Category Archives: Arthur N. Budge, Jr.

All Good Things Must Come to an End

The Proposed Liquidation of Five States Consolidated I, II & III, Ltd.

Investments in Five States Consolidated I, II & III, Ltd. (“Legacy Funds”) have been generating returns for investors for fifteen to thirty years. The average investor has received over three times his invested capital in distributions, for a weighted average Internal Rate of Return (“IRR”) of over 20% net to the investor. However, the assets making up these funds have depleted to the point that they can no longer carry the overhead needed to maintain the funds.
Lower oil and natural gas prices combined with normal depletion have resulted in the income from the Legacy Funds declining to a level that is close to break-even after overhead and debt service. For the majority of investors, the residual value is no longer material relative to their original investment, nor worth the cost and administrative “hassle” of owning the funds. Management is therefore proposing that the funds be liquidated.

Fund Life Cycle; Why Liquidate?

Oil and natural gas properties are depleting assets. It is the nature of an oil and gas fund to reach a point where declining volume combined with increasing operating expenses and overhead on a per barrel basis translates to diminished distributions. The high oil prices in the 2005 – 2014 period greatly extended the economic life of the Legacy Funds. The price decline since 2014 had the reverse effect, materially reducing the profitability and economic life of the funds.
Distributions have been minimal/non-existent for several years. Unless oil prices increase above $60 and remain there, or material capital investments are made in the form of property development through drilling/re-drilling, distributions will not increase/resume for several more years. The Legacy Funds are not financially viable enough to borrow enough money to make the potential capital investments in the future. Capital investments would require infusions of new equity.
Restructuring of the Legacy Funds would be required in any event. Reservoir depletion results in lower production volumes over time. The “fixed costs” of operating expenses and overhead increase both on an absolute basis and as a percentage per barrel produced. Expense items such as engineering, evaluating lease operating expenses and third-party operator charges, plugging expenses on abandoned wells, annual audits, tax returns and state filings are fixed charges and tend to increase over time.

Why Not a Legacy Funds Reconsolidation?

Late last year we discussed a “reconsolidation” plan. However, given the projected income after operating costs and overhead, the expense burden is still too heavy. Following a reconsolidation, forecast initial yield would still be nominal relative to the liquidation value of the funds. Liquidating the funds will maximize distributions to the investors, assuming current oil futures prices.
The good news is that there is still value in the properties that can be captured through liquidation. The net liquidation value is over $10 million after payment of all liabilities. In a liquidation value calculation, overhead costs are not included in the calculation of present value.

Proposal for Five States Energy Company to “Buy in” Investor Units

Five States Energy Company, LLC (“FSE”), the General Partner of the Legacy Funds, will make a cash offer to buy in the interests of all limited partners in the Legacy Funds. This would be a cash tender offer based on our calculated liquidation value using the same methodology on which we report each year. This valuation would not include any “burden” for fund level G&A/overhead on a “go forward basis”, or any implied sales costs such as sales commissions, etc. The investors would pay the “wrap up” costs of the individual partnerships (final audit and tax return).
Our logic is that FSE owns 25% of each fund. When combined with the direct ownership in the funds by the stockholders in FSE, the General Partner group owns over 50% of the total value of the Legacy Funds. Two-thirds of the limited partners on a “head count” own less than 10% of the total value of the Legacy Funds. This clearly results in an “overhead imbalance”.
FSE proposes to buy the producing properties from the Legacy Funds rather than conduct a third party sale. FSE has sufficient net worth and can absorb most of the fund overhead and costs through its current structure. Valuation of the producing properties will be calculated at a 9% net present value (PV9). This is about 11% higher than the industry standard 10% net present value (PV10). Proved non-producing assets (Behind Pipe, PDNP and PUDs) will be valued at PV9 and reduced by 50%, 50% and 70%, respectively (standard industry “risking”). The risking is less in some cases. We believe this is fair and equitable pricing for a portfolio of non-operated working interests. The costs associated with a public sale and the risk of a lower bid at auction will be avoided. The valuation will be audited by an independent third-party engineering firm.
This seems like a “fair” time in the oil price cycle to do this. During the life of the funds prices have ranged from $10 to $147 per barrel. Current wellhead prices are in the mid $60s and appear likely to stay in the $40 to $65 range for the next five to ten years. Wellhead prices are currently at the high end of that range. Having just had a major recovery from the $30/$40s, we feel that this is an appropriate time to liquidate the funds.

Optional Sale at Auction

Some investors have expressed concern with a conflict of interest in that FSE is the buyer in this transaction. If over twenty percent of those who do not accept the offer from FSE wish, we will carve out their share of the producing properties and sell them at auction on Energy Net, the largest on-line auction house for oil and gas properties. At auction these properties may receive a higher or lower value than FSE is offering. The amount received will be distributed to this subset of limited partners, less their share of the partnership wrap-up costs.
FSE may bid on these assets at auction. FSE would do so in a “blind” format, so that others in the auction could not see that FSE is bidding. If FSE is high bidder at a value lower than that offered prior to the auction, it will pay this lower price to the subset of investors choosing the auction, not the original offered price.

Why Not a Sale to FSEC Fund 2?

A sale of the properties to FSEC Fund 2 is not contemplated because FSE would be the recipient of the bulk of the sale proceeds. This could be misconstrued if oil prices were to move significantly in either direction.

Conclusion

It is bittersweet to shut down our funds that have performed so well for decades. We are proud of our record of a weighted average 20% IRR and over 3:1 cash on cash returns. But we believe liquidation is the optimal decision for our partners, and we are pleased that we can liquidate the funds with a nice final cash distribution.
The liquidation of our fifteen to thirty-year-old funds does not imply withdrawal by FSE from the market place. Five States plans to continue offering production investment funds in the future. To a large extent we “stayed out” when the market was valuing assets on “$100 per barrel oil”. Now that oil and natural gas prices are back to levels we consider reasonable, we are aggressively pursuing acquisitions again.
We believe the market for investing in producing properties is the best we have seen since our major liquidity event in 2006/2007. We are working on placing the remainder of the FSEC Fund 2 capital now and plan to launch FSEC Fund 3 this summer.

Déjà Vu All Over Again (Again)

Those who have read my articles over the last 25 years know my favorite Yogi Berra quote: “It’s déjà vu all over again.” This is such an apropos description of the oil business I can’t resist continuing to use it frequently.  In this article, I will discuss how the oil and gas industry went from boom to bust and how Five States as a value investor intends to take advantage of the opportunities the bust has created.

The oil and natural gas industry is very cyclical. Oil and natural gas supply and demand are very price inelastic[1].  This results in small changes in supply or demand having a material impact on wellhead prices.  Drilling projects require large capital investments with long cycle time between commitment and deployment.

Producing oil and natural gas properties[2] have a lot of operating leverage[3].  During periods of expansion, “Wall Street types” want to “teach” oil producers “financial engineering” (financial leverage, i.e. using more debt).  This increases total leverage, further increasing fixed costs, thereby increasing risk and volatility.  The combination of these factors results in a recurring pattern of boom and bust.

Today we see the cyclical pattern playing out again. Too much oil production has resulted in lower oil prices.  The oil patch is in the middle of a financial wash-out due to lower wellhead prices combined with too much debt.  The U.S. is once again the world’s largest oil producer, providing the increased supplies that caused oil and gas prices to fall.  Capital investment in new development (outside of shale) is slowing around the world.

These cycle changes are normal for this industry that has enabled the creation of our modern economy. Consensus is that the U.S. will remain the world’s marginal oil producer for the next decade or longer[4]. The U.S. can currently produce as much oil as the world economy demands, but only at high prices.

By the most optimistic forecasts, solar, wind and other renewables will not have a major impact on world oil or natural gas demand for at least a decade or longer. Neither will electric cars.  The most impactful change is the shift from coal to natural gas as the primary fuel used to generate electricity (natural gas now exceeds coal and will continue to take market share from coal[5]).  For the next twenty years, world demand for oil and natural gas will continue to increase, depleting the lowest cost shale formations which over time will result in rising prices.

World Supply and Demand and Future Oil Prices

Oil trades in a world market. Oil prices are a function of world-wide supply and demand. Despite increased U.S. production, if world demand grows faster than world supply the price of oil will increase.  Almost all major forecasts predict increased demand for oil over the next decade.[6]

Future prices for natural gas are less clear. Natural gas is the most logical fuel to transition the world away from coal as the world’s primary energy commodity.  It provides the most environmental benefit per dollar invested (more than solar or wind).  However, U.S. reserves are so plentiful that it may take a long time for the price of natural gas to increase materially.

The U.S. shale boom resulted in a huge reversal in oil and gas supply trends. The development of unconventional resources (production from shale formations) resulted in a renaissance in oil and natural gas development in the U.S.  These new U.S. shale deposits account for more than 80% of total world shale oil reserves.  By comparison, the Energy Information Administration (EIA) estimates total world conventional proven oil reserves to be 1.7 trillion barrels, and unconventional reserves to be 5 trillion barrels.  The U.S. now has over half of the proven world oil reserves.  However, much of these reserves are only economically viable at prices over $60 per barrel.

Increased supply from shale production has resulted in lower world oil prices and the belief that the U.S. can become energy independent. But the EIA, in its Annual Energy Report 2017[7], projects U.S. shale oil production in the U.S. will peak in the next decade. The peak may be reached as early as three to five years from now, or it could take ten years or longer.  Given that 80% of the world shale reserves are in the U.S., it is likely world shale production will peak near the same time as U.S. production. Unlike oil, the unconventional natural gas supply in the U.S. is expected to last for decades without any impact on the ability to develop new supplies.

