometime, in the distant future, we might even have excess oil to export.

Five Hundred Million

We reached an interesting milestone at Five States this year. Total distributions from Five States partnerships over our history have now exceeded half a billion dollars. This is about three times the total equity invested1 in the Five States partnerships from 1989 through 2005. About half of this was operating income generated from our producing properties and about half was from the property sales in 2006 and 2007. We completed investing Five States Energy Capital Fund 1 earlier this year, and we expect it to “ramp up” to provide distributable income similar to our earlier partnerships. We consider these results to be a good example of “Value Investing”.

Investment managers are often classified as “Growth Investors” or “Value Investors”. Growth Investors generally have a strategy of seeking investment opportunities where the primary return is expected from growth in the underlying business, translating into growth in investment value. Growth Investors are willing to pay a higher price relative to current earnings because they expect earnings to grow. Returns are achieved primarily from appreciation, so are realized upon sale. Current returns such as dividends are typically low or nonexistent. A good example of a growth investment is Apple stock. The value of the stock is much greater than the current earnings alone justify, and it has historically paid out a low percentage of earnings in dividends.

Value Investors seek investments that are attractively priced based on the existing financial fundamentals; a “what you see is what you get philosophy”. After analyzing revenue, expense and income of their target investments, as well as the component value of the assets and offsetting liabilities, Value Investors calculate what they think the investment is worth based on these fundamentals, typically using a discounted cash flow methodology. A disciplined Value Investor invests only when the target investment can be obtained at or below their calculated value. Utility stocks are an example of a value sector. Most of the valuation is based on the existing income potential of the company. Much of this income is paid in dividends.

We at Five States have always considered ourselves a Value Investor. Our investment decisions are based on analysis of the underlying fundamentals of target assets. We expect to earn the return from owning an asset, relying on the income the asset generates for the majority of our return. We expect to sell an asset only if someone is willing to pay us more than we think it is worth.

A Value Investing approach has a consequence that is sometimes frustrating. There are times when others in the market are willing to pay more for an asset than we are, and we become “priced out of the market”. Periods like late 1997/early 1998 and 2006 to 2009, when we closed few if any transactions, are good examples. In both of these periods we processed plenty of transactions, but someone was usually outbidding us. So we would wait until market values came back in line with our calculated valuation. We do not consider this a contrarian philosophy. We consider ourselves realists.

Fracking

In the 2006 – 2007 period we thought that “peak oil” was going to result in a continually shrinking inventory of domestic assets in the U.S. for us to invest in. New recovery technologies developed in response to higher oil and natural gas prices have reversed that trend. The development of 3-D seismic and horizontal drilling have resulted in the ability to recover economically viable oil and natural gas from formations that would provide insufficient yield with only vertical wells. These technologies have also substantially reduced the “dry hole” risk of new development, often approaching zero.

The reduced dry hole risk of developing new fields has been replaced with new risk. The cost of implementing these new technologies is much higher on an individual well basis. Completion risk is also greater. In long horizontal wells it is not uncommon that the cost to complete the well exceeds the cost to drill it. The break even cost to drill and complete oil wells in many of the active domestic plays is $40 to $60 per barrel, and for natural gas is $3.50 to $6.00 per thousand cubic feet (mcf). This adds operating leverage, resulting in increased systematic risk (the impact of oil and gas price volatility). This risk was realized in the natural gas sector at the end of the last decade as the success of horizontal drilling increased domestic supply so much that the price of natural gas declined from over $10/mcf to as low as $2.00/mcf. It has recently recovered back to the $4.00/mcf range.

In 2007 when we expanded our investment tactics to include mezzanine, we did so in recognition of the increased systematic risk. At that time, we did not expect the industry to expand at the rate it has in the last six years, but did see that the systematic risk had increased materially. We needed additional tools to structure new investments appropriately in light of that risk. Ironically, the mezzanine structure was used in only 20% of the FSEC Fund 1 portfolio as it exists today. It would have been over 50% if a very substantial mezzanine commitment known as Coachman had not prepaid.

Increased oil production volume has dampened the consensus expectation that oil prices will increase materially in the near term. Domestic production rates are approaching levels of twenty years ago, and are expected to continue increasing.

NYMEX Futures Curve Comparison

Today, the futures contract price for oil to be delivered one to seven years from now is materially lower than the wellhead price. This is occurring for the first time in decades.

Energy Demand by Region – OECD vs. Non-OECD

Energy Demand by Region - OECDEnergy Demand by Region - Non-OECD

The waning optimism regarding futures prices is actually good for us as a Value Investor. Over the last decade many of our competitors were counting on higher oil and natural gas prices in the near term to support their investments. Now that these competitors are not expecting higher prices in the near term, the assets for which we are competing are more attractively priced.

We believe that this “softening” in oil and natural gas prices is an intermediate term phenomenon. World demand for energy is expected to continue to grow as the world economy expands. The vast majority of this energy demand will be met by oil and natural gas.

The United States is shifting from a net consumer to a net producer. This is already having a material impact on the U.S. economy as our balance of trade deficit shrinks and our economy benefits from the high paying jobs and high return investment of the redevelopment in our domestic energy infrastructure. North America will become hydrocarbon independent, and will likely become an exporter of natural gas.

