Petroleum Development Corp. (PDC), based in Denver, has long been known as an experienced operator with high-quality assets. But recently, the company has broken with its past. It has shed many of its drilling partnerships—its previous business model—to form a joint venture (JV) with a private-equity investor. The goal: to fund development of its 500 potential Marcellus locations.

Throughout its 40-year history, the firm has operated more than 5,000 wells, with 1,900 of those in the Appalachian Basin. It also has assets in the Rockies and Michigan’s Antrim shale.

Until 2007, PDC’s capital-raising strategy was to sponsor oil and gas limited partnerships, operating as many as 77 at a time. The drilling partners were comprised of high-net-worth individuals seeking to invest in oil and gas properties. The company raised a pool of money and then itself invested from 20% to 33% in the partnerships. For example, if it raised $70 million, PDC contributed another $30 million, thus creating a $100-million drilling partnership. Each partnership owned a discreet and agreed-upon pool of assets.

Such partnerships are very illiquid, because ownership is exchanged from one individual to another. This lack of liquidity is in marked contrast to E&P and pipeline master limited partnerships with publicly traded units, although both are income-oriented without taxation at the corporate level.

“Each partnership owns a set number of wells,” says Rick McCullough, PDC chairman, president and chief executive. “It never increases, it never decreases. Each partner receives his share of income net of expenses on the wells and production, without expectation of new acquisitions. Other than the tax benefit flow-through, it operates much like any other E&P company.”

Initially, PDC found this partnership model to be an efficient and reasonably cost-effective way to grow a fairly small company. It had an effective network to raise money for each new partnership and earned fee income for operating and managing the properties.

The disadvantages? Most of the money was raised in very small pools. It sometimes took three months to raise capital, from start to finish, whereas a traditional E&P could raise money in the capital markets within a few days, McCullough says. And finally, as the value of drilling locations increased in the market and as PDC increased in size, the conventional E&P capital structure made more sense.

“We moved the business model away from partnerships because we don’t think it is scalable. As the company continued to grow, it became impractical to continue to use the network to raise money in a timely manner. It works well for a small company, but less so as you grow,” he says.

In the 1970s and 1980s, many E&Ps sponsored such oil and drilling partnerships as well. Today, that number is less than a handful. “I think most of the companies exited for the same reasons we have,” McCullough says.

Another disadvantage to partnerships is the time they require from the management team and core staff. Each partnership’s accounting is managed separately. “That added a tremendous level of complexity as the number of partnerships grew,” McCullough says. “As we reached the scale we have achieved, it just made sense to move away from that model.”

In 2006, PDC began to buy out its partnerships. That year it bought back 44, mostly in the Appalachian Basin, and it has some 31 partnership left to buy back, primarily in the Rockies. Along the way, it is shedding complexity, increasing cash flow and gaining reserves from the developed properties.

For the individual partners, the buybacks come in the form of cash offers, with partners voting their units individually. To complete a buyback, the votes must represent approval from at least 50% of the individual partners, excluding PDC, which does not vote. When a majority is reached, the dissenting or nonvoting partners are “drug along” with the plan. Everyone sells to PDC, and then the partnership is dissolved.

It’s a long process, says McCullough. PDC announced in March 2010 that it would like to buy back its remaining partnerships. That process could last up to three years.

Seeking a JV

In 2008 and 2009, as PDC moved away from partnerships, it began to eye the capital markets. While looking for a JV or partner, the company continued to drill its properties in the Rockies and the Appalachian Basin.

At the end of 2008, as natural gas prices fell, PDC—along with the rest of the industry—knew it faced a challenge. Because the E&P wanted to acquire assets offering a better return, finding a good partner became even more important.

“But, in 2009, we had constrained gas prices and the bond and equity markets were effectively closed to us, because we were one of the smaller companies seeking capital. That kind of capital just wasn’t available to small companies like PDC.”