Prohibiting exports would not make any difference. In fact, allowing free trade in oil and natural gas should result in slightly lower world prices. With a near “unlimited” supply, natural gas prices will be determined by the marginal cost to produce natural gas relative to demand, and thus should remain around current levels.  The U.S. will remain a net importer of oil for the foreseeable future, but should become a major net exporter of natural gas.

According to the EIA we have plenty of oil and natural gas. The key questions from an investor standpoint are “at what price?” and “for how long?”  Maintaining the supply of unconventional crude oil will require higher prices[8].  A widely accepted estimate is that crude oil needs to be above $60 per barrel to sustain current production volume.  Recently we have seen improving statistics on a cost per barrel (oil) basis and cost per mcf (gas) basis.  But as the best shale oil reserves are depleted, the sustainable wellhead price per barrel must increase to support the development of lesser quality reserves.  Over time, the trend will revert to upward pressure on oil prices.

 

Value Investing Defined

Motley Fool defines value investing as “investing in assets trading at prices below their Intrinsic Value. Value investors, therefore, are essentially buying assets at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their Intrinsic Value.

To better understand value investing, investors should understand a few related terms:

  • Intrinsic Value: An estimate of an asset’s worth. Importantly, intrinsic value differs from an asset’s Market Price in that it represents the calculated present value of the underlying income stream.
  • Market Price: The price at which an asset is trading at any given time in the asset’s market. Value investors hope market price volatility will occasionally drive an asset’s market price irrationally below its Intrinsic Value, thus creating a value investing opportunity.”[9]

Five States applies this logic to investing in proved, producing oil and natural gas properties. However, there is one caveat to the Motley Fool definition.  If oil and natural gas properties can be purchased for their Intrinsic Value, an investor can earn the implied rate of return as current income over time from owning the asset.  The investor does not have to sell the asset at a Market Price exceeding the Intrinsic Value to make a profit.

The Intrinsic Value of a property is calculated using traditional fundamental analysis.  Engineering forecasts on the future production volume from a developed field are prepared.  Forecasts of production volume on mature, proved developed fields tend to be very accurate in a portfolio context.  Future oil and natural gas price forecasts and production expenses are then used to calculate our forecast of Present Value[10] of projected future income.  A standard reference discount rate is 10%+/- (before the impact of G&A and any debt leverage).  This is referred to in the industry as the PV10 value (PV for present value, 10 for the 10% discount rate).

A buyer may adjust the discount rate up or down depending on his subjective assessment of risk and quality of the producing properties. The likelihood of more income than forecast over the long-term from future development that is not included in the projected income may also be a factor in using a lower discount rate.  If the Market Price of a property is at or below the Present Value of future projected income (the price that generates our target rate of return), a value investor will buy it.  If not, they would pass.  Most of the time during the last decade, the Market Price of producing properties has been higher than the Intrinsic Value.  Over the last three years, this trend has reversed.

Value Investing requires discipline, and results in very few exciting transactions. It tends to be a slow return process.  An investor must wait to invest when the Market Value is greater than the Intrinsic Value.  It can be like a day of fishing where they don’t bite very often.  You get frustrated, but over time you catch enough to get you to keep putting your line back in the water!

I find Value Investing the most logical way to deploy capital in the oil and gas sector.  But it requires patience, discipline, and can be counterintuitive in execution.  The best time to buy often does not feel right. Intrinsic Value often equals or exceeds Market Price following a decline in the overall sector, when investors are hurting from overpaying when the Market Price was higher than Intrinsic Value.  Market momentum does not matter in Value Investing.

Over the last several decades, most Value Investing has been in the form of private equity.  In the public markets, the most successful investors were executing growth strategies that benefited from declining interest rates through price/earnings expansion[11].  Since the early 1980s, investors have been willing to pay ever higher prices, in essence accepting ever lower yields, for stocks and bonds.

Private equity investors using value strategies have been able to compete in part by capturing the Liquidity Premium[12] inherent in illiquid assets.  They could then arbitrage the difference between the private and public market valuations on exit, by buying in the private market and selling in the public market.  Examples of the Liquidity Premium are easiest to see in real estate and oil and gas.  Real Estate Investment Trusts (REITs) and energy Master Limited Partnerships (MLPs) have traded at 1.5 to 2.5 the private market value of the underlying assets.  This has always seemed like a huge premium for liquidity to me.  With interest rates bottoming, the arbitrage potential has become less available.  However, the liquidity premium can still be captured through new investments in oil and gas properties.

Value Investing in the Oil Patch

The Market Price of producing oil & natural gas properties is a function of three factors:

  • Expected Future Price of oil and natural gas and expenses
  • Discount Rate on which the Present Value of properties is being calculated
  • Sentiment, manifest in Availability of Capital and Supply of Producing Properties for sale

Future Prices are currently much lower than they were forecast to be a few years ago. This has resulted in a decline in the value of proved producing properties of two-thirds to seventy-five percent[13].  A property that would have sold for $1 million or more in 2014 has a present value today of $250,000 – $350,000, and can be purchased to generate first year free cash flow of over 10%.

Discount Rates currently used by the market when calculating the Present Value of properties are “reverting to the mean.”  When properties could be financed with debt at 4% to 8% interest, competitors were using discount rates of 8% or lower.  Now that “cheap leverage” is no longer available, discount rates are reverting to the long-term range of 8% to 15%.

Sentiment is more negative than it has been since the late 1990s. The discipline of Capital Rationing[14] has returned to the oil and gas industry. Capital Rationing reflects a limit of capital available to a business relative to the amount of investment opportunities they have that are projected to generate a return higher than their cost of capital.  Capital rationing has historically been the norm for the oil and gas industry. An oil company almost always has more investments it projects to be profitable than it has access to cash with which to drill those prospects.

During the boom oil companies could get all the funding they wanted for almost any project. Many projects that were funded are not profitable at current wellhead prices.  Most new acquisitions made toward the end of the boom when oil prices were higher will never achieve payback of the investment.  Many oil companies are now in a debt or liquidity squeeze. Debt levels that three years ago looked conservative have proven to be excessive. Capital investments in oil and gas are now more disciplined, providing a greatly improved environment for deploying new capital. This is providing both an increased supply of assets available for purchase and an improved environment for companies like Five States who are making new oil and natural gas investments.

Conclusion

2018 is starting to feel a lot like the 1990s:

  • Oil & natural gas properties can be purchased on attractive valuations based on today’s wellhead prices.
  • Intermediate to long-term expectations are for higher oil prices. But the Market Price of producing properties today does not reflect material increases in oil prices over the next decade.
  • Capital rationing is creating a greater supply of mature properties than has been available for purchase in over ten years.

This sets up a great fundamental investing opportunity:

  • Market Values are once more aligning with Intrinsic Value. Producing properties can be bought at the most attractive value available in over a decade.
  • Current Yields on producing properties are extremely attractive compared to stocks, bonds or real estate. Yields on newly acquired mature producing properties can be expected to exceed rates currently available from junk bonds with much better “collateral coverage”.

This provides an ideal Value Investing opportunity.  New investments will provide an attractive yield to cover the “time value” of owning properties.  At the same time, an investor has a “free option” on the upside potential in oil prices. Under this scenario, the timing of the inevitable increase in prices is unimportant.  An investor can collect an attractive yield each year while waiting for the price increase.

The key to success will be accumulating good quality, long-lived production at or below Intrinsic Value and managing and administering those assets efficiently. This is the basic strategy Five States executed in our first twenty years.  It really is like déjà vu all over again (again)!


[1] Inelastic is an economic term used to describe the situation in which the quantity demanded or supplied of a good or service is unaffected when the price of that good or service changes. Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged. https://www.investopedia.com/terms/e/inelastic.asp

[2] Producing oil and natural gas properties are defined in this article as oil and gas wells that have been drilled, completed, and on production for several years. This provides historical production and operating expense data for forecasts of future income.

[3] Operating Leverage describes businesses or assets with a high fixed cost structure. Businesses with high operating leverage cannot reduce their costs when prices for their product fall. This results in a rapid erosion of their profit.

[4] https://oilprice.com/Energy/Energy-General/U.S.-Shale-A-Marginal-Not-Swing-Producer.html

[5] https://www.eia.gov/tools/faqs/faq.php?id=427&t=3

[6] Energy Information Administration (EIA) International Energy Outlook 2017, page 35

[7] Energy Information Administration (EIA) Annual Energy Outlook 2017, page 43

[8] Energy Information Administration (EIA) International Energy Outlook 2017, page 13

[9] https://www.fool.com/investing/2016/12/09/what-is-value-investing.aspx  I substituted “asset” for “stock”.

[10] Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.  https://www.investopedia.com/terms/p/presentvalue.asp

[11] Price/earnings expansion defined https://seekingalpha.com/article/4128629-price-earnings-ratio-expansion-explained-care

[12] Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects. https://www.investopedia.com/terms/l/liquiditypremium.asp

[13]

The decline in the value of properties is discussed in my 3rd quarter 2015 article in The Producer.

https://fivestates.com/change-in-the-oil-industry-and-the-impact-on-five-states/

[14] Capital Rationing in the Oil and Gas Industry is discussed in detail in my 1st quarter 2015 article in The Producer of the same name. https://fivestates.com/capital-rationing/

Five States Legacy Fund

We have been attempting to wind-down and liquidate Five States Energy Capital Fund 1, LLC (“Fund 1”) this year. Until the last few weeks we thought we were on schedule to do so. However, for reasons discussed in this article, we do not expect to be able to do so until next year.

