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Mezzanine Financing: Portal to Profits

Recently, Arthur, Don and I, along with members of the Five States staff, have been meeting with investor groups throughout the country. We have been explaining the business plan of our capital partnerships and reporting on the ongoing activities and results of our currently active funds. What we have learned as we have committed capital to FSEC Fund 1 and those projects have matured, is that each project has yielded interesting insights about the clients with whom we are investing, while also providing opportunities to enhance the profitability of individual deals and to participate in financing other developing oil and gas projects. As we anticipated when we modified our business plan in 2007, the business of providing mezzanine financing is proving to be an effective means of opening doors to relationships that would not otherwise have been available to us.

The basic strategy of Five States is classic and fundamental: provide capital on projects in which we would like to own an interest. We provide capital to operators who need funds for making acquisitions, drilling development wells, buying lease equipment, constructing pipelines and gathering systems, and for other capital needs, while placing our investment in a preferred position. During the period funds are employed, Five States receives monthly interest payments and most of the revenue the project generates, before any payments are received by the operator, thus reducing our overall risk. When Five States recovers its committed funds and interest payments, it also receives an additional financial benefit. Most often this takes the form of a working interest in the production, but sometimes it may be a net profits interest or some other previously contracted fee. The ultimate objective of Five States is to accumulate equity interests in long-life, high-quality producing oil and gas properties. Therefore, we are always interested that the “residual interest” earned will have value for ourselves and our investors for years into the future.

For Five States, success in achieving our anticipated economic target depends largely on two factors: the character and ability of the operator to effectively manage the project, and the credit quality of the collateral available to guarantee the loan. An early decision about the operator and his staff’s reputation, knowledge, experience, and history is often sufficient to deter us from devoting excess time analyzing and evaluating the collateral.

Fortunately, during the more than 25 years of purchasing oil and gas properties, Five States has developed a highly qualified team of reservoir and operational engineers, financial analysts, and staff. These same people analyze the producing properties pledged as collateral with the same diligence and expertise they used in analyzing properties for acquisition. Although we never enter into a transaction with the expectation of foreclosing on the operator’s collateral, we need to ensure the collateral is of sufficient value to provide recovery of our loaned funds should it become necessary to do so.

The type of “bonus” opportunities that can occur in mezzanine financing are exemplified by two projects that evolved in the current partnership. One was a request to provide mezzanine financing to participate in drilling as many as 40 horizontal wells within the limits of a known East Texas field. Upon analysis, the capital required was more than the applicant was comfortable borrowing. As a result, Five States financed the borrower for as much as he needed, and Five States allocated partnership funds to also participate in drilling as a working interest owner. The partnership’s projected rate of return is estimated at 19%, and may prove even higher.

Another project involved a request by a company to participate in drilling unconventional Bakken wells in North Dakota. After review, we authorized a $16.2 million loan to be drawn from an $85 million facility, to be expended over a period of two or three years. However, soon afterwards, the borrower sold its position in the project to a third party, who paid off the Five States loan and plans to drill the field with the third party’s own resources. We would have preferred the initial borrower to remain as owner since the wells would have generated more revenue to Five States, but for us the transaction was profitable as a short-term investment. The partnership’s realized rate of return was 56% (about 28% “cash on cash” with the high IRR due to the short investment period).

The two lessons we have learned thus far are that by having funds available to offer for mezzanine projects, we attract “deal flow” that often provides associated opportunities to enhance the economic returns of a project for both parties. Second, the relationships and mutual trust developed with operators during the period of examination and negotiating one project often results in the operator bringing other projects to Five States for funding or participation that we may not otherwise learn about.

Cycles

The universe functions in cycles. Stars are born and die, providing the material for the birth of new stars and planets. Galaxies and solar systems revolve in their cosmic dance. Current theory holds that the universe began with a massive explosion of energy, and will continue to expand for millions of eons, at which point it will begin to collapse on itself in the ultimate cycle of existence as we understand it.

Here on earth, we live in a world of cycles. Night follows day. We rise, are active, tire and then sleep. Spring follows winter. Each generation is born, lives and dies, begetting another generation to follow the same cycle. Cycles of temperate and harsh weather are recorded throughout history. Periods of famine and periods of plenty have been the norm throughout human existence, documented as far back as Joseph’s prophecy to Pharaoh of “seven years of plenty followed by seven years of famine.” Archaeological records throughout the history of man show that this cycle was often the key driver of the birth and death of civilizations.

