Unless you follow the energy industry closely, your awareness of oil and gas may be limited to the occasional mention of oil and gas prices or drilling rig count reported in the mainstream news. While prices and rig counts are certainly important, there are many other factors that dictate the success of Five States funds and the returns they provide to investors. One of these factors is the availability of investment capital. Without investment capital, development of oil and gas assets slows to a crawl, production drops significantly, and revenues drop. This is the very environment that we are operating in now, but fortunately it is working to our advantage. Here’s why…
Operators of oil and gas properties have four sources of capital to drill new wells or recomplete existing wells. Two of these sources are organic (internally generated) and two are from external sources. These are:
Organic Sources:
Cash Flow from Operations
Cash from Asset Sales
External Sources: Private Equity
Commercial Debt
Cash Flow from Operations is typically slow and steady, and hedges can make it fairly predictable and reliable. However, operating cash flow is seldom enough to support even a modest development drilling or recompletion program.
In contrast, Cash from Asset Sales can produce enough cash for a development program, even a major one. Likewise, Private Equity and Debt can finance major development programs. However, these sources of capital are more expensive, subject to market forces, and recently, subject to the societal demands on investors and banks. It is the combination of these factors that is setting up for what we believe is a tremendous opportunity for Five States funds. Why? Because two of these three sources are very hard to access now, and the third plays right into our core investment strategy. Let me explain further.
Private Equity - As a result of the poor performance of risky investments in U.S. oil and gas shale plays, coupled with a drop in oil prices from 2014-2020, the markets have shut off the spigot of plentiful, low-cost capital flowing into our industry. Despite the enormous run-up (150%) of oil prices in the last 12 months, private equity capital has remained parked on the sidelines aided in part by environmental, social, and governance (ESG) sensitivities and societal pressure.
Commercial Debt – Similarly, banks have curtailed funding to our industry, mostly in response to regulatory compliance pressure requiring them to limit risk exposure. There has been a notable reduction in the number of banks serving our industry and those that remain are taking on fewer new clients in favor of strengthening relationships with existing ones. In many cases, they have reduced lending limits and made their debt covenants much more “banker-friendly”. As a result, banks have significantly curtailed the amount of capital available to operators and have made that capital much harder to get.
With less access to Private Equity and tougher lending from banks, what option is left for operators?
Cash from Asset Sales. Many operators are now using proceeds from asset sales to fund their development programs. These companies are evaluating their portfolio of assets, identifying their core assets that have critical mass, then aggressively marketing and selling those that are deemed to be non-core assets. Many of these properties are quite valuable but not geographically located well for the sellers; it is these assets that are of particular interest to Five States. Some of the properties we are seeing are of very high quality yet offered at reasonable valuations. As you might expect, buyers with cash-in-hand are highly prized because they can close sales without the contingency of raising capital. This is precisely why a few weeks ago, we launched Five States Energy Income 2021 so we can continue to be a buyer with ready access to capital.
As mentioned earlier, the current environment is setting up well for Five States funds. As of this writing, our FSPA 2020 is working toward full deployment only 15 months after it was closed, and it will make its first distribution to investors only ten months after its first asset acquisition. Likewise, we expect the capital of our new fund, Five States Energy Income 2021, to be at least 20% deployed before the fund is even closed this fall.
It is an interesting and exciting time for the management and staff of Five States Energy and its affiliated companies and funds. We look forward to sharing more information about our funds soon, and we thank you for your trust in us.