Oil Capital: A Review
11.04.22
“You may all go to Hell, and I will go to Texas.”
— Davy Crockett, 1835
Just north of the Rio Grande, in Hidalgo County, Texas, a mile-long hypersaline lake sits above a prehistoric salt deposit. Known as La Sal del Rey (The King’s Salt), the lake’s crystal-covered shores were once the destination of an ancient salt trail, and its four million tons of salt — the “mineral equivalent of a gold bonanza” — were lugged out by camel caravans during the Civil War.
Modern visitors aren’t impressed. “Have you ever been catfished by nature? This is the place,” complained one pilgrim, who was convinced that its “red tide” spelled instant death for wandering pets or adventurous salt bathers. “Let’s be frank: it was a little smelly,” said another. “The mosquitoes, the smell, and the caustic environment were a tradeoff for the convenience of easy hunting and abundant salt at this spot.”
Unbeknownst to disgruntled tourists, the putrid lake may also be singlehandedly responsible for the international dominance of the United States’ oil and gas industry. Ownership disputes over the lake served as the catalyst for an 1866 Texas constitutional amendment that cemented private mineral rights — a revolutionary departure from the state-owned model favored by other countries. Drawn from the Latin phrase ad coelum et ad inferos, landowners in the U.S. own from the heavens above, coelum, to hell below, inferos.
“Compared with almost every other oil-producing country in the world, ownership of oil and gas in the U.S. by private parties, often landowners, is an anomaly,” writes Buddy Clark, co-chair of the energy practice at Haynes & Boone, in his sweeping account of American oil and gas financing, Oil Capital: The History of American Oil, Wildcatters, Independents and Their Bankers. “It is no coincidence that nowhere else is oil and gas technology and infrastructure better developed than in the U.S.”
He cites dramatic differences in production levels based on ownership model: in 2007, national oil companies controlled over 80% of the world’s reserves, yet only increased production levels by 3.2% from 2007–2014. The U.S., thanks to the Shale Gale, increased daily production by more than 40%.
“The [shale] revolution happened in the U.S. not because of any great advantage in geology — China, Argentina and Algeria each has larger recoverable shale gas reserves. It didn’t happen because … enlightened mandarins in the federal bureaucracy and national labs were peering around the corners of the future. For the most part, they were obsessing about the possibilities of cellulosic ethanol and other technological nonstarters,” declared Pulitzer Prize-winning journalist Bret Stephens in 2014. “Instead, fracking happened in the U.S. because Americans, almost uniquely in the world, have property rights to the minerals under their yards.”
This week, in the wake of two new reports quantifying the “massive scale of North America’s shale oil and natural gas resources” (an estimated 60 billion barrels of oil remain untapped), we reviewed Oil Capital, the first comprehensive history of oil and gas lending in the United States.
The Rule of Capture
Early oil exploration was driven by the rule of capture, a “relic of barbarism,” as one early scholar described it, that encouraged the frenetic production of oil. Since oil and gas are fluid, ownership of the assets often depended upon who got there first. “A landowner owns all the oil that can be extracted from her land, even it comes from a reservoir shared with a neighbor,” writes energy law professor James Coleman. “As soon as your neighbor begins drilling for oil, you experience … an ‘oil and gas emergency.’”
As a result, early independents were choked off from traditional suppliers of capital. Eugene McElvaney, senior vice president of Dallas’ First National Bank, remarked in a 1954 report that it was irresponsible practice to lend against “a fugitive asset hidden deep in the bowels of the earth beyond the sight or touch of man, and which a scant few years ago would have been rank speculation.” Wildcatters themselves could provide no measure of predictability: “unable to predict future production rates and prices necessary to pay back the loan, few producers were able to get more than a cup of coffee from his local banker,” writes Clark.
Instead, early wildcatters turned to their own creative devices. “A typical independent’s ‘business plan’ in the early days was to follow the geological trends, talk a farm or two into leasing a small parcel and finagle or cobble together a second-hand rig, steam boiler and drilling crew that he paid with food when short of cash — thus known as ‘bean wages’ — to drill a well with the hope of hitting oil before his money ran out,” writes Clark.
Mythical “grubstake tales” such as drug store clerk Harry Sinclair’s improbable rise were the norm: “instead of shooting the ground and discovering oil, Harry Sinclair got his start when he shot off his big toe,” said Clark. After dislodging his big toe while rabbit hunting, Sinclair collected $750 dollars from an insurance company, the seed capital that would lead to his discovery of Cushing Field and turn Sinclair Oil into a billion-dollar empire.
For those without a pound of flesh to spare, other potential seed funders included “wealthy persons ignorant of oil — doctors and lawyers and their widows — were favorite clients.” Playing off the gambling culture of the 1920s, Texas corporations adopted the comforting language of the casino, sporting names such as the Double Five Company, the Straight Eight Oil Company, the Lucky Ten Oil Company, and the Magic Eighty Oil Company. “The presence of this vigorous class of small investors was a major reason why development in the US so far outstripped that in the European oil fields of Romania and Galicia, where this class of persons hardly existed and the technological advance necessary for effective development had to be funded by foreign capital,” argues Clark.