US Crude Oil Production – Texas and North Dakota

US Crude Oil Production - Texas and North Dakota

This is providing an incredible Value Investing opportunity in an otherwise depressed environment. We believe that this renaissance in the domestic oil and natural gas industry will present Five States investors excellent opportunities and returns for the next decade.


Energy Partnerships and Investments Continue to Push Pecos River Pipeline

Five States Energy Capital Joins West Texas Development Project; Partners with Advantage Pipeline

DALLAS, TX (March 7, 2013) – Five States Energy Capital, LLC, a private-equity investment group, today announced plans to invest $17.5 million, joining Advantage Pipeline, LLC in the development of its Pecos River Pipeline.

Originating in the Delaware Basin near Pecos, Texas and terminating in Crane, Texas where it will connect to Magellan’s Longhorn Pipeline, the 16-inch diameter pipeline will transport up to 150,000 barrels of crude oil per day to terminals and refineries in Gulf Coast markets.

“With drilling risks at an all-time low, demand continuing to increase and more than $250 billion to be spent on midstream infrastructure development in the next 25 years, now is the time to invest in energy,” said Five States Energy President and CEO, Arthur Budge, Jr. “Our partnership with Advantage Pipeline not only fits our core, long-term investment strategy, but also supports our nation’s trek toward energy independence.”

The pipeline is scheduled to be operational by the end of May, completing the first phase of the project. The second phase is expected to be operational by summer 2013.

“We have a history of bringing together the right partners and investors to provide a more efficient and safer way to transport crude to market,” said Mike Shelton, President, Advantage Pipeline. “This endeavor could benefit all parties involved from investors and producers to operators and logistics customers as well as our economy.”

About Five States

Founded in 1985, Five States is a private equity investment group based in Dallas, Texas. With roots in the acquisition and financing of conventional oil and gas resources throughout the U.S., the company focuses on long-term, income-generating opportunities for its investors. Established in 2007, Five States Energy Capital, LLC provides customized capital solutions to independent producers located throughout the lower 48 states. Combined with its affiliate, Five States Energy Company, LLC, Five States manages more than $250 million in oil and gas investments.

 About Advantage Pipeline, LLC

Awash in Oil!

Exxon recently published its annual Outlook for Energy issue, in which it projects trends of the world’s energy supply and demand needs to 2040. It makes for interesting reading.

According to Exxon, the world’s population will rise by more than 25 percent from 2010 to 2040, reaching nearly 9 billion. An expanding population, as well as economic growth will require increases in energy sources and uses. At the same time, modern technology is developing new resources and making energy more affordable.

With global energy demand increasing around 35 percent from 2010 to 2040, a more diverse and affordable fuel mix will be needed. Nevertheless, oil and natural gas will supply about 60 percent of global energy demand in 2040, up from 55 percent in 2010. Oil will remain the largest single source of energy to 2040, growing around 25 percent. Production of natural gas is expected to grow faster than any other major fuel source, with demand up 65 percent by 2040. Because they are abundant in supply and more economical to develop than other fuel sources, oil, natural gas, and coal will provide approximately 80 percent of total global energy by 2040.

Thanks to the combined technological developments of 3-D seismic, horizontal drilling and multi-staged hydraulic fracturing, the United States is experiencing an astonishing resurgence of its oil and natural gas industries, the results of which can hardly be overstated. The global energy map is being redrawn…away from the unstable Middle East and to the West.

Most people in the US do not understand the role that energy plays in our economy. They don’t understand that the boom from 1900 to 1925 was fueled primarily by the oil found at Spindletop in Texas in 1901. They don’t understand that much of the success of the US and its Allies in World War II was fueled by oil from the East Texas field and discoveries in the Permian Basin, as were the economic booms that followed in the 1950s and 1960s. The boom in the 1990s was also stimulated by oil and natural gas prices that were well below replacement costs. Literally, the energy that drove all of that productive capacity was initiated with the East Texas discovery of 1930. The East Texas field is the second largest in the US, exceeded only by Alaska’s Prudhoe Bay. However, having yielded more than 5 billion barrels to date, it is still the larger producer.

The size of the discoveries found recently could dwarf both. More than 20 new major shale plays are currently being drilled in the US Each one of these could contain 20 billion or more barrels of recoverable oil, four times that of East Texas. In fact, some experts are projecting that the one most recently recognized, the Cline shale in west-central Texas, could contain 3.6 million barrels of recoverable oil per square mile, or about 30 billion barrels for the entire shale play.

We are sitting on the biggest economic and financial opportunity in the history of our country. Yet even as the discoveries mount and production increases, all the new oil is creating some current difficulties for producers, as well as opportunities for groups such as Five States.

Lack of local infrastructure is costly. Many of the new oil and gas plays are in areas that do not have the transportation facilities that exist in the more mature producing areas. For example, a new discovery well in North Dakota might be capable of initially producing 1,000 barrels of oil per day. However if the well is located 40 miles from the nearest paved road, and if no pipelines are available, the oil may have to be trucked 1,200 miles to Cushing, Oklahoma in 160-barrel tank trucks for delivery. Hauling charges could be as much as $30 per barrel, easily absorbing much of what otherwise would be profit.