The company had been operating for four decades in Appalachia, drilling the Devonian, and it had accumulated close to 115,000 acres in the play. Because the Marcellus shale is a horizontal play, average drilling costs, at press time, were running at about $4 million. For a small company like PDC, the exploratory risk of drilling the Marcellus was too high.

“We also own the deep rights in some of the Marcellus shale,” says McCullough. “We knew we had this asset, and if we could find the capital to develop it, we felt that it would have great strategic importance.”

At that point, McCullough and his team began to look for a partner to bring capital to the assets to de-risk the play. They decided a JV structure would help the company accelerate and grow its position during the tough times.

But although PDC sought a partner, it also wanted to leverage its expertise and continue to operate its properties. “If we sought industry partners, we could find them, but they would likely be inclined to want to operate the positions,” he says.

“Because we have operated in Appalachia for four decades, we have experienced personnel on the ground there. We have technical staff and existing shallow wells already in place. We felt like we brought a lot to the table and we wanted to continue to operate.”

Enter private-equity firm Lime Rock Partners. Based in Houston, Lime Rock manages $3.8 billion of private capital through Lime Rock Partners, which invests growth capital in energy companies worldwide, and Lime Rock Resources, which acquires and operates oil and gas properties in the U.S.

McCullough says, “Lime Rock saw we had a long track record of operating success and extensive relationships. A lot of the wells we will be drilling in the Marcellus will be sites we have already cleared for our shallower wells.” Other advantages PDC brings to the venture: its low-pressure compression facilities, road access and gathering systems.

At the time PDC and Lime Rock formed the JV, called PDC Mountaineer LLC, in October 2009, PDC held 46,000 acres in the Marcellus shale. Today, the JV has 58,000 total Marcellus acres, including 42,000 in West Virginia and 16,000 in Pennsylvania, all in the over-pressured dry-gas areas. It has seven vertical wells in the play and is producing gas with 1,100-Btu content.

PDC contributed 115,000 acres in the Appalachia Basin to the JV; of that, 46,000 acres were prospective for the Marcellus. The acreage now produces about 12 million cubic feet of natural gas per day and holds some 113 billion cubic feet of total proved reserves in the shallow Devonian sands. The E&P also contributed its existing low-pressure gathering and compression facilities and existing 2-D and 3-D seismic data, with the total package valued at $158.5 million.

“At that time, Appalachia represented less than 10% of our total assets,” says McCullough. “Our market cap was about $300 million or less, so this was a substantial valuation. It has certainly been a catalyst for our stock during the past six months.”

Lime Rock initially contributed $45 million, which PDC was allowed to take out of the JV as a return of capital at closing. The company also has an option to take a second cash contribution of $11.5 million by year-end 2010.

Subject to agreement provisions, Lime Rock has an obligation to fund in full by December 31, 2011, to earn a 50% interest. Lime Rock anticipates it will satisfy its funding obligation by early to mid-2011, however, at which time all costs and capital investment in the JV will be shared equally. PDC Mountaineer plans to contract for the construction of a new gathering system for its Marcellus volumes, primarily within its current right of ways.

Dewey Gerdom, chief executive of the JV, is a 10-year veteran of PDC and was instrumental in its significant Rockies growth. The E&P has designated another 90 employees to directly support the JV, which will be headquartered in Bridgeport, West Virginia.

The JV’s development plan includes about 500 potential horizontal and vertical wells on its existing net Marcellus acres. The initial focus will be to execute its 2010 operating budget and gather additional technical analysis from the first horizontal wells, to better refine potential upside.

The company is currently drilling its initial horizontal well, the first of 10, and 16 more verticals are planned for later in 2010. Initial production rates from its past seven vertical wells range from 200- to 480 thousand cubic feet per day.
“We’ve confirmed the thickness of the shale in our play at somewhere between 103 and 240 feet, and confirmed the gas in place as 30- to 60 billion cubic feet per section,” says McCullough. “It looks like this is going to be an economic opportunity with strong upside potential for our shareholders.”

The first well will be in Taylor County, West Virginia, with tests conducted in the second quarter.