Natural Gas: The Hybrid Model Is Expanding

Thinking Strategically

Dar & Company 6845 Wilson Lane, Bethesda, MD 20817

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Natural Gas: The Hybrid Model Is Expanding (First published on www.SeekingAlpha.com on September 29, 2010)

The hybrid model is the joint production of natural gas and gas liquids, or natural gas and light oil, or all three, from relatively narrow and fairly difficult to delineate "windows" within extensive shale and tight sands (TS) natural gas basins. The marginal cost of producing the liquids or oil is quite low while the gross profit contribution is very high because on a per Btu basis the liquids are several times more valuable than the natural gas. This propels the total return on capital to most attractive levels and encourages capital deployment and risk taking in gas shale basins in the US despite low (very low in real terms) natural gas prices. In turn, this positively differentiates companies by helping them articulate a compelling investment theme to investors. Almost all the top 20 natural gas producers in the US are pursuing this model.

The hybrid strategy is part of a broader investing trend: the determined change in business mix by E&P companies operating in North America, away from natural gas and towards gas liquids and light oils, reflecting the tremendous divergence between per Btu prices of natural gas and liquids in North America. It is, of course, cyclical. If and when natural gas prices soar, the trend will reverse.

For example, Chesapeake Energy (CHK) believes that it can make the transition from liquids accounting for about a tenth of its output at the end of 2010 to about a quarter at the end of 2015, while still expanding total output and reserves at double digit rates. This is premised on notable success in developing liquids production from both shale and TS natural gas basins and from tight oil plays. Two years ago Chesapeake was virtually an all gas company and branded itself as such.

EOG Resources (EOG) claims that it will be primarily a North American oil and gas liquids company by the end of 2011 compared with being a predominantly natural gas company at the end of 2007. Even a company as large as Conoco-Phillips (COP) is shifting capital allocation away from natural gas to oil and gas liquids in the US.

The hybrid model is barely four years old but it has garnered not merely national but international attention within the industry and the community of oil and gas investors. EOG Resources claims to be the industry pioneer in developing, refining and extending the hybrid model and many in the industry agree. However, since then the model has been enthusiastically adopted by companies ranging from the quite small to very large independents, mini majors and the biggest integrated majors (Petrohawk Energy (HK), Chesapeake Energy, Conoco-Phillips, Exxon-Mobil (XOM) are representative and well followed examples). Based on investor presentations, it seems that over 200 companies are pursuing the hybrid model. The operational and financial evidence does not, however, support these claims. The model is difficult to apply and execute.

Successful development and implementation of the model requires leveraging highly detailed and proprietary local knowledge with a substantial corporate competence in efficiently and safely producing from low permeability natural gas and oil basins, with widely varying characteristics. It is not at all clear that, at present, more than two dozen independents actually possess this required combination. Doubtless, the ranks will grow but it is unlikely the number of credible and successful independents will even double in the next 3 years. Consequently mini-majors and majors will be able to use their tremendous access to capital and deep technological and business skills to become very significant "fast followers."





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Many small and medium independents will end up being the highly lucrative front end of the hybrid model -- discovery and proving the concept -- while big to mega companies will be the less well rewarded (on an ROE basis), much lower risk profile, back end of the model -- rapid production and footprint growth and efficient expansion of production and optimization of the gross margin stream. For large independents the hybrid model is becoming a magnet for both domestic private equity and international industry capital. This capital enables the companies to monetize a portion of their business position on very favorable terms indeed. The large independent that can replicate this monetization across multiple basins can turn such financing into a significant contributor to earnings and enterprise value.

So far, the model has been dominated by Texas basins but it is spreading geographically. The first application of the model was in the Barnett (EOG) then the Cleveland Sands in the Granite Wash (spreading from Texas to Oklahoma and within the Granite Wash to the Des Moines formation) and now most vigorously, profitably and famously in the very young Eagle Ford shale basin (so young that the first well was drilled barely two years ago by Petrohawk). The author has discussed these initial plays in some detail in previous articles.

The Eagle Ford play is now believed to have the best natural gas economics in North America because of the liquids window, beating even the Marcellus. Natural gas production from this new but strategically important area is expected, by industry participants, to exceed 1 billion cubic feet per day (Bcfd) and 35,000 barrels per day (Bpd) of oil by end 2012, inducing new infrastructure investments as well. Already, 50 companies are active in the Eagle Ford (compared with around 60 in the much older Barnett), which is viewed as a corporate resume enhancer for even large companies. Several of the bigger players who accumulated skills and experience in the Barnett are also now prominent in the Eagle Ford.

