independents discover an attractive natural gas investment ... · the model is very young but is...

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Independents Discover an Attractive Natural Gas Investment Model (First published on www.SeekingAlpha.com on July 22, 2010)

US E&P independents continue to innovate domestically, giving them a pioneering competitive advantage over the majors and mini majors, which they then leverage through international expansion.

The development and initial rapid growth of natural gas production from shale and tight sands by independents, often quite small or start up companies, is well known. However, as established shale basins get crowded and global companies bring great capital and scale to this industry and natural gas prices remain low in real terms, independents have created a new and for now quite lucrative investment model within established shale and tight sands business: this is the hybrid play. It involves the joint production of gas and gas liquids or gas and oil from carefully delineated "windows" within gas shales or tight gas sands basins that are rich in condensates or oil.

The model is very young but is being adopted with the alacrity and enthusiasm typical of North American E&P independents. At present this model is almost entirely a Texas play but doubtless it will spread geographically, just a gas from shale began as a Texas play but now is becoming multinational. The 3 plays where the model is being applied are the Cleveland tight gas sands, the Barnett shale and the Eagle Ford shale.

The Cleveland tight gas sand formation is in the Texas panhandle (as far southwest as Hemphill county), extending into Oklahoma (Ellis, Custer, Dewey Counties). It is a subset of the now famous and increasingly successful Granite Wash. While the first horizontal well was drilled in 1997, it is the combination of multiple technical innovations and the discovery of oil and gas liquids rich windows that have made this area the focus of greatly increased interest, participation and investment.

US E&P independents continue to innovate domestically, giving them a pioneering competitive advantage over the majors and mini majors, which they then leverage through international expansion.

The development and initial rapid growth of natural gas production from shale and tight sands by independents, often quite small or start up companies, is well known. However, as established shale basins get crowded and global companies bring great capital and scale to this industry and natural gas prices remain low in real terms, independents have created a new and for now quite lucrative investment model within established shale and tight sands business: this is the hybrid play. It involves the joint production of gas and gas liquids or gas and oil from carefully delineated "windows" within gas shales or tight gas sands basins that are rich in condensates or oil.

The model is very young but is being adopted with the alacrity and enthusiasm typical of North American E&P independents. At present this model is almost entirely a Texas play but doubtless it will spread geographically, just a gas from shale began as a Texas play but now is becoming multinational. The 3 plays where the model is being applied are the Cleveland tight gas sands, the Barnett shale and the Eagle Ford shale.

The Cleveland tight gas sand formation is in the Texas panhandle (as far southwest as Hemphill county), extending into Oklahoma (Ellis, Custer, Dewey Counties). It is a subset of the now famous and





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increasingly successful Granite Wash. While the first horizontal well was drilled in 1997, it is the combination of multiple technical innovations and the discovery of oil and gas liquids rich windows that have made this area the focus of greatly increased interest, participation and investment.

EOG Resources (EOG) is a prominent and insistent advocate of the hybrid model and, in the past four years, has focused on developing and executing this model. In the Cleveland Sands, EOG identified the oil window from old production from vertical wells. It then used horizontal drilling to verify the conclusion. The company liked the results and now has 60,000 net acres. The company has a reserve base of 8.5 million barrels of oil and 130 billion cubic feet of gas in this play and has achieved attractive economics, with an after tax return close to 40% at current strip prices and a finding cost of $15 per barrel of oil equivalent (BOE). This success has become the template for EOG's search for other hybrid opportunities.

In the Oklahoma extension of the Cleveland, Chesapeake Energy (CHK) has found success in developing assets that are prolific natural gas and gas condensate producers in Ellis County. The company reports that of its potential 625 wells, it has drilled only a few dozen. Per well resources are claimed to be 640,000 BOE. Smaller independents have stated that they are discovering and producing from hybrid assets in Northern Custer and Southern Dewey Counties.

Another Granite Wash formation, the Des Moines, is also emerging as a hybrid opportunity. Penn Virginia Corp has drilled a wildcat (in Oklahoma) that had good gas and condensate flow. Mewborne Oil had similar success with two wells that produced gas and high gravity condensate (in Texas).

In the Barnett, EOG claims to have pioneered the hybrid strategy. This strategy has attracted the close attention of many other companies, which include the most skilled in horizontal drilling and shale resource development and also the best capitalized E&P companies in the world. The Barnett hybrid play is so new that even EOG has been operating there for a little over 2 years. The company has told analysts that the Barnett oil potential makes it the 17th largest oil field ever discovered in the US. A recent EOG well drilled in the thickest portion of the Barnett oil window yielded 1,800 barrels of oil per day and 4 million cubic feet of gas. The investment return on wells in the Barnett oil and gas liquids window are reported to be 45% to 75%. The resource potential of recent wells is almost twice that of wells drilled in 2008, indicating that continued technological innovation, increased local knowledge, adapting business processes to specific sites and transferring skills gained by operating in the Bakken oil prone shale (now reputedly the 5th largest oil field ever discovered in the US) has a dramatic impact on well productivity and investment returns.

Should the oil and liquids potential and drilling economics of the hybrid play continue to be validated there is likely to be a step increase in the deployment of technology, capital and management resources in the Barnett. Companies such as Chesapeake Energy (CHK), Marathon (MRO), Devon Energy (DVN), ExxonMobil (XOM), Forest Oil (FST), Quicksilver Resources (KWK) and Anadarko Petroleum (APC) already operate there and have the ability to identify and develop resources in the oil and condensate window of the Barnett, assuming that it is still feasible to buy or buy into significant net acres at acceptable cost.

