How Do We Know?

Our most frequently asked question the last several months can be summarized as “How Do We Know?” Some specific questions are, “How do we know:

  • When oil prices have bottomed?
  • When it is time to buy?
  • When the banks will force their non-compliant or insolvent borrowers to sell?
  • When it is time to “back up the truck” and buy “everything”?

We do not know the answers to these questions . . . we never do. We depend on the market to tell us when to close on individual transactions. As value investors, we know it is time to close on an individual transaction when it is priced at a level that we believe will generate our targeted rate of return.

I often state that we are “Benjamin Graham investors in oil and gas.” Graham is considered by many to be the “father of value investing”[1]. Graham’s thesis was that by performing fundamental analysis of the financial condition and financial performance of companies you can determine their true value. He believed that fundamental analysis differentiates investing from speculation. He posed that through fundamental analysis one can calculate the true value of a stock, and should only buy a stock at that calculated price or a lower price. Conversely, when a stock trades above its true value, one should sell.

As value investors in oil and gas assets, we perform a fundamental valuation of every asset we consider, using a process similar to that described by Graham. However, we use additional metrics that are unique to the oil and gas industry.

When buying producing oil and gas properties, we start with a list of what type of properties we want to own. This eliminates the need to perform superfluous work analyzing assets we do not want as part of our portfolio. We primarily target properties that have:

  • Long-lived reserves,
  • A high Proved Developed Producing (“PDP”) component in the valuation. We want the Proved Developed already Producing to be large compared to the potential production from additional development,
  • On-shore production,
  • Permian/Delaware Basin & Midcontinent production. This includes almost everything between the Rockies and the Mississippi River,
  • Solution-gas drive reservoirs,
  • Low lifting costs, and
  • Locations in the United States (no Canadian or Mexican assets).

We avoid projects with a high debt component in the capital structure. We are investing in a high operating leverage industry. It does not lend itself to high financial leverage.

In our analysis, we attempt to forecast the range of earnings an oil or gas property can generate in the future, much like a fundamental analyst tries to forecast the future earnings of a company. We also attempt to calculate likely outcomes under a range of scenarios and the probability of those outcomes. Scenarios include lower oil and gas prices, varying production levels and other variables discussed in this article. We calculate the price we are willing to pay based on our target rate of return applied to the forecast income. We avoid investments in which our analysis calculates that, in the low case, we can lose the majority or all of our invested capital.

Valuation Process

Future Production Volumes

The valuation of a producing property begins with a forecast of future production volumes. This forecast is based on historical rates of production which decline over time. Other data such as producing rate versus cumulative production help estimate the remaining reserves, as do measurements of bottom hole pressure and comparisons to nearby analogous well histories. The following is an example of the production curve of a property. The “squiggly” part of the graph is the actual production from the past. The smooth line on the right is the forecast future production.

Olivia Marie 32-5H


We use the forecast future production to calculate estimates of future revenue. We typically use the New York Mercantile Exchange (“NYMEX”) futures prices for West Texas Intermediate (“WTI”) crude oil to calculate the estimated revenue for oil produced each month in the future. For example, on July 27, 2015 the price for a barrel of oil sold in Cushing, OK in September 2015 was $47.39. The price for a barrel of oil to be sold in August 2016 was $53.17, and so on. We typically use the 48th month’s price as the estimated price for all months after the 48th month.

Crude Oil Futures


The term “differential” refers to the difference between the reference price (i.e., WTI) and a regional price (e.g., Williston, Midland, etc.). Bottlenecks in the transportation system and differences in quality account for the variance between prices. The Bakken has historically experienced a wide differential due to the lack of infrastructure and high production volume.

Revenue forecasts are adjusted for the impact of field differentials. Differentials change over time, so understanding the impact of this potential volatility is another variable in our valuation equation. We receive a “field price” for our production at the wellhead that may be higher or lower than WTI. This results in basis differential risk that we are usually unable to control or mitigate.

Differentials Map

Source: Coquest Daily Report 7/28/2015


Using the NYMEX contracts described above, when we buy a producing property we hedge a portion of the production for the next three to five years. The hedge is an actual physical forward sales contract for delivery of 1,000 barrels of WTI delivered to Cushing, OK on the expiration date. Using hedges reduce the price volatility risk in new investments.

Operating Expenses

Producing properties have several categories of operating expenses. Fixed costs include lease overhead and pumpers (i.e., field employees). Variable costs include electricity/fuel, subsurface maintenance and repair, surface equipment and repair, wastewater disposal, and production taxes. In the single well example below, fixed annual operating costs total $36,000 per year. Variable costs total $30 per barrel. These costs as well as severance and ad valorem taxes are subtracted from revenue to give us the property level cash flow. As illustrated below, the economic limit of the property is the point where property level cash flow is negative. At this point, the well should be shut in and possibly plugged and abandoned.

