NEW OPPORTUNITIES SEEN FOR INDEPENDENTS

Oct. 22, 1990
Glenn A. Adams Wolverine Exploration Co. Ft. Worth The collapse of gas and oil prices in the mid-1980s significantly reduced the number of independent exploration companies. At the same time, a fundamental shift occurred among major oil companies as they allocated their exploration budgets toward international operations and made major production purchases. Several large independents also embraced a philosophy of budget supplementation through joint venture partnership arrangements.
Glenn A. Adams
Wolverine Exploration Co.
Ft. Worth

The collapse of gas and oil prices in the mid-1980s significantly reduced the number of independent exploration companies. At the same time, a fundamental shift occurred among major oil companies as they allocated their exploration budgets toward international operations and made major production purchases. Several large independents also embraced a philosophy of budget supplementation through joint venture partnership arrangements.

This has created a unique and unusual window of opportunity for the smaller independents (defined for this article as exploration and production companies with a market value of less than $1 billion) to access the extensive and high quality domestic prospect inventories of the major and large independent oil and gas companies and to participate in the search for large reserve targets on attractive joint venture terms.

Participation in these types of joint ventures, in conjunction with internally generated plays selected through the use of today's advanced technology (computer-enhanced, high-resolution seismic; horizontal drilling; etc.) and increasing prices for oil and natural gas, presents the domestic, exploration-oriented independent with an attractive money-making opportunity for the 1990s.

METHODS OF EXPLORATION

Exploration opportunities for the independent are of three basic types: 1) internal generation, 2) purchase of an interest in individual prospects from a third party, and 3) project joint ventures. The allocation of scarce resources (capital, people, time) between these three approaches is one of the most daunting tasks facing senior management of the independent oil and gas exploration company.

INTERNAL PROSPECTS

A decision to generate internal prospects, which include participation in joint bid groups, requires the staffing of exploration teams with landmen, geologists, geophysicists, and engineers. Exploration teams generally range in size from 5 to 12 so if an independent targets six exploration plays, primary team member staff levels would range from 30 to over 70.

Teams cannot exist without support personnel such as data processing, research/rock lab personnel, geotechs, production clerks, land administration, etc., which can add two or three support personnel for each person on the team. A company can easily employ 100-300 people in direct support of an exploration effort covering just six plays.

Besides the need to build a large infrastructure, another problem with internal generation is the need for application of leading edge technology to generate high quality exploratory prospects. Computers to process seismic data and to manipulate the data via workstations, scanning electron microscopes, and other components of a rock lab, and research-oriented scientists to utilize these assets can no longer be considered luxuries by independents or exclusively the domain of the major oil companies. Charles Darwin knew that organisms must adapt to their environment or die; for an independent oil company the task is not merely to adapt but to sustain a pattern of growth-or die.

The need to shift assets rapidly from a current focus area to an emerging play or new area can cause a substantial amount of down time for a team as it accesses a new data base and creates new prospects. The life cycle of prospect generation varies, but in general, 6 months to 3 years is required just to get several prospects ready to drill in a new trend.

This time frame commences with the spark of an idea in the mind of an explorationist, through the building of a data base, geophysics, geologic interpretation, rock lab work, land acquisition, and (since most independents do not drill exploratory wells 100%) the sales process necessary to acquire adequate capital participation by other exploration companies. Generally, the larger the company, the more of this 3 year time frame is required for prospect generation.

THIRD PARTY PROSPECTS

The second way to build a prospect inventory is through the purchase of individual prospects from third parties,

Deal screening cannot be overlooked as a source of new ideas, but this approach has inherent problems, such as:

  • Heavy promotes. Sellers generally recoup sunk costs (overhead and land/G&G expenses incurred in prosect generation) plus a profit (often equal to sunk costs) in the form of an up-front fee and the retention of a substantial carried working interest, or the purchaser pays a disproportionate share of the well costs.

  • Inconsistency. Deal screening makes it difficult to target the best operator or exploration team in the particular play, since deals come in on a haphazard basis. An attempt to drill a basket of prospects in a given trend may result in a different operator on each prospect. This approach does not provide a company with exclusive access to the established track record of the lead company in an area but relies on the expertise of the purchaser to attempt to high-grade all the prospects which have been reviewed. Separating quality prospects from marginal prospects is not difficult, but attempting to high-grade quality prospects-ones which have all their technical components well thought out-is extremely difficult, if not close to impossible.

