When I was a boy growing up in West Texas in the 1960s, there was a frequent television commercial for the Western Company. The ad concluded with a beautiful young woman in roughneck overalls and a hard hat hanging off the side of a drilling rig, speaking the famous tag line:
“If you don’t have an oil well, get one! You’ll love doing business with Western!”
Although I don’t attribute my desire to own oil and natural gas production to Eddie Chiles, I still believe that owning producing properties is an outstanding portfolio component.
At Five States we were excited in early July to close our first investment in several years in a group of producing oil properties for FSEC Fund 2. Based on recent calls from investors, I decided to cover some “whys” in my article this quarter:
- Why Own Direct Oil & Gas Interests?
- Why Is It Taking So Long to Deploy New Funds?
- Why Is It Worth the Wait?
WHY OWN DIRECT OIL & GAS INTERESTS?
The primary reasons to own producing oil and natural gas properties in a portfolio include:
- Current Return – producing properties provide return through current cash income, unlike many other asset classes where the investment must be liquidated to realize the majority of the return.
- Inflation Hedge – increasing energy prices have been a core component to price inflation over the last fifty years.
- Attractive Total Return – producing properties have priced at a net present value of engineered future cash flow in a range between 8% – 12% (unleveraged) for much of the last thirty years.
- Why Not Oil & Gas Stocks
- Low Correlation – the return from producing properties has a low correlation to financial assets. The following correlation coefficients are calculated on the changes in oil and natural gas prices to the other asset classes.
- Liquidity Premium – some advocate that owning energy stocks to invest in oil and gas entails a high liquidity cost. Sabine Royalty Trust (“Sabine”) is a mature oil and gas royalty trust. Following is a comparison of the Market Cap of Sabine compared to the Net Present Value (“NPV”) of its oil and gas holdings calculated at a 10% discount rate. The liquidity premium; the difference between the Market Cap and the PV10% value of the PDP Sabine owns is currently almost 4.5x. This is over twice the average liquidity premium in the 1980s and 1990s. This is a huge cost if the investor plans to make a long-term investment in oil and gas for income. Oil and gas “flow through” vehicles such as Royalty Trusts and MLPs (much like REITs, except that they invest in oil and gas) accumulate properties in a publicly traded investment vehicle and distribute the income to investors. These are the “purest plays”, as the assets consist almost entirely of oil and gas production.
WHY IS IT TAKING SO LONG TO DEPLOY NEW FUNDS?
The market for direct oil and natural gas properties has been in a state of flux since the crash in oil prices. As discussed in my fourth quarter 2016 article in The Producer, the 50% drop in oil corresponded to a 75% drop in the PV10% value for producing properties. The Proved Non-Producing and Proved Undeveloped (“PDNP” and “PUDs”) declined as much or became worthless.
The typical first lien loan advance rate on an oil and gas production loan is around 60% of PV10%. Therefore, without making aggressive assumptions about price recovery, most loans have been “underwater” by historical underwriting standards. The decline in oil prices from $85 per barrel to $45 per barrel resulted in an average decline in loan value of 80%, so the net present value of the collateral for most production loans fell below the loan amount.
Lenders have been holding onto underperforming loans, hoping for a partial recovery. Throughout the last ten quarters, many analysts have been calling for a quick recovery back to $60 per barrel. A recovery of oil prices back to $60 per barrel would have resulted in a doubling from the value at $45 per barrel. This has not happened, and the properties have continued to deplete.
Many of the properties that have been on the market are making their third or fourth round now without closing. However, many sales are now being forced by the lenders and banking regulators, or are coming out of bankruptcy. We believe we are now beginning to see financial discipline return to the market.
The asset in which we invest is “used up” daily as it is produced. This has several unique characteristics:
- Depleting assets generate more cash flow than the real return. For example, a property that generates cash of 15% on cost for the first year after purchase is only generating a real return of 8%. The other 7% is depletion (return of capital). Often all of this cash flow does not make it to the lender, but instead is consumed by the operator in overhead.
- The depletion erodes the value of the asset. In the preceding example (all else being equal), the value of the property decreased by 7%.
Depletion reflects the amount of oil that is produced each year, which decreases the total remaining. It appears we are approaching a point where lenders are much less willing to tolerate the annual reduction of their collateral while hoping for things to get better.
WHY IS IT WORTH THE WAIT?
