Most upstream operators in the Rockies began as pure E&P companies. Today, with an oversupply of natural gas from the region and not enough takeaway capacity for their output, many of these producers find themselves at the mercy of low, local spot-market prices and capital constraints to fund further growth. One Denver-based company-Western Gas Resources-began as a midstream operator and fortuitously backed into the Rockies upstream at the right time. The result: it now finds itself in control of its own destiny-in terms of growth opportunities, the capital to fund them and attractive pricing for its product. Formed in 1977 as a private operator with several gas-gathering and -processing facilities in Wyoming, the company publicly offered units in Western Gas Processors Ltd., a master limited partnership (MLP), in 1987. Two years later, a new publicly traded corporate entity, Western Gas Resources Inc. (NYSE: WGR), was formed to acquire a majority interest in and assume the duties of WGP, the general partner of the MLP. In 1991, the partnership and parent were combined. As an MLP, the company grew substantially, acquiring midstream assets in Texas, Louisiana, Oklahoma and New Mexico. "Our strategy was to acquire midstream assets, improve their operations, reduce costs and expand our presence in various basins," says William J. Krysiak, Western Gas Resources executive vice president and chief financial officer. That growth strategy, which continued well into the 1990s, included expansion into Wyoming's Powder River and Green River basins, as well as North Dakota's Williston Basin, New Mexico's San Juan Basin, Oklahoma's Anadarko Basin and the West Texas Permian Basin. "We started 25 years ago with one small gas-processing plant and now have 18 and gathering operations-in particular our core Midkiff/Benedum complex in West Texas and our Cheney Dell and Westana systems in northern Oklahoma-that provide stable income and cash flow to fund our growth prospects in the Rockies," says Krysiak, who has been with the company since 1985. Putting this growth into financial terms, total assets were about $85 million in 1985; revenues, around $110 million; and net income, roughly $14 million. Last year, its total assets were $1.3 billion; revenues, nearly $3.4 billion; and net income, $95.6 million. When Krysiak talks about prospects in the Rockies, he's not simply referring to midstream opportunities. That sole focus ended in 1996. "That year, we began noticing some coalbed-methane (CBM) production occurring in the Powder River Basin. The play up to that point hadn't gotten much respect in the industry, but we believed in it. In fact, Brion G. Wise, our chairman, had 'We Believe' bumper stickers made." Western Gas began snatching up small, rank-exploration leases in the region, and then-in a company-altering move-took aim at buying the assets of American Oil and Gas (AOG). The privately held Powder River operator had 20 billion cubic feet of coalbed-gas reserves and 20 million cubic feet of daily gas production. "We saw this acquisition as a way to fill our regional pipeline infrastructure-and better control our own destiny by adding a new leg of upstream growth." He wasn't alone in this assessment of the huge potential of the Powder River's untapped CBM. Peter A. Dea, now president and chief executive of Western Gas and then vice president of exploration for Barrett Resources, shared the same view of the play-and interest in AOG's assets. In 1997, however, it was Western Gas that made the successful, $23-million bid. Still, WGR felt it needed an experienced upstream partner with a strong enough balance sheet to grow in the play. It turned to Barrett Resources, and developed an AMI (area of mutual interest) agreement with the Rockies producer. "This event is what set the coalbed play on fire in the Powder River," says Dea, who joined Western Gas last year. Dea, who holds a master's degree in geology from the University of Montana, was an exploration and production geologist with ExxonMobil for 10 years, prior to his involvement with Barrett. Since 1997, Western Gas has built up the largest CBM leasehold position in the Powder River, with control of 515,000 net acres. This is separate from its aggregate 202,000-net-acre position in the Greater Green River Basin in southwest Wyoming and the Sand Wash Basin in northwestern Colorado. Overall, including other interests, the company controls 824,000 net acres in the Rocky Mountain region. Last year, the company drilled 858 wells, setting record operating and financial records: 2001 equity gas production rose 31%, to 120 million cubic feet equivalent (MMcfe) per day, and reserves increased 15%, to 476 billion cubic feet equivalent (Bcfe), as the company replaced 275% of 2001 production. Meanwhile, it grew cash flow from operations 24%, to $174 million. "Notably, the E&P segment of our business last year represented 25% of our overall net operating income or EBITDA (earnings before interest, taxes, depreciation and amortization)," says Dea. "We project that by 2004, our net operating income will be equally balanced between our upstream and our midstream gas-gathering and -processing activities-just by drilling into our high-quality leasehold position in the Powder and Greater Green River basins." Dea likens the company's gas-resource position in the Rockies to a pyramid. Today, at the very tip of the pyramid, the company has proven reserves of 476 Bcfe. "But the phenomenal part of the future value for shareholders is that we have an additional 2.1 trillion cubic feet equivalent (Tcfe) of probable and possible reserves in the Powder River CBM play and the Pinedale Anticline in the Green River," he says. "These aren't pie-in-the-sky exploration prospects-these are known