Panhandle explains business model

From left: Michael Coffman, president and CEO; Lonnie Lowry, vice president, CFO, secretary; Paul Blanchard, senior vice president and COO.

From our founding in 1926 as Panhandle Cooperative Royalty Company through our IPO in 1979 when we issued shares to existing shareholders, our strategy was to accumulate mineral rights. Since our IPO, we've never had a secondary offering in the history of the company. That makes us unique when compared to other small cap E&P companies.

Our operating strategy really morphed in 2006-2007 when the shale plays started to develop, principally in the Fayetteville shale play in Arkansas and the Woodford shales in Southeast Oklahoma. In addition to receiving our royalty income from wells drilled on our acreage, we started adding working interest components that allowed us to grow our business quite a bit faster. Over the years, we've expanded into several other plays using this same concept - the STACK, SCOOP, Cana/Woodford, and the Permian, just to name a few.

PAUL BLANCHARD: So to decide whether or not we participate in the working interest of a well, we look at the economic viability of a well without our royalty payment. We look at the working interest expense, capital cost, and projected revenue on each proposal that comes to us. Then we do our own geologic and engineering reviews. This allows us to come up with a risk weighted rate of return on projects with the royalty excluded. If it's expected to generate an acceptable rate of return, we participate. If we don't, we lease our minerals to the highest bidder in that area for that project. This way, we get an upfront lease bonus and a fairly attractive royalty - approximately 18.75% to 25% without having capital investment and operating expense requirements.

"We are unique because we've been accumulating minerals since our founding (in 1926). Panhandle's cost basis for our minerals is $90 per acre. The entry point to own minerals is now very high. A lof ot minerals are owned by individuals so they don't want to participate in the working interest of wells. Most people are happy to take their royalty, call it good, and not participate." - Michael Coffman

Historically, we've participated in about two-thirds of the wells that are proposed to us. So even during the up-cycles, we've felt one-third of wells proposed to us were not economically viable on a stand-alone basis. In the current downturn, we've received significantly fewer proposals. Instead of participating in two-thirds of the wells proposed, we've participated in 40% of them. So there's an even bigger difference in our view of the world and the operator's view of the world. They may be drilling because they have leases expiring; it may be because they have contracted rigs; or perhaps they believe the economics are better than what we think they are. In any case, our optionality has resulted in very low capital costs for us and provides us the opportunity to use cash flow and lease bonuses to pay down debt and return capital to shareholders through a regular dividend - not because we have to but because we believe it's the right thing to do.

OGFJ: Earlier this year, Panhandle leased out two mineral acreage blocks in the Permian Basin - one in Andrews and Winkler Counties and the other in Cochran County. Has the Permian always been an area of focus for Panhandle?

BLANCHARD: Panhandle has owned minerals in the Permian Basin for many years. Historically, it's only represented a small portion of our revenue, but in the last seven months we had two large blocks representing a total of 8,400 net acres leased from us. The first block is located in Andrews and Winkler Counties and is approximately 44 square miles. We leased the block to a large independent oil and gas company. In December 2015, the company drilled a well on the property to test a new concept. They are actually completing the well as we speak. Several hundred wells could be developed here. So this could be a substantial new play for us in the Permian. In December, we leased the other 35 square mile block in Cochran County to a well-respected, private equity-backed company. They haven't started drilling yet but we believe another several hundred wells could be drilled here as well.

OGFJ: Are you a working interest partner on any of these wells, or was it all leased?

BLANCHARD: We have a very interesting agreement on both blocks. We leased them so we received bonuses up front, and we have a 25% royalty. In addition, we have the right, on a unit-by-unit basis, to buy back the lease and participate with up to a 10% working interest. We're entitled to all well information from wells drilled on the blocks, so this means we can let the operators drill the first couple wells to test and de-risk the play before we start buying back our interest to participate with our capital. It's a very low-risk, high upside proposition for us.

