The past 20 months have witnessed the U.S. energy sector slide into a state of distress not experienced since the 1980s. The magnitude of the price collapse and its duration is causing pain everywhere, with producers trying to cut their operations to the bare bone in an attempt to avoid bankruptcy or, in many cases succumbing to it. Commonly, these oil and gas bankruptcies end with wholesale liquidations rather than classic reorganizations.
The story of the current oil and gas crisis is not unique in the world of financial distress: participants with overambitious growth plans fueled by an orgy of easy Wall Street money, leadership teams with little skin in the game, and inferior assets only made profitable only by unsustainably high prices. The overreactions by lenders and regulators made (and continue to make) matters worse.
Many operators simply had no chance when prices started to slip: their inferior or fringe acreage positions quickly became negative, making recapitalization, refinancing, and debt service all but impossible in a capital-constrained world. All that great acreage containing decades worth of “running room” became worthless, asset valuations collapsed, operators’ balance sheets ran out of gas (pardon the pun), and the ability to borrow or stabilize liquidity may have disappeared.
The punishment has been severe and play/basin agnostic. Whether a producer’s fringe acreage is in Williston, DJ, Powder River, Mid-Continent, Appalachia, or elsewhere, some acreage just requires much higher oil, gas and/or NGL prices to justify continued exploitation.
When all this eventually ends, much will be written about the shale-driven and Saudi-induced price collapse. Indeed, that one of the world’s longest-running and most powerful international cartels turned on itself and nearly collapsed will be the worthy subject of several books. And even after things turn around, aftershocks will reverberate through the economy.
In the meantime, opportunistic investors like me continue to look for diamonds in the rough: cheap assets we think are worth buying and good operators we think are worth investing in. It’s not easy, but it’s what we do.
The oil industry tends to be overly optimistic. Ill-fated early optimism should be a lesson to all investors: a homogeneous reservoir (i.e., a blanket formation) is sort of like a unicorn. Neither exists. Nevertheless, we hear the same chorus echoed at meetings throughout the oil patch and oil capital centers. We commonly hear things like:
We’re different, we have a better idea/team/technology than the guy that tried it last time.
We are modeling oil going back to $70 by year-end, we strongly believe it will.
Bankers, by nature, have to have short memories.
With the cushion of robust prices, producers were in a rush to produce as much as possible, and by any means. Competition for land in productive basins, any for any land for that matter, was fierce. For many producers, upfront science was more of an afterthought.
For these reasons, prior to the downturn, it was common to hear that a certain unconventional play had a ‘blanket’ formation, implying the formation was geologically homogeneous across an expansive area and therefore provided lower risk with consistent economics. Oil prices exceeding $100 had a way of hiding the fact that Mother Nature has a way of throwing the industry an endless supply of curve balls. Water saturation, thickness, porosity, thermal maturity, brittleness and pressure are just some of the factors that can change significantly and rapidly within a play.
One basin seems to have stood out and overcome the challenges: the Permian Basin and its twin to the west, the Delaware Basin. Incredibly, certain portions currently command greater acreage prices than when oil was at $100. The optionality of multi-stacked pay — delineated by thousands of wellbores within a robust infrastructure footprint at rock bottom service costs – comes as close to perfection as anyone can hope. This permitted certain operators to tap the capital markets even in the face of a generally skittish market. As production volumes dropped elsewhere, Permian volumes continued (and continue) to uptick.
In second place would have to be the Permian’s longtime nemesis, the STACK and SCOOP plays in the Mid-Continent. Similar to the Permian, the plays have multi-tasked pay zones, infrastructure from decades of conventional development, and other characteristics that help drive break-even prices to a level at which operators can still make money.
Oil languishing in the $40s requires producers to be far more disciplined, and locating the best rock is paramount. Research and analysis may take time and experience, but it turns out that investing in the right zip code is just as important in oil and gas as it is in other real estate contexts. Of course, all of those stacked pay zones in the Permian, Delaware, Scoop and Stack are blanket formations…what could possibly go wrong!
Jeffrey A. Beunier, CPA, CIRA, has extensive operational, management, investment analysis, financial analysis, and accounting and finance-related experience with a focus on natural resources. Over the course of his career, he has originated, analyzed, underwritten or restructured more than $500 million in energy centric assets, investment transactions and/or companies. Professional and Educational Background Jeffrey began…
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