We plan to propose in 2018 that the producing properties owned by Fund 1 be contributed to Five States Legacy Fund, LLC (“Legacy”), a new entity, in exchange for units in that entity.  We plan to simultaneously propose the consolidation of the three Five States legacy partnerships, Five States Consolidated I, Ltd., Five States Consolidated II, Ltd. and Five States Consolidated III, Ltd. (“Cons 1, 2 & 3”) into Legacy. We are targeting the consolidation to occur effective December 31, 2018.

We originally anticipated completing the consolidation by December 31, 2017. However, issues involving Fund 1 require it to exist into 2018.  Consolidating Cons 1, 2 & 3 into Legacy in 2017 then adding Fund 1 assets the next year does not make sense economically or administratively.

Fund 1 Liquidation

The Rule 144 holding period (six months from the acquisition date) for the Plains All American units (NYSE: PAA) received from the sale of Advantage Pipeline has lapsed.  However, we were informed in late October by PAA counsel that, although the PAA stock is marketable, they will not transfer shares without the Rule 144 “legend” until April 2018, the twelve-month anniversary of the Advantage sale.  We anticipate distributing the PAA stock to Fund 1 investors as soon as the legend is removed in April 2018 or shortly thereafter.

We also learned in late October that the Great Northern Midstream (“GNM”) lawsuit, which involves the distribution of the remaining escrowed sales proceeds, will likely not settle before year-end.  Therefore Fund 1 will not receive the remaining cash or final K-1 from GNM until 2018.

Following the PAA distribution, the remaining assets of Fund 1 will be cash and receivables, and an interest in North Permian Well Service (“NPWS”).  This asset is currently “on the market”.

All net cash and proceeds from the various sales will be distributed to the Members. If consolidation is approved, producing properties in Fund 1 will be contributed to Legacy.

Investors who choose to stay will receive a pro rata share in Legacy.  Those who wish to liquidate will be paid their pro rata share in cash.

Cons 1, 2 & 3 “Reconsolidation”

This proposed consolidation is the same process used when we formed Five States Consolidated I, Ltd. in 2000, Five States Consolidated II, Ltd. in 2005 and Five States Consolidated III, Ltd. in 2009.  Continued depletion has reduced the production volume from the partnerships over the last decade. The retrenchment in oil price over the last several years has reduced the cash flow from each partnership.  General and administrative costs are consuming a material part of the cash flow from each partnership.

Cash Tender Option

The remaining value to some investors in the various funds is small after twenty or more years of distributions and depletion. We recognize that some investors may elect the “tender” purely from a “size” perspective.  Others may no longer wish to participate in oil and gas investments.

Investors who do not wish to participate in the consolidation will have the opportunity to “tender” their interests for sale for cash at the time of consolidation. The valuation for the tender will be the same as the values used in the consolidation.

If necessary, we will raise capital through the sale of units in Legacy to generate cash to pay to exiting investors who choose to tender. Management plans to participate for its pro rata share in any additional funds raised.

Consolidation Logic

The producing properties that are owned by the four entities are the type of assets we continue to target for new investment. We believe a “restructure” that results in a financially stronger entity is advantageous to all involved.  We estimate attractive quarterly distributions relative to the liquidation value of the assets following the consolidation.  We also believe there is significant potential for increased returns from continued development of these assets and from the possibility of higher oil and natural gas prices over the long-term.

Investors in any of the four entities who do not wish to participate in the consolidation will be offered a cash liquidation option. For those who elect the cash option, we believe that the lack of transaction fees and the appropriate risking of undeveloped reserves results in an attractive exit.

For regulatory purposes[1], Legacy must be composed only of working interests. Legacy will not include any securities such as notes receivable or LLC interests.

Benefits to forming Legacy include:

  • Continue to hold high-quality long-lived properties for Income and Appreciation. We would resume quarterly distributions to all investors.
  • Decreased general and administrative costs. The savings are primarily attributable to a material reduction in the combined professional fees (tax returns and audits).
  • Enhanced property diversification. As properties in the partnerships deplete, the remaining value of each partnership becomes concentrated in a smaller number of properties. Consolidating the partnerships will increase the well, field and geographic diversification, providing the partners with diversification closer to that of the original partnerships.
  • Low Average Debt Ratio. The debt ratio of Legacy following the consolidation is estimated at about 30% – 35% of the value of the properties. A senior debt ratio of 50% is considered normal.
  • Improved operational decision-making. Consolidation allows us to make prudent capital expenditures to enhance the long-term value of partnership assets, without as much concern for the impact on quarterly distributions. This mitigates the predicament of being hindered from making large capital expenditures when warranted because the size of a partnership has decreased.
  • Improved administrative efficiency. Several properties are owned by more than one entity. Consolidation will increase administrative efficiency.

Valuation Methodology for Consolidation

The price proposed for the consolidation will be the present value of the producing properties owned by each entity using current oil and gas price assumptions and a 10% discount factor, increased or reduced by outstanding debt, hedge positions and working capital. There are no imputed transaction costs or fees.  Each entity will be allocated a pro rata share of Legacy based on these values.

For example, if a fund is valued at $200 and the total value of all entities is $1,000, then the investors in that entity would be allocated 20% of Legacy.  The valuation of the properties in each entity will be audited by an independent engineering firm.  Details on valuation will be distributed upon completion of the audit.

Debt

Legacy will have debt in its capital structure. The debt of the partnerships participating in the consolidation will be assumed by Legacy. In addition, Legacy may borrow funds to acquire additional properties in the future. The total debt of Legacy is estimated to be in the range of 30% of total asset value.

Hedges

Legacy will assume the existing hedge positions of the four participating entities. The hedge positions are included in the economic analysis.  The settlement value at the time of closing will be “netted” from the allocation value.

Consolidation Process

Investors and financial advisors will receive a Private Placement Memorandum for Five States Legacy Fund, LLC.  They will also receive a schedule of their pro rata share of the calculated value of their interests in the entities being consolidated. Investors will be asked to vote for the consolidation.  They will also be asked to indicate whether they will participate in the consolidation or liquidate.

Following are approximate dates anticipated in the consolidation process:

June 2018                 Private Placement Memorandums distributed

August 2018             Ballots from all investors due back to Five States

December 2018        Effective date of consolidation

Conclusion

Five States senior management continues to believe that high quality domestic oil and natural gas properties are an attractive long-term component to a diversified portfolio. Jim and I plan to continue operating Five States into the foreseeable future for ourselves, our families and our investors who share our expectations and investment philosophy.  We believe that we are on the cusp of a very good period for making new oil and gas investments.

As with previous major corrections in the oil and natural gas markets, the rationalization of value has taken years. We are seeing credit tightening by many banks, tighter regulation of oil and gas loans by the OCC and bankruptcy of competitors.  We are also seeing capital rationing returning to the oil and gas markets, resulting in more conventional properties coming on the market than we have seen in a decade.  These are the conditions that are best for value investors like Five States.

Continuing to hold the portfolio of high quality long-lived assets through Legacy is consistent with that philosophy.  This proposal provides a good option for all investors.  Those who share our philosophy and expectations can continue to participate in owning these assets. For those who do not share our philosophy and expectations or who no longer wish to be invested in this sector, this proposal will provide a liquidity option over the next year.

The economic benefits of forming Legacy to “holders” include reduced overhead, no “dead deal cost” and strong understanding of the undeveloped reserve potential in a long-lived portfolio of producing properties.  For those choosing the cash tender option, there will be no commissions or fees burdening the sale, and the valuation includes appropriate risking (good value) of the undeveloped reserves and avoids the risk of discounted valuation on the sale of the small working interests.

We hope you will join us by endorsing this proposal as we work through 2018. Please call me at (214) 560-2569 with questions or comments.

If You Don’t Have an Oil Well

When I was a boy growing up in West Texas in the 1960s, there was a frequent television commercial for the Western Company[1].  The ad concluded with a beautiful young woman in roughneck overalls and a hard hat hanging off the side of a drilling rig, speaking the famous tag line:

“If you don’t have an oil well, get one! You’ll love doing business with Western!”

Although I don’t attribute my desire to own oil and natural gas production to Eddie Chiles, I still believe that owning producing properties is an outstanding portfolio component.

At Five States we were excited in early July to close our first investment in several years in a group of producing oil properties for FSEC Fund 2. Based on recent calls from investors, I decided to cover some “whys” in my article this quarter:

  • Why Own Direct Oil & Gas Interests?
  • Why Is It Taking So Long to Deploy New Funds?
  • Why Is It Worth the Wait?

WHY OWN DIRECT OIL & GAS INTERESTS?

The primary reasons to own producing oil and natural gas properties in a portfolio include:

  • Current Return – producing properties provide return through current cash income, unlike many other asset classes where the investment must be liquidated to realize the majority of the return.
  • Inflation Hedge – increasing energy prices have been a core component to price inflation over the last fifty years.

