Texas Issuers Budget for Drilling Boom, Remain Wary of Falling Prices

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DALLAS — As a man twice burned in his career by the volatile oil and gas industry, Daryl Fowler raises an eyebrow when he hears the words: "This time it's different."

Fowler's first job as a graduate of Texas Christian University lasted five months, curtailed by the mid-1980s collapse of the oil market that tanked the Texas economy.

When oil prices rebounded in the new millennium, Fowler stepped away from his job in insurance and learned the ropes as a landman, prospecting for mineral rights in an age of high-tech exploration. That phase of his career ended abruptly when oil prices tumbled from their all-time record $148 per barrel in July 2008 and kept falling in the "Great Recession."

Today, Fowler is overseeing another boom as county judge, the top administrator, for DeWitt County, Texas. Sitting in the heart of the Eagle Ford Shale, DeWitt County and its county seat of Cuero have seen their tax base soar tenfold in just three years.

"I have the luxury of applying some personal experience in life to what is happening in DeWitt County now," Fowler said. "I can offer valuable knowledge about how things can wither away very rapidly."

Like most Texans, Fowler is not eager to see the boom times created by the "Shale Revolution" go bust. But it would not surprise him.

With the new techniques of horizontal drilling and hydraulic fracturing of tight shale formations, wells can deplete up to 90% of their reserves in the first two years. If the market price of the fuel no longer provides a profit, drillers can stop work abruptly.

"When the last well is drilled, you have two years left to capture any revenues before you're back to a pre-boom level," Fowler said. "It's a very short window of time. Anyone who goes into debt based on that sort of volatility is plumb nuts in my opinion."

To that end, Fowler has discouraged issuing bonds, despite an estimated $432 million need for road repairs and a tax base that has expanded to $10 billion from just $1 billion three years ago.

Instead, he has sought to capture the additional revenue as reserves in case of another energy market collapse. Unlike some counties that have faced tax rollback elections when revenues grew in excess of 8%, DeWitt County voters - at Fowler's urging -- did not petition for a rollback election. Under state law, taxpayers are allowed to seek a rate reduction when revenues from higher property values exceed the 8% growth level.

Fowler said he campaigned before "every Lion's Club, Rotary Club or any other group that would listen" to discourage a tax-rollback petition.

"Over the last three years we have been able to build a significant reserve -- about $28 million to $30 million as we speak," Fowler said. "If there is a bust coming, Lord willing, with our cushion and our anticipated tax revenues, we're hoping for a soft landing. Because we're not deeply in debt, we think we can achieve that."

On Oct. 9, Moody's Investors Service affirmed Fowler's approach and the county's A1 rating.

"The affirmation of A1 reflects the continued growth in the county's tax base, heavy concentration in the energy sector, and healthy reserve levels," Moody's analyst Ryan Hazlett wrote. "The rating further considers below-average wealth levels, an average debt burden, and future infrastructure needs."

DeWitt County's total debt comes to about $9.6 million from certificates of obligation issued in 2003 and 2006. The county's population of about 20,000 has ballooned with drilling crews and related services, creating more demand for roads, housing, law enforcement and schools.

Unlike the county governments, school districts are more inclined to issue debt to capture some of the increased value of the tax base, Fowler said.

Under the state's "Robin Hood" school finance system, school districts that are "property wealthy" must share excess tax revenues with those that are classified as "property poor."

In the Eagle Ford Shale, the sparse populations are generally poor, despite the fact that they inhabit a resource-rich region. That means a surge in property values for a small population could send excess tax revenue to another school district. The only way around Robin Hood is to pledge that property value to debt service, which is based on a separate tax formula.

Neighboring Karnes County has seen its assessed property values grow nearly eightfold from $400 million to $3 billion in five years. Like other counties in the Eagle Ford shale play of South Texas, Karnes is coping with an influx of workers and the need to provide schools, roads and services to the increased population.