Cushing, Oklahoma, is the point of delivery where the price of West Texas Intermediate (WTI) or oil of equivalent quality is determined. The difference between the price a producer in the Permian Basin receives for his oil has typically been about 85 cents less than the NYMEX posted price. This “differential” is the imputed cost of delivering the oil via pipeline to Cushing. Today, because storage facilities at Cushing are full, the oil coming out of Texas and other producing areas is being penalized by a differential of about ten percent. In other words, with WTI posted at $90 per barrel, the operator receives only about $80 per barrel, less imposed taxes and landowner royalties.

Because of transportation and storage arbitrage, the opportunity exists for Five States to provide funding for gathering and storage facilities, rail terminals, pipelines, and transportation equipment and materials. . . . We are currently reviewing dozens of fund requests to find the few that meet our requirements of those having solid principals, strong collateral and good economics.

Sunset to Sunrise: Fundamentals & Trends

Industry consensus is that the increase to United States oil production volume in 2012 will exceed growth in world oil demand for the first time in half a century. The increase in the rate of US production is expected to continue for the foreseeable future. The success in development of new natural gas reserves is comparably staggering. The change from the US requiring ever-increasing oil and natural gas imports to possible North America energy self-sufficiency, or even energy exports, is one of the greatest reversals of expectation in industrial history.

North American production of oil and natural gas has increased by 18% in the last five years. This follows decades of constantly declining production rates and reserves. Over the next several decades, proved US crude oil and natural gas liquid reserves are expected to grow five times, from twenty billion barrels to one hundred billion barrels. The US natural gas reserve life is expected to increase from a twelve year supply to a one hundred year supply.

This reversal of fortune is due to the development of new drilling and completion technology that allows for economically viable production of oil and natural gas from shale and low permeability conventional reservoirs. Advances in information technology and materials science that occurred during the oil and gas depression of the 1980s and 1990s have now been applied to the oil and gas industry. These have contributed to the development of three dimensional seismic surveys, horizontal drilling and the ability to perform multi-stage hydraulic fracturing on horizontal wellbores, making this seventy year old stimulation technique exponentially more effective.

These new and improved recovery technologies have increased the cost of drilling and completing new wells. The average well cost in the US has increased three fold, from an average of $1.7 million in 2005 to over $5.7 million today. Recoverable reserves per well have increased proportionately or more. It is estimated that the increased cost of development and expansion of the new opportunities in the US will translate to new capital needs of $35 billion per year for the oil and gas industry. This is over and above the reinvestment of retained earnings and use of the increased borrowing capacity created by the expanding reserve base.

The growth in production is also spurring a boom in required infrastructure. This is referred to as “midstream” in the industry. Midstream includes everything in the “middle of the stream” of the commodity “flow” between the wellhead and the refinery. Production volumes in most parts of the US have outgrown existing infrastructure. In new areas the infrastructure does not exist at all. It is estimated that new investment required to deal with the growing production volumes is about $10 billion per year (including Canada) for natural gas transmission, storage, gathering and processing; oil pipelines; and natural gas liquids pipelines. This is quite a boom in high skill, high wage manufacturing!

The increase in natural gas consumption has had a greater impact on emissions than all of the subsidized investments in renewables combined. Most of the increase in natural gas consumption has been used to generate electricity. Much of the electricity generated with natural gas is replacing the older high emission coal plants. Natural gas emits 45% less carbon per energy unit. CO2 emissions in the US are at the lowest level in twenty years.

Little of this decline in emissions is due to “alternatives.” It is estimated that the shift from coal to natural gas has reduced US emissions by 400-500 megatons of CO2 per year. Wind turbines account for a reduction of about one-tenth of that amount, biofuels 2.5% and solar panels less than 1%. Some experts calculate that the conversion to natural gas has reduced emissions more than required in the Kyoto Protocol.  Further development of natural gas as our core asset, particularly in fueling vehicles, can have additional economically efficient impact on further reducing emissions in an economically productive way.

The risk profile of oil and gas investing has changed with the improvement in development and recovery technology. In the 1985 – 2005 period, our primary risk focus was on individual project (unsystematic) risk. With oil averaging well below replacement cost at $20 per barrel, we were not nearly as concerned with price risk. New technology and the type of reserves being developed have materially reduced the risk of failure of an individual project. For example, we have participated in twenty-two Bakken oil wells in North Dakota in our production partnerships, drilled on acreage positions we own from production purchases made in the 1990s. All of these wells are calculated to be economic successes. Today, with oil over $80 per barrel and replacement cost in the $40 – $50+ range, we are much more focused on oil and gas price (systematic) risk. That is why we continue to lock in current high prices with hedges, and are making some of our new oil investments using mezzanine structures, so that we are in a priority position if oil prices decline in the near term.