 

 

 

 

 

 

 

 

 

 

  • Attractive Total Return – producing properties have priced at a net present value of engineered future cash flow in a range between 8% – 12% (unleveraged) for much of the last thirty years.
  • Why Not Oil & Gas Stocks
    • Low Correlation – the return from producing properties has a low correlation to financial assets. The following correlation coefficients are calculated on the changes in oil and natural gas prices to the other asset classes.

 

 

 

 

 

    • Liquidity Premium[2] – some advocate that owning energy stocks to invest in oil and gas entails a high liquidity cost. Sabine Royalty Trust (“Sabine”) is a mature oil and gas royalty trust. Following is a comparison of the Market Cap of Sabine compared to the Net Present Value (“NPV”) of its oil and gas holdings calculated at a 10% discount rate[5]. The liquidity premium; the difference between the Market Cap and the PV10%[6] value of the PDP Sabine owns is currently almost 4.5x. This is over twice the average liquidity premium in the 1980s and 1990s. This is a huge cost if the investor plans to make a long-term investment in oil and gas for income. Oil and gas “flow through” vehicles such as Royalty Trusts and MLPs[3] (much like REITs[4], except that they invest in oil and gas) accumulate properties in a publicly traded investment vehicle and distribute the income to investors. These are the “purest plays”, as the assets consist almost entirely of oil and gas production.

 

WHY IS IT TAKING SO LONG TO DEPLOY NEW FUNDS?

The market for direct oil and natural gas properties has been in a state of flux since the crash in oil prices. As discussed in my fourth quarter 2016 article in The Producer, the 50% drop in oil corresponded to a 75% drop in the PV10% value for producing properties. The Proved Non-Producing and Proved Undeveloped (“PDNP” and “PUDs”) declined as much or became worthless.

The typical first lien loan advance rate on an oil and gas production loan is around 60% of PV10%. Therefore, without making aggressive assumptions about price recovery, most loans have been “underwater” by historical underwriting standards. The decline in oil prices from $85 per barrel to $45 per barrel resulted in an average decline in loan value of 80%, so the net present value of the collateral for most production loans fell below the loan amount.

 

 

 

 

 

 

 

 

 

Lenders have been holding onto underperforming loans, hoping for a partial recovery. Throughout the last ten quarters, many analysts have been calling for a quick recovery back to $60 per barrel. A recovery of oil prices back to $60 per barrel would have resulted in a doubling from the value at $45 per barrel. This has not happened, and the properties have continued to deplete.

Many of the properties that have been on the market are making their third or fourth round now without closing. However, many sales are now being forced by the lenders and banking regulators, or are coming out of bankruptcy. We believe we are now beginning to see financial discipline return to the market.

Depletion

The asset in which we invest is “used up” daily as it is produced. This has several unique characteristics:

  • Depleting assets generate more cash flow than the real return. For example, a property that generates cash of 15% on cost for the first year after purchase is only generating a real return of 8%. The other 7% is depletion (return of capital). Often all of this cash flow does not make it to the lender, but instead is consumed by the operator in overhead.
  • The depletion erodes the value of the asset. In the preceding example (all else being equal), the value of the property decreased by 7%.

Depletion reflects the amount of oil that is produced each year, which decreases the total remaining. It appears we are approaching a point where lenders are much less willing to tolerate the annual reduction of their collateral while hoping for things to get better.

WHY IS IT WORTH THE WAIT?

I have received calls from investors asking “What have you been doing?” The calls come mostly from “new investors” (those who have been investing with us for less than ten years). We have been busy. A year in which we close multiple investments looks a lot like a year in which we don’t close any.  In a typical year, we process 250 to 300 submittals (any investment opportunity that gets recorded in our log).  Submittals are generated through attendance at trade shows, referrals and direct solicitations.

Submittals receive a preliminary screening by the Preliminary Investment Committee (“PIC”).   The PIC is four senior members of the Investment Committee who review new submittals in a preliminary “triage” to determine if it might be a “fit” for Five States.  About a third of submittals make it through PIC and receive some level of additional research and due diligence.  About half of those that make it through PIC get deep analysis, consisting primarily of engineering, geologic and financial review.  Of those, about two-thirds are rejected, and we attempt to close about one-third. So in a good year, we hope to close only about 4% of transactions initially screened.

VALUE INVESTING (FIVE STATES STYLE) 

I am also asked, “Why aren’t you closing deals?” The answer is, the deals we have wanted either aren’t closing, or are pricing too high.

I was discussing new investments with a successful real estate promoter recently. I asked how he could continue to invest all the funds he was raising, when the price of income producing properties continued to rise, resulting in the project yield continuing to decrease.  His response was “my investors make the decision to ‘buy the market’ when they invest with me.  It is not my place to decide if the market is pricing correctly.  My job is to place the money entrusted to me as efficiently as possible.”

The real estate promoter’s rationale doesn’t work for me in directing Five States. Perhaps it is satisfactory for real estate (since they don’t deplete), but I don’t think it is for direct investments in oil and gas properties.  Investors do not have the insight or access to information to understand how the market is pricing assets.  Based on significant research and analysis, we believe we have a much better handle on this.

I think the most valuable service we provide to our investors is the deals we don’t do. Many deals we analyzed we passed on closed.  The question is whether the buyer made a good investment.  Over the past few years, most who closed would have to say “no”.  But we still have “dry powder” to invest when the market values assets attractively.

Despite adhering to our discipline, Five States’ returns on new investments over the last ten years have been disappointing. The decline in oil and natural gas prices from the +/- $80 per barrel range resulted in material decline in the value of producing properties. Also, the degree of slow-down resulted in a decrease in the valuation of pipelines and other midstream assets. We saw bids for Great Northern and Advantage both drop by one-half to two-thirds from the time we received initial bids until closing.

Although disappointed in our results, we are proud that we did not incur a major loss of capital. We have always said that we underwrite to a low double-digit return, where expected outcome can range from 0% to 20%. We always believed that targeting a higher return increased our risk of material loss of capital. FSEC Fund 1 final results are anticipated to be in the -5% to 4% range. This is disappointing, but given the severity of the crash in the oil market, I am pleased that our discipline resulted in our ability to return the majority of our investors’ capital.

CONCLUSION

I still consider producing oil and natural gas properties a cornerstone of my portfolio.   I make all of my investments in this sector through Five States.  The value investing philosophy embraced by Five States is the only way I believe one can maintain a significant allocation to this sector without taking material risk of loss of capital.  And I trust the integrity of the Five States investment team to continue to adhere to a strict value investing discipline.

I like to compare oil and gas investing to riding a roller coaster blindfolded. As long as you don’t get thrown out of the car, you should have a good ride.  The average returns from long-term oil and gas investing are strong.  But the volatility is high.  In order to “stay in the car” for the long-term, a disciplined investing methodology is required.

We believe the market for producing properties is finally entering the stage in the cycle where value investors can find attractive purchases. We continue to believe Five States is one of the best options available to those who wish to have an allocation to direct oil and gas.


 

[1] The Western Company was a major oil services firm, primarily in acidizing, fracturing and cementing, run by Texas icon Eddie Chiles, famous throughout the region for his “What are you mad about today, Eddie” political radio spots and as co-owner of the Texas Rangers baseball team. At its peak, the Western Company had over 5,000 employees and annual worldwide revenues of over $500 million. It was liquidated through sales to other major service companies in the 1990s.

[2] Liquidity Premium – the explanation for a difference between two types of financial securities (e.g. stocks) that have all the same qualities except liquidity. https://en.wikipedia.org/wiki/Liquidity_premium

[3] MLPs – Master Limited Partnerships

[4] REITs – Real Estate Investment Trusts

[5] Source – Sabine Royalty Trust 12/31/2016 Form 10-K

Changing Expectations

What a year! This time last year, I thought Mr. Trump was in the race to provide a media shill to allow the “real Republican candidates to debate the real issues.” After the primaries I thought a Republican victory over the Clinton machine was impossible. Equally surprising to me was the Republican dominance in Congressional and state races.

Closer to home for Five States, we have seen a strong recovery in oil prices. The spot price for WTI crude is in the low $50s per barrel, up from the high $20s – low $30s this time last year. This translates to a doubling or more of well-level cash flow. Natural Gas and Natural Gas Liquids (“NGLs”) have also rallied strongly.

The U.S. has resumed exporting crude oil for the first time since the 1970s. The first export shipment of Liquefied Natural Gas (“LNG”) from the U.S. was in February 2016. The U.S. Department of Energy forecast the U.S. becoming a net exporter of oil and natural gas in their 2017 report by 2026.[1]

Over the last decade, the U.S. has reduced its per capita output of noxious pollutants and CO2 more than any major nation in the world. The primary reason for this decrease has not been renewables, but the conversion from coal to natural gas as our primary electricity source fuel, combined with energy efficiency.

The expectations for the oil and gas industry from recent political and economic changes are intertwined. Increased U.S. oil and natural gas supplies have resulted in lower world energy prices. Reduced regulatory overreach should result in continued development of these supplies. Continuing the transition from coal to natural gas should continue the decrease of U.S. emission levels and contribute to increased U.S. economic competitiveness. The U.S. petrochemical industry is undergoing massive expansion.

The U.S. is once again a major world energy supplier. Through U.S. exports of oil, natural gas and natural gas liquids, the U.S. is now the “swing producer”[2], to the detriment of the ability of the Middle East and Russia to increase world prices through manipulation of supply.