Karnes City Independent School District issued $14.3 million of bonds in August to deal with increased demand but kept the maturity to 10 years, reducing long-term risk. The bonds came with an underlying upgrade from Standard & Poor's to AA-minus from A-plus. With a guarantee from the Texas Permanent School Fund, the bonds carried triple-A ratings.

"I'm not sure I've ever seen a credit have such dramatic growth in assessed value," said S&P analyst Oscar Padilla.

Like the school districts themselves, the Texas PSF has a lot riding on the price of a barrel of oil. The fund is made up of revenues from state lands, primarily oil and gas leases, and investments.

The PSF this year reached a record value of $37.5 billion, making it the largest public education endowment in the nation. The fund has gained more than $12 billion in value in five years after falling by more than 13% in 2009. Most of that came from a bull market in stocks, bolstered by the fracking frenzy and steady fuel prices.

The oil and natural gas industry makes up about 17% of the Texas economy, which is four to five times greater than the industry's share in the nation's economy, according to Comptroller Susan Combs. Thus, oil and natural gas sectors have helped Texas outperform the national economy since the 2008 recession.

In recent weeks, however, the industry has been feeling tremors.

The benchmark price of oil has fallen 20% from its peak, qualifying as a bear market for the commodity. In Texas, the price of gasoline has fallen below $3 per gallon.

For some producers in the Eagle Ford Shale, the breakeven point is around $80 per barrel.

Oil fell briefly below that price last week. The break-even price varies according to the difficulty of extracting the resource. Some areas of Eagle Ford have a breakeven price as low as $53 per barrel, according to industry experts.

In her biennial revenue projection for the current fiscal year issued in January 2013, Combs predicted oil would decline to $82.18 in 2014 and $80.33 in 2015. On Friday, oil closed at $82.92.

Charts show the price falling steadily from the peak of $104.44 in July.

"Some of these plays on the high end of the supply stack -- meaning higher prices -- they are going to get hurt," said Gurcan Gulen, research associate and energy economist at the University of Texas Center for Energy Economics in Houston. "The longer the prices stay at a lower level, the more challenged the operators are going to be."

Many producers operate on very thin margins already, and some have lost money on fracking operations.

According to Bloomberg News, most of the operators are relying on junk bonds and investors to sustain operations.

"Most are spending money faster than they make it, an average of $1.17 for every dollar earned in the 12 months ended on June 30," a recent Bloomberg analysis showed. "Only seven of the U.S.-listed firms in Bloomberg Intelligence's E&P (Energy & Production) index made more money in that time than it cost them to keep drilling."

Foreign producers, particularly Saudi Arabia, see the shale producers as vulnerable to competition and are willing to keep pumping at unprofitable prices to regain market share in the U.S., analysts say.

"The challenge for Saudis and OPEC in general is that, if they cut back in oil, they know that they're going to help these unconventional producers," Gullen said. "They might need that higher price, but too high a price might help their competitors."

While the oil market is global, the natural gas market is more regional, Gullen said.

"The demand for natural gas will likely increase in the next few years," he said. "We're going to shut down a lot of coal-fired power plants, so gas consumption is going to go up."

Regardless of how the market turns in coming weeks, Fowler and other county judges in oil-producing regions are counting on help with road work from a constitutional amendment known as Proposition 1 on the Texas ballot Nov. 4.

With voter approval, the amendment would authorize annual disbursements from the state's oil and gas production tax collections to the State Highway Fund. An estimated $1.7 billion would be transferred in to the State Highway Fund in the first year, according to official estimates.

"If companies begin to cut back on their drilling activities, those revenues will come down," said Fowler, who supports Proposition 1, despite reservations about its adequacy.

According to a study by Naismith Engineering Inc. an estimated 3,250 wells are served by DeWitt County roads. Maintaining those roads under the stress of thousands of heavy trucks would cost the county $432 million, or almost $133,000 per well, the study showed.

"Juxtaposed against our $432 million need, Proposition 1 doesn't go very far," Fowler said. "It's a very significant, history-making bill, but it's not a permanent fix for us."

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