AN INTERVIEW WITH JONATHAN FELDMAN - Patriot Exploration: An E&P company with a lending function

OIL & GAS FINANCIAL JOURNAL: How and when did Patriot Exploration get into the oil and gas business? Isn’t your background in real estate financing?

JONATHAN FELDMAN: I got into the oil and gas business through a personal investment in 1999. Initially, the tax benefits for the personal investors were what attracted me to research the industry. What I discovered was that the commodity prices were extremely low - oil was trading in the mid-teens and gas was below $1.50. It seemed to me that it was a good time to invest based on my recent experience in the real estate market with inventory. As the market recovered, prices began to escalate in a hurry. I was seeing a similarity in what OPEC was doing in the oil markets - flooding the market with inventory. And I saw upside potential to get involved even further in oil and gas investments.

OGFJ: Can you explain how your business model (using real estate financing methods in the oil and gas business) works and how it differs from more conventional forms of energy financing?

FELDMAN: Our business model evolved as a result of our risk management philosophy. We are an E&P company that invests as a working interest partner either as a lender or joint venture partner, depending on the project and level of risk associated with it. As a non-operator and non-generator of prospects, we needed low-risk drilling opportunities to offset higher-risk prospects in any given year in order for us to take a portfolio approach to risk management.

In the real estate business, many developers lend money to other developers at mezzanine rates - the philosophy being that a developer may like the project, but not at that price. So, instead of becoming an equity partner, the real estate developer becomes a lender. If the project is a success, they will realize a mid-teen return on their money. If the project fails, they end up owning the project at the cost they were willing to pay.

What I discovered in the oil business is that many lenders who lend to the small- to mid-sized driller (our sweet spot) often require the borrower/operator to borrow the entire capital structure at mezzanine rates in addition to offering warrants in the company. In the real estate business, mezzanine lenders allow less expensive senior debt to be part of the capital structure, and any equity requirement is project specific - not company wide.

We felt that we could offer project-based financing to small- to mid-sized operators at lower cost than is available in the marketplace and allow them to maintain 100% ownership in their company. Any equity paid would be project specific. This allows us to be involved in projects that are much lower risk, while we look to grow the company through our joint-venture deals with such investment partners as Bill Barrett Corp. and Carrizo Oil & Gas.

OGFJ: Can you elaborate? What advantages does this model have over other, more conventional financing methods?

FELDMAN: The advantages are simple: after pay-out has occurred, any retained interest is well-specific working interest - not company stock, warrants, or net profits interest. As a non-operator/generator, our industry partners know they will never see us compete against them, such as leasing adjacent acreage or using their technology in a certain basin.

Furthermore, we are an investment partner that raises a new fund every year, so we are not dependent on any one project’s cash flow in order to reinvest. If we like the initial results, this cuts months off the development of any project.

OGFJ: The oil and gas business, especially the upstream sector, is traditionally considered to be a high-risk, high-reward type of business. How do you minimize this risk to protect your investors from excessive risk?

FELDMAN: We minimize risk mostly through diversification. We try to limit capital exposure of any year’s total investable cash to 5% of the total per well bore and 30% to area of operation. So, if a hurricane shuts in production in the Gulf of Mexico, the Rockies are still producing.

OGFJ: What kind of projects is Patriot interested in participating in? What are the characteristics, typically, of those projects - onshore vs offshore, domestic vs international, gas vs oil, conventional vs unconventional, high tech vs low tech?

FELDMAN: We are opportunity driven. We invest in land deals, then shoot seismic in order to create drilling prospects. On the other end of the spectrum - drilling, we invest in downspacing drilling and in-fill drilling programs. The only investment we will not make is international.

OGFJ: What are your thresholds for risk tolerance and how do you determine the relative risk of a project? And, what percentage of your portfolio do you invest in high-risk, medium-risk, and low-risk projects?

FELDMAN: Risk and uncertainty are a part of the exploration and production business. Some projects by their nature involve a certain amount of uncertainty due to the limitations of the technical information available. We address these uncertainties by thoroughly evaluating the technical information on a project with experienced and knowledgeable professionals and ensure that the risk of disappointment in a project is offset by a sufficient reward upon success.

We strive to keep a balance in our portfolio across the risk spectrum so as not to have too many higher-risk projects. Since we are opportunity driven, our portfolio will look different from year to year in regards to the percentages of high-, medium-, and low-risk projects.

OGFJ: What sort of professional staff (engineers, etc.) do you employ to evaluate potential projects? Or do you contract this out?

