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.
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.