Prices and Price Volatility

The decline in world oil and North American natural gas prices is a direct result of the “Shale Revolution” in the U.S. Over the last decade, the world oil price declined from the $80-$100+ per barrel range to the current ±$50, after recovering from a drop to the high $20s in 2016. North American natural gas prices declined from $8-$12+ per mmbtu to the current ±$3 per mmbtu.

Banning Fracing

The threat of banning hydraulic fracing was the biggest energy wildcard in the 2016 election. Hydraulic fracing has been used to complete the majority of domestic oil and gas wells in the U.S. since World War II. Over a million wells have been fraced in the U.S. in the last 70 years, with no documented impact on fresh water aquifers or other adverse ecological impact from the fracing process.

Hydraulic fracing combined with horizontal drilling has resulted in a huge increase in recoverable oil and natural gas reserves in the U.S. Shale development led to a reversal of the U.S. trend of increasing oil imports. Ten years ago we were importing two-thirds of our oil from places that don’t like us. The world oil market was dominated by OPEC[3], a cartel that manipulated supply to achieve higher energy prices.

Banning fracing would have shut down shale development. Domestic production would have declined to pre-2005 levels in a few years. This would have given OPEC the ability to once again manipulate world oil prices and would have strangled the North American supply of natural gas. Higher prices for oil and natural gas would have returned us to dependency on Middle East supplies. Perhaps the threat by Ms. Clinton to ban fracing was election posturing, but that threat is now “off the table.” This should help keep U.S. supply healthy, with average oil prices below $70 per barrel and natural gas prices below $5 per mmbtu for the foreseeable future.

 Conversion from Coal to Natural Gas

A decade ago the U.S. was using a lot more coal to generate electricity. The drop in natural gas prices from an expected level of ±$10 per mmbtu to $2-$4 has been the primary driver in the switch from coal to natural gas over the last decade. This has resulted in lower electrical costs, with the side benefit of the U.S. reducing its output of noxious pollutants and CO2 more than any other industrialized country in the world.[4]

Regulatory Overreach

Throughout the U.S., regulation of business has exploded over the last decade. The notion that having every business in the country filling out forms and everyone being audited by various regulators is insane. If that worked, we could eliminate crime through regulating it.

I have read more than once “if they’re not doing anything wrong, why do they object to increased regulation?” The reason is that complying with regulation is costly. When regulation is ineffective it is wasteful. When regulatory overreach is used to execute policy that is not approved by Congress, it is politically predatory.

Five States supports appropriate regulation of extractive industries. However, the outgoing administration was using the bureaucracy to obstruct the fossil fuel industry in ways that Congress never authorized. The injunction against Dakota Access and the cancellation of Keystone XL have been very costly to the U.S. oil and gas industry. Judging by the media, one would think there are no pipelines in North and South Dakota. In reality, there are tens of thousands of miles already in place, moving crude and natural gas in the most environmentally friendly and cost efficient manner.

These policies have materially adversely affected Five States. Blocking Keystone and Dakota access has resulted in North Dakota crude being moved by truck and rail. Our North Dakota oil production has sold for $12-$25 per barrel below national averages over the last five years because of the obstruction of pipeline development. The huge negative differential was the primary reason we sold Great Northern Midstream last year, as we believe the Bakken in North Dakota is not economic even if average U.S. oil prices return to $60 per barrel.[5] Unwarranted delays in obtaining the lake crossing permit for Great Northern Midstream cost as much as $50-$100 million in the sales price. Regulatory delay has been a major drag on many other Five States investments over the last eight years. A change in federal policy in this area should be beneficial to the oil and gas industry and Five States.

Consensus on the “New Normal”

In a recent Deloitte survey [6], 84% of industry participants believe oil prices will be in the $40-$80 per barrel range in 2017, with 73% expecting prices to be in the $60-$100 per barrel range in 2020. This is a much “tighter” range of expectations than in recent years.

Disparity in assessment of value between buyers and sellers makes it difficult to get transactions done. When there is a wide difference among buyers, sellers and lenders on price forecasts, there is a wide disparity in valuation. When there is consensus it is much easier for transactions to close.

Last year, when the price of crude crashed into the $20s and $30s, almost no transactions closed. Buyers were not willing to bet on higher prices soon, and sellers and lenders were not willing to sell on valuations that would have resulted in devastating losses, being willing to take the risk that prices would recover. Now with prices at what the majority consider the “new normal,” things are beginning to move again.

Bids and Competition

We submitted more bids on producing properties in the last six months than we did in the past several years. We have been high bidder on several property packages (although none have closed yet) and have been close on others. We feel like “we’re in the hunt again.”

During 2016, we saw a number of changes in the oil and gas upstream financial market. Several of our peers failed, financially unable to make it through the period of volatility and no transactions. Several middle market and community banks are exiting the market. We also believe many of the remaining banks will be stricter in their lending, providing more opportunities for “mid-risk” investors like Five States.

New Transaction Team Member

The biggest competitive issue was the shutdown of the oil and gas finance group of GE. This provides two great things for Five States. The first is the elimination of the largest non-op working interest owner in the U.S. from the pool of competition.

The second benefit of the GE shutdown is the addition of Mike DePriest to the Five States team. Mike was a Managing Director with GE Energy Financial Services for almost 20 years. He started as Head of the Portfolio group, and then moved into an origination role. Mike closed almost $1 billion of transactions for GE. These deals were very similar to the deals that Five States wants to close. Mike is a petroleum engineer and has over 35 years of experience. After spending seven months in another division of GE, Mike decided he wanted back into oil and gas. We have known each other for a long time, and have often talked of working together. Mike joined Five States as Executive Vice President and Chief Acquisitions Officer in late-November. It’s always great when you get to hire “a ringer”!

Valuing Properties

Many have asked with the recent rally in oil and gas prices if we “missed the bottom.” Not at all. The market is composed of two parts: expectations of future oil and gas prices and expenses, and the discount rates at which the market values those assets.

Forward prices for commodities are quoted publicly every day for most major commodities. For example, the price of a barrel of oil to be delivered in April is different from May. In calculating estimated future income from properties, we assume a different price for each month. Over the last year, although the spot price has increased, futures prices have remained in the mid-$50s.

When we buy properties, we “lock in” the majority of the price for the first three to five years through forward sales (“hedges”). Because we lock in the price in the early years, volatility in the short-term price has little impact on our returns.

Equally important in valuing properties is the discount rate with which we value the estimated future income stream. We could buy everything on the market every day if we would just lower the required discount rate (pay more for the property). To understand this concept, which of the following would give you a better return: buying a property assuming $45 per barrel at a 10% discount rate, or $50 per barrel at a 30% discount rate? The answer is the present value calculates the same.

High quality producing properties are a unique asset class. Most of the return from owning these assets is in the form of current income, they have historically been a good inflation hedge, and they have historically had a low to negative correlation to financial markets. Volatility is higher than in many other classes, but long-term returns have historically more than compensated for the volatility.

Expectations for 2017

We believe that this is a great time to be acquiring interests in producing properties. The industry is in the middle of a huge upheaval, and the values of producing properties are about half of what they were three years ago, while the rate of return per new dollar invested has improved (values are lower and yields are higher). The oil and gas industry is deleveraging, both operationally and with less debt. This bodes well for disciplined value investors. We are surprised that we have not closed any new acquisitions, but we are pleased with the increased volume of good assets we are seeing. We are also very pleased to have Mike on board leading our acquisition team. With the rationalization of the market around more consistent future expectations of oil and gas prices, we are expecting the changes to be good for Five States investors.


[1] U.S. Energy Information Administration http://www.cnbc.com/2017/01/05/united-states-may-become-net-energy-exporter-by-2026-eia-reports.html

[2] Swing producer is a supplier or a close oligopolistic group of suppliers of any commodity, controlling its global deposits and possessing large spare production capacity. A swing producer is able to increase or decrease commodity supply at minimal additional internal cost, and thus able to influence prices and balance the markets, providing downside protection in the short to middle term. Examples of swing producers include Saudi Arabia[1] in oil, Russia in potash fertilizers,[2] and, historically, the De Beers Company in diamonds.[3] https://en.wikipedia.org/wiki/Swing_producer

[3] OPEC – Organization of Petroleum Exporting Countries https://en.wikipedia.org/wiki/OPEC

[4] Source: World Bank, Carbon Dioxide Information Analysis Center, Environmental Sciences Division, Oak Ridge National Laboratory, Tennessee, United States. http://data.worldbank.org/indicator/EN.ATM.CO2E.PC?end=2013&locations=US&start=2000

[5] WTI reference price of $60 per barrel – $12 differential = $48; this is below the total cost to continue Bakken development

[6] Deloitte Center for Energy Solutions, 2016 oil and gas industry survey

How We Purchase Oil and Gas Properties

Financial theory is based on the assumption that money has Time Value.  The idea is that a dollar available to you today is worth more than a dollar available to you later.  The mechanics are fairly simple:

  • Borrowers will pay interest to get money now and repay it later.
  • Lenders will be paid to give up money now and be repaid later.

Time Value (Discounted Cash Flow) calculations are used to determine the cost or reward. Following the financial crash of 2008, the concept that money has “Time Value” has been somewhat turned on its head. The Federal Reserve has maintained what has become a 0% interest rate policy since the crash, which effectively makes borrowing to the most “prime” borrowers free, and lenders not being paid for providing capital.

producer-pic-for-ab2-article

Since 1981, declining interest rates contributed to inflation in the stock market and real estate. As interest rates fell, investors “bid up” the value of income streams.