development fairways where we've experienced virtually 100% drilling success during the past few years." Western Gas plans to drill between 800 and 1,000 wells annually-the vast majority in the Powder River CBM play-as it works its way through a 10-year inventory of prospects. "These are low-cost, low-risk, long-lived-reserve wells," says Krysiak. Indeed, a recent study by investment-banking firm Howard Weil pegs Western Gas' average five-year finding costs during 1997-2001 at 48 cents per thousand cubic feet equivalent. With complementary upstream and midstream operations, the company is not only able to drill and operate the bulk of its wells, but has at the ready gas-gathering and -compression facilities. "We're not in the disadvantaged position of having to wait-sometimes as much as two years-for somebody else to come in and hook up our wells," says Dea. "We're able to get our gas and liquids to the best possible market, at the best possible time and at the best possible price. So we're largely immune from the basis differential that exists in the Rockies." Western Gas has overcome the regional basis differential-the price a Rockies operator receives for its gas production versus a Henry Hub or Nymex price-by owning 166 million cubic feet per day of firm transportation capacity. This allows it to move gas out of the Rockies into the more lucrative Midcontinent market. Through late October, the company was receiving about $1.15 per million Btu (MMBtu) more for its gas than the average Rockies spot gas price, which was about $1.50 per MMBtu at the time on 29% of its gas production. Also shoring up the returns-focused company's income and cash-flow stream is its hedging strategy. For second-half 2002, it has locked in a minimum gas price on another 63% of its equity production, using collars with a floor price of $3.40 per MMBtu, net of basis differentials and transportation costs. "By locking in good realizations on 92% of our gas, we're able to protect our capital budget and hence, keep our company growing," explains Dea. "Right now, we're looking at 30%-plus growth in gas output for 2002, with a target of at least 15% annual production growth during the next five years." Future growth With a 2003 capital budget of $140- to $150 million, the company next year plans to drill more than 800 wells in the Powder River CBM play and another 35 wells in the Greater Green River and the San Wash basins. While Western Gas has already booked 393 Bcfe of reserves from the 300- to 1,000-foot-deep and 60-foot-thick Wyodak coal around the city of Gillette, Wyoming, the company believes there's still another 600 Bcfe of probable and possible Wyodak reserves it can book within that fairway. However, the most promising part of the CBM play is the 800- to 2,000-foot-deep and 120-foot-thick Big George coal. "Based on core analysis, the gas content of the Big George is twice that of the Wyodak." To put the potential of the Big George in some perspective, Dea notes that in 1996 the Wyodak was producing only 25 MMcfe per day of gas industrywide; today, daily output there is 900 MMcfe. "We think the Big George, from which we're now producing 15 MMcfe per day out of total industry output of 40 MMcfe, has at least the same production-growth profile-and a net reserve potential to Western Gas of 1.4 Tcfe." During the next five years, the company expects its daily net gas output will more than double from year-end 2001, to 250 million cubic feet equivalent-with the Big George increasingly becoming a bigger and bigger component of that growth. Western Gas also expects to tap into another 100 Bcfe of probable and possible reserves in the Green River Basin's Pinedale Anticline, where it has enjoyed a 100% drilling success rate this year and last. Dea believes the Powder River Basin is poised to rival the San Juan Basin in CBM production. The state of Wyoming and the industry estimate 25 Tcfe of recoverable gas in the Wyodak, Big George and other coal seams within the basin. "Fortunately, we have not only the largest leasehold position there with our partner The Williams Cos., but also the leading midstream infrastructure." Gregory LeBlanc, research analyst for Wellington Management Co. in Boston, says that whereas most producers are being challenged to grow gas supply, Western Gas already has a huge resource for growth in the Rockies-one of the least explored areas in the U.S. "What makes Western Gas attractive is that its recent stock valuation suggests investors are paying a reasonable price for its current assets," he says. "This means that investors have upside, in terms of stock-price appreciation, if the company continues to add value in the upstream through the development of its CBM resources." Also notable is the fact that Western Gas has core midstream assets in West Texas and Oklahoma that generate sufficient free cash flow to fund the company's gas-reserve growth in the Rockies, he adds. "Most producers have to reinvest the cash flow from their current production and raise external capital to grow reserves and output." Irene Haas, E&P equity analyst for Sanders Morris Harris in Houston, expects Western Gas' output from the Powder River CBM play and Pinedale Anticline to grow more than 30% annually, at current drilling rates. "Western Gas can be close to a $60 stock during the next couple of years," she says. It was about $33 at press time. Currently, taking into account its booked reserves and midstream assets net of debt, the Western Gas story is worth about $36 per share, she explains. "However, between its Wyodak and Big George CBM gas reserves that haven't yet been developed, there's another $20 worth of value-and yet another $3 of value underlying its undeveloped Pinedale Anticline tight-sands gas reserves."