Economic limit of a property


We calculate the value of a producing property by applying an appropriate discount rate to the expected cash flow to calculate. This is the net present value of the projected future production. At this point we have estimated value of the PDP portion of the property.

In many cases, there are believed to be proved undeveloped reserves[2] on the property (i.e., PUD or Proved Undeveloped). Depending on the risk in developing this potential, we may attribute some value to these undeveloped reserves. We estimate the timing and capital costs to develop the new reserves. Then, we calculate the expected cash flow and net present value as we did with the PDP reserves. But these reserves are less certain, so we then “risk” the calculated present value by reducing it by as little as 20% or as much as 90%. We then add the risk adjusted valuation of the undeveloped reserves to the valuation of the PDP to calculate the value of the property.  If we believe we can buy the property at this price, we should achieve our risk adjusted return if the base case scenario proves to be reality. This is how the market tells us when to buy.

Contract Closing

If we are successful in identifying an asset that meets our valuation parameters we will attempt to get it under contract. We will structure our investments in direct purchases, preferred or “mezzanine” investments or high interest rate loans on any of these types of assets.

We then enter into the closing process. This includes review of the leases (title review), review of all existing contracts and operating agreements, physical inspections and any other documentation related to the structure of the deal.

Various Oil & Gas Segments

The previous example was for the purchase of producing properties. We actively pursue investments in four basic subsets of the oil and gas industry:

  • Oil Properties– properties that primarily produce crude oil
  • Gas Properties – properties that primarily produce natural gas
  • Midstream – assets such as pipelines, storage, and processing facilities
  • Service – well workover and maintenance, waste disposal & transportation other than pipeline

We invest in direct purchases, preferred or “mezzanine” investments or high interest rate loans on any of these types of assets. Investments in assets other than producing properties are based on underlying production fundamentals. We perform a valuation analysis on midstream and service assets similar to what we do on producing properties. The economic life in midstream and service assets is a function of the economic life of the underlying production they service, so much of the skill set required to perform this analysis overlaps with production assets. The legal and contract work is also related.


I often joke that investing in oil and gas is like riding a roller coaster blindfolded. You cannot really see where you are going, but you know there will be big highs and lows, and as long as you do not get thrown out of the car you will have a great ride. The inherent returns in oil and gas are high, due to a large part because of the volatility. Over the last thirty years we have “had a great ride” being well compensated for accepting volatility of the ride. We avoid “getting thrown out of the car” by managing our risks. We use our fundamental analysis to determine the appropriate levels of debt and non-producing exposure as we make new investments. As long as we avoid too much debt and too much exposure to non-producing assets we can structure our portfolio to generate positive cash flow through the inevitable downturns, and be positioned to profit in the upturns.

We are also asked what area we like today: oil, natural gas or midstream? Right now I like gas. But that tends to have little to do with what we will actually buy. Opinion is not the driver. By sticking to our disciplined fundamental analysis, the market tells us which sector is being priced the most attractively on a risk/reward basis. The market will also tell us when not to buy.

Some are surprised that we have not made many new investments since the price crash at the end of last year. It takes time for those incurring huge losses to process changes of this magnitude, something akin to the five stages of grief.[3] Late last year the mentality was denial and anger, with the consensus that “this cannot be happening and it cannot last.” By the late first quarter we saw many bargaining for the terms and pricing they believed were available before the crash, hoping that they could somehow turn back the clock. We are now beginning to see depression and acceptance, which is translating into acceptance by sellers and others seeking capital of the new reality.

We believe this is an excellent time for making new investments in oil and gas. We are in the low end of the cycle, and long-term upside potential exists. This is probably the best oil and gas investment market we have seen in over a decade. Downturns are always the best investing environment for value investors like Five States.

As discussed in my Producer article last quarter, pretty much every independent in the industry that was using 50% debt in their capital structure is in a difficult position. Debt levels in the oil and gas industry reached all-time highs before the crash.  The need for capital to restructure the excessive debt will be great over the next few years. We are well positioned to provide that capital to private independents. We do not know when the bottom will occur, or which segments will be the best. But by sticking to our disciplined value investing methodology, we expect to continue to make solid investments during the current trough of our industry’s roller coaster ride that will justly reward our investors for the risks taken.

[1] “Benjamin Graham.” Wikipedia: The Free Encyclopedia. Wikimedia Foundation, Inc. 27 June 2015. Web. 5 August 2015.

[2] Proved Non-Producing (‘PDNP”) or Proved Undeveloped (“PUD”) reserves.

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