Historically low interest rates continue to drive capital away from traditional “safe” liquid investments such as CDs, money market funds and bonds in pursuit of yield. Investors are paying ever higher prices in an attempt to lock in current return. The increasing flow of capital into riskier assets–such as stocks that pay dividends and income-producing real assets–is resulting in “asset inflation.” The risk associated with the end of “0% interest rates” is unknown, but I suspect it will not have a “happy ending.” I find this flow of capital concerning. I have always found “chasing yield” to be a lousy investment strategy with the potential of driving the price of income producing assets above their fundamental value.
Valuations of income-producing assets move inversely to changes in yield. As investors become willing to accept lower yields from riskier assets, the value of those assets increases. For example, if the market is willing to accept a 10% yield, an asset paying $100 per year is worth $1,000.
$100 ÷ 10% = $1,000
If the market subsequently accepts 8% as the market yield for the same asset, the asset would price at $1,250.
$100 ÷ 8% = $1,250
When the imputed yield on an income-producing asset is used to calculate the value of the asset, the imputed yield is called the “discount rate.” So as discount rates (i.e., yields) fall, the value of assets rise.
Of course, all of the change in asset values is not due to interest rates. There are other variables impacting valuation. Investor perception of changes in risk and expectations of future performance of the assets also impact value. Additionally, expectations of improvement or deterioration of broader economic conditions (i.e., fear of inflation or recession) impact valuations.
Oil and gas assets have not been immune from the pressure of declining interest rates and yields. As discussed in previous articles, declining discount rates have contributed to higher valuations of producing properties and midstream assets (e.g., pipelines, etc.). The oil and gas sector has been further stimulated by higher oil and gas prices since the late 20th century and by real growth being experienced in the sector due to the renaissance in domestic conventional energy development.
Crude Oil Acquisition and Development (“A&D”), Natural Gas A&D and Midstream Development are three very different segments within the oil and gas industry. Each segment is being impacted by different fundamentals, and the three are not in lock-step. The current risk profiles of each segment and the potential returns have diverged.
Crude Oil A&D
Crude Oil A&D is in favor in the investment world. Valuations are high–a function of high oil prices and low interest rates combined with the success of shale oil development and redevelopment of conventional oilfields (Note: I wrote this section prior to the correction being experienced in the oil sector, so these conditions may be changing).
There are many who believe that current oil prices are sustainable and that lower prices are unlikely. They point to the stability of world prices since 2008 as oil production in the US dramatically increased.
In our assessment, the risk of a price correction in the intermediate term remains. Production is increasing in the US at an amazing rate. But production overseas has declined by more than the increase in the US. Over the last three years, oil production in the US has increased by over 3.0 million barrels per day, while over 3.5 million barrels per day worldwide have been lost due to disruptions, primarily in the Middle East. Without this loss of production overseas, it is almost certain that the increase in supply would have driven prices lower.
The consensus is that, barring a price collapse, US oil production will continue to increase. Without further supply disruptions overseas, this will likely result in a decline in oil prices. As it has been for the last several years, the expectation of a decline in oil prices is reflected in the futures price of oil. The increased US production volume is from high cost/rapid decline shale formations, so a price correction will likely result in a quick decline in US production.
NYMEX Futures Prices for Crude Oil, October 20, 2014
The risk of a decline in oil prices makes new investments in producing oil properties and high cost development riskier. As discussed last quarter, many shale oil projects become marginal if the reference price of crude oil drops into the $70 to $80 range.
In the oil sector, Five States continues to focus on mezzanine financing. Participating in new transactions in a preferred position provides us a lot of downside protection if prices decline, while allowing us to continue to participate in the attractive returns available in this space.
The shale oil boom appears to be peaking. We expect to see continuing development financing opportunities as long as prices remain at current levels. Slightly lower prices will materially reduce the borrowing capacity of shale projects, which could stimulate more mezzanine opportunities as independents need additional capital to shore up their financial condition to continue their development projects.
The shale oil “land rush” appears to be slowing down. The major shale plays are all identified, and the open acreage in these plays has been leased. Most oil companies participating in shale plays have all of the land inventory they can develop.
We have been marketing our interests in the Bakken in North Dakota through the summer. If we can capture the future value of the development in today’s market, we would like to sell these assets. If we cannot capture the value of future development, we will continue to hold them for current income.
Focus on conventional oil redevelopment
Those of you who have been investing with Five States since before 2008 will recall that one of our primary expectations when we modified our investment strategy was the tremendous potential in the redevelopment of conventional tight oil fields.
One of our most successful investments in Five States Energy Capital Fund 1, LLC (“FSEC Fund 1”) is the OSR Halliday, which is a conventional oil redevelopment project. In our legacy funds, we own interests in several other conventional fields that are attractive for redevelopment. Our primary engineering consultant is completing a development analysis of one of our largest holding, the S.E. Adair in Five States Consolidated III, Ltd. We plan to redevelop this field in 2015, and use it as a prototype for pursuing opportunities to fund redevelopment of other fields with independent producers in the Permian Basin.
Financing redevelopment is an ideal investment for Five States Energy Capital Fund 2, LLC (“FSEC Fund 2”). The financing need tends to be small–in the $10 million to $25 million range. This size tends to keep our larger competitors out of the space. “Dry hole” risk is very low. The development is “down spacing” (i.e., where new wells are drilled in defined fields between producing wells) and, unlike the shale plays, the break-even is well below $40/barrel. Our knowledge in this area provides us a competitive advantage. Over the last 15 years, we have invested and developed extensively in this area. The rate of return is lower than in riskier mezzanine shale financing, but the return is still in the double digits. We think such a focus is ideal for investors with our level of risk tolerance. We are actively doing the research to identify private independent producers we believe will be interested.
