Five States made remarkable progress on a lot of fronts this fall, and in this issue of The Producer, I want to highlight two areas that have received the lion’s share of our attention – Investor Capital Deployment and Asset Risk Management.
Investor Capital Deployment
Over our 35-year existence, market conditions have occasionally revealed the need to pivot our strategic and tactical thinking about how best to deploy investor capital. Most often these pivots were subtle, driven by soft signals that suggested modest changes in our acquisition strategy and methods. On a few occasions however, our pivots were significant, causing us to change our target asset class and our fund offerings. COVID-19 aside, market forces today are again signaling the need to pivot; yet this pivot falls somewhere in between subtle and significant.
The existence of very low interest rates, providing low-cost investment capital, continues to drive up property valuations. The drop in oil price that sidelined shale development, has contributed to the problem by making conventional, long-lived production (Five States’ preferred asset class) even more expensive. The result is that buying assets at high valuations means we must accept low investor returns, sometimes well below Five States’ target range. So we find ourselves in the grey area, caught between staying conservative, winning few bids, and slowly deploying capital, versus getting more aggressive, deploying capital quicker, but accepting sub-par returns. It is quite a dilemma, but it is also a false choice, because fortunately there are other options.
The pivot we are making is to nudge our valuation approach to make our bids slightly more aggressive. Then, to offset the impact on expected returns, we will weave into our portfolio, assets proved but undeveloped reserves. Proved undeveloped assets are those that require some combination of rework, recompletion, and development drilling programs. Because they involve some level of additional risk, proved undeveloped reserves are heavily discounted so that when successful, they can provide significantly higher yields. This combination of high-value, low-risk, proved developed reserves with a modest fraction of low-value, modest-risk, proved undeveloped reserves is an approach that we expect will yield acceptable returns in this challenging market. Importantly, what this requires is buying assets operated by proven operating companies known to be both active and disciplined; this leads to our second focus area.
Asset Risk Management
Five States’ work to acquire assets does not mark the end of our work with an asset; it marks a point where our work shifts from asset acquisition to asset risk management. This involves continually monitoring asset performance, staying up to date on workover/drilling activity to unlock upside potential, evaluating billings to gauge operators’ cost control, and reviewing revenue statements to assess oil and gas marketing activity. These efforts span many Five States functions including Accounting, Operations, Engineering, and Finance. An important aspect of this also involves our Business Development group.
Our Business Development group is in the process of evaluating Five States’ operator network with a specific charge to high-grade and expand our operator network in 2021 and beyond. This is important because it will help us identify the operating companies with which we want to partner. Having proven, trustworthy and financially stable operating partners will expand our asset acquisition opportunities by allowing us to bid on both non-operated assets (our traditional target) and operated assets. Like Five States, operators are also in the market to acquire properties, so having strong operating partners should bring more deals to our attention.
Building out Five States’ operator network is an initiative that will occupy much of 2021 and 2022, and maintaining that network will be an ongoing part of Five States operations going forward. This effort is an integral part of our success, both for our existing Five States funds as well as those planned to be launched in the coming months and years.
I look forward to sharing the results of these efforts with you.
John Kiser