Energy imports account for about one half of the US balance of payments deficit. Reducing or eliminating this deficit would have a highly stimulative impact on our national income equation. Much of our military budget is spent in an attempt to maintain stability in the Middle East. If we eliminate the stranglehold of OPEC on the industrialized west, US military expenditures and foreign policy can be greatly modified.

What Goes Around

I have previously commented in The Producer about the cyclic nature of the oil and gas industry. For those of us who have been involved in upstream exploration and development for a decade or more, we’ve become accustomed to the ebb and flow of business activities, and acutely sensitive to clues that may indicate the next stage or direction of movement within a cycle.  Correctly interpreting directional trends over the intermediate term allows one to place strategic bets on specific plays and opportunities. Getting these generally right over the long term ultimately determines the success or failure of an enterprise.

Profits emerge from adjusting corporate plans to the constantly changing stream of structural and temporal events that affect every company.  Explosive oil industry growth was initiated in 1972 when the Texas Railroad Commission lost control of its ability to hold world oil prices near $3 a barrel where it had been for decades, allowing OPEC to raise prices to levels never previously seen.  Such a fundamental change in the price structure created conditions that fostered new growth of old companies, the creation of many new ones, and the subsequent intellectual and technological developments in the industry. Results of the change can hardly be overestimated.  Almost none of the oil and gas the world uses today could have been profitably found and produced within the price structure that existed prior to 1972.

Events of such magnitude and significance are rare, but a multitude of other factors that can move commodity prices weigh in daily.  OPEC still maintains production quotas for its members. Policies of non-OPEC countries often determine export volumes. Wars, insurrections and labor strikes throughout the world interrupt orderly supply deliveries. At times, hurricanes, floods and other weather related events require that wells be shut in.  Seasonal weather patterns do not always follow predicted forecasts, causing temporary misallocations of production and product deliveries. In the U.S., federal, state and local politics, public demonstrations and anti-development movements, environmental regulations, tax policies, and a myriad of other issues add cost, uncertainty and delays to planned activities. Each of these factors may cause temporary difficulties, but are generally considered more as annoyances than major issues.

The most recent revolutionary and structural industry game changer has occurred not only as a result of increases in oil and natural gas prices, but by advances in petroleum technologies.

Hydrocarbons can now be produced from shale rocks that contain a high percentage of organic matter that were previously considered too “tight” to produce the oil and natural gas they contain.  The combined application of horizontal drilling within a shale layer and hydraulic fracturing (“fracing”) has opened large new areas of the U.S. and elsewhere to petroleum production. The result has been that estimates of the world’s producible reserves of oil and natural gas are being increased substantially, making the benefits of abundant energy supplies available to millions of additional people.

For Five States, the opportunities to support and finance activities and construction projects in these new areas are increasing.  The number and size of projects that are being submitted to Five States for review and analysis are increasing, and the quality of projects is improving.  As individuals and companies expand their drilling and development commitments they may need additional equity and mezzanine capital, consulting expertise, or a financial partner. Five States has the reputation, funds, experience and personnel to provide help in these situations.

Currently we are processing data on almost a dozen submittals, with a prospective total commitment of $180 million. Typically, only one or two of these are likely to be approved, but others are being received almost daily. Five States’ financing activities are focused in three areas:  infill drilling and lease enhancements of existing properties; infrastructure construction of pipelines, compression facilities and stripping plants; and acquisitions of producing property interests.

In the past two years, we financed a company that owns and operates workover rigs, provided millions of dollars of credit facilities to companies to acquire and develop producing properties and establish water floods, invested with a consortium of industry partners to build a pipeline, loading facilities and a rail line to move oil out of North Dakota to a contracted purchaser, and acquired producing properties for our Fund 1 investors.  In all cases, our focus remains the same: to acquire high quality producing interests and related infrastructure that will generate attractive income.

We anticipate having the remaining committed funds of Fund 1 invested by year-end or early in 2013.  We now are planning to open Fund 2 in early 2013.

Sunset to Sunrise

My father loved the oil business. He grew up in West Texas during the World War II oil boom and worked his way through college “roughnecking” in the oilfields. Because the derrick crew did the dangerous work out in the weather on the rig floor, my grandfather told Dad to go to college so he could be a “company man” as they did all the “think work” in the trailer. When Dad graduated, he got his dream job as a geologist with Gulf Oil and took part in one of the greatest industrial developments in history. The World War II boom and the domestic oilfield development of the ‘50s and early ‘60s led to a surplus of deliverable supply, which provided the U.S. with low cost oil into the 1970s.

From my childhood, Dad taught me about geology, the oil industry and that oil was a depleting resource. Like most in the industry, he recognized that the abundance of cheap oil was finite and depletion of domestic reserves meant domestic oil was a sunset industry (i.e., an industry believed to be in terminal decline). This low-cost, secure domestic resource contributed to the creation of the modern American middle class during the greatest period of growth in U.S. history. Because domestic production was in rapid decline, we believed an alternative to domestic oil and natural gas would be necessary in my lifetime.

The resource is finite. But the supply is much greater than we believed just five years ago. The creation of recovery methods for developing “unconventional” oil and natural gas resources is a game changer. The U.S. can replace much of its imported oil with domestic oil and generate needed electricity with domestic natural gas rather than with coal. The development of domestic reserves can be a major part of the engine of economic recovery.

