EnerVest, an investment fund that for 25 years had been buying up oil and natural gas wells, just went from being worth $2 billion…
To basically zero.
In the process, many investors have lost stakes, including pension funds, university endowments, and some otherwise savvy market players.
What happened here shows the perils of using debt to leverage investments in energy without expert advice – something I never recommend…
And it also reveals the next big investment opportunity in U.S. oil.
Here's what you need to know…
Things Aren't as Easy as "Buy Low, Sell High"
Conventional wisdom has it you should "buy low, sell high." Investment funds have certainly been following this mantra when it comes to depressed oil company assets.
Unfortunately, in some cases they make no attempt to understand the underlying market dynamics.
In recent years, several investment funds sought to buy up producing and prospective oil or natural gas wells in some of the best-performing basins in the United States.
The process began when prices were high (i.e., prior to the fourth quarter of 2014). In fact, the most spectacular collapse involves a fund that has been doing it for more than 25 years: EnerVest.
There, some $2 billion in investments has essentially been written down to zero.
EnerVest is certainly not the only fund to have seen the decline in oil prices result in intense pressure on hard asset well investments. Thus far, the others are holding on.
What sets EnerVest apart is the Houston-based fund's decision to boost its acquisition spree with some spirited leveraging via borrowed money.
Now, creditors are attempting to take over management of the fund and determine what actually remains under a more realistic estimate of aggregate asset value.
The approach is simple enough, at least in theory. I've talked about it before.
Rather than acquire entire companies (with their range of debt, nonperforming holdings, idle equipment, and payrolls), focus on cherry-picking the wells themselves.
But there is a fair amount of serious and detailed study that needs to be done before any acquisitions are determined.
These Three Steps Would Have Saved EnerVest
Prior to any move, three overarching elements require careful analysis.
First, genuine wellhead costs and proceeds must be determined. These figures tell us what it costs to bring the oil or gas out of the ground compared to what can be obtained when it is sold to a wholesaler.
The wellhead price is the price in the first of a series of transactions as the resource moves from producer through a chain of wholesalers and distributors.
This wellhead price is well below the market price and is the actual indicator of any genuine breakeven.
Second, a careful examination must be completed of the available extractable reserves. This involves the geological structure and reservoir logs of each well prior to acquisition.
Third, potential wells must be considered against likely market conditions. Considered here are pricing dynamics, expected aggregate supply, and a range of demand scenarios.
Even in a high market price environment, all wells are hardly created equal.
Unfortunately, much of the most recent commitment of investment capital took place with WTI (West Texas Intermediate, the benchmark crude standard used to set futures contracts in New York) near or above $90 a barrel.
Today, WTI is barely half of that price.
The combination of increasing the rate of well acquisition, the higher risk that comes with using borrowed funds, a curious lack of adequate research on either sustainable production from each well or the condition of reservoirs, and the lack of any adequate provisions for pricing changes resulted in a perfect storm.
The collapse of EnerVest illustrates how this can go very wrong. It also provides a sterling example of fundamental misreads of the U.S. oil production sector. Primary among them was the incorrect view of operational debt.
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.