Compounding this inflation has been an increasing amount of debt used in the capital structure of many investments and companies. Almost all real estate transactions were financed with at least 80% debt. When markets began correcting in 2008 (that is, values of assets began falling) it became clear that real estate values could decline by 20% or more. Given that 20% equity in real estate was considered “strong” the prospect of real asset values falling by more than 20% was catastrophic. It would have led to most real estate loans being greater than the underlying collateral value. This would have led to the insolvency of many financial institutions, as well as material collapses in the value of pension and insurance company portfolios. Similar collapse was faced by many companies with high levels of debt in their capital structure.

Ben Bernanke, the chairman of the Federal Reserve (“The Fed) at the time, took what was probably the only rational course by materially increasing liquidity in the system and materially decreasing interest rates. This resulted in a rapid re-inflation of property and other asset values, thus ending the crisis.

However, as often happens at the end of a long-term cyclical trend, the Fed (likely encouraged by the Treasury Department), has kept this policy in place ever since. For the Fed, it is like a “free lunch, increasing asset values at no cost (although it came with no underlying fundamental growth).  An additional bonus from the perspective of the nation’s largest borrower (the U.S. government) is that it dropped the cost of borrowing materially, which was attractive during a period of rapidly expanding deficits.

During this current cycle, the Fed appears to have altered its priorities. Rather than the historical mandate of maintaining price stability, many of the governors are focused on maintaining the growth of investment markets.  They appear to have accepted the idea that forcing investors to take more risk in order to earn yield was the way to do it.

The perversion in all of this is that those who contributed to the collapse in 2008 prospered from this new policy, while those who “did the right thing,” particularly those who had saved and not over-borrowed, bore the brunt. Wall Street and the big banks prospered.  Retirees and others living on savings could no longer earn any return on their savings without materially increasing their risk exposure. John Mauldin published an excellent article on this topic on October 9, 2016.

Valuing Investments – the Financial Theory

If you studied this in college, skip this section.

The concept of Time Value of Money is extended into valuing equity investments.  As in the case of a borrower and a lender, investors give up money today by investing it in exchange for the expectation of receiving one or more payments totaling a greater amount in the future.  Valuing the uncertain future returns is performed using the concept of Discounted Cash Flow (cash flow being the investment returns paid to the investor).

The value of the Discounted Cash Flow is the Present Value.  If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment.

Financial academia has stated Present Value of an equal and the Net Present Value of unequal payments over time in algebraic terms as follows, Net is added to present value to reflect the change in the math to include the payment of the initial investment in the formula.

producer-equation-2

 

 

 

 

 

 

 

 

 

Looks complicated, doesn’t it! But it is not. I will attempt to restate this in plain English in the next section.

Valuing Investments – the Financial Theory

Here is a plain English explanation of Discounted Cash Flow. If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment. Based on the estimated amount and timing of Future Earnings, the Present Value of those earnings can be calculated using the assumed Rate of Return required by an investor.

Following is an example:

Investor’s required Rate of Return (i.e., Discount Rate)                                               10%

Future Value(i.e., Payment from Investment to be received 1 year from today)     $110

Present Value of Investment Today                                                                                 $100

If the investor invests $100 today, and actually receives his investment of $100 back in a year plus $10 in profit, he will have made 10% on his money ($100 * 10% = $10 + $100 = $110).

To calculate Net Present Value (that is, to calculate the value of an uneven series of payments over time), you do this calculation for each payment to be received over time and add them together. All financial analysis programs and spreadsheets perform this function.

This simple arithmetic is the basis of financial theory, and it is what all of the Greek formulas and algebra above say. This calculation underlies almost every investment evaluation I have ever seen.  All of the financial terms used to describe the components – Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flow and a number of others – describe an attempt to solve for one of the three variables based on assumptions about the other two.

Determining The Discount Rate

Financial theory then attempts to explain how the Discount Rate should be determined. Broadly stated, the discount rate should be as follows:

Discount Rate = Risk-free Rate + Inflation Rate + a Risk Premium

For example if the Risk-free Time Rate is 4%, the Inflation Rate is 1% and the Risk Premium is 5%, the Discount Rate used to value the future stream of earnings would be 10%.  The calculated Net Present Value is the amount that would result in the return from the investment equating to a 10% yield.

Example in Oil Properties

We use Discounted Cash Flow to value oil properties. To calculate future cash flow we estimate future production volume, make an assumption on future prices by year, and subtract our estimates of future expenses per year.  We then calculate the present value of each income payment expected to be received using an appropriate Discount Rate.

Fifteen years ago, the Discount Rate used to value mature, fully developed producing properties was around 12%. Backing into the Discount Rate calculation above, we can calculate the Risk Premium as follows:

Risk Premium = Discount Rate – Risk-free Rate – Inflation Rate

So if the:

  • Discount Rate = 12%
  • Risk-free Rate = 6%
  • Inflation Rate =  2%

then the Risk Premium must have been 4% (12% – 6% – 2% = 4%).

It is easy to see how applying this logic led some during the energy boom to decrease their Discount Rate in valuing oil and gas properties into the single digits. If the:

  • Risk-free Rate = 0%
  • Inflation Rate =  0%
  • Risk Premium = 6%

a Discount Rate of 6% is calculated. (0% + 0% + 6% = 6 %).

If an investor buys properties using a 6% discount rate, and borrows 60% of the money to make the purchase at 2%, he can then generate a 12% Return on Equity.

producer-3

Looks pretty good in an environment of 0% interest rates.  But there is a flaw in this “relative return” logic.

What Happened to the Oil & Gas Industry?

During the last decade many of our competitors decreased their discount rates into the single digits. In order to maintain high yields, they borrowed money at low interest rates to achieve yields on equity higher than the return from the producing properties.  As I discussed in the prior two issues of The Producer, this combination proved deadly.  As oil prices dropped in half, cash flow from producing properties decreased by 75% or more.

Most producing properties continued to generate positive cash flow before debt service.  But this is partly because some of the investment is being liquidated every day.  However, if oil prices over the next five years average lower than $80-$100 per barrel, which is now widely accepted, many properties will never generate enough cash flow to pay off the debt.

The error made by many investors over the last ten years was assuming that oil prices would remain high.  Some argued that “Peak Oil” would result in decreasing supplies outside the U.S.  Others argued that the high cost of shale development would create a “floor” for oil prices, and that prices could not fall below the floor.

But oil and natural gas are commodities.  They do not behave any different than any other commodity.  When supply is tight or decreasing and demand is constant, prices rise.  When demand is constant or decreasing and supply is increasing, prices fall.

Absolute Return

“Absolute return is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period of time. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.”

Conclusion

We are Absolute Return investors at Five States.  We believe that the appropriate unleveraged return for owning producing properties is in the 9%-12% range.  We therefore use this metric regardless of changes in the risk-free rate. We believe that this is the only way to be a rational value investor in this crazy economy.  As the market for oil and natural gas prices continues to rationalize, we are once again high bidder in some cases.  Frustratingly, in several recent asset sales in which we were the high bidder, the sales have not closed.

Patience is the most difficult virtue in value investing.  But in strange times like these, sticking to fundamental discipline is the only investment methodology that makes since.  We believe strongly that financial markets will rationalize, and that oil and gas markets already are doing so. We continue to review hundreds of assets each year for possible acquisition by our funds.  We saw a large number of assets that we are interested in owning over the last three months.  We have been high bidder on several of these assets, but the sellers are still holding out for more.  So they have not sold. As the market rationalizes, market prices for producing properties are approaching our fundamental valuations.  Our peers who are long-term investors, with whom we “compare notes”, are holding the same valuation metrics.  As the market continues to rationalize, we expect to be able to make the best acquisitions of producing properties we have made in over a decade.

 

 

The Five Stages of Loss & Grief

In the last few issues of The Producer, I have discussed and illustrated the impact of the decline in oil prices on the value of producing properties. Also discussed was the fact that most producers who had what were previously considered “prime” debt levels drawn against their properties are now insolvent (their assets are not worth enough to pay off their debt).

The first question that is often asked is “How is this sustainable?” Unlike many businesses or assets, many oil companies (or producing properties) will continue to generate free cash flow before debt service. It’s like a business that sells its inventory at less than cost. As long as sales exceed the cost of operations, there is free cash flow . . . until they run out of inventory. In the case of an oil producer, enough free cash flow is generated to pay the overhead and the interest on the loan for a while . . . even though there is little likelihood that the debt will ever be fully repaid.

This results in a phenomenon we call “kicking the can.” Rather than dealing with the problem, the producer and/or the lender will often defer the problem as long as possible, in the hope that prices will return to former levels and they can avoid the pain of losing money.

In many cases, the operator or owner is not motivated to address the problem. Doing so could result in the loss of everything, including overhead payments (which includes his salary, club dues, car, expense account, etc.). The borrower has no motivation to solve the problem.

The lender is similarly conflicted. Energy bankers, at least the competent ones, have known what was coming for some time. But they were not motivated to solve the problem. They knew that directly addressing the problem by forcing borrowers into liquidation or foreclosure would result in losses for the banks, negatively impacting the banks’ earnings. . . and their bonuses. Kicking the can and hoping things would get better was much more attractive.

There was also a large degree of denial. “How could all those highly profitable prime loans go from grade A to subprime almost overnight?” It is emotionally unacceptable. Throughout 2015, most bankers were claiming that “their portfolio was solid, and they had only minimal problem loans.” But this was not true for most, if any.