Many cycles that exist in nature and in human activity are long in comparison to the human life span. Currently geological theory believes that we live in an Ice Age, and that we are now in the Third Interglacial stage. Yet few of us are stocking up for the end of this interglacial stage and the resumption of the Ice Age. The longer the cycles, the more we perceive them as changes from “normal”. If we grew up under a certain set of circumstances, we consider them the norm and any change from that to be the exception. We thought my grandmother, who was a Depression orphan, was peculiar in her hoarding habits, always having two freezers full of food (in addition to the kitchen refrigerator, a cellar full of home-canned food and a garden) and saving used aluminum foil and jelly jars. But the Depression was her “norm”, and our time of plenty was an anomaly.

In our modern times, we have shielded ourselves from many of the impacts of natural cycles. We produce and store so much food that in industrial societies we no longer face the specter of famine. In many areas, we no longer even “suffer” the inconvenience of the seasonality of our favorite foods, shipping them half-way across the world so we can have fresh berries on our cereal every day. But the natural cycles are still functioning in the background, applying their pressure to various portions of the economy.

Financial cycles mirror natural cycles in many ways. In early civilization, agriculture was the primary industry. Times of plenty resulted in low prices of goods and higher standards of living. Hard times resulted in periods of economic contraction. As we all learned in school, the Great Depression was initially ignited by overexpansion of the agricultural sector followed by a great drought.

Financial cycles continue. The information technology boom of the last thirty years has apparently eliminated the inventory cycle, which was the most regular cause of business expansion and contraction. However, it did not eliminate the financial cycle, as we have so painfully learned over the last five years.

The current financial cycle began in 1981, when Paul Volcker, then Chairman of the Federal Reserve, decided to break the inflation cycle of the 1970s by raising interest rates. Treasury yields peaked at over 21%. President Reagan introduced a series of new policies targeted at cutting government spending offset by lower marginal tax rates to counter the contractive effect of reduced government spending. The higher interest rates squelched the inflation, and the lower marginal tax rates stimulated the economy, but the spending cuts were never achieved. The decline in inflation translated into declining interest rates, which set off a price/earnings expansion cycle in both financial assets and real property values that lasted 25 years.

Declining interest rates resulted in a rise in the value of all income producing assets. If one could no longer get 20% interest on their government bonds, then they would consider paying more for stocks, bonds or real estate, thus driving up the price of those assets and driving down the yields. With the Federal Reserve continually lowering interest rates, the economy grew and we were able to ignore the time bomb we had created in the actually unsound social entitlements that Congress continued to expand. We now hear some pundits speak of the current situation as “the end of . . .” (fill in the blank depending on the political leaning of the speaker), requiring drastic measures (personally, I think a little pragmatic reassessment of our expectations would go a long way to resolving these issues). Asset values escalated beyond sustainable fundamentals. The sub-prime collapse is often credited with causing the boom, but in reality it was the inevitable end of a 25 year expansion that had been manipulated to last beyond all reason. Asset values were materially overinflated. A correction was past due.

In the background to this drama, and influencing the boom and the bust, was the evolution of the energy market. Prior to 1970, the world oil market was effectively controlled by the United States (history students will recall that the Japanese attack on Pearl Harbor was in retaliation for the Roosevelt Administration’s blockade of Japan’s oil supply in Indonesia). During that period, the Texas Railroad Commission was successfully manipulating the deliverable oil supply to maintain a constant oil price. In the early 1970s, the leaders of the OPEC countries (Saudi Arabia, et. al.) realized that the United States no longer had the production capacity to control world oil prices, but that OPEC functioning as a cartel could. With the Arab Oil Embargo of 1971, OPEC set off the resumption of the boom/bust energy cycle that began in the early years of the industrial revolution, which was only briefly interrupted by the success of the United States in manipulating the world market in the early 20th century.

Energy cycles are long. The last two have been particularly extreme. The 1970s/early 1980s boom resulted in the development of excess deliverable supply, resulting in a fifteen year bust that lasted from the early 1980s through the 1990s, when oil and natural gas sold at prices below replacement cost. As the excess deliverable supply was consumed, the current growth cycle in the energy industry began. The consensus of many pundits was that “this is the end, we are running out and oil and natural gas prices can only go to the moon.”

The length of the bust impacted investor and government behavior during that portion of the cycle. The low energy prices contributed materially to the economic stimulation of declining interest rates during the 1990s. Little money was invested in energy conservation. Despite the lessons of the oil embargoes, gas guzzlers once again became the vehicle of choice. Little capital was invested in new oil and gas exploration and recovery technology. The trend was one of rising demand in the face of falling supply.

