When Things Change, Things Change

Only a decade ago, many economic seers were predicting that oil prices would be in the $150 to $200 per barrel range in this current decade.  But there is an old adage in commodity industries: “the cure for higher prices is higher prices”.  It is analogous to a most basic economic concept, “change begets change”.  Changes in prices lead to change in behavior by both consumers and producers.  These changes manifest on both the supply and demand side of the equation.

Twenty-five years ago, in classic Malthusian[1] thinking, many economists believed “energy was different” because the supply is finite.  The following chart illustrated a “truth” that was widely believed: that energy prices would continue to increase in the future at an accelerating rate because we had “used up” the existing supply.  In that environment, future oil prices were higher than the spot price[2].

Wellhead Crude Oil Prices

History has shown us repeatedly that extrapolation of extreme trends following changes do not accurately predict future results.  In this case, higher oil and natural gas prices have led to the development of new technology that was considered unrealistic a decade ago.  Consumption behavior, both at the consumer and industrial level, has changed demand.

Today, industry consensus is that oil will trade in the $70 to $100 per barrel range for the long term, and that natural gas will stay below $8/mmbtu for decades.  As discussed in my third quarter 2012 article “Sunset to Sunrise”, the energy outlook for the United States has changed materially.  Once again, Malthusian expectations have been debunked by free market economic forces and human ingenuity.  The development of new technologies such as 3-D seismic and horizontal drilling led to the ability to tap huge unconventional[3] formations that were previously uneconomic.  These new technologies, combined with improvements in hydraulic fracking (a core extraction technology in the oil and gas business since the 1940s), have led to a bonanza in oil and gas development.

For the foreseeable future, rising oil prices may no longer be the norm.  Tremendous success in the development of unconventional oil and natural gas reserves in the United States is reversing this trend.  Prices for crude oil to be delivered in the future are now much lower than the spot price.  Spot prices have been fluctuating between $85 and $100 per barrel for the past several years, while the contract for crude oil delivered in five years is now fluctuating between $75 and $80 per barrel.  This may reflect expectations of lower prices in the future–or it may be that buyers are not as afraid as they were a few years ago, and are less interested in locking in future prices.

Commodity Prices - Crude Oil (WTI)

This change in U.S. energy is very stimulative.  The average U.S. family spends over $4,000 per year on gasoline (over 11% of their disposable income).  Total U.S. household expenditure for gasoline last year was about $461 billion.  A few years ago this expenditure was expected to increase by 150% to 200% in this decade.  Now it looks like it may decrease by as much as $100 billion per year.  The net change in expectation is equal to over half of the total amount spent on the American Recovery and Reinvestment Act of 2009, but every year!  And we no longer have such a strong national interest in “protecting” unstable foreign governments to protect our energy supplies.

We have seen comparable reductions in natural gas prices and expectations.  Lower energy prices for natural gas and electricity, combined with more secure supplies, are increasing corporate profits and are a leading reason for the renaissance in U.S. manufacturing.  They are also resulting in stable to declining utility costs for consumers.  As an added bonus, the shift from coal to natural gas has resulted in the greatest reduction in emissions of any country in the world.  Although not a signatory to the Kyoto protocol, the U.S. is the only country in the world expected to achieve the emission reductions that would have been required by that treaty.

Change in Drilling Risk

The biggest risk in oil and gas investing has changed.  The primary risk in the 20th century was unsystematic, or project risk.  The risk of a project resulting in a dry hole was the primary focus.  New technology has greatly reduced the risk of drilling a dry hole.

Today the vast majority of drilling for both oil and natural gas is in unconventional fields.  There is also a significant amount of increased density drilling[4] in existing conventional fields.  In both cases the reserves being developed were previously known to exist.  The higher price of oil and natural gas makes it economically viable to develop reserves that would not have been cost effective ten years ago (even if the new technology had been available).  For example, our legacy partnerships have participated in 38 Bakken wells in North Dakota in the past seven years on leases that we owned, all of which have been economically productive properties.

The chief risk in new development is systematic, or market price risk.  If oil prices do not continue to trade in the expected range of $75 to $100 per barrel, the newly developed oil fields will not generate the expected returns.  If prices fall below $70, some investments will lose money.

Systematic risk has already resulted in material disruption in the natural gas industry.  The unconventional development of the last decade was so successful and generated so much new supply that prices collapsed.  This occurred despite the increase in consumption from electrical generation.

Change in Decline Rates – Unconventional Wells

Unconventional wells deplete more rapidly than conventional wells, resulting in a faster rate of decline of production.  Therefore new wells must be drilled at a faster pace to maintain production rates.  The cost of these new wells is high.  Depending on the formation, a working interest owner must receive somewhere between $40  to $60 per barrel to recover their investment. If the price falls below this level, drilling will slow and the supply will decline.  This is 50% to 100% higher than the price needed to break even on conventional wells, where breakeven averages between $30 to $40 per barrel.  The ratio between unconventional and conventional natural gas is similar.

West Texas Intermediate Crude Oil Breakeven Price for 15% After-Tax Return by Play

Source: Copano Energy Presentation (data per Credit Suisse Small/Mid Cap E&Ps research report released April 10, 2012)

Change in Leverage

This shift in the basic economics has resulted in a greater degree of operating leverage[5].  The risk of this increased leverage is the most disconcerting factor in underwriting many of the investments we see.  In addition to operating leverage, financial leverage (debt) is continuing to grow as a percentage of capital deployed in the industry.  When you combine the operating and financial leverage, the volatility in cash flow as wellhead prices change is greatly amplified.  The potential volatility of profit (or loss) is much greater than a decade ago.