  • Budgeting. When the best deal of the year comes in the door in November and the budget is committed for that year, it can be difficult to access adequate capital for a prospect in a short time frame.

PROJECT JOINT VENTURES

The third form that exploration opportunities take are project joint ventures covering an entire trend or basin. Majors have generally structured these deals in plays which were marginally economic or so high-risk they didn't want 100% of the exposure.

Tight gas plays are but one example of this type of deal, many of which have been done over the last 20 years with less than stellar results for the independent investor.

Major and large independent exploration companies were generally able to fund all their "Class A" prospects internally and were very often net buyers of prospects from the independents.

THE OPPORTUNITY

This entire "business as usual" scenario collapsed, along with prices, around 1986, which leads to the central theme of this article: that the independent domestic exploration companies in the country are faced with a unique and unusual window of opportunity to combine a) internal prospect generation in areas where an extremely aggressive approach and low land prices can result in substantial exposure to large reserve potential for minimal cost, and b) joint ventures with selected major and large independent companies, which can lead to the discovery of substantial new reserves of oil and gas at low finding costs.

Several events have occurred simultaneously in the domestic exploration arena which have substantially reduced overall competition for today's independents in their search for quality prospects:

  • Nine years of declining oil prices, from the mid-$30s/bbl in 1981 to the mid-teens in 1990, and the drop in gas prices from an average spot price in 1983 of over $3/Mcf to less than $1.50/Mcf by the summer of 1990. According to Oil & Gas Journal statistics, U.S. well completions dropped from around 85,000 in 1984 to 30,000 in 1989.

  • Major oil companies and large independents have curbed domestic exploration spending due to a) reallocation of exploratory budgets to overseas operations, and b) the acquisition of producing properties which occurred in the recent selloff of several large producing companies.

  • The domestic exploration teams of the major companies are reduced in size through attrition, layoffs, and transfers to international operations. The remaining teams focused on the domestic plays that made the most economic sense based on lower prices of approximately $15/bbl of oil and $1.50/Mcf of gas. During this period (1986 to present), these teams continued to generate high quality projects, which targeted large reserves, while budgets continued to be reduced.

    Research and development activities continued to advance new technologies such as computer-enhanced, high-resolution seismic to assist the search for sand channels, fractured reservoirs, and sub-salt plays, and the application of horizontal drilling/completion techniques, which has taken marginal plays such as the Austin Chalk to the forefront of today's revitalized exploration plays.

    This research and development effort was evident during Wolverine's review of the exploration prospect inventory of several large companies. The continuing internal process of high-grading prospects and the application of new technology were evident in the very good to superior technical work observed during numerous prospect reviews over the last 3 years.

  • Tax law changes have reduced exploration capital. The most significant change was the reduction in top individual tax rates from 70% to 28%, which contributed to the decline in exploratory drilling funds from a high in 1981 of $2.074 billion to $65 million in 1989, with only a very small rise expected this year.

  • The Independent Petroleum Association of America reports that the number of independent companies producing oil and gas has fallen from 15,000 in the early 1980s to less than 10,000 today. The investment house of Smith Barney, Harris Upham & Co. has compiled statistics which show that in 1982 there were 57 exploration and production companies with market values between $1 billion and $50 million. Today there are only 38 companies with market values between $1 billion and $50 million. Many of the remaining independents have been operating under high debt loads, which along with the flight of exploratory capital in the drilling fund arena and the tough sell in the equity markets, have reduced exploratory capital outlay.

    Many independents have essentially ceased exploratory drilling, instead concentrating on buying production, because capital was available for production purchases. Additionally, many independents (and majors for that matter) feel that exploration opportunities in the domestic arena are moderate-size (in terms of reserves) prospects or the delineation of existing fields or trends.

Wolverine's experience refutes this thinking. An example is the Gulf Coast exploration agreement structured between Wolverine and Amoco Corp. The per prospect gross trap reserve size for the first year of the program (1990) ranges up to 1 tcf of gas/prospect. This type of exposure to technically sophisticated, large-reserve-target prospects in new trends located in the midst of existing trends in the Gulf Coast sets a formula for success. As of this date only two of the eight 1990 program wells are at TD; the first was dry, and the second has logged commercial pay and has tested gas and condensate and is currently awaiting completion.

