Riding the Cycles

No one needs to inform west Texas citizens that the oil and natural gas industry is currently in a slump. All one has to do is drive from Midland to Odessa and count the number of drilling rigs standing idle in storage yards, or pick up a copy of Midland’s The Daily Observer to read about oilfield layoffs, diminished company profits, and numerous mergers and acquisitions.

Anyone who has lived in the Permian Basin for more than a decade has experienced the effects of major downturns. Old-timers who can remember the days in the 1950s and 1960s when $3 per barrel oil and 18¢ per MCF natural gas were the norm have lived through five major price collapses. Most of us who have been around the business for any length of time have learned to accept periodic industry retrenchments as normal, and have developed something of a bunker mentality about dealing with them.

Cyclical downturns can actually be the “Best of Times” or the “Worst of Times” for oilmen and their investors. They are created when oil and natural gas prices decline rapidly, usually unexpectedly, and remain low for an extended period. The first major decline since $3 oil started its upward run in 1973 occurred in 1985, when the benchmark price of a barrel of West Texas Intermediate crude oil dropped 62.4%, from $30.81 to $11.57. The resulting jolt was sufficient to create havoc in the oil fields, bankrupt companies, and ultimately contribute to toppling major banks in Dallas, Houston, Oklahoma City, Denver, Chicago and elsewhere that carried large positions of oil and gas debt in their loan portfolios.

Five States was chartered in 1985 in the midst of the wrenching price decline of that year. As prices withered, banks initially began calling in oil loans of borrowers who were in default on debt covenants. Within months, as their debt to asset ratios continued to worsen, the banks began calling in loans from their “good” customers who were still current with scheduled repayments and still compliant on their covenants. Some of these borrowers, unable to raise funds from alternative sources, lost their properties and sometimes their companies in the melee.

Billions of dollars of oil and gas equipment, producing properties, royalties and minerals, oil field service companies and operating companies were thrown on the market, available to anyone who had enough money and courage to bid on them. For some individuals, it was the end of the line. For others it was the beginning.

In such times, the difference between losing a company or starting one is often the availability of or access to capital. Although Five States had only modest assets and a small bank account at the time, we had the experience to recognize that good value properties were on the bargain table. We also had little overhead and no debt. The only missing ingredient was cash. We began knocking on doors as far from the oil patch as possible, hoping to find investors who would listen to our story. A few did, most noteably fee-only financial advisors.  Five States’ upward cycle had begun.

Although oil prices began to recover the following year, it took more than a decade for confidence in the industry to be fully restored, for new banks and capital sources to become well established, the glut of producing properties to finally be settled in new hands.

For most young companies, and those aspiring to grow rapidly through acquisitions and the drill bit, institutional capital and bank debt are essential elements in their development. Serious problems can and do arise when, in the flurry of their activity and achievement, a drop in commodity prices slashes revenue, debt becomes unmanageable, and the companies fail.

In recent years, the commodities futures markets have come to be utilized much more widely and effectively to lock in forward prices, protect collateral and reduce risks of commodity losses. Even so, companies who carry high debt loads, especially over longer periods, always face the possibility of catastrophic losses.

Five States has always been a conservative player. Our focus on investing in long-life legacy oil properties that generate strong operating margins provides us a stable financial foundation.  With excellent financial partners willing to provide capital when needed, a knowledgeable and experienced staff, relatively low debt ratios, an envious track record, and a reputation for competence and integrity, we believe that we are again moving into a new cycle of attractive acquisitions, growth and success.

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