drill research letter

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www.drillcapital.com

R E S E A R C H

January 7, 2014

Drill Report #1.0

Energy Positive Outlook going into 2014. Bullish AR, CRK, BCEI

** For access to our models and analysis please contact [email protected]

As specialists in researching the North American energy space, we have canvassed the industry and have taken a deep dive into the companies that we believe will benefit from the boom in shale oil and gas production. In this research piece we walk you through our views of the industry from commodity prices to the actual shale plays we prefer and finally to the companies we believe are best positioned to take advantage of the prevailing investment environment. Using our ranking methodology we believe that Antero Resources (AR), Comstock (CRK) and Bonanza Creek (BCEI) are well positioned to outperform the prevailing exploration and production E&P indices.

Introduction

The third quarter of energy earnings reporting ended in mid-November. Since then we have had follow

up meetings and calls with several energy companies in our coverage universe. Below is a summary of

our key takeaways with an emphasis on the Utica Shale region in Ohio where our investment arm Drill

Capital is currently deploying capital. We continue to canvass various energy data points across the

sector while conducting due diligence on certain areas in order to identify future investment

opportunities. Our analysis and approach is geared towards following longer term market fundamentals

while at the same time keeping a close eye on short term developments in the space.

Commodity Price Insights

Energy management teams remain bullish on long term natural gas market dynamics with a view that a

structural tightening is setting in for the next few years while remaining bearish in the short term. We

also noted volatility in regional basis prices and the pace at which fundamentals (supply increases versus

industrial demand pickup) will ultimately dominate weekly market speculation (driven by storage

numbers and maintenance activity). At $1.00-$1.50/mcf basis differentials we could see some material

pullback in northeast production as this seems to be the price at which producers become constrained

from an economics perspective. The market appears to be focused on the pace at which the Marcellus

can grow given a historically strong track record by the likes of Cabot, Range, Southwestern, Anadarko,

EQT, Antero and Chesapeake. When speaking individually with these producers, there appears to be a

noticeable inclination for them to behave rationally in a post 2008 environment. The majority of the

sample set believes that there isnt an infinite capacity to produce in the basin (given a fixed inventory of

low breakeven core inventory and given natural well decline rates). Several producers have articulated

that the ~3bcf/d growth seen in 13 involved taking a significant backlog of wells into production and



that you would likely not see that pace of growth going forward. If these assertions are true, then the

natural gas production growth we saw should be balanced going forward. Either way, we continue to

monitor the market - gas exports to Mexico have been growing (>15% YTD) and that is a data point to

keep an eye on going forward from a gas exportability potential.

Oil prices held up throughout the year, with some observed volatility going into year end. Producers

remain constructive around oil price fundamentals. Energy investors have voiced concerns around

domestic U.S. oil production outpacing the current U.S. refining system (given success in the Bakken,

Eagle Ford and Permian plays). The counter argument for this is that Permian production is lower quality

oil and will likely not be able to compete with Eagle Ford or Bakken oil in the refining system. According

to EOG (a market leader in all three plays), the rate of growth in US oil production is slowing (driven by

natural declines) normalized at 600 Mbbls/d in 2013 versus 1 MMbbls/d last year and projected to be

roughly 700 Mbbls/d in 2014. We think volatility will persist in the oil markets as the tug of war between

geopolitical risks in the middle east on one hand and strong production domestically on the other hand

continues (not to mention refinery maintenance and turnarounds). Over time we expect a reversion to

towards prices equating supply cost fundamentals.

Energy Insights and Views

The energy industry has become more in tune with returning or at the very least taking measures to

return value to shareholders. This in turn has driven producers towards a more refined and measured

approach towards 1. Proactively hedging commodity prices to stabilize future capital programs 2.

Rightsizing asset portfolios through dispositions of non-core properties in addition to share

buybacks/dividend increases and 3. Spending capital only in the highest impact, highest return plays

Natural Gas Prices (Henry Hub)

$3.90$4.40

$4.00

$2.80

$3.74$4.26 $4.16 $4.19 4.25

$0.00

$2.00

$4.00

$6.00

2009 2010 2011 2012 2013 ytd 2014 2015 2016 2017

$US/Mcf

Sourced to Bloomberg Financial Markets.