The Great Economic Drag

Until recent years, U.S. oil consumption increased in lockstep with the growth of the economy. Domestic production decreased each year and imports increased. It is probably not a coincidence that the deterioration of the U.S. economic condition correlated with the loss of energy independence, increased oil imports and increased deficit in our balance of payments. The cost of maintaining a military presence, fighting multiple wars in unfriendly parts of the world and using our Navy to protect critical shipping lanes has compounded the economic drag.

The U.S. has run a balance of payments deficit for the last 40 years. In essence, we buy more goods and services from foreign countries than we sell to them. This can be beneficial when we purchase goods for less than we can produce them domestically. In relation to oil, such has been the case.

Energy is incredibly important to economic output. Imagine your life without it. What would your day be like without oil and electricity? Tomorrow, turn off your electric meter and avoid cars, buses, planes and trains, and see where you focus your time! No economically competitive substitute for oil as our primary transportation fuel currently exists, even at $100 per barrel. The failures in “alternatives and renewables” illustrate the difficulty of doing without oil. Ethanol as a substitute is a politically driven scam. The failure of other government financed alternative energy companies in the past year illustrates the difficulty of the problem.

But the economic cost of imported oil is high. In 2010, the United States spent about $265 billion on net oil imports. Moreover, a tremendous amount of the U.S. military budget is allocated to security of oil producing nations. Economic forecasters estimate that every $10 per barrel increase in the price of oil reduces U.S. economic growth by 0.2% due to the impact of oil imports. The money that we send abroad provides little stimulus to our economy. It has no “velocity”.

Velocity of Money

Economists talk about money spent or invested as having “velocity”. High velocity is good for economic growth. Low velocity is less so. The problem today with much of the government stimulus is that it has no velocity. If the government provides capital to a bank and the bank buys U.S. Treasury securities, the funds do not do much good. The government is providing the money to the bank for less than the bank is lending it back to the government by buying U.S. Treasury securities. Other than the earnings accrued to the bank in this cycle, there is no economic stimulus. This money has no economic velocity; it is merely cycling in a non-productive treadmill. The government is effectively giving money to the banks.

If the bank takes the same money and lends it to a company to build a factory, there is a lot of velocity. The company hires contractors who provide wages and consume products from subcontractors, and so forth. When finished, the factory provides jobs and produces a product (hopefully at a profit). Employees from these companies spend their wages on goods and services, stimulating other businesses to hire more employees, and the cycle continues. Those dollars loaned had a lot of velocity and contributed to a lot of economic activity.

Money spent on imported oil has limited velocity for the U.S. It is much like the first example. But we now have the opportunity to replace low velocity money spent on foreign oil with domestic production. Developing domestic resources is highly stimulative to the U.S. economy. Money invested in developing domestic production is high velocity money, creating high paying jobs and consuming goods and services that stimulate other businesses.

The 21st Century Domestic Energy Boom

The current boom in domestic energy production was inconceivable ten years ago. Since the ‘60s, each year more oil and natural gas was imported to meet our country’s energy needs. In the ‘80s Mitchell Energy began to attempt to produce natural gas from the Barnett Shale. Up to that time it was widely believed shale formations were too “tight” to recover the natural gas trapped in the rock. It took years of experimentation and millions of dollars before Mitchell Energy began to have commercial success. As natural gas prices rose in the early 2000s other companies were drawn to the Barnett play and new techniques and technologies quickly evolved. The most significant of these were the widespread use of horizontal drilling and improved hydraulic fracing methods. Today almost all new unconventional (and many conventional) wells include horizontally drilled lateral “legs”, and all require hydraulic fracing to increase the permeability of the reservoir rock.

The technology and techniques developed in the Barnett Shale were applied in other natural gas shale plays across the country. The Fayetteville in Arkansas, the Haynesville in Western Louisiana and Eastern Texas, and the Marcellus in Pennsylvania all became significant natural gas plays. The speed at which the reserves in these plays were being developed was astonishing. The number of rigs drilling for natural gas went from approximately 500 in the mid ‘90s to over 1600 by ‘08. The pace of drilling combined with the high initial production from these shale plays flooded the market with natural gas.

Sunset to Sunrise

Similar exploration and production began taking place in oil plays. Engineers and geologists began to revisit formations previously thought to be uneconomic. As natural gas prices fell in 2009 natural gas focused operators began directing more of their capital budgets to more lucrative oil plays. These companies, armed with the knowledge they acquired drilling for shale gas, soon began to develop new oil fields throughout the country. The Bakken formation in North Dakota and Montana, the Permian Basin in Texas and New Mexico, and the Eagle Ford Shale play in south Texas have led the way in this revitalization of domestic oil production.

The results have been astonishing! The Bakken shale has elevated North Dakota to the 2nd largest oil producing state in the U.S. Today North Dakota produces over 600,000 barrels of oil per day. The development of the Eagle Ford shale and the reemergence of the Permian Basin have pushed oil production in Texas to over 1.7 million barrels a day, the highest level in twenty years. Today our country produces more oil than it has in over ten years, and the rate is still increasing.

