Beyond the Storm, Bright Horizons

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

Oil Price and US Production Volume

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

Declining Operating Margin Per Barrel

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

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

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

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

The Oil and Gas Industry

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

US Crude Oil Production and Rigs

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

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

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

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

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

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

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

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

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

Five States

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

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

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

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

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

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

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

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

Capitalizing on the Downturn

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

The investment thesis is:

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

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

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

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

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