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

[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]

[3] OPEC – Organization of Petroleum Exporting Countries

[4] Source: World Bank, Carbon Dioxide Information Analysis Center, Environmental Sciences Division, Oak Ridge National Laboratory, Tennessee, United States.

[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

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