Whirlwind of Change

Looking back, I am astonished by the changes that have occurred in the development of U.S. energy supplies over the last decade. In fewer years than a kindergartner becomes a teenager, the U.S. oil and gas industry has found the keys to unlock literally billions of barrels of oil and trillions of cubic feet of natural gas in our country, and to completely reverse the trend of ever increasing dependency on foreign oil. The consequences are truly profound.

As recently as 2000, the energy industry’s consensus was that all the large fields in the United States had been found, oil and gas production in the U.S. would continue to decline, and oil imports from abroad would continue to increase. Although hydraulic fracturing (fracking) has been a standard industry practice since 1947, applied to more than a million wells in the U.S., its use in opening dense oil and gas-bearing shale formations had never been successful. All that changed in 2000 when Mitchell Energy Company finally demonstrated that new hydraulic fracturing techniques, utilized in horizontal sections of wells, could economically recover the treasures stored in tight rocks deep underground.

U.S. oil production peaked in 1970 at 9.6 million barrels of oil per day (bopd). However, by 2009 production had declined to 5.0 million bopd. A Malthusian projection of the trend would have led to the expectation that today’s production would be near 4.5 million bopd. However, owing to the “shale revolution,” U.S. production has risen to almost 7.5 million bopd, and continues to increase . . . a three million bopd difference. At an average price of $90 per barrel the differential amounts to $270 million dollars a day, or almost $100 billion per year, that will not be sent abroad. Perhaps that’s small potatoes by government standards, but it is still very significant to the U.S. balance of trade.

Consider U.S. crude oil imports. In 2005 the U.S. was importing oil at the rate of 10.1 million bopd. By the end of 2012 imports had dropped to 8.5 million bopd, a 1.6 million bopd reduction. In June of this year, Bloomberg reported that U.S. domestic crude oil production exceeded imports for the first time in 16 years. The resurgence of industry activity resulting from the combination of new horizontal drilling techniques and improvements in the sixty-five year old hydraulic fracturing technology has created a tidal wave of new business formations and elicited strategic changes throughout the industry.

Soon after George Mitchell’s early successes in producing oil and gas from the Barnett shale formation in north Texas, other companies immediately seized upon the new technologies to rapidly develop the Fort Worth basin’s Barnett shale and to apply them in other basins. A land grab that rivaled the early days of the 1800s gold rush began.

For the next several years, until around 2007, legions of agents representing individuals and companies of all sizes leased as many acres as they could finance. Larger companies bought acreage to drill; individuals typically bought leases with the intention of “flipping” them to the large companies at a profit.

The beginning of 2013 marked the beginning of a new phase of their operations. By now, most companies have acquired all the leases they could, consolidated their positions into a few core areas, established a drilling inventory that can keep them busy for years or decades, and laid out plans to develop their acreage, or prepare for an IPO, sale or merger.

For Five States Energy the shale revolution has been exciting to witness, but it has offered few opportunities for our participation. A primary strategy of our business is collateral-based investing, not speculative lease buying and selling, technology development, or exploratory drilling. Although massive amounts of capital have been required to fuel the party to date, only a very few situations have been appropriate for Five States to participate.

However, we believe our time is at hand. As new wells are drilled and put on production, money will be needed for pipelines, oil storage facilities, gathering systems, truck and rail terminals, water treatment plants, water supply and disposal wells, and construction of other midstream assets. Without these, producers cannot produce or sell their products. With value created by production from new wells, collateral will be available to support senior and mezzanine debt and development equity.

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