One such group drawn in by these advertising ploys was a Catholic ladies’ fellowship in New York, which funded the discovery of Santa Rita №1, a well leased from the University of Texas that launched the Permian Basin. “These women became a little worried about the wisdom of their investment and consulted with their priest. He apparently was also somewhat skeptical and suggested that the women invoke the aid of Santa Rita, who was the patron saint of the impossible,” writes Clark. Divine intervention succeeded: to this day the University of Texas rakes in $6 million a day off its Permian Basin holdings, putting it on track to outpace Harvard as the richest university in the US.
Proration & The Entrance of Traditional Capital Providers
On October 3rd, 1930, the discovery of the East Texas Field — the largest U.S. oil field at the time — upended the industry. The city of Kilgore, once a quiet town of 600, swelled to 8,000 people as speculators swarmed the field. “They ripped stores in half along the town’s main street, in one instance erecting 24 derricks on half a city block. They tore down the First National Bank and drilled right through its terrazzo floor. They even sliced the sacristy off the Presbyterian Church, throwing up three more derricks in its place,” reports Clark.
By its peak in 1931, the field was producing 750,000 barrels a day, accounting for 60% of Texas oil, 37% of U.S. oil and 22% of world oil. Prices subsequently dropped from $1.10 a barrel to 15 cents, and, for a few bleak days, 2 cents. Unable to regulate themselves, wildcatters destroyed their own profitability. “In a painful, five-year struggle punctuated by violence, oilmen adapted to government regulation,” wrote Roger Olien and Diana Davids Hinton in Wildcatters: Texas Independent Oilmen. “The passage from freewheeling flush production to proration and regulation was rocky and turbulent.”
State regulators limited the number of wells that could be drilled (in Texas, this often meant one oil well for every forty acres) as well as setting an “allowable” for what amount could be pumped per day. They also provided incentives for landowners to group together to maximize the long-term value of production. “Proration rules slowed the initial rate of well production and had the side effect of slowing the pace at which the producer was able to recover his investment,” writes Clark. “This created demand for longer-term credit. Fortunately, slower production also led to more disciplined commodity markets, which, in turn, created the crucial element: a predictable cash flow that bankers needed to lend with confidence.”
In the earliest days of bank lending, short-term loans were underwritten “on the basis of the net worth of the borrower or secured by crude oil in storage or in transit.” This soon transformed into reserve-based lending (RBL), where banks relied upon large oil producers to vet the reserves of smaller producers seeking credit. “The method essentially gives oil and gas developers a credit limit based on the net present value of their reserves — notably not based on their assets,” writes business journalist Gregory Morris. “It has proven to be an adaptable and effective approach for both lenders and borrowers.”
In 1983, with the introduction of NYMEX and the ability to hedge future production, RBL became even more refined. Initially dismissed by oil companies as “a way for dentists to lose money,” the industry soon changed its tune. “Nymex was one of the greatest things that happened,” declared Jack Randall, co-founder of asset-marketing firm Randall & Dewey, in 2011. “It simplified the valuation. When you’re looking at buying a property, you have to look at what prices are going to be over a period of time. That was difficult to do. [Nymex] really takes the oil and gas price out of the game and makes the emphasis more on the reserves and what you perceive the upside to be.”
The Shale Gale & Beyond
Clark discusses the rise of OPEC, the destruction of the 80s, the loss of the Texas energy banks, the invention of 3-D seismic and lateral drilling technologies, and the industry’s reinvention through the fracking renaissance. The narrative cuts off before environmental concerns reached a crescendo, and does not discuss how renewed interest in green energy has diverted investment flows.
That being said, the United States doubled its oil production between 2010 and 2018, and in 2022 it became the world’s biggest exporter of LNG (up 14% y-o-y). While many fear that fracking — which runs through its production capacity in just a few years of operations — will soon tap out, new reports beg to differ.
“We believe the fear around near-term shale drilling inventory exhaustion is largely overblown,” said Dane Gregoris, managing director at Enverus Intelligence Research. “The limited response of U.S. crude oil and gas production to high commodity prices primarily reflects ongoing capital discipline by producers as well as availability constraints of drilling rigs, frac fleets and labor. Inventory exhaustion is not the problem in our view.”
According to RigZone, the leading reporter for oil and gas news, the world will spend $369B on 310,000km of new oil and gas pipelines, with North America providing the lion’s share of new development to meet rising demand. “With ultra-deep offshore and unconventional on-shore development costing many millions of dollars per well, capital requirements will only go higher,” concludes Morris. “In geological terms, hydrocarbons are a limited resource. But for all practical and economic means, the only limits are what consumers are willing to pay at the pump, and what bankers are willing to lend against. This is that story.”
About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.