[Most] of our assets are in known producing shale basins or unconventional plays. We like stacked pay, multi-zone areas that are in some phase of development. [This] fits our model nicely...The reserves on existing and future wells are faily well known and not too variable. And when a play reaches a manufacturing mode, we feel pretty comfortable that when we drill we can produce reasonable rates of return on a repeatable basis. - Paul Blanchard

COFFMAN: Don, these two deals really show you the value in our unique strategy of owning the minerals. We get a lease bonus, 25% royalty in both projects, and have the opportunity to participate in the well if we think it's appropriate. Only by owning the minerals can you do all of that. Lastly, given the current commodity environment where drilling is slowing, as owner of the minerals, our position does not expire if the operator decides to delay drilling.

OGFJ: Do you have many competitors?

COFFMAN: A few but not many - Noble Royalty, Black Stone Minerals, and a few other smaller companies. Dorchester Minerals in Dallas, but I'm not sure if they take working interests. We are unique because we've been accumulating minerals since our founding. Panhandle's cost basis for our minerals is $90 per acre. The entry point to own minerals now is very high. A lot of minerals are owned by individuals so they don't want to participate in the working interest of wells. Most people are happy to take their royalty, call it good, and not participate.

BLANCHARD: One big impediment to duplicating our strategy is as minerals get passed down over generations, the interests keep getting smaller and smaller. So when you try to find and negotiate with each individual owner, you find it is very time consuming and not very efficient. It's really not a business model that can be duplicated. We've added to our position overtime in pieces. Our last large mineral acquisition was in 2001 when we bought a private company out of Tulsa. They had 75,000 mineral acres and small interests in 2,000 producing wells. They operated very similarly to us, so it was a perfect fit. We haven't found a perfect fit recently but lately, we've been focused on acquiring proved producing properties that are held by production and complement our low-risk profile. We don't buy greenfield leaseholds - we like producing wells with infill locations where we can drill additional low-risk development wells.

OGFJ: You mentioned Panhandle is active in the Eagle Ford, Anadarko Basin, Fayetteville, Woodford, and Permian. What similarities exist across these basins that fit or support your unique strategy?

BLANCHARD: The vast majority of our assets are in known producing shale basins or unconventional plays. We like stacked pay, multi-zone areas that are in some phase of development. Horizontal drilling in unconventional resource plays fits our model nicely because it coincides with our conservative nature. The reserves on existing and future wells are fairly well known and are not too variable. And when a play reaches manufacturing mode, we feel pretty comfortable that when we drill we can produce reasonable rates of return on a repeatable basis.

COFFMAN: The other reason we like resource plays is it usually ends up aligning us with the large independents who want to come in and develop the resources as fast and as efficiently as possible. Large independents care about efficiencies, cost savings, and improving well performance, so they are a good partner to have. Likewise, our operating partners benefit from having a royalty owner and working interest partner that knows the business and can move quickly with them.

OGFJ: So where are you deploying your capital in today's environment?

BLANCHARD: Really the only place we're investing capital is the STACK and SCOOP plays of Oklahoma, and even then they have to be very special situations. We are looking for wells drilled on the highest quality acreage or some other unique reason for us to invest in a well.

OGFJ: As a non-operator, how do you manage your capital budget?

COFFMAN: As a non-operator, you need to be flexible because you are never sure who will propose wells or where they will be proposed. Fortunately for us, other than the two areas in the Permian, our mineral acreage is pretty well dispersed. This has really been a risk mitigation strategy for us. We don't have large contiguous acreage blocks so no one can come in and propose a ton of wells all together. It would be a highly unusual situation to have a bunch of wells proposed at the same time, but if we do we keep a line of credit so we have capital available. We like to stay as nimble as possible so we can react to wells that are proposed.

OGFJ: You said that Panhandle has been actively looking to expand its asset base. Are you starting to see more opportunities for acquisitions or are the bid-ask prices still too far apart?