The strategic questions investors and companies are now asking:

1. Can the hybrid strategy be replicated on scale outside the three areas mentioned above? 2. Does the hybrid strategy face competition from emerging oil plays in North America?

The answer to the first question can be based on informed speculation at best. Public documents and investor presentations are now lagged revealers of true strategic intent by the more astute and successful independents and the majors are traditionally reserved about forward looking activities and nascent investments. Several independents are now very reticent about disclosing their investment and operational plans for new shale or TS gas plays or new tight oil plays. They realize how great an advantage accrues to the first and second entrants. They understand how every promising play will be swarmed by competent and financially capable companies and the mini-majors and majors will be swift to amass formidable business positions. Small or medium independents no longer have time on their side once they have made the serendipitous effort and taken the risk to be resource pioneers. The window of opportunity between opening up the unmarked frontier and having it thickly settled is quite narrow.

There is evidence, often tenuous but sometimes supported by actual drilling success and financial results, that outside the initial 3 areas, the liquids window is being discovered in: Bienville Parish, Haynesville shale (landowner talk, really); Horn River shale basin in British Columbia; Bone Spring trend in the Delaware Basin, greater Permian, in eastern New Mexico and western Texas and the Collingwood/Utica in the Michigan Basin.





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An investor presentation by Quicksilver Resources (KWK) states that it has encountered significant mobile oil saturation (based on sidewall core results) in the Exshaw/Bakken in its extensive Horn River basin holdings. A horizontal test well is planned in 2011. As usual the oil is at a shallow depth (about 4,000 feet) above the deeper dry gas. If there is an oil or liquids window in the vast Horn River it could be developed swiftly. Oil takeaway infrastructure is close and capable companies surround the Quicksilver position. These companies include EOG Resources, EnCana (ECA), Nexen (NXY), Apache Corp (APA) and Devon Energy (DVN), all with extensive holdings.

The Bone Spring trend, covering 5 million acres, is becoming documented as having a credible liquids window in its shale formations (called Avalon or Leonard, depending on the company) now that 250 horizontal wells have been drilled. Decades ago the Bone spring began producing oil and gas from conventional sandstones; then production moved to carbonate lenses, then to low permeability sandstones and now to shales. The Leonard-Avalon play (southeastern New Mexico, West Texas) is very recent and production is about equally divided amongst natural gas, gas liquids and oil. The drilling depths are 6,500 to 9,000 feet. Its most enthusiastic proponents view it as the next great hybrid play in Texas and environs after the still new Eagle Ford: such is the appetite of the industry for confirming that the liquids window is not confined to the three already discussed above.

Companies already drilling include Concho Resources (CXO), Marbob Energy, Cimarex Energy (XEC), SandRidge Energy (SD), Clayton Williams Energy (CWEI), Energen Corp (EGN), FieldPoint Petroleum Corp (FPP), Vanguard Natural Resources (VNR) and the largest independents: Anadarko Petroleum (APC), Devon Energy, Chesapeake Energy and EOG Resources, which has provided the most detailed and persuasive evidence so far.

EOG told investors recently that the Leonard-Avalon may hold more net potential after royalty (at 2.1 million barrels of oil equivalent, Boe, per acre) than the Bakken/Three Forks where it also operates (0.72 million Boe per acre) or its Eagle Ford holdings (1.8 million Boe per acre) but less than its Barnett combination play (2.5 million Boe per acre). EOG has asserted that the Bakken, Eagle Ford and Barnett may rank as the 5th, 6th and 17th biggest oil fields in the US. Given the per acre potential and extent of the Leonard-Avalon shales, the Bone Spring trend may again emerge as a very important liquids field.

In the Collingwood/Utica shale, in the very well known and once important Michigan Basin, an EnCana Corp subsidiary drilled a well recently that made 2.5 million cubic feet per day of gas with some liquids. The Utica lies above the Collingwood, a shaly limestone, found at around 10,000 feet. The shale can be up to 40 feet thick. This discovery has impelled considerable interest in this play. At an auction in May, 2010, state owned parcels collected $178 million in bonus payments, compared with the cumulative bonus payments of $190 million from 1929 to this auction.

Atlas Energy (ATLS) and Breitburn Energy Partners (BBEP) have also been accumulating shale acreage in the Collingwood for some time. Other companies that have received location permits include Whiting Petroleum (WLL), Merit Energy and Savoy Energy. EnCana, being a large independent, is present in other shale basins that have liquids windows.