Booms Lead to Busts

My grandfather was a drilling contractor in the World War II boom and during the following two decades. He started as a roughneck and worked his way up to foreman, saving enough money to start his own company and make a down payment on a drilling rig, which was the primary asset of his company over the next 20 years. He never went to college, but over my 30 years in the industry, his counsel has proven to be some of the most salient I ever received. As the boom of the ‘70s peaked, he warned me that every boom sows the seed of its own end.

The record production in natural gas outpaced record demand and resulted in the current price collapse. Fear of such a collapse was a primary factor in our decision to sell our natural gas assets in 2007. Current prices are below replacement cost, making natural gas attractive on a fundamental basis. We believe there will be wonderful new investment opportunities in natural gas in this lower price environment over the next three to five years.

The boom in unconventional oil, combined with the worldwide recession, may result in a decline in oil prices. Many argue that without the political instability in the Middle East prices of oil would be much lower today. Although we do not believe that a downturn would last as long as in natural gas, management of price volatility is critical in these investments. That is why we continue to maintain an active hedging strategy, locking in future prices to reduce the volatility of our expected results.

Conclusion

I sometimes think of investing in oil and gas as riding a roller coaster blindfolded. You can have a great time as long as you don’t get thrown out of the car! Hedging smooths the peaks and valleys, in this case making the ride much more enjoyable.

Familiar Ground

Articles in two recent investment newsletters reminded me once again how volatile the prices of oil and natural gas can be and how many factors are continually in play to move markets, sometimes dramatically.  Price volatility makes investment planning and project analyses difficult, and can create havoc with investment results over both short and longer terms.

Several years ago, Morgan Stanley issued a report of the relative volatility of all traded commodities, listing oil and natural gas the most volatile of all.  I have not seen a recent update of the statistics, but I would not be surprised to learn that the two continue to top the list.

The June 18, 2012, issue of U.S. Research, produced by Raymond James, discusses future crude oil markets and projects rocky days ahead.  Only four months ago, the publication substantially cut its 2013 oil forecast due to concerns about a rapidly growing U.S. oil supply and a deteriorating outlook for global oil demand growth. In a recent report, U.S. Report lowered its 2013 West Texas Intermediate (“WTI”) price projection to $65 per barrel (down from $83).  The new oil price forecast is well below the WTI futures strip at $85 per barrel and the street consensus at $110 per barrel.  Also lowered was the long-term (10-year) WTI forecast to $80 per barrel.

Goldman Sachs issued its Equity Research Report on the great Marcellus Shale expansion on July 8, 2012, discussing U.S. natural gas prices in depth.  Summarizing its natural gas price estimates for 2013, they “believe 2013 natural gas prices are likely to surprise to the upside versus the current strip as a greater gas rig count will be needed once storage moves to more normal levels, assuming continued low range bound prices for the rest of 2012.” Goldman Sachs believes demand and takeaway constraints warrant ‘price sensitive growth’ for Marcellus development to be in the $4.00 to $4.50 range.

“Getting it wrong” can be costly.  Oil and gas operators who drill wells with a reasonable assumption of a future product price range face capital losses if prices drop below their projected break-even point.  Producers who are well capitalized, have little or no debt, and with substantial current production that can be hedged are the most able to weather periods of low prices.  Producers with high cost structures and weak balance sheets are especially vulnerable to market weakness.

Timing of sales of production may be a major problem in many of the new areas of development.  Many of these are in previously unproven territory–areas with few existing wells to provide good analog data to assess the risk of new exploratory wells and inadequate takeaway infrastructure to provide good markets.  It is a chicken and egg conundrum.  New wells must be drilled and tested before the cost of pipeline construction can be judged as attractive.  Yet expensive, newly completed wells must remain “shut-in” until new facilities are planned and constructed. Because of cost of capital, otherwise economic wells may become non-economic if they remain shut-in for an extended period.

Exacerbating the problem is that many states no longer allow “associated gas”— that which is dissolved in oil in the producing formation and is produced with it–to be flared or vented. These states require that gas must be transported by pipeline to points of sale or use in order for oil to be produced and sold.  In other words, connections to natural gas pipelines are needed as soon as possible after wells are completed. Thus, financing construction of natural gas gathering and transporting systems is a primary investment target for Five States.

Even where adequate infrastructure and markets exist, events may have negative effects on wellhead prices.  Punitive governmental policies and regulations, weaker domestic and foreign economies, shortages of drilling and completion supplies and equipment, unseasonably mild weather, and increased competitive factors can all diminish profits.

We at Five States spend much of our staff time discussing current conditions and possible future events which could impact our business.  Fortunately, as has been discussed in previous issues of The Producer, hedging has become a major risk mitigation strategy of Five States. Tom Costantino, our chief hedging tactician, brings more than 20 years of knowledge and experience as an institutional commodities trader.  We are delighted to have Tom aboard to help us.  Having weathered several previous business cycles, all of us are very aware of the deleterious consequences of poor planning, lack of foresight or bad decisions, and we remain focused on our business plan of making money for our investors while building an inventory of long life, high quality producing oil and gas interests.