Change in Natural Gas

Natural Gas Futures (NYMEX)

Natural gas remains out of favor. Future price expectations have changed materially, resulting in more attractive valuation for a buyer of producing natural gas properties.  The current spot price and the expectation of future prices are now about half of what they were six years ago.

Most independent producers are interested in projects that can add value through drilling additional gas wells, but drilling new gas wells in most shale developments is not attractive at current natural gas prices.  We continue to seek opportunities in this sector where we can make acquisitions based on the existing production income, with the potential for future development when prices warrant.

Change in Midstream Opportunities

One of the most exciting new opportunities is that we once again find midstream[6] investments attractive.  At the time of the 1980s energy collapse, there was sufficient infrastructure to handle the decreasing volumes of domestic production in the U.S.  Public MLPs[7] were aggregating income producing midstream assets, creating investment vehicles much like portfolios of utilities stocks.  This drove up the valuations of midstream assets beyond levels that were attractive to private equity.  Oil and gas production volumes have now recovered to levels where the existing infrastructure is “full”.  This is driving demand for new midstream infrastructure and creating attractive development opportunities.

Five States is pursuing investments in midstream development.  Projects in the “first 100 miles from the wellhead” are well-suited to independents.  The primary risk in these projects is the economic volumes of the oil and gas fields that they service.  The development cycle time of these projects is long (around two years) and these projects tend to be “one of a kind”.  It is a very “clubby” part of the business, where teams of investors like Five States partner with developers.  The developers tend to want sophisticated industry partners rather than Wall Street money.  Projects can be operated for an attractive yield once completed, with the MLP market providing a viable conduit for future sales at attractive valuations.


The current price of crude oil is $100 per barrel, compared to the replacement cost of $40 to $60.  Typically, one does not get to earn a gross profit of this magnitude in a commodity.  However, demand is still growing at a strong pace and may overwhelm the recent increases in production.  Some experts are predicting a slow-down in the rate of production growth.  As is always the case in finance, uncertainty is risk.  Because of our sensitivity to oil price risk, we will continue to invest in oil projects in a mezzanine structure, where our preferred position will mitigate some of this price risk.  We will also continue to aggressively hedge our oil prices in new transactions.

Natural gas continues to look attractive from a macro perspective for value investing.  However, the transactions we expected following the natural gas crash in 2008 – 2010 have not materialized.  We are currently evaluating an investment in a large natural gas acquisition with a Midland independent with whom we have a long-term relationship.  We expect to see more opportunities in natural gas over the next few years.

By far the most lucrative area has been midstream.  The need for new infrastructure is an excellent fit for Five States.  The continued expansion of domestic oil and natural gas development should continue to provide opportunities throughout the next decade.

In recognition of the shift in risk, we are taking more unsystematic risk than we did in our first twenty years.  We are moving away from areas with higher systematic risk and where plays are overpriced or overleveraged on a value basis.  The last few years, midstream has been the most attractive area.  However, we will continue to base our investment decisions on fundamental analysis and true value investing, rather than following the most popular trends.

We at Five States remain bullish on the domestic oil and natural gas industry.  It will take a generation or longer to transition from traditional fossil fuels.  Until viable options are developed, the most efficient direction for the United States from both an economic and ecological perspective is to prudently develop our bountiful resources and use those resources more efficiently.  We can continue to lead the world in emission reduction while achieving the economic growth needed to finance future energy research and development.

The world may not be in a period of rising prices.  But the oil and gas industry is in a period of tremendous growth, and the need for capital to sustain this growth is at an all-time high. Recognizing the impact of the changes of the last decade will contribute to our ability to more accurately assess risk and allow us to continue to find attractive value investment opportunities in domestic oil and gas for the foreseeable future.


[1] Robert Malthus (18th/19th century) espoused the idea that human population increases geometrically while supply increases only arithmetically, which eventually leads to calamity.   In the case of energy, demand is expected to increase exponentially while supply is finite, resulting in increasingly higher prices.

[2] The “spot” price is the price being paid for a commodity sold and delivered at the current time, as compared to a price for delivery at a time in the future.

[3] Unconventional reservoirs are shale formations.  These low permeability reservoirs have been known to contain hydrocarbons since the beginning of the industry.  The pores that contained the hydrocarbons are not well connected, so in earlier times it was not economically viable to produce these reservoirs.  The oil and natural gas produced from unconventional reservoirs is the same as that produced from conventional reservoirs.

[4] Increased density drilling is drilling between existing wells in a producing field to recover oil in-between the existing wells that will not be produced from those wells.

[5] An investment has high operating leverage when it has a high fixed-cost component.  In the case of oil and gas development, when the capital cost per unit of recoverable hydrocarbon is high, small changes in prices have a big change in project profitability.

[6] Midstream is the infrastructure between the wellhead and the refinery; pipelines, gathering systems, storage facilities, compression and processing facilities, rail facilities and rail tank cars, ships, barges, tanker ships, etc.   It is the “middle of the stream” between the wellhead and the refinery.

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