I have received calls from investors asking “What have you been doing?” The calls come mostly from “new investors” (those who have been investing with us for less than ten years). We have been busy. A year in which we close multiple investments looks a lot like a year in which we don’t close any. In a typical year, we process 250 to 300 submittals (any investment opportunity that gets recorded in our log). Submittals are generated through attendance at trade shows, referrals and direct solicitations.
Submittals receive a preliminary screening by the Preliminary Investment Committee (“PIC”). The PIC is four senior members of the Investment Committee who review new submittals in a preliminary “triage” to determine if it might be a “fit” for Five States. About a third of submittals make it through PIC and receive some level of additional research and due diligence. About half of those that make it through PIC get deep analysis, consisting primarily of engineering, geologic and financial review. Of those, about two-thirds are rejected, and we attempt to close about one-third. So in a good year, we hope to close only about 4% of transactions initially screened.
VALUE INVESTING (FIVE STATES STYLE)
I am also asked, “Why aren’t you closing deals?” The answer is, the deals we have wanted either aren’t closing, or are pricing too high.
I was discussing new investments with a successful real estate promoter recently. I asked how he could continue to invest all the funds he was raising, when the price of income producing properties continued to rise, resulting in the project yield continuing to decrease. His response was “my investors make the decision to ‘buy the market’ when they invest with me. It is not my place to decide if the market is pricing correctly. My job is to place the money entrusted to me as efficiently as possible.”
The real estate promoter’s rationale doesn’t work for me in directing Five States. Perhaps it is satisfactory for real estate (since they don’t deplete), but I don’t think it is for direct investments in oil and gas properties. Investors do not have the insight or access to information to understand how the market is pricing assets. Based on significant research and analysis, we believe we have a much better handle on this.
I think the most valuable service we provide to our investors is the deals we don’t do. Many deals we analyzed we passed on closed. The question is whether the buyer made a good investment. Over the past few years, most who closed would have to say “no”. But we still have “dry powder” to invest when the market values assets attractively.
Despite adhering to our discipline, Five States’ returns on new investments over the last ten years have been disappointing. The decline in oil and natural gas prices from the +/- $80 per barrel range resulted in material decline in the value of producing properties. Also, the degree of slow-down resulted in a decrease in the valuation of pipelines and other midstream assets. We saw bids for Great Northern and Advantage both drop by one-half to two-thirds from the time we received initial bids until closing.
Although disappointed in our results, we are proud that we did not incur a major loss of capital. We have always said that we underwrite to a low double-digit return, where expected outcome can range from 0% to 20%. We always believed that targeting a higher return increased our risk of material loss of capital. FSEC Fund 1 final results are anticipated to be in the -5% to 4% range. This is disappointing, but given the severity of the crash in the oil market, I am pleased that our discipline resulted in our ability to return the majority of our investors’ capital.
I still consider producing oil and natural gas properties a cornerstone of my portfolio. I make all of my investments in this sector through Five States. The value investing philosophy embraced by Five States is the only way I believe one can maintain a significant allocation to this sector without taking material risk of loss of capital. And I trust the integrity of the Five States investment team to continue to adhere to a strict value investing discipline.
I like to compare oil and gas investing to riding a roller coaster blindfolded. As long as you don’t get thrown out of the car, you should have a good ride. The average returns from long-term oil and gas investing are strong. But the volatility is high. In order to “stay in the car” for the long-term, a disciplined investing methodology is required.
We believe the market for producing properties is finally entering the stage in the cycle where value investors can find attractive purchases. We continue to believe Five States is one of the best options available to those who wish to have an allocation to direct oil and gas.
 The Western Company was a major oil services firm, primarily in acidizing, fracturing and cementing, run by Texas icon Eddie Chiles, famous throughout the region for his “What are you mad about today, Eddie” political radio spots and as co-owner of the Texas Rangers baseball team. At its peak, the Western Company had over 5,000 employees and annual worldwide revenues of over $500 million. It was liquidated through sales to other major service companies in the 1990s.
 Liquidity Premium – the explanation for a difference between two types of financial securities (e.g. stocks) that have all the same qualities except liquidity. https://en.wikipedia.org/wiki/Liquidity_premium
 MLPs – Master Limited Partnerships
 REITs – Real Estate Investment Trusts
 Source – Sabine Royalty Trust 12/31/2016 Form 10-K