Forward Strip Prices

Oil Prices (West Texas Intermediate)

$62.00

$79.50$95.10 $94.10 $97.99 $94.94 $88.21 $84.27 82.13

$0

$20

$40

$60

$80

$100

$120

2009 2010 2011 2012 2013 ytd 2014 2015 2016 2017

$US/bbl

Sourced to Bloomberg Financial Markets.

Forward Strip Prices



with a de-emphasis on exploratory spending. We continue to see evidence of this trend through year-

end.

Producers are still expected to spend more in 2014 than in 2013 barring any material and sustained

(multiple quarter) drop in oil or gas prices. The third quarter reporting season marked the beginning of

2014 capital budget announcements for the energy sector. Based on preliminary budgets and our

discussions with corporates, overall spending is expected to be robust in 2014 relative to 2013 an

approximate 5% increase with a relatively flat rig count (an expected drop in vertical rig count offset by

a continued increase in horizontal rigs) and well count growing by 4-5% relative to 2013. It would be

misleading to look at the expected flat rig count (typically seen as a proxy for oil and gas activity) as a

negative indicator for 2014 spending as this is really a function of 1. Oil/liquids drilling requiring less

horsepower than gas wells and 2. Positive momentum in capital efficiencies (wells take less time and

therefore less capital to bring online).

The industry has taken advantage of high oil prices throughout the year to lock in a significant portion

of their 2014 oil weighted production between $87-$95/bbl WTI which bodes well for oil/liquids

activity going into next year. We continue to see a strong appetite for capital allocation away from

natural gas towards liquids rich, oil or hybrid plays in fact some producers that have been articulating

this change in their production mix over some time have now clearly made the transition from being

pure play gas producers towards a more balanced production and asset portfolio. As it relates to natural

gas, producers need to see a sustained $4.50/mcf gas price before resuming operations in the dry gas

portion of their portfolios.

Pricing in the energy services sector remains relatively soft across the U.S. - Producers have benefited

and continue to benefit from this trend. Spot pricing for rigs and completion services (with the

exception of more specialized completion product lines) is trending lower (or at the minimum remaining

flat) across various basins as the industry continues to digest the oversupply in equipment and service

providers. Labor remains a challenge in certain areas, in the Permian and Bakken specifically.

Energy Investment Climate and Positioning

We believe that capital spending in the energy sector will remain robust in the foreseeable future and

that information inefficiencies in the private space will make for compelling investment opportunities

around Greenfield businesses within plays that are expected to receive capital inflows going

forward. We think that risk reward within the private energy market sector will be lucrative going

forward. We think the Utica shale play will emerge as a top tier shale play in the US and our investment

arm Drill Capital is deploying capital to build businesses in that region.

Our view is that public market investing will continue to be a stock pickers environment with a bias

towards E&Ps (exploration and production companies) that can grow, on a debt adjusted basis, and

that are positioned in the highest return regions. We believe that on the public side, Antero Resources

(NYSE: AR) screens as a top tier oil and gas company that will provide the best leverage to the

energy sector. Both the energy integrated and large cap US firms can still provide good exposure to the



energy sector but growth will remain a challenge given their already large production and asset bases.

On the other hand we like the domestic midsize E&P companies as their growth prospects are relatively

attractive we remain cautious though as outperformers in this sample set still have to be disciplined in

their capital allocation decisions and their exploration programs.

The Drill Portfolio

We introduce the Drill Portfolio a basket of stocks, including our top pick Antero Resources (AR),

which we think will outperform the EPX and XLE. We also like Comstock Resources (CRK) and Bonanza

(BCEI).

- We believe AR is an enviable position with its core acreage blocks in the heart of the Utica and

Marcellus shale plays. We believe the company delivers on strong production growth over the

next few years and as a result brings forward value from its NAV. We think that Street estimates

on its midstream assets are too low and that any MLP IPO or split will be well received by the

investment community.

- We believe CRK is taking the right steps in growing its base inventory while at the same time fine

tuning its current operations in the Eagle Ford where it has a core position in McMullen County.

We expect liquids growth to be strong going forward. We also believe that investor concern

around the companys lack of drilling inventory will be addressed going forward, we like the

optionality the company has in the Tuscaloosa Marine Shale where it will be drilling 2 wells this

year.

- We believe BCEI has a strong balance sheet and a dominant position in the Niobrara

(Wattenburg) play where drilling economics are top tier. We think the company continues to

deliver strong production growth this year. We also like the catalysts going forward especially

the super section tests where multiple formations and various well configurations will be

experimented with; this could greatly increase the companys drilling inventory and reserve life

going forward.



