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.
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 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!