The leading hybrid shale play, however, is one of the newest shale basins to be developed: so new that the first commercial well drilled in the basin was less than 2 years ago by Petrohawk Energy (HK) when there was no indication there was a significant oil and gas liquids window in this basin....the now internationally famous Eagle Ford basin. No shale basin has gone from complete obscurity to global recognition and enthusiasm as quickly as the Eagle Ford. The trend is big: it ranges over 330 miles from Grimes County in Northwest Texas to Webb County on the border with Mexico. It extends into Louisiana and likely into Mexico. It ranges, we now know, from a shallow oil window to a deeper condensate





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window to dry gas at much deeper levels in the direction of the dip. E&P companies call the oil window the updip and the condensate and gas plays the downdip.

The Eagle Ford oil and gas liquids resource base is so large that the industry believes it is second only to the Bakken in recoverable reserves. If this so, then the 5th and 6h largest oil fields ever discovered in the US are both in their early stages of development, with rapidly rising arcs of liquids production, suggesting that hybrid shales and tight sands and oil prone shales are turning the onshore US into a frontier liquids province, yet again.

The economics of the Eagle Ford liquids window is compelling. Petrohawk, which has equal amounts of net acreage in Haynesville and Eagle Ford (about two-thirds in the oil and condensate window) is reallocating capital spending away from the former to support greater drilling in the latter, going from 4 to 8 rigs (over 2,000 potential drill sites in the liquids window). The company estimates that its Eagle Ford position has 340 million barrels of risked resource potential. While Petrohawk is the pioneer, it hardly has the play to itself. Over 30 companies already operate in the Eagle Ford.

EOG has over 500,000 net acres (2,840 potential well locations) in the oil window with potential reserves of nearly 700 million barrels of oil. In the NGL window the company has additional acreage with an estimated 100 million barrels of potential reserves. The company calculates that its direct after tax rate of return for Eagle Ford ranges between 66% and 95%, depending on the well and product mix. A typical Eagle Ford well drilled by EOG is thought to be 77% oil, 12 % condensate and 11% gas, so that the current low price of natural gas is not an impediment to resource allocation.

Conoco-Phillips (COP) is reportedly allocating a majority of its North American exploration budget to Eagle Ford, where it has 300,000 acres. Royal Dutch Shell (RDS.A) has acquired 150,000 acres in the liquids window and started drilling. This asset is expected to become an important part of Shell's North American E&P portfolio. BP bought into a position held by Lewis Energy Group giving it half interest in 80,000 acres. France's Total (TOT), via its joint venture with Chesapeake Energy, may be entering the basin as well. Chesapeake has 400,000 net acres in the Eagle Ford, substantially in the liquids window. There is industry speculation that Chesapeake Energy may be looking for a Chinese partner to take a 20% interest in its Eagle Ford position. ExxonMobil has a position in the play as well (LeSalle and McMullen Counties) but details, of course, are not available since the company considers such information confidential.

India's Reliance Industries (RELFF.PK) recently agreed to pay $1.3 billion for a 45 % interest in Pioneer Natural Resources' 260,000 net acres, of which 70% is within the gas liquids window. Other independents that have built or are building significant positions in the Eagle Ford include Cabot Oil and Gas, Murphy Oil, Forest Oil, Talisman Energy and Goodrich Petroleum.

There are 2 strategic questions the industry is now asking:

1. Are the hybrid shale and tight sands plays of Texas replicable in other basins?

2. Can these plays be scaled to attain the status of a new industry that may have, eventually, global reach?





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It is likely to be another 2 to 3 years before these questions can be addressed for North America, another 5 before they can be addressed for Australia, another 10 years, at least, before they can be addressed for China, India, Poland and Hungary and perhaps another 15 years before they can be addressed for the other parts of the world.

In North America there is tentative evidence (or perhaps just local, optimistic, talk amongst knowledgeable landowners) that there is an oil or gas liquids window in Bienville Parish in the Haynesville shale. There is more informed discussion about a liquids window in the tremendous Horn River shale basin in British Columbia. Most of this seems to have been generated by a single slide in a presentation by Quicksilver Resources. The company notes that it has had good oil shows in 4 wells recently drilled there. These are at approximately 4,000 feet (about the right depth for an oil window) in the Bakken-Exshaw section. An analysis of core samples revealed 80 feet of mobile oil. The company plans to reenter a seismic well later this year and then drill a horizontal leg for initial testing in the Bakken-Exshaw zone.

Companies and investors alike are following this keenly. The shale resources of the Horn River Basin cover over a million acres. Companies experienced in shale resource development and enthusiastic about the hybrid play already operate in the Horn River Basin. These include EOG, Conoco-Phillips, Devon Energy and Apache Corp. (APA). BP (BP) also has a presence, so the integrated majors are already represented. Should a notable oil and gas liquids window be confirmed, entry and development will be very rapid, rivaling the accelerating commitment to the Eagle Ford. Oil pipelines close to the Horn River basin already exist to oil and liquids takeaway capacity could be developed swiftly.

independents discover an attractive natural gas investment ... · the model is very young but is...

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