Reversal of Fortune

In the last decade, we have experienced a complete reversal of expectations regarding the future of our domestic energy supply. Today we have the potential to materially improve both our geopolitical and economic situation.

In the 1970s it was widely believed that U.S. oil and natural gas reserves had been depleted to the point that we had no choice but to rely on imported foreign oil. Many also concluded that the U.S. needed to import natural gas. The actual experience of the last 10 years has proven key parts of these assumptions wrong.

Regulation of oil and natural gas prices during most of the early 20th century was the root cause of the errors. Oil and natural gas prices were highly regulated during most this period, primarily to keep prices low. As low cost reserves were depleted, the incentive for producers to develop more expensive new reserves was less than it would have been if prices had been allowed to gradually rise. This distortion amplified the apparent decline rate in reserves, leading to misguided energy policy which exaggerated the already volatile oil and natural gas markets.

Oil and natural gas prices were deregulated in the 1960s to 1980s. The deregulation of oil prices was fait accompli as the U.S. became a major importer of oil and could no longer control prices through manipulation of domestic production. As prices rose through the 1970s, the ensuing drilling boom developed an overhang of supply of oil and natural gas, which lasted for almost two decades, resulting in the low energy prices we experienced throughout the 1980s and 1990s. Over the last decade, as the supply overhang was depleted, we saw energy prices increase substantially.

The two decades of excess deliverable supply and low prices were also a period of limited investment in energy research and development. The energy industry was in a prolonged depression. Despite the fact that the long term outlook was problematic, politicians were not concerned because gasoline and natural gas prices were low, therefore constituents were not complaining.

By the end of the 20th century, the bonanza from the 1970s boom had been consumed. Oil and natural gas prices began to rise. As prices rose, capital investment in research and development accelerated. The results have been phenomenal!

Oil and Gas Prices Decouple

The U.S. economy is once again in a period where high oil prices are negatively impacting our economy. Oil products are our primary transportation fuels. Our oil supply remains dependent on politically unstable areas of the world.

Higher oil and natural gas prices have stimulated tremendous success in developing new supplies. The development boom in natural gas has been so successful that prices have fallen to levels that, five years ago, we thought we would never see again. As a consequence, the historic price correlation between crude oil and natural gas has decoupled. The chart below shows this dramatic change.

Oil-and-Natural-Gas-Prices

 

The difference in price per unit of energy between oil and natural gas is incredible. Natural gas is currently trading at approximately $2.00 per MMBTU (MM = million, BTU = British Thermal Units, a measure of energy content). The equivalent for oil is about $18.00 per MMBTU. At current market prices oil costs 8.9 times as much per unit of energy as natural gas.

The development of horizontal drilling technology combined with hydraulic fracturing technology has resulted in a tremendous increase in natural gas production in the U.S. This increased supply has resulted in a collapse in domestic natural gas prices. Natural gas prices are 80% below the high of five years ago. Prices are 80% lower in the U.S. than in Europe and Asia, providing our nation with a huge competitive advantage.

Increasing Consumption of Natural Gas

 

Shale-Production-of-Natural-Gas

In the early days of the oil industry natural gas was something of a nuisance. The gas was found in association with crude oil or dissolved in the oil when under pressure in the formation. As the oil was produced, the gas was also produced or came out of solution as the oil reached the surface. To dispose of it, the gas was often flared. Over time, pipeline systems were developed to distribute gas for industrial and residential consumption.

U.S.-Consumption-of-Natural-Gas-Trends-BCF

Typically the price of a commodity rises when consumption increases. But the increase in the deliverable supply of natural gas in the U.S. has been so successful that natural gas prices have collapsed while consumption increased. The increased consumption is primarily due to the use of natural gas as electrical generation fuel.

2011-U.S.-Consumption-of-Natural-Gas-by-End-Use

Lower Emission Electrical Supply

Many of the new electrical generating facilities in the U.S. are natural gas powered. Electrical generation is one of the easiest applications for the additional use of natural gas. An advanced distribution infrastructure exists for both the natural gas consumed and the electricity produced. Capital cost to build natural gas powered generating capacity is low relative to alternatives such as coal, nuclear and renewables. In addition to superior economics, there is a big bonus in that most of the generation being powered by natural gas, with significantly lower emissions, is in lieu of coal fired power plants.

Coal is currently used to generate 45% of the electricity in the U.S. Natural gas fuels 24% of U.S. electric generation.

2010-Electricity-Net-Generation-by-Sector

A recent Congressional Research Service report concluded that “if natural gas powered combined cycle plants utilization were to be doubled from 42% capacity factor to 85%, then the amount of power generated would displace 19% of the carbon dioxide (CO2) emissions attributed to coal-fired electricity generation.” According to a GE Report, CO2 emissions could fall by 150 million tons per year by year 2020 if natural gas powered combined cycle plants replace coal. This is in addition to the material reduction in air pollutants such as carbon monoxide, non-methane organic gas and nitrogen oxides as well as ash waste.