In addition to the quantitative part of what is happening in the market for oil and natural gas properties, there is also a psychological part. It appears very similar to “The Five Stages of Loss & Grief” by Julie Axelrod:

1. Denial
2. Anger
3. Bargaining
4. Depression
5. Acceptance

At the beginning of the downturn, there was Denial. Producers claimed prices would recover quickly, they were adequately hedged so that it did not impact them, and some were misleading in how they presented their costs and expenses.

Then they became Angry. “How could the banker imply such a thing? How can I work my way out? How could the banker treat me like this after so many years as a great customer? Does he not understand?”

Bargaining became the next step. We saw a lot of this in the latter part of last year. Many deals we had reviewed prior to the price collapse started coming back around. “Well, you were willing to value it at $20 two years ago, how about $15 now (even though the current net present value is only $5). That would be a good deal!” We saw a long period of low transaction closings throughout the industry as sellers tried to bargain on unrealistic expectations.

We have finally begun to see Depression and Acceptance. This is evidenced by the increasing number of companies that are filing bankruptcy, and the increasing number of quality producing properties that are coming on the market.

Assessment of the Market Today

Quality of assets available is materially improving. We would like to own many more of the assets we are seeing. We have made more bids in the last few months than we did all of last year.

Velocity is accelerating. Many deals are coming in “ready to close” with realistic data packages, time lines and seller expectations. We are “weeding out” deals more quickly that are not of interest. I suspect we will review many more deals than the usual 300 +/- submittals we normally process in a year.

We are now seeing many deals that did not close last year. They are coming around again, but with more reasonable terms.

Some assets are starting to come out of bankruptcy. All the “hair is off,” so assets from bankruptcy almost always transact.

The market is rationalizing. We believe that the market valuation on producing properties is moving back to a net present value of 9% – 15% (at the asset level, without allocation for overhead, etc.). This is a significant improvement compared to net present value in the low to mid-single digits at the peak of the boom.

Most Proved Undeveloped assets (“PUDs”) have little or no value at current oil prices. The buyer still gets this potential upside, but pays little if anything for it. The assets that do have PUD value are really good.

Most submittals we are seeing are Working Interests (“WIs”) for sale. The Mezzanine opportunities (“Mezz”) are almost all first liens. The economics of buying working interests or making first lien loans are about the same:

  • The internal rate of return (IRR, or imputed real yield) is about the same for WI and Mezz
  • Payback is faster on Mezz loans than on WIs
  • Total return is higher on WIs than on Mezz
  • The Mezz loan has some preference compared to buying the WI, which reduces risk

We still prefer to own Working Interests. The higher total return and greater upside potential appeal to us. We will only make Mezzanine loans on assets we would like to own at the loan value. Then we are happy regardless of whether the loan pays off or we end up with the underlying collateral (the producing properties).

Some investors have expressed concerns about the long investment period since the closing of Fund 2, and the “drag” that the management fee can have on total returns. This is of concern to Five States management too. However, the primary issue is to not overpay for properties.

An old adage is that the profit is made when you buy. That is, the profit is determined by buying at the right price. Because of material re-pricing of oil and gas assets, any acquisitions that we could have made (but did not) in the couple of years following the closing of Fund 2 would be underperforming today. I am proud of our adherence to our disciplined methodology, “keeping most of our powder dry” for the opportunities that are now presenting themselves.

The returns from investing in producing properties in today’s pricing environment are sufficient to cover the overhead we incurred before we begin generating our target yield. If we buy properties at a price that will generate the lower end of our target return, the return to the investors should exceed the priority return without a major recovery in oil and gas prices.

I have commented in several previous articles about the conditions that make for great value investing:

  • Low oil and natural gas prices
  • High discount rates on valuing future oil and natural gas income streams
  • Unpopularity of the oil and gas sector

The News is So Bad!

I have received a number of calls recently with a common theme; “The News is So Bad!” This statement is usually followed by:

  • “I read that the price of oil/gas will never recover”;
  • “The drilling industry is collapsing”;
  • “I read that the collapse of the oil/gas industry may go on for decades”; or
  • “How can we make money if oil/gas prices don’t recover?”

For value investors, this is as good as the environment gets for making new investments!

The Boom

The boom in oil and gas was driven by several factors. The first was growth in world demand. Despite slowing growth in energy demand in the developed economies (the US, European Union and Japan) primarily due to more efficient use of energy, world demand continued to grow over the last decade. Total energy demand from the emerging economies (China, India and others) is now greater than from the developed economies. The rate of growth in demand by the emerging economies has slowed in the past few years, but world energy demand continues to increase every year.

World Oil Demand

The increase in energy demand resulted in higher prices, which led to the development of unconventional oil and gas development. The method of development is not what is unconventional. Hydraulic fracturing has been used throughout the world since the 1950s. The unconventional part is developing shale formations, which is not economically viable when oil is less than $40 – $50 per barrel. When oil was over $80 per barrel, there was a “gold rush mentality” in the industry, with attempts made to develop almost anything that would produce.

The development was very successful. The majority of the new production developed was in the US. Domestic oil production increased by two-thirds over the last decade, from six million barrels per day to over 10 million barrels per day. Last year, the US was the world’s largest oil producer. But this led to excess deliverable supply and a price collapse.

US Oil Production

Too Much Debt

The boom and subsequent collapse were fueled by a combination of success in drilling and too much debt. The location of the shale formations is well understood and documented, so few dry holes were drilled. This led to the perception that drilling shale wells was not risky, so greater levels of debt were used to capitalize the development than was historically normal.

Oil Price and Unexpected Market Tightness

Debt and Leverage Have Increased Sharply in the Energy Sector

Since interest rates were low, the addition of low interest debt to the capital structure of oil companies became common. The “cost of money” to develop or buy oil properties decreased tremendously.

Historically, good quality proved producing oil properties were valued at a 10% – 15% discount rate. That is, the value of the estimated future income stream is valued at a price that would generate a 10% – 15% net yield over the life of the well.

Low cost debt resulted in the discount rate declining into the 6% – 8% range, increasing the market value of these wells by two to three times or more. And these yields were being calculated on assumed future oil prices continuing at record levels.

Record Prices and Production Volume

Until late 2014, oil was selling for record prices, ranging from $80 – $140 per barrel. The consensus view was that oil would continue to sell for $80 – $100 per barrel. It was assumed it would “spike” above that range during periods of international instability, and that any declines below that range would be short-lived.

By late 2014, world production began to increase to a level greater than world consumption, as demand growth began to slow. Inventories reached historic highs, and prices collapsed. US production has peaked, and is expected to decrease by 700,000 barrels per day this year.

When Do We Buy?

I am often asked “How do we call the bottom?” The answer is, we can not. I have no idea if the bottom was last quarter or if the price of oil will decline again later this year.

However, it is time to buy. We are clearly in the bottom quartile of the cycle. Oil prices are low and discount rates are high. There is “a lot of money on the sidelines,” but most of it is focused on public companies and assets over $100 million.

We believe that over half the oil and gas companies in the US are insolvent. The values of producing properties have decreased by over 80% in the last two years. Many of the transactions will be liquidations of companies. We expect more assets to change hands than in the 1990s.

What’s the Deal?

The answer to the original question is, we will make money by owning income-producing assets. Producing properties are at a value that generates a double digit current yield based on current wellhead prices. Little, if any, value is being paid for future development potential.

We will be using forward sales (“hedges”) to lock in the price of the majority of our production for four years. This ensures that if we are early and prices are lower over the next few years, we will have “locked in” the double digit yield over this period, and be almost certain we have made a profitable investment.

By using hedges, we are giving up the potential to earn superior returns in the short-term. I like this trade. It allows us to accumulate high-quality, long-lived assets, which will earn a very attractive current yield while we wait for an intermediate-term recovery in oil prices which we believe is inevitable.

“Déjà Vu All Over Again” – The Market for Oil and Gas Assets

What a difference a year makes! At this time last year, oil was around $60 per barrel, and we thought we had taken a beating. When oil fell from $85 to $60 per barrel, the present value of the future production fell in half. Little did we know that, in 2015, we would see the wellhead price of oil fall another 50% and the value of producing properties fall even further.

The story was similar for midstream assets (i.e., pipelines). Although most midstream assets are still generating strong earnings, the value of many midstream assets fell by a factor of three or more. The dramatic drop in value occurred as the market began to believe oil prices will not recover significantly and domestic volumes will continue to decline.

We first discussed the likelihood of a decline in oil prices in my article “A Correction in Oil Prices?” in the fourth quarter 2013 issue of The Producer. Due to our concern, we took a defensive position in our investing activity over the last several years. Despite our caution, overall results from investments made during the boom have been disappointing.

The oil and gas industry is in in a devastating down-turn, but our financial condition remains healthy. Five States Energy Capital Fund 1 and Fund 2 have no debt. The managing entities of the various funds are also solvent, and have only operating liabilities. All of our entities remain solvent and have healthy balance sheets.

Our “legacy funds” (Five States Consolidated I, Ltd. Five States Consolidated II, Ltd. and Five States Consolidated III, Ltd. ) generated the majority of the cash distributions investors have been receiving over the last decade. These returns were from investments made primarily in the 1990s, and have already generated over 3:1 returns and an IRR of ~20% over the last 25 years. However, we now need to be cautious and increase the strength of the balance sheets of the legacy funds. We incurred conservative levels of debt over the last cycle to participate in development opportunities on properties owned by those funds. We now believe it is conservative to accelerate paying down our bank lines on these funds. The cash distributions for these funds will be suspended for the next two to four quarters.