Play by Play Insights

Below we walk you through our takeaways and views across select oil and gas basins that we monitor in

North America:

Utica (Ohio)

- Activity remains strong, capital continues to flow into the play. Carroll County continues to

dominate incremental drilling and permitting activity levels followed by Harrison, Noble,

Belmont and Guernsey. You are starting to see an accelerated shift from the wells

drilled/drilling category (i.e., wells that were drilled and awaiting pipeline connections) towards

the wells producing category as gathering and processing capacity is brought online across the

basin.

Ohio Utica Shale Activity Profile - March 2013

0

40

80

120

160

200

Carroll Harrison Columbiana Noble Monroe Belmont Jefferson Guernsey Mahoning

Wells Permitted Wells Drilled / Drilling Wells Producing

Sourced to Ohio Department of Natural Resources.

Ohio Utica Shale Activity Profile - August 2013

0

40

80

120

160

200






Some Notable Utica Developments include:

- As at December 7, 2013, 48 rigs were running in the Utica shale, up from 18-20 rigs earlier in the

year. 1,015 permits have been issued compared to 858 permits in our previous update in August

(and 548 permits in March). Of these total wells permitted as at December, 627 wells have been

drilled to date compared to 547 wells drilled in August and approximately 250 wells drilled in

March. All these data points are all strong indicators reflecting capital spending increases in the

area

- Antero Resources went public during the third quarter. Another Utica player, American Energy

Partners, led by ex-Chesapeake CEO Aubrey Mclendon has filed for a public offering to raise up

to $2bn proceeds will likely be used to accelerate development of the companys Utica

acreage recently acquired. There is also chatter around Rice Energy (a private Marcellus/Utica

operator) going public in 2014

- Utica processing and infrastructure projects continue to come online:

o MarkWest and Energy & Minerals Group started up their first cryogenic gas processing

plant at the Seneca complex in Noble County. The initial plant capacity is 200 MMcf/d

with more capacity additions going into next year. It is important to note that the plant

is supported by long term, fee based contracts

o Marathon Petroleum (one of the largest domestic refiners) plans to increase its total

crude plus condensate processing capacity in its Canton and Cattlesburg refineries from

25 Mbbls/d to 60 Mbbls/d. This will include over $640 mm of projects including

condensate splitters, pipeline connections and truck and barge connections. Also of

note in this package is the $140 mm Cornerstone pipeline that will run through Carroll

County and is expected to be completed by 2016

o Kinder Morgan announced the signing of a letter of intent with NOVA Chemicals to

develop a pipeline running from the Utica shale (Harrison County) to Ontario, Canada.

The pipeline is expected to transport (NGLS) natural gas liquids this is a positive sign

for getting takeaway capacity out of the growing liquids basin

Ohio Utica Shale Activity Profile - December 2013

0

40

80

120

160

200






- According to Ohio State University Professor Chris Penrose the energy activity driven by the

Utica shale industry has created approximately 550 millionaires out of landowners in Carroll

County since drilling has begun

Drill Capital investment view: Very positive. Drill Capital is deploying capital in the play.

Duvernay (Alberta)

- Incrementally positive data points from industry well results, operators are moving towards pad

drilling into the winter drilling season

- Midstream configuration is underway to facilitate a full development scenario

- Capital continues to flow into the play evidenced by tightness in the domestic services space

- Waiting for Encana to declare commerciality on the play (although field condensate data points

and well costs reductions are encouraging to date)

- Drill Capital investment view: Positive. Economics are strong and rig count is expected to

grow. Drill Capital is actively exploring investment opportunities in the play while monitoring

well economics / midstream build-out and various energy data points.

Tuscaloosa (Louisiana / Mississippi)

- Increased capital allocation by industry players Encana and Goodrich driven by supporting

Crosby well result also seeing entry into the play by Comstock, Sanchez and Halcon

- Starting to see several midstream companies looking to negotiate gathering / compression lines

and associated infrastructure with producers in the region

- Need to get comfort around well costs below $12.5-13.5 mm to justify longer term development

economics looking for spud to casing days to go down

Drill Capital investment view: Positive, cautious. Drill Capital is actively exploring investment

opportunities in the play while monitoring well economics / midstream build-out and various

energy data points.