COFFMAN: Bid-ask prices are still too far apart. Sellers still have non-realistic expectations. We are in no hurry to expand. Currently, we have an inventory of 4,600 identified undeveloped locations on a 3P basis. Our belief is if things don't turn around in the next few months, we'll be able to buy things even cheaper. If we found something that was perfect fit now, we'd look at it. But we think things will get better later this year. Assets keep coming to market. Every time you see a company announce an acquisition, they also announce they are selling non-core assets.

BLANCHARD: I agree. We don't have to do an acquisition, but we always like to be opportunistic. We have a large inventory so we are waiting for the opportune time to buy. If prices stay low, it will keep getting better for us. If prices snap back, we think we'll have plenty of drilling activity to focus on because we believe our plays will be the first to come back on in the rebound because of where they are located.

OGFJ: As you may know, our January cover story was Felix Energy, a STACK player that was acquired by Devon Energy. Do you expect more activity or consolidation in the play?

BLANCHARD: The four main players, Newfield, Cimarex, Devon, and Continental, have the core acreage locked up. Near-term, we don't believe we'll see much more M&A in the core. But we are seeing a northwestward expansion of STACK moving into Dewey County and even activity in Woodward County in Northwest Oklahoma. That's where there might be more activity.

OGFJ: Panhandle has paid a dividend for the past consecutive 50 years. That is pretty amazing. Is the dividend safe in the current environment?

COFFMAN: Like all companies, we evaluate our dividend payments every quarter. As you said, we've paid a dividend for 50 years. It's in our DNA to pay a dividend. We must be mindful of what's going on in the industry so we'll continue to evaluate it as we go quarter to quarter. To say it's safe forever would be foolhardy, but we certainly intend to keep paying it.

OGFJ: Panhandle has successfully navigated many cycles since 1926. What are the keys to weathering cycles, and what are some of the alternatives you are assessing to ride out the current low commodity price environment?

BLANCHARD: We're focused on preserving and expanding our opportunities during the downturn. We continue to pay down debt as fast as possible when we don't have wells to invest in. Not because we feel like we have to but because we feel like it will give us more availability for funds in the future when things are better priced to generate returns. We paid off more debt last quarter than any quarter in the company's history, which is a little unique for small cap E&P companies in the business right now.

We like our position - we have regular cash flow coming in, but lower than normal because of prices. This has been offset somewhat by our hedges. We're not making many investments, and we've had two large leasing deals that generated material cash bonuses for us. We'll continue to look for ways to expand the value of our land and mineral positions. Traditionally, we wait for people to propose wells and then we decide whether or not we want to participate. In the current environment, we think some plays are showing signs of a "bubble" in the value of leasing or minerals. So we're considering leasing and even selling some small pieces of our 199,000 undeveloped mineral acres. We might sell a few thousand acres if we believed that was better for our shareholders than waiting to drill it later.

OGFJ: In your minds, is this the most severe downturn in our industry?

COFFMAN: This is definitely the most severe downturn since the 1980s but that one went on for much longer than this one. If the current macro environment continues, then it will certainly rival the 1980s in my mind.

OGFJ: Do you see a recovery any time soon?

COFFMAN: We see and read the same things you do, I'm sure. One side says we could see a recovery in the second half of this year. Some say two years. Regardless of what happens, at Panhandle, we've set up our business to operate in whatever commodity environment we're in. We're conservative, and we've always been that way. If a recovery is two years away, we'll still be here.

BLANCHARD: The one thing I'd add is that we're a little bit more optimistic about the natural gas market. We think it's bottomed. No one is making money at this price, and the rig count has fallen severely. The Fayetteville doesn't get much play but behind the Marcellus and Utica, it's probably the third least expensive dry gas resource play in the US. So if we see a rebound in natural gas prices, we'd see an uptick on our activity there.

OGFJ: Thank you both for your time and for explaining Panhandle's business model.