OVEREXPANSION PRESSURES TEMPT FIRMS AGAIN

Thomas H. Neel
President,
Chief Operating Officer Dekalb Energy Co.
Denver

With oil prices at levels not even dreamed of in the past 5 years, and the promise of increased natural gas prices closer at hand, the temptation for independent energy producers to expand their horizons inevitably reawakens. This springs not only from the aggressiveness of oil and gas professionals, but also from the encouragement of government, financial institutions, and the public to do more to find new sources of domestic energy. Considering what the industry has been through in the past few years, it may seem inconceivable that investors will ever again be pushing money into the upstream energy business, but the pressures to expand will return as better prices stay around long enough to be believed.

As we independent producers begin to reestablish strategies in light of the possibility of dramatically improved economic conditions for our industry, we ask ourselves: What areas should we explore? Should we expand to cover much larger parts of North America? Does a total North American strategy make sense?

During these times of major change, we would all be wise to remind ourselves of the lessons we have learned in the 1980s as we plan for the future. Most of the companies that are now financially strong enough to consider expansion are here today only because they have redirected and refocused their efforts, down-sized their staffs, aggressively controlled costs, and brought their balance sheets back into the conservative realm. It would be tragic for the industry if the allure of higher prices caused us to forget the painful lessons of the recent past.

There is an argument to be made for a diversified portfolio of producing assets. Throughout our 50 years of operations, Dekalb Energy has always been exclusively a North American producer. However, we have benefited from a production base that is balanced between oil and gas and a geographic diversity that extends from Canada through the Rockies, West Texas, New Mexico, and California.

BENEFITS CLEAR

The benefits of having both oil and gas production have never been clearer than they are today, but the fundamentals have been present for a long time. The prices of these two closely related energy sources simply have not, and still do not, track one another. This is because oil prices and gas prices are driven by different factors. That could not have been more apparent than in September, when gas was selling at 5 year lows while West Texas intermediate posted prices for oil were higher than they have been since January 1982.

But this is not the first time we have seen this divergence, and in the past, the price relationships have been reversed. In 1986, when Dekalb Energy's oil price dropped 56%, our Canadian gas prices fell only slightly, providing us with a stabilizing factor in an otherwise disappointing year. Our revenue mix is currently about 55% oil and 45% gas. In late spring and early summer as the "gas story" was in vogue, we almost felt like apologizing for our oil component. As you can well imagine, we are now very pleased to have it.

There is also something to be said for geographic diversity. During the '80s we learned that economic relativity between areas can change rather dramatically overtime. The Gulf of Mexico has recently been the salvation for many independents, and those who are exploring there are often the favorites of Wall Street.

However, it has not always been so. Those independents who entered the offshore with the first area-wide sales in 1983, a time when oil and gas prices were both strong, found themselves severely hampered by a lack of pipeline access. The price of gas is of no importance if you cannot put it on production. The delays for pipeline hookups were not only frustrating, but nearly disastrous, considering the carrying costs of high lease bonuses which were prevalent at the time.

At Dekalb Energy, diversity of producing areas has proved beneficial to us as we have seen gas markets and prices differ sharply by area. Our Canadian prices held fairly steady in 1986 and 1987, buffering our bottom line as U.S. natural gas prices fell sharply. We now expect U.S. prices to recover more rapidly than our average Canadian netbacks.

Similarly, over the past few years, we have found our New Mexico gas shut-in for extended periods due to lack of transportation or to prices lower than our threshold. However, success from our active gas exploration program in California substantially offset this curtailed production, and over the past few years, our gas there has been sold at an average price of around $2/Mcf. In fact, today our California gas is being sold for over $2.40/Mcf, while our Gulf Coast, New Mexico, and Canadian gas prices are very soft.

EXPANSION JUSTIFIED?

But do the benefits of diversity, along with the promise of improved long-term economics, justify aggressive expansion by independent producers into many new areas? I think not. First, not even the strongest independents have the financial strength to support rapid, large-scale expansion. Many in the independent producer community have taken draconian steps in the past few years just to bring their debt load down to barely tolerable levels. We have all learned valuable lessons about the dangers of too much financial leverage in an industry that is as cyclical as ours has proven to be. We must maintain conservative balance sheets, no matter the short-term promise, in order to remain durable during any future downturns.

Dekalb Energy was fortunate to have only modest debt levels during the late '80s, and our recent $130 million acquisition of Gulf Coast properties moved us up to a total debt to total capital ratio of only 41%. Even that level, however, is above our comfort zone, and we have plans to reduce it to 35% within the next 2 years.

Secondly, independents should be cautious in moving beyond their areas of expertise. During the last boom, most of us were guilty of thinking we could easily move into unfamiliar areas and enjoy the same level of success we had achieved on our home field. Most of us who survived were humbled by the experience and have since narrowed our focus to the areas we know best.

Having said that, Dekalb Energy has recently made an aggressive move into the Gulf Coast by joining an offshore exploration group and purchasing the Texas Gulf Coast producing properties of Royal Oil & Gas. We made this move after we spent 3 years getting extensive, relatively low cost exposure in the area and building a management team with direct Gulf Coast experience.

Thirdly, independents must concentrate their assets so that they can achieve operating efficiency and improved markets for their products. As a result of the last period of expansion, many independent producers ended up with minor interests scattered all over the place. In areas in which a critical mass is not achieved, operating inefficiency or neglect is generally the result.

Most of the industry has been and still is engaged in programs to rationalize their producing assets by selling properties which represent minor interest or are in nonstrategic areas, and buying additional interests in their prime areas.

At Dekalb Energy we recently completed a divestiture program by selling 23% of our U.S. properties, but in total these constituted only 9% of 1989 net lease operating revenues. This divestiture was only a first cut, and we will continue to concentrate our assets even in an environment of improved economics.

Critical mass is especially important when it comes to marketing production. The days when everyone got the same price for production seem gone forever. We have found that the creation of an internal marketing department to take control of our own oil and gas sales has resulted in significantly improved wellhead netbacks over those we previously received. However, a marketing staff needs concentrated production to be effective. Little can be done to enhance the price received for scattered or minor interest production.

THE LONG TERM

Finally, we must plan for long-term success, avoiding the temptation to simply turn a fast buck. The North American upstream energy business is going to stay around for a long time, and we believe it should become increasingly dominated by the independent producers. The major companies have moved much of their exploration spending into foreign areas and exited many North American basins.

The types of plays which remain, while too small for the majors, are just fine for the independents.

During the last boom, many long-term players forgot that their longevity depended on efficient production of oil and gas, rather than just turning deals. The independent producers who are active and healthy in the year 2000 will be those who have concentrated on areas they know, paid close attention to control of costs, achieved premium markets for their production, and maintained strong balance sheets. Improved oil and gas prices will justify some expansion, but the survivors of the next decade will be those who best remember the errors of the past decade, and those who recognized that overexpansion was one of the most common mistakes.