Niobrara (Colorado)

- Industry is drilling longer laterals (9,000 feet versus 7,500 feet) and trending towards 40 versus

80 acre spacing. Focus is around getting comfort on spacing results

- Still seeing production shut-ins due to highline pressures

- Coddell performing relatively better than expected, the plays eastern boundary is expanding

- Greenhorn well tests are to be followed

- Investment view: Positive, improving well economics.

Woodford/SCOOP (Oklahoma)

- New play within a legacy field. Continental leading the way in terms of ramp up, planned 6 rigs

addition over the next 12 months

- Discovery wells will be defining the ariel extent of the region, resource potential appears to be

present



- Play is under delineation / derisking mode

Investment view: Positive, monitoring data points.

Permian (New Mexico / Texas)

- The basin continues to be a key focus for U.S. energy operators seeing an increased amount of

capital and rigs going into the basin and planned for next year. Geoscience work continues as

various intervals within the basin are being delineated

- Delaware basin and Bone Spring seeing incremental capital (and excitement) on a relative basis.

- Delaware basin still underappreciated relative to Midland but returns could compete as the play

gets delineated Concho leading the initiative

- Operators are high grading their acreage and comparing economics across intervals (Wolfcamp

vs. Joe Mill vs. Spraberry and Tier 1 vs. Tier 2 within these intervals)

- Pressure pumping and completion service costs continue to come down. Labor in the basin is

generally tight but improving at the margin

Investment view: Positive however investment opportunity set is relatively crowded at

present.

Eagle Ford (Texas)

- Overall operating success continues across the basin - the play continues to attract capital and

operators are accelerating the pace of their programs

- Service costs are coming down and pad drilling is driving cost savings

- Look for Upper Eagle Ford well results going forward to confirm early well results from Penn

Virginia and Pioneer. Success could add a substantial amount of drilling locations to existing

acreage portfolios as this could be an entirely separate reservoir in some areas of the play

Investment view: Positive however investment opportunity set is relatively crowded at

present.

Bakken (North Dakota)

- The majority of private operators have been taken out, the play is in a high grading phase, the

acreage grab is also largely over basin is focused on pulling value forward by accelerating well

count and production (despite a drop in the rig count) and focusing on cost cutting initiatives

- EOG is leading the way in terms of best practices and well testing results using close to double

the average quantity of sand than the industry (on a per frac stage basis) with a relatively similar

decline curve and 30% more cumulative production. On the flipside there is an industry concern

of sand supply if every operator where to follow in EOGs footsteps

- The service pinch is largely over. Producers have the ability to get the equipment they want. It

takes a day to get a pressure pumping crew. Labor is still an issue however

- Barrels are not getting stranded there is ample takeaway capacity in the basin. The volatility in

differentials continue, ultimately differentials will be dictated by transport cost fundamentals

and not mere quarter to quarter market speculation



- The fringe parts of the play are starting to get access to infrastructure, so we will likely see

improving economics outside of the Core

Investment view: Neutral investment opportunity set is crowded.

Marcellus (Pennsylvania)

- The marginal gas operators are now largely out of the basin, larger operators have the majority

if not all of their acreage held by production

- Incrementally positive quarter from a production growth and well results perspective

o Although spacing tests remain county specific there is a downward trend across the

play, more specifically Cabots recently announced 10 well pad

o Upper Marcellus initial results are positive and to be followed

- Basin wide basis differentials continue to be a challenge for operators; looks like we will see a

big pinch going into the summer of next year from a basis pricing perspective

- Service costs (frac crews, drilling) continue to get negotiated down

- Drilling efficiencies continue to drive overall well costs down

Investment view: Neutral Basin pricing differentials dampen an otherwise robust production

growth trajectory.

Mississippi Lime (Kansas, Oklahoma)

- Drop in activity given Chesapeake and Sandridge portfolio rightsizing both companies are only

focused on the core of the play

- Trend is to move in the northwestern part of the play and from upper target to middle and

lower target horizons

- Infrastructure control and access to gathering will continue to dominate ability to command the

best economics in the play, marginal acreage holders will likely give up / have given up

- Spot pricing for services is going down

Investment view: Negative Seeing capital outflow from the basin.

Fayetteville (Arkansas)

- Basin is declining at 30%, with Southwestern the only operator with rigs in the basin

- Both BHP and XTO are down to zero rigs

- Investment view: Negative Seeing capital outflow from the basin.



Best Regards,

Farid

Farid Guindo,

Managing Partner

[email protected]



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