Natural Gas A&D
Natural gas prices remain soft. The low natural gas prices in North America are due to the success of shale development in the last decade. The success of the development resulted in a huge increase in production volumes and drastically lowered prices for natural gas throughout the US.
Until the last couple of years, the consensus was that natural gas prices would recover quickly. This expectation seems to have reversed. Although the current spot price for natural gas is higher than a few years ago, futures prices have fallen to new lows. This results in a lower net present value for producing properties, leading to more attractive valuations for any given asset.
Futures prices are now at a level where the discounted cash flow valuation is practical to buy and hold, regardless of the length of time until recovery. Before the decline in futures prices, a large part of the imputed value on many gas properties was the value of new wells expected to be drilled. At today’s lower futures prices, the expectation of the future drilling has been pushed into the future, decreasing the present value significantly.
The cost of most shale gas development is high. The imputed cost is between $3.50 to $5.50 per mmbtu, depending on the formation (i.e., location). With natural gas trading at $3.50 – $4.00, drilling new wells in many areas would, at best, be a breakeven proposition.
Due to low natural gas prices, little drilling for conventional dry gas is being undertaken. The number of rigs drilling for gas has been decreasing over the past five years. The increasing demand for gas is currently being met by associated gas from oil wells and continued development in the lower cost shale plays. Demand is projected to exceed supply in the next several years. When demand exceeds supply, gas prices should increase, and we expect to see a resurgence of natural gas development. When prices are over $5.00, there are material volumes of gas to develop.
The current returns on new natural gas production acquisitions are lower than could be achieved when discount rates were higher. We believe the downside risk on gas prices is low, and, unlike crude oil assets, limited value is being imputed to future development.
The potential for a cyclical recovery in natural gas prices appears high. Due to depletion and increasing demand, it does not seem possible for natural gas prices to remain below replacement cost for more than five to seven years. Natural gas demand is increasing. The low cost of natural gas translates into materially lower costs for industries that directly consume natural gas as both a feedstock and an energy source, as well as a primary fuel for electric generation. The technology is evolving for using Liquefied Natural Gas (“LNG”) as a large fleet transportation fuel. LNG is discussed in depth in Jim’s article “Liquefied Natural Gas,” and in the Midstream section of this article. An additional indirect cost is the material reduction in emissions from shifting from coal or diesel to natural gas.
If we can identify good quality acquisition targets, we believe we can buy them on a valuation that will provide an attractive yield while we wait. We are putting contract land people in the field this fall to directly solicit these types of assets. Patient acquisition of producing gas properties at this time may be a good longer-term play.
Midstream (e.g., pipelines, rail terminals, processing plants and other infrastructure) has been the “sweet spot” for Five State over the past three years. Great Northern Midstream in FSEC Fund 1 may prove to be our best investment of the last decade. Advantage Pipeline is also proving to be a strong performer despite the delays, budget overruns and management issues we experienced earlier in the investment. Our expectations for the Tenawa natural gas processing plant in FSEC Fund 2 also remain strong.
Economic fundamentals are driving the growth in midstream. There is a lot of demand for the development of new infrastructure. Many are small projects in the $50 million to $100 million range. These projects are typically too small for the larger public energy capital firms. Many of these projects are “one off”, not lending themselves to mass production. Such projects are management intensive, so they are typically being developed by industry veterans, ideal for our type of private equity.
We have positioned Five States to provide “Independent Capital for Independent Producers”®, which is proving to be a competitive advantage. Many independents recognize that they need a partner who will not be predatory in such projects, where unexpected timing events and underlying business changes are likely. Independents are recognizing the advantage of a financing source that has considerable experience with working interest investments, operations, and upstream activities; one that will look at the ups and downs of the industry practically and not like a classic investment banker.
There are two changes to our historic investment profile as we add more midstream. The investment in each project is a larger percentage of each fund. Unlike the acquisition of producing properties which generate operating cash flow almost immediately, midstream development projects may take a year or more before they start generating cash distributions. The returns generated from these investments in the intermediate term more than compensate for the lack of yield during the construction period.
New investments in oil acquisition and development are tough. Helping capitalize independent producers in conventional redevelopment plays is a sweet spot for us. At current valuations, direct participation in shale deals do not provide the return we believe appropriate for the risk.
We perceive good long term value in natural gas. Acquisitions based on current prices should provide good yield, with upside in future price increases and additional development. Natural gas properties are still not actively trading. We have seen few gas deals this year. We assume that this is partially due to the fact that independent producers do not see a development play at current prices. Some natural gas producers must be financially stressed. We are putting in place a program to actively solicit gas properties.
Good values and high returns for the risk are available in midstream development. We expect continued growth in this area, even if there is a correction in oil prices and if drilling slows down.
We continue to add value to our legacy funds through increased density drilling. This is a very high return for the incremental investment. Unlike shale development, the break-even oil price on conventional redevelopment is very low.
The outlook for FSEC Fund 1 is getting stronger. At this time, we anticipate returns greater than the target pro forma for the fund, despite the long time it took to fully place the fund. We liquidated two of our weaker performing assets in the third quarter at values materially higher than the values used in our year-end report. These sales added over six percent to the value/return of the fund. Realizing returns on sale higher than our “carrying value” continues to support our disciplined value investing thesis.
We hope to have FSEC Fund 2 fully committed in 2015. At this time, we plan to open FSEC Fund 3 in the first half of 2015.