FELDMAN: We have a managing director in Houston, Carter Henson, who is a petroleum engineer with more than 25 years of industry experience. He leads our efforts in evaluating the technical aspects of potential projects. He draws on his 16-plus years of broad-based experience in evaluating properties at Netherland, Sewell & Associates in screening projects. He utilizes the services of contract geoscientists and other engineers, depending on the project evaluation needs.

Jack Bayless is vice president of Patriot and leads the charge for business development. He was vice president of land for Carrizo Oil & Gas and has more than 25 years of industry experience managing land and business development activities for Carrizo and others, including Union Oil Company of California.

OGFJ: How important is the price of natural gas and oil to your financial success? In other words, what are the threats that you have to deal with?

FELDMAN: We manage commodity price volatility using a very conservative price deck that does not escalate with time. We figure that we can withstand substantial price reduction provided the drilling program is successful.

OGFJ: What about cost and availability of rigs and other equipment? Day-rates are very high right now and gas prices are relatively low. How cost effective is it to drill for and produce gas in this environment? Some companies - Chesapeake, for example - have shut in some of their unhedged gas production.

FELDMAN: Rig availability is an issue for everybody. It makes planning difficult in terms of drilling schedules and actual costs of the well. Fortunately, in the majority of deals we have done, there’s been a rig scheduled prior to our commitment. Rig costs are factored into our initial economic forecasts.

OGFJ: Do you hedge?

FELDMAN: No, we don’t hedge. Because we have no long-term debt and are not a public company, we feel the benefit of hedging is outweighed by the costs and lack of flexibility in the future. If I were to see macro-economic issues on the horizon that would affect the general director of commodity prices, we would hedge.

OGFJ: Where are most of your projects at the present time - Rockies, Gulf Coast, Permian basin?

FELDMAN: Right now, we are pretty well balanced with about 25% of our investments in the Rockies, 35% in West Texas, 20% offshore and onshore Gulf Coast, and the remainder in the Mid-Continent region.

OGFJ: Do you expect this will change in the next few years?

FELDMAN: We would like to get involved in the Trenton Black River play going on in New York and Pennsylvania. We intend to make investments in the area sometime in the next 12 months. We like the play a lot - it’s just a question of finding the right operator partner.

OGFJ: Can you explain your due diligence process and how long it takes?

FELDMAN: The due diligence process can vary widely, depending on the project. Normally, the process is rather straightforward and not very time consuming. The land and legal work is usually already done by the operator, and we check their documents. The technical review might take a day or two. When a larger amount of acreage or producing properties is involved, our timeframe will be a little longer. But, given our organizational structure, we can always make our decisions quickly and close on our deals in a matter of days. Even our most complicated deal structures can be done in less than a month.

OGFJ: Who are your investment partners?

FELDMAN: Wealthy individuals and small institutions.

OGFJ: Can you explain the process you go through when you approach an investor or group of investors about funding a particular project?

FELDMAN: Our investors’ money is consolidated into a blind pool, which is then used to fund a diverse number of projects. That’s about as far as I want to go on this subject because of competitive reasons. (Coke doesn’t tell Pepsi.)

OGFJ: As a non-operator, you don’t have to deal with operational risk directly - but you do indirectly. How do you go about choosing an operator partner - one that will be fast, use cost-effective measures, and be safety conscious at the same time?

FELDMAN: Since we don’t operate, partnering with capable and successful operators is critical to our projects’ success. Our business model is based on doing business with operators that have a strong track record of experience in executing projects similar to ours. We also prefer that the operator’s intent be aligned financially with ours, so that we know that experience will be put to use to our benefit. When dealing with new companies, we research the backgrounds and reputations of the management team before deciding to invest with them.

OGFJ: Are any other companies doing what you are doing? Who do you see as your competitors?

FELDMAN: We are not aware of any E&P company with a lending function serving the $1 million to $20 million market.

OGFJ: Looking forward, where do you think Patriot will be 5 years from now?

FELDMAN: We intend to maintain our annual drilling budget of $50 million and expand the company through the drillbit. We will execute on this growth strategy by continuing to choose our operator partners wisely based on sound technical risk evaluation. We’re looking for operators we can partner with over the long term - partners who will continue to bring us in again and again on attractive projects.

OGFJ: One final question - how did you come up with the name of your company?

FELDMAN: I was on my way to a [New England] Patriots football game when I thought of the name.

OGFJ: Thanks for taking the time to talk with us.