EXPLOITING THE OPPORTUNITY

All these factors have combined to create the opportunity for independents to access high quality prospect inventories of majors and large independents in the U.S. The opportunity exists, and there are three key components to exploiting this opportunity, capital, contacts, and management.

CAPITAL

Large exploration joint ventures can raise capital for independents. Even though there is an appearance of "promote" on the surface-through payment of disproportionate well costs-the point must be made that often the major will bear all land, G&G, and overhead expenses, resulting in a ground floor deal to the independent.

For example, Wolverine paid 100% of the dry hole cost in the initial exploratory well on each prospect in its 2 year joint venture with Union Pacific Resources Co. (UPRC), to earn a 50% working interest. UPRC bore all the land, G&G, and overhead expenses, resulting in a ground floor deal to Wolverine. Our joint venture with Amoco is structured along similar lines.

These types of deals have appeal in the equity market. These two joint ventures, combined with two joint ventures with Oryx Energy Co. (a leader in horizontal drilling), one in the Austin Chalk and the other in the Fractured Niobrara in the Sand Wash basin of Northwest Colorado; multihorizon play on a 78,000 acre ranch in the Maverick basin (Wolverine 66% working interest); and a 90,000 net acre position in the Fractured Niobrara in eastern Wyoming in the vicinity of Silo Field (Wolverine 100% working interest) have enabled Wolverine to access almost $185 million in exploratory drilling capital in 3 years. The deals ran the gamut of financial instruments: preferred stock private placement, common stock offerings, senior subordinated exchangeable reset notes, and convertible exchangeable preferred stock. Wolverine does not incur debt to drill exploratory wells.

The company also raised capital through the sale of fully mature, declining-reserve production from the shell company used to form Wolverine. A line of credit has been used for development drilling. Quality programs that are properly managed and marketed to the equity community by the independent and investment banks which understand and support the exploration business can access new capital in the marketplace.

CONTACTS

There is an old saying about being at the right place at the right time. Independents must be at the right place at the right time-able to move quickly when opportunity presents itself.

The ability to take advantage of these opportunities is more than just receiving the first telephone call that a joint venture is available. Independents cannot afford to be constrained by a quarterly/annual budget mindset. If a first class project is presented, they must move quickly to access the capital or bring in additional partners to reduce the capital requirements.

Additionally, Wolverine feels strongly that independents must avoid the "not invented here" syndrome-the reluctance to accept new ideas from explorationists outside the company.

MANAGEMENT

It is important that the management of an independent seeking to form a partnership with a large company have broad-based exploration expertise and that enough control/oversight functions remain with the independent so that the joint venture does not become merely an exercise in cutting checks upon receipt of invoices.

Continual contact between all levels of personnel in both companies, from drilling engineers and joint venture coordinators to senior management, is critical to a smooth-running joint venture. Flexibility and willingness to modify or renegotiate the joint venture agreement as the oil patch changes during the course of a joint venture allow the partners to continue to reap mutual benefits of the venture, rather than creating a win/lose relationship which could potentially damage the companies' ability to form future partnerships.

This niche is largely untapped because of the unique combination of capital, contacts, and management required to access, evaluate, and manage large multiwell projects spread over several geological basins or even across North America.

As previously mentioned, internal generation does play an important role in the portfolio of today's independent. When generating internal prospects, an independent must utilize its inherent strengths-such as an entrepreneurial command structure which allows the rapid concentration of human and financial assets on a new exploration opportunity.

To recoup land budget for additional plays of this nature, go to the smartest money around; i.e., seeking out larger independent companies that combine some discretionary budget, leading edge technology, and aggressiveness, and bring them in as joint venture partners. The object is not to heavily promote the partner (since promoters generally do not impact the per share value of a company), but to establish a mutually beneficial relationship with the joint venture partner.

Wolverine has employed these strategies since its creation in May 1987. When old production was sold in the spring of 1988, the company had essentially no cash flow and only a few hundred barrels per day of oil equivalent production. Now it has over 12,000 b/d of oil equivalent production and cash flow in excess of $50 million/year. Wolverine believes that this window of opportunity still exists for independent exploration companies and should exist for several years into the future.

Copyright 1990 Oil & Gas Journal. All Rights Reserved.