Five Hundred Million

We reached an interesting milestone at Five States this year. Total distributions from Five States partnerships over our history have now exceeded half a billion dollars. This is about three times the total equity invested1 in the Five States partnerships from 1989 through 2005. About half of this was operating income generated from our producing properties and about half was from the property sales in 2006 and 2007. We completed investing Five States Energy Capital Fund 1 earlier this year, and we expect it to “ramp up” to provide distributable income similar to our earlier partnerships. We consider these results to be a good example of “Value Investing”.

Investment managers are often classified as “Growth Investors” or “Value Investors”. Growth Investors generally have a strategy of seeking investment opportunities where the primary return is expected from growth in the underlying business, translating into growth in investment value. Growth Investors are willing to pay a higher price relative to current earnings because they expect earnings to grow. Returns are achieved primarily from appreciation, so are realized upon sale. Current returns such as dividends are typically low or nonexistent. A good example of a growth investment is Apple stock. The value of the stock is much greater than the current earnings alone justify, and it has historically paid out a low percentage of earnings in dividends.

Value Investors seek investments that are attractively priced based on the existing financial fundamentals; a “what you see is what you get philosophy”. After analyzing revenue, expense and income of their target investments, as well as the component value of the assets and offsetting liabilities, Value Investors calculate what they think the investment is worth based on these fundamentals, typically using a discounted cash flow methodology. A disciplined Value Investor invests only when the target investment can be obtained at or below their calculated value. Utility stocks are an example of a value sector. Most of the valuation is based on the existing income potential of the company. Much of this income is paid in dividends.

We at Five States have always considered ourselves a Value Investor. Our investment decisions are based on analysis of the underlying fundamentals of target assets. We expect to earn the return from owning an asset, relying on the income the asset generates for the majority of our return. We expect to sell an asset only if someone is willing to pay us more than we think it is worth.

A Value Investing approach has a consequence that is sometimes frustrating. There are times when others in the market are willing to pay more for an asset than we are, and we become “priced out of the market”. Periods like late 1997/early 1998 and 2006 to 2009, when we closed few if any transactions, are good examples. In both of these periods we processed plenty of transactions, but someone was usually outbidding us. So we would wait until market values came back in line with our calculated valuation. We do not consider this a contrarian philosophy. We consider ourselves realists.


In the 2006 – 2007 period we thought that “peak oil” was going to result in a continually shrinking inventory of domestic assets in the U.S. for us to invest in. New recovery technologies developed in response to higher oil and natural gas prices have reversed that trend. The development of 3-D seismic and horizontal drilling have resulted in the ability to recover economically viable oil and natural gas from formations that would provide insufficient yield with only vertical wells. These technologies have also substantially reduced the “dry hole” risk of new development, often approaching zero.

The reduced dry hole risk of developing new fields has been replaced with new risk. The cost of implementing these new technologies is much higher on an individual well basis. Completion risk is also greater. In long horizontal wells it is not uncommon that the cost to complete the well exceeds the cost to drill it. The break even cost to drill and complete oil wells in many of the active domestic plays is $40 to $60 per barrel, and for natural gas is $3.50 to $6.00 per thousand cubic feet (mcf). This adds operating leverage, resulting in increased systematic risk (the impact of oil and gas price volatility). This risk was realized in the natural gas sector at the end of the last decade as the success of horizontal drilling increased domestic supply so much that the price of natural gas declined from over $10/mcf to as low as $2.00/mcf. It has recently recovered back to the $4.00/mcf range.

In 2007 when we expanded our investment tactics to include mezzanine, we did so in recognition of the increased systematic risk. At that time, we did not expect the industry to expand at the rate it has in the last six years, but did see that the systematic risk had increased materially. We needed additional tools to structure new investments appropriately in light of that risk. Ironically, the mezzanine structure was used in only 20% of the FSEC Fund 1 portfolio as it exists today. It would have been over 50% if a very substantial mezzanine commitment known as Coachman had not prepaid.

Increased oil production volume has dampened the consensus expectation that oil prices will increase materially in the near term. Domestic production rates are approaching levels of twenty years ago, and are expected to continue increasing.

NYMEX Futures Curve Comparison

Today, the futures contract price for oil to be delivered one to seven years from now is materially lower than the wellhead price. This is occurring for the first time in decades.

Energy Demand by Region – OECD vs. Non-OECD

Energy Demand by Region - OECDEnergy Demand by Region - Non-OECD

The waning optimism regarding futures prices is actually good for us as a Value Investor. Over the last decade many of our competitors were counting on higher oil and natural gas prices in the near term to support their investments. Now that these competitors are not expecting higher prices in the near term, the assets for which we are competing are more attractively priced.

We believe that this “softening” in oil and natural gas prices is an intermediate term phenomenon. World demand for energy is expected to continue to grow as the world economy expands. The vast majority of this energy demand will be met by oil and natural gas.

The United States is shifting from a net consumer to a net producer. This is already having a material impact on the U.S. economy as our balance of trade deficit shrinks and our economy benefits from the high paying jobs and high return investment of the redevelopment in our domestic energy infrastructure. North America will become hydrocarbon independent, and will likely become an exporter of natural gas.

US Crude Oil Production – Texas and North Dakota

US Crude Oil Production - Texas and North Dakota

This is providing an incredible Value Investing opportunity in an otherwise depressed environment. We believe that this renaissance in the domestic oil and natural gas industry will present Five States investors excellent opportunities and returns for the next decade.

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