Natural gas is a much more economical option for power plants to mitigate CO2 than carbon capture and storage (CCS). For the first time in history, natural gas is cost competitive with coal.

Substitution of natural gas in lieu of coal is taking place in the domestic power generation sector. The Energy Information Administration reports that, in February and March 2011, coal-fired generators had the largest year-over-year decline, down 6.9%. Natural gas prices are even lower today than last year, so this trend is likely accelerating.

Growth Potential for Natural Gas

In some applications, natural gas can be substituted for oil products (for example, as a boiler fuel or heating fuel instead of fuel oil). Because the price differential has made natural gas so much more attractive, most of the “easy” substitution that makes sense has occurred.

Because it is a gas at ambient temperature and pressure, natural gas is not easy to store or transport by vehicle. Natural gas is almost always delivered by pipeline (not to be confused with natural gas liquids such as propane, which are used as fuel in remote areas where pipelines are not cost effective). This is why we have traditionally considered it a “domestic fuel” with our imports coming by pipeline from Canada.

LNG – Import to Export

Liquefied Natural Gas (LNG) is natural gas temporarily converted to liquid form by cooling. LNG takes up about 1/600th the volume of natural gas in the gaseous state. In liquid form, it is possible to transport natural gas by ship in cryogenic containers.

Five years ago some companies were developing facilities to import LNG into the U.S. With the lower prices today, this development has reversed and companies are now working on LNG facilities to export U.S. natural gas.

Natural Gas as a Transportation Fuel – Compressed Natural Gas

Compressed Natural Gas (CNG) is being adopted by many government agencies and companies as a fleet fuel. The lower cost compared to petroleum, combined with the reduced emissions, makes this a very attractive fuel. However, the lower energy density of CNG compared to gasoline and diesel limits the attractiveness of this option. In addition, wider spread adoption of natural gas as a vehicle fuel would require major infrastructure development in compression and pipeline systems.

Gas-to-Liquids (GTL)

Major advances have been achieved in gas-to-liquid (GTL) technology. GTL overcomes the two major disadvantages of CNG. The liquid fuels produced using this process have comparable energy density to traditional liquid fuels refined from crude oil, and can be mixed with conventional liquid fuels and distributed through the existing systems that we use to distribute liquid fuels today.

Shell is a leader in this area. Shell developed its first Pearl GTL plant in a joint venture with the state of Qatar. This facility produces 260,000 barrels of oil equivalent per day of cleaner-burning diesel and aviation fuel, oil for lubricants, and ingredients for plastics and detergents from natural gas. The first shipment of refined products from this facility occurred in June 2011. Shell recently announced plans for a Pearl GTL plant in Louisiana.

Improvement to the National Income Equation

The current economic and political discourse revolves around decreasing spending and increasing taxes. These are painful choices, but the discourse is leaving out a key component: net exports (actually imports).

In elementary economics, the National Income Equation is defined as:

National Income = C + G + I + NX + net foreign factor income – indirect taxes – depreciation where:
C = Consumption
G = Government Spending
I = Investments
NX = net exports (exports minus imports)

Decreased Government Spending decreases Consumption. Increased taxes decrease Consumption and Investments. These options reduce National Income, shrinking the economy. This is the dilemma facing policy makers.

An improvement in Net Exports (a decrease in imports; reduction of the balance of payments deficit) would increase National Income. For decades we have run a trade deficit, primarily due to energy imports. Increased domestic energy production can materially reduce imports, increasing our National Income. This would be very constructive toward growing our way out of our current fiscal dilemma.

The potential also exists to break OPEC’s stranglehold on world oil prices. Replacing 10% to 20% of U.S. oil imports with domestic oil and natural gas has the potential to materially effect on world prices. Our goal should not be energy independence. It should be to develop sufficient energy supplies both domestically and internationally that no nation or cartel can manipulate world prices.

Conclusion

The decrease in natural gas prices over the last five years once again provides indisputable proof that free market forces control the price of oil and natural gas. Massive capital investment has produced new supplies, collapsing the domestic price of natural gas at the expense of the companies that made the investments.

Current natural gas prices below $2 per MMBTU are not sustainable. The cost to develop new natural gas supplies are in the $4 – $6 MMBTU range. But at a $4 – $6 MMBTU level, natural gas would still be about one-fourth the current world price of oil on an energy equivalent basis.

Natural gas is an excellent transition fuel for breaking the stranglehold of foreign suppliers and allowing the transition time period for the development of economically viable renewable energy. Natural gas should continue to take market share from coal for electric generation. The development of export systems and systems for expanding the use of natural gas into the transportation market will further expand supply.

Most renewables being implemented today are based on 20th century technology. Current investment should be in research and development of economically viable new technology, not installing cost ineffective alternatives which reduce our national economic output. Natural gas is cost effective, produces lower emissions and is readily available in the U.S. Gas can provide an economically viable energy supply while we develop alternative energy technology.

Natural gas can be a major contributor to reducing our balance of payments deficit by reducing oil imports, and possibly oil prices. This can play a major part in easing the difficult spending/tax choices we currently face in the government sector.