Alan Smith

“I’m a firm believer that operational excellence doesn’t just happen by osmosis. There is a method to the madness,” says Alan Smith, Quantum Resources Management.

Believe it or not, some savvy management teams in this business are not chasing shale acreage or joint ventures to exploit unconventional resources—and they are quite happy to pursue a different business model.

Houston-based, privately held Quantum Resources Management LLC is one of them. In May the company quadrupled its reserves—all conventional—by acquiring oil and gas properties in three basins from Denbury Resources Inc., for $900 million. The assets, which are in the Permian and Anadarko basins and in East Texas, came with Denbury’s recent purchase of Encore Acquisition Co.

Quantum Resources was formed in 2006 as a $1.2-billion private-equity fund with 56 institutional investors under Denver-based chairman Donald D. Wolf. The focus of the fund is to buy and enhance long-lived, mature domestic assets for its investors. Many E&P companies are ready to divest these so-called conventional properties because they don’t fit the shale plat du jour, and this fits Quantum Resources’ strategy just fine.

President and chief executive Alan L. Smith joined the company in April 2009, replacing the former president. It was not exactly a fun time to be heading an acquire-and-exploit firm, with capital markets clogged up and buyers and sellers of assets cowering. Smith, a petroleum engineer from Texas Tech University, knew he had a big job ahead of him. He had previously worked at Ocean Energy Corp., Burlington Resources, Arco Oil & Gas Co. and engineering consulting firm Ryder Scott Co.

More importantly, he had led an E&P company. In 2003, Quantum Energy Partners funded his own start-up, Chalker Energy Partners LP. Upon successfully building and selling Chalker in 2006 for more than $250 million, he joined Quantum Energy Partners, an energy-focused private-equity fund, as a managing director.

Now he is on the E&P side of the table again, managing the $1.6 billion of legacy assets acquired since inception, including the latest deal.
Investor To clarify, what is the relationship between Quantum Resources and Quantum Energy Partners?

Smith We get asked that question a lot and we’ve really worked hard to differentiate the two. Quantum Resources is an E&P company managing a fund for our own investors, although two of Quantum Energy Partners’ principals serve on our board (QEP founders Wil VanLoh and Toby Neugebauer).

Also, while QEP invests in multiple upstream and midstream management teams, none of its funds are invested in us. We have 56 unique investors of our own, from university endowments, pension funds and other institutions.

Investor: You were with Quantum Energy Partners previously. What prompted the move back to E&P?

Smith: Before I joined, Quantum Resources had bought the Jay Field in Florida, but early on there were some technical challenges and it turned out to be difficult to manage. Then, for about two years, it was a difficult time to get any deals done. The two toughest times to buy are in a steadily rising commodity-price environment, which is what we saw in 2007-2008, and then, we had the crash in 2008, when oil fell all the way to $38 a barrel. When you are at either of these extremes, or when people think prices are close to the bottom, it’s a tough time. There was such a buyer-seller disconnect.

Our board decided that with oil down to $38, the prudent thing to do from a financial perspective was to shut in Jay Field and make some management changes. That’s when I came in, and the decision was made to move the company from Denver to Houston, mainly to enhance deal flow.

It’s not like the board changed our basic strategy. But at the end of the day, Jay was not working out as well as anticipated, and this drove many of the changes that were made.

Investor: What challenges did you face when you joined in April 2009?

Smith First, we went from 47 people to only five when we relocated to Houston, so we had a huge challenge to rebuild the team. We got that accomplished by September 2009, at which time we ramped up our deal-screening effort. But there’s no one on this leadership team we didn’t already know well, which mitigates much of the risk of such a large change in personnel.

Investor: Where does Jay sit now?

Smith We are optimistic we can extend the life of the field. It’s been restarted after some major modifications: rotating equipment reconfiguration, reducing our fuel costs and shutting down the nitrogen-rejection unit, which was causing most of our downtime. Now we are putting full wellstream gas and nitrogen back into the ground and eliminating natural gas sales.

Jay was only producing about 3,800 barrels a day when we shut it in. We made facility adjustments to align with the current volumes and were able to reduce our costs by more than 30%, and now have production back up to roughly 3,000 barrels a day. By the end of the year we anticipate production will exceed pre-shut-in levels.

Investor: So far, you’ve not acquired any shale assets. What gives?

Smith Our whole strategy is almost a contrarian play. The idea was, let’s create a fund that buys conventional, legacy oil and gas reserves that have a longer life, in some of the more proven areas. Let’s manage those assets to enhance the value for our investors, similar to what other successful E&P funds have done. That original strategy has not changed.

We think there are a lot of opportunities out there. The shale plays take a lot of capital to drill all those leases…companies generally have to issue equity, structure additional debt, or sell their non-core conventional assets—which are what we want to buy.

Investor: Has the strategy changed, given the gyrations in oil and gas prices?

Smith It’s a longer-term concept. This is up to a 12-year fund of roughly $2 billion, including debt utilization, so we intend to acquire, exploit and enhance the value of mature assets for our investors over several years. Once we’ve done that, maybe north of five years out, we’d look to sell some strategic assets, but not the whole company. Due to assets being located in several basins, it is unlikely we’d ever sell the entire company at once.

Investor: How did the Denbury deal happen?

Smith We’d looked at several deals, but when I heard about Denbury buying Encore, I called the guys I knew at Denbury immediately and stayed close to the situation as the merger played out. We were familiar with these assets and knew they would uniquely fit our strategy.

There was no data room—but we were invited to a limited process led by an investment bank in Houston. The Denbury assets fit all our criteria. I’d told our investors we’d focus on larger transactions, north of $300 million. We look for large legacy assets with a lower production decline, low maintenance capex requirements, a high percentage of PDP (proved developing producing), and we want to operate. The new assets are 84% operated, the proved R/P is 16 years, and 64% of the proved reserves are PDP, and less than 30% of the cash flow is needed to maintain production.

Investor: What are your current operating plans?

Smith We’ve bought a large number of fields and increased our production by 176% to roughly 19,000 barrels per day equivalent, so for the next six months we’re focused on execution, reducing costs and getting the new assets integrated into the company. I’m a firm believer that operational excellence doesn’t just happen by osmosis. There is a method to the madness. We aim to achieve superior returns—to do that we have to be good at buying it and we have to be good at operating it.

Investor: How does this deal change Quantum Resources?

Smith Before this deal, 50% of our production was in the Gulf Coast region, but now Gulf Coast production is only 20%—and the other 80% is where we want it to be, pretty evenly split between the Permian, Midcontinent and East Texas. Some of the Permian assets are 70 years old and still producing. Those are the kind of long-life assets we want to own.

Our production mix is now about 47% oil, so we are well balanced between oil and gas in our portfolio. We also are firm believers in risk management, so we hedged a large chunk of the production for five years at the signing of the purchase and sale agreement.

Investor:r And what comes next?

Smith Our focus is on integrating the Denbury assets and our existing assets to maximize value and create some good returns for our investors. As some of the assets begin to “ripen,” we’ll consider asset sales.

There are several operational priorities we’re working on. First is to continue to enhance the value of Jay Field with the new configuration we initiated. Then with our new acquisition, we have lots of cool things to work on like infill drilling opportunities, waterflood optimization projects, workovers and recompletions and production optimization. In 2010, we’ll spend about $50 million as we execute these projects.

We currently have about $450 million of buying capacity remaining in this fund. But again, our main focus is to integrate the new acquisition, show some positive operational results and continue to build upon our track record. If we do this successfully, we will be well-positioned to begin raising our next fund in the next six to 12 months.