By the early part of the last decade, the excess deliverable supply was used up, as the existing producing properties followed their natural decline and consumption continued to increase. As expectations of higher oil and gas prices resumed, capital returned to the energy sector. Focus on conservation returned. Research and development into ways to consume energy more efficiently once again came into focus. New technology developed over the last two decades was applied to exploration and recovery. The results have been stunning.

Natural gas closed below $2.50/mmbtu last week – a price level not seen on a sustained basis since 2002. Natural gas prices peaked at over $10 in 2008. The current collapse is due to the success of the development of shale reservoirs, which has turned expectations for the U.S. natural gas supply on its head. It is now estimated that the U.S. have as much as 100 years of reserves based on current projections of future demand. Five years ago projects were under way to import liquefied natural gas into the U.S. Now the cycle has reversed and several projects are underway with the goal of exporting U.S. and Canadian natural gas.

The same technologies that are used to develop shale gas formations are also being successfully applied to shale oil formations. Ten years ago, Five States scoffed at a U.S. Geological Survey estimate that the Bakken Shale formation in North Dakota, Montana and southern Canada might be the largest oil field in North America. [sentence omitted from original article]

This is a paradoxical time for us in our planning. Oil and natural gas markets are moving in opposite directions for the first time. Oil is booming while natural gas is crashing. We are grateful that we sold our gas properties in 2007 and are in a position to once again accumulate natural gas properties when the market presents opportunities. We continue to actively solicit natural gas acquisition opportunities. Depressed markets are often the best environment for making great value acquisitions. However, failure of regulators to enforce traditional discipline on over-extended banks continues to allow them to keep non-conforming producing natural gas off the market, “waiting for the market to recover”.

As Jim discussed in his article “The Froth is on the Punkin’,” it feels like boom times in the oil business. There is an atmosphere of frenzy around several of the major oil plays. Articles are being published rationalizing why it is different, and why oil prices cannot fall. We are bullish on oil over the intermediate to long term. But one concern is that the pace of development could result in short-term periods of excess deliverable oil supply resulting in unforeseen corrections in oil prices. The investment structure of Five States Energy Capital, LLC allows us to continue to participate in high quality acquisition and development projects, but to do so in a preferred position. With the customer (the producer/borrower) in the “first loss” position, and our crude oil production hedging program limiting short-term price exposure, Five States can remain active in the oil sector without exposing investor capital to the risk of material loss in the event of a short-term price collapse.

Our biggest concern is the continued efforts of government to thwart the cycles. Some steps taken in the Troubled Asset Relief Program (TARP), signed into law by President Bush, stopped the collapse. But the shoring up of overinflated markets left excessive loans on the books of many financial institutions, resulting in the “investment bubble” in real estate and in other sectors never fully correcting. The financial reform bills passed by the Democratic controlled House from 2008 to 2010 avoided key issues, and left those most responsible unaccountable and further entrenched “too big to fail”. The current Republican controlled House has done nothing to address these issues and there has been no leadership in this area from the White House. The excesses that led to the debacle are as bad as ever. Not only do we have gridlock in Washington, but we have gridlock in several key sectors of the financial system. We do not believe this is sustainable. It is a scary time.

Five States Energy Capital, LLC Announces $85 Million Financing for Bakken Shale Producer

Dallas, Texas – August 29, 2011 – Five States Energy Capital, LLC (“FSEC”), which provides Independent Capital for Independent Producers®, is pleased to announce the closing of $85 million in financing for a Bakken Shale Producer (“Client”) on August 18, 2011 to further develop its Bakken assets and acquire additional working interests in the trend.  The financing agreement consists of a $25 million senior credit facility, $50 million junior credit facility and $10 million acquisition facility.

After assessing several financing strategies and proposals, FSEC was selected by the Client as its preferred partner partly due to FSEC’s own experience in the participation of drilling oil and gas wells in the Bakken the past 6 years.  The Client expects to participate in the drilling of an additional 50 Bakken wells in the next 18-months in Williams and McKenzie Counties, North Dakota.

“We are very excited to enter into this financing agreement.” said Five States Energy Capital, LLC President and CEO, Arthur N. Budge, Jr.  “We have been active in the Bakken for several years, and we continue to search for ways to participate in the development of oil and gas assets in the trend.  We expect this partnership to be mutually successful for several years as we partner to further develop these assets.”

About Five States Energy Capital, LLC

FSEC was established in 2007 to provide 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.

For more information contact:

Dallas Office: 4925 Greenville Avenue, Suite 1220 • Dallas • Texas • (214) 560-2573