The hybrid model and investment strategy, being a quest for oil and gas liquids in North America, is beginning to face competition from emerging or existing but rapidly developing tight oil or oily shale or oil-prone shale formations and basins (these terms are used interchangeably by many). The recent realization that the Cardium (in Canada) and Niobrara (Powder River and DJ basins) tight oil plays could be highly significant and that below the lower Bakken there is an entirely separate oil province is





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causing scores of E&P companies to, yet again, reassess strategic priorities and investment plans for 2011 and 2012. There is also nascent but, to some anyway, a most intriguing oily shale play in Western Newfoundland (another old province that technology and risk capital may revive).

The Cardium formation covers much of West-central Alberta, typically sandstone within shale. It is very complex and its hydrocarbon potential (in theory) is immense. It is an old producing area, with the core held by production, mostly small to medium Canadian independents. Technology, however, has turned this seemingly tired basin into a frontier oil and gas -- especially light oil amenable to recovery in attractive volumes per site using horizontal drilling and fracing -- province (as it is doing in the Permian).

New entry into the core is via acquisitions, but outside the core there is considerable land accumulation opportunity and activity. In addition to the small independents, companies currently pursuing this possible immense light oil play include SunCor (SU), PennWest (PWE), Hunt Oil, Shell Canada, Conoco-Phillips, Talisman (TLM), Imperial Oil (IMO), and Devon. This technology driven play may exceed the Bakken in terms of resource base and reserve potential.

The Rocky Mountain oil and gas community is not reticent about proclaiming the Niobrara as being the most likely next big oily shale play. The Niobrara has produced for decades from natural fractures. It can be 150 to 1,500 feet thick. What is new and potentially very large and lucrative is the application of modern technology, operational and management practices to producing oil and gas from low permeability formations. The Niobrara is particularly suitable to this application. The Powder River, North Park, Hanna, Sand Wash and portions of the DJ basin are oil rich.

This is where the greatest industry attention is being directed and acreage is being bid up swiftly. Nearly 50 E&P companies operate in the Niobrara and many more are investigating entry opportunities. At least half a dozen of these companies are both skilled and experienced in identifying and developing oil and gas liquids windows in shale and TS basins and producing from tight oil formations (oil prone shale) and a couple already have very large net acreage positions across the Niobrara. Most of these companies have already been mentioned in this essay.

The Bakken, already a magnet for E&P companies (over 70 companies including big ones such as Conoco-Phillips, EOG Resources, Marathon (MRO), Hess Oil and Gas, Newfield Exploration (NFX) are already operating there; Whiting Petroleum and Continental Resources Company (CLR) are among the biggest producers) recently became even more attractive. There is a growing belief in the industry that below the lower Bakken that is an entirely separate oil province. These are the Three Forks and Sanish formations. There is industry speculation or informed guessing or maybe just hopeful chatter that this province may rival or exceed the potential of the rapidly growing Bakken itself. Some observes have suggested that there is, at least in some parts, a third province called the Lower Lodgepole just above the upper Bakken Shale. Perhaps this is hasty extrapolation from some success reported by Marathon Oil in the North Murphy Creek field. Marathon itself notes that there are 5 distinct "districts" in the Bakken but has not claimed that these are entirely separate provinces.

It is clear to the global E&P industry that North America is once again a frontier province for oil and gas liquids reserve and production growth. Liquids window and oily shale plays are proliferating. Both the deep below ground in shallow waters and in the deep and ultra deep waters oil potential of the Gulf is impressive. There is a generational opportunity for America, based on the imagination and drive of independent E&P companies, technological innovation unexpected even a decade ago and risk capital





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to not merely arrest the decline in liquids production but to significantly expand it. The good consequences for jobs, income, balance of payment and national security are obvious and tangible.

The most significant obstacles are egregiously bad public policy, Wall Street distortion of capital markets and MSM hostility based on both malice and ignorance. For many small independents and for many medium sized ones this is a toxic combination. However, the independent has faced similar circumstances before and not just endured but overcome. The US independent has experienced multiple cycles of hostile and friendly business environments and doubtless will experience more.

The current hostile cycle will also end because ordinary Americans want domestic oil and gas, good jobs, a chance to make a decent living doing real things that are of national value and reduce dependence on energy tyrants. They want the oil and gas independent to succeed more.

Natural Gas: The Hybrid Model Is Expanding

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