Expected results from Five States Energy Capital Fund 1 have deteriorated with the collapse of oil prices. We have stayed within our targeted risk band, which will allow us to operate through the downturn. We now expect Fund 1 will have full capital recovery with a low single digit return over the life of the investment. If prices stay this low for an extended period, we may incur a small loss.

Such forecasts are materially lower than we were estimating a year ago. The biggest negative was the decline in value in our two pipeline assets. Great Northern Midstream was sold this month. While we made a profit, it was not nearly the result we expected a year ago. The decision to sell was primarily driven by the risk of North Dakota Bakken production, the majority of which is not profitable below $60/barrel. The owners of GNM unanimously agreed it was better to recover our capital than to continue to own this risk. This quarter, we are distributing proceeds from the Great Northern sale. After this quarter, Fund 1 distributions will be materially lower

Many in the industry are faring far worse. More than 250,000 jobs have been lost in the energy sector. Most oil and gas companies that had what was considered conservative debt levels in 2014 are now insolvent. More than 40 oil companies filed for bankruptcy protection in 2015. Some analysts are predicting that half the companies in the industry will fail in 2016.

Five States is well positioned to take advantage of the downturn. We plan to pursue acquisition of producing oil and natural gas working interests through the downturn. More than 65% of the capital committed to Five States Energy Capital Fund 2 has not been deployed. We anticipate opening Five States Energy Capital Fund 3 mid-year, as soon as the majority of Fund 2 has been committed to new investments.

Buy Low

I am often asked why we want to buy oil or natural gas properties now if wellhead prices are low and are not expected to recover in the near term. As value investors, we adhere to the old adage, “buy low, sell high.”

The current situation is much like it was when we started Five States in 1985:

Low Wellhead Prices – wellhead prices of crude oil and natural gas are down two-thirds over the last 18 months. When prices are low, there is less room for them to fall.

In order to continue producing the 92 million barrels humanity is consuming each day, new reserves have to be developed. The marginal replacement cost of oil is in the $60 per barrel range. If the price remains below $60, natural depletion will result in declining production, supply will decrease and prices will increase.

 “But what about the Saudis and Iran?” Saudi Arabia, Iran and others have materially lower production costs than the US, Russia or Venezuela. But Middle Eastern producers do not have the capacity to supply world demand alone. Conventional production has peaked. Without renewed development of the more expensive North American production from sources such as shale, world supply will decline.

Although demand growth has plateaued in the US and Western Europe, world demand is continuing to grow. Consumption has not declined. Only the rate of growth has slowed.

Oil prices will recover. The question is when, and how much. We are assuming in our evaluation of new producing properties that prices remain low for four to five years, average in the $50s in the intermediate term and $60+ in the long-term. Through hedges, we will “lock-in” the oil and gas prices on the majority of our new acquisitions for the first four to five years to minimize income volatility as we recover the majority of our investment from the early current income. Hedging will ensure investor payback and a profit if a price recovery takes longer than we forecast.

High Discount Rates – the Cost of Capital for the oil and gas sector is increasing. We believe the discount rate for valuing producing properties is once again in the 9% – 12% range.

During the recent boom, the market underestimated the systematic risk[1] inherent in owning producing properties. Many incorrectly assumed that because new oil and natural gas production from shale is expensive to develop, wellhead prices would not fall below the cost to develop it. Compounding this error, many lenders failed to recognize the increased risk inherent in the higher operating leverage caused by the much greater drilling costs. They continued to loan money using conventional loan to value metrics, which have proven to be too high. Wellhead prices have fallen materially below the capital cost to profitably drill and complete the new unconventional wells. Looking forward, investors will require an additional risk premium in their cost of capital to compensate for this additional risk.

Junk bonds and inflated stock and MLP valuations provided Five States’ competitors with “cheap currency”, allowing them to pay more for oil and gas assets than Five States would as a cash buyer. Public companies and MLPs financed the drilling boom with “cheap debt” or raised cash at inappropriately high stock prices, allowing public companies and MLPs to spend more than true value to develop new reserves.

We recognize that there are “hundreds of billions of dollars waiting on the sidelines.” But the majority of those dollars are with hedge funds and large institutional investors. Many are recognizing their lack of the skill sets necessary to evaluate individual producing properties. With many of the smaller oil and gas companies insolvent, restructuring is not an option. The opportunity for Five States will be to buy real property interests in producing oil and gas properties, a skill many financial firms lack.

Some ask, “How will you get the good deals?” The reality is, there are no “steals”. This is a very competitive market, and it is always competitive. Buying producing properties was as hard in 1998 when oil was below $10 per barrel as it was during the boom. The reason the 1990s acquisitions look so good in hindsight is that we “bought low”. Today, discount rates are much more normal, so new acquisitions are good value and can generate high cash yields at current prices. We can earn a good current yield from owning the production without needing prices to recover to pre-crash levels. This is an excellent scenario for long-term value investors.

We Buy “Oil in Ground”

The majority of the focus in the media is on the spot price of oil. However, we are not buying barrels of oil to sell in all at once. We are buying producing oil and natural gas properties that we will produce over time. There is an inherent return imbedded in owning these assets.

We Get “Paid to Hold”

Financial theory is based on the assumption that money has “time value”; that a dollar in hand today is worth more than a dollar received in the future. It is similar to investing in income producing real estate. If you buy a house for $100,000, make $10,000 a year for five years then sell it for $100,000, you earn a 10% return without the value of the house or the rent increasing. The same concept applies in buying producing oil and gas properties when discount rates are in the double digits.

Greatest Value Investment Opportunity in Decades

We believe the ongoing collapse of the oil and natural gas industry represents the greatest value investment opportunity we have seen in decades. However, prices for future delivery of oil and natural gas are higher than current wellhead prices, reflecting the market expectation of some recovery over the next few years. The collapse in prices might last longer than we expect, so we will use futures contracts (hedges) to mitigate the price risk during the period when we are recovering our capital, “locking in” the price on much of our production during the payback period. That way the majority of our risk will be the rate of return realized, not whether we will recover our capital from the investment.

The upside potential in buying properties at current prices is huge. A recovery to $60 per barrel could easily double or triple the income from and value of producing properties. As prices rise, not only does the price per barrel increase, but total economically recoverable reserves also increase.

Proved Undeveloped Reserves (PUDs) or the “undeveloped locations” on the majority of domestic properties have little net present value at current prices. But if prices recover into the $50 – $60 range, the value of the undeveloped locations on many properties become profitable to develop, adding material value.

As Yogi Berra said, “It’s like déjà vu all over again!” In many ways, this is a repeat of the late 1980s-90s. We can acquire producing properties at attractive values while prices are low. These new investments will generate an attractive current yield at the prices we can currently “lock-in”. While we are enjoying the attractive yield, we can wait for the appreciation that will come with an inevitable price recovery. With values and yields this attractive, it almost does not matter when the price recovery occurs!


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.

Change in The Oil Industry and the Impact on Five States

The Oil Market

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

Crude oil prices have basically fallen in half over the last twelve months. This translates to a decrease in Operating Cash Profit for most producing properties in the US of 65% to 85%.  If low prices are assumed to continue into the future calculated present value of producing properties have fallen by a comparable magnitude. Operating Cash Profit is Net Revenue less Operating Expenses and Property Level Taxes. It does not include recovery of the capital investment to drill and complete the well.

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

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

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

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

The Oil and Gas Industry

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

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

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

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

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

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

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

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

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

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

Five States

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

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

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

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

Five States Consolidated I, II & III have returned multiples on the money invested in cash distributions, and they still have residual value. These partnerships contain good quality, long-life producing assets that are profitable at current prices. Five States Energy Capital Fund 1 is fully invested and has no debt.   The decline in oil and gas Operating Cash Profit has been offset by increased income from its midstream investments.  All of the producing properties are cash flow positive at current prices.  We have profitably “harvested” some of the portfolio.  We recognized major loss reserves against our materially underperforming investments at year-end last year.

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

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

Capitalizing on the Downturn

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

The investment thesis is:

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

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

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

How Do We Know?

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

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

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

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

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

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

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

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

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

Valuation Process

Future Production Volumes

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

Olivia Marie 32-5H

Revenue

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

Crude Oil Futures

Differentials

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

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

Differentials Map

Source: Coquest Daily Report 7/28/2015

Hedging

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

Operating Expenses

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

Economic limit of a property

Value

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

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

Contract Closing

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

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

Various Oil & Gas Segments

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

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

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

Conclusion

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

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

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

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

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


[1] “Benjamin Graham.” Wikipedia: The Free Encyclopedia. Wikimedia Foundation, Inc. 27 June 2015. Web. 5 August 2015. https://en.wikipedia.org/wiki/Benjamin_Graham.

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

Capital Rationing

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

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

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

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

Capital Rationing in the Oil and Gas Industry

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

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

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

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

Debt and Leverage Increase in Energy Sector

 Debt and Leverage in Energy Sector

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

 Energy Private Equity Fund Growth: 2001-2004

Energy Private Equity Fund Growth

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

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

 Upstream Equity Issuances by Quarter
($ in billions)

Upstream Equity Issuances by Quarter

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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 INO.com

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.

Self-Correcting

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.

Conclusion

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.