Seeking Oil

Lariat Rig #20 drills the #6 Davidson 37 in Midland County, Texas, for SandRidge Energy Corp. The well targets oil production from the Spraberry and Wolfcamp formations.

As the blood-red sun cracks the cloudless horizon of the West Texas plains south of Midland, sparkling off a rare sugar-coating of snow from the day before, Sand­Ridge Energy Corp.'s Lariat Rig #20 grinds away 9,000 feet below the frozen surface, seeking the Spraberry and Wolfcamp formations at a total depth of 10,600 feet. Ten days earlier, the #6 Davidson 37 well was a stake in the ground, one of nearly 2,700 locations the company now has in the Permian Basin following its $800-million acquisition of several key Permian assets from Forest Oil Corp. in December.

This Permian Basin acquisition tilted the reserves value of Oklahoma City-based Sand­Ridge from a primarily gas-weighted company to about 50% oil weighted, and the company wasted no time in deploying a fleet of six rigs into the play to ramp up its oil production.

David (Buster) Groves, production superintendent for SandRidge's southern Permian Basin region, says the company has embarked on an aggressive drilling effort on the new properties. "If ever you're going drill oil wells," he says, "now's the time."

That's because margins for oil production are as high as they've been in years, enlarged by low service costs coupled with strong and stable oil prices. And combined with lingering doubt about any near-term rebound in natural gas prices, interest in oil assets is high. In its quest for oil, SandRidge is not alone.

"It's very competitive," says RBC Richardson Barr principal Scott Richardson. "There is more demand than supply."

"People are very bullish on oil prices. It's a commodity people are comfortable with," says RBC Richardson Barr principal Scott Richardson.

Even as high-dollar shale-gas deals have captured headlines, discount rates for oil assets have subtly pushed down into single digits and metrics per flowing barrel have pushed up into six figures in some areas. While the 12-month gas strip price closed 5% lower in 2009 than at year-end 2008, the strip oil price gained 52%.

"People are very bullish on oil prices," says Richardson. "It's a commodity people are comfortable with. An $80 strip is a good price for both buyer and seller."

Marshall Adkins, director of energy research and managing director, equity research, for Raymond James & Associates, spotlights why acquirers are bullish on oil and bearish on gas—and could be for some time. He told an audience at an Enercom Inc. oil-services conference in February that the structure is in place for crude oil to move "meaningfully higher" over the next three to five years, topping $100, but "gas prices will average five bucks." The disconnect between oil and gas will linger for several years, he predicts.

"Oil is still the better long-term investment in my mind."

That prediction reflects the sentiment of the president of at least one privately held company, who says, "We are chasing oilier deals because we think, both in the short term and long term, there is much more potential price upside in oil than natural gas." He believes prolific shale-gas production has put a lid on any U.S. gas-price upside for a long time, while oil is constrained and competes globally in price, and a major cartel can rein in prices by affecting supply.

Buyers perceive greater oil-price upside over gas, agrees Jefferies & Co. managing director Bill Marko. "The worldwide economic recovery story is exciting," he says. "Thousands of new shale-gas wells tamping down near-term gas prices is not so exciting." He sums up the sentiment: "We'll see $100 oil before we see $8 gas."

Price and profits

An oil sample from #1 Davidson 38 in Upton County, Texas, one of hundreds of Permian Basin wells acquired recently by SandRidge Energy Corp.

Michael Bodino, managing director and head of energy research with Global Hunter Securities LLC, New Orleans, and formerly with Madison Williams and Co. in Dallas, emphasizes that "absolutely" we are seeing a trend to oil-weighted transactions. Two things are driving oily A&D, he says: commodity price stability and margins.

"We finally have a close relationship between expectations of the buyer and seller," says Bodino. The big hurdle, he says, has been in finding a comfort level with long-term prices. "You've got to have confidence in the forward curve."

While buyers and sellers were chasing the strip up in 2007 and 2008, it was difficult to get transactions done. Now that markets have flattened after a volatile period—even to a slight contango in oil—aligning buyers and sellers has been easier. "We've seen more oil-weighted transactions for that reason. On the gas side we don't have the same phenomenon."

The other driver is margins. "You make money on invested capital after you acquire assets by accelerating development of those resources in the ground," says Bodino. "The profitability driven by the commodity price and the margin certainly has gotten more companies interested in the oil side of the equation."

In the past several years, gas assets had commanded about 60% to 70% of the marketplace, but since early 2009 as many oil assets have been available as gas, thanks to a combination of opportunistic sellers bringing oil assets into a strong marketplace and potential gas sellers holding back in a weak market.

In 2009, 24 oil deals of between $10 million and $2 billion were announced, compared with 18 for gas, according to Dallas-based advisory firm Energy Spectrum Advisors Inc.—a significant flip-flop to historic trends of gas deals dominating the overall market.

And oil assets are trading at a premium to gas for the first time in a generation. Acquisition metrics in the Permian Basin are in excess of $100,000 per flowing barrel of oil, up by 20% year over year, per RBC Richardson Barr. Oil assets in Oklahoma, the Rockies and other long-lived oil regions are trading near $90,000. Cash-flow multiples are up to eight times for oil deals, says Richardson.

Metrics are as high now as in first-half 2008 when we had much higher oil prices. Oil is frothy. We're seeing big premiums."

By contrast, gas assets are trading at about $60,000 to $70,000 per flowing equivalent barrel for like-kind properties, giving oil-weighted assets a 30% to 40% premium. Before 2008, gas had held that advantage for years.

Ward Polzin, managing director of Tudor, Pickering, Holt & Co., sees similar metrics, quoting an average of $90,000 per flowing barrel and as much as $120,000 in the Permian, particularly in the Wolfberry trend.

"Everyone desires more oil these days," he says, "while volatility in gas has made gas a little tougher."

In 2009, 24 oil deals of between $10 million and $2 billion were announced, compared with 18 for gas, according to Dallas-based advisory firm Energy Spectrum Advisors Inc.

Who's chasing oil?

Following a year and a half of suppressed A&D, data rooms are now brimming with eager buyers. And oil assets are all the rage, benefiting from confidence in the long-term strip and the perceived upside.
Richardson says buyer demand for oil assets is at "unprecedented" levels.

"I've never seen so much buyer pent-up demand as we have now." Where historically an asset package might receive 15 to 20 data room visits, "today we're seeing 40-plus."

Randy King, managing director with Bank of America Merrill Lynch (BAML) in Houston, says buyers of oily assets are tending to be aggressive because of confidence in where prices are headed. And, "the long reserve life is attractive to them." On two recent transactions involving Permian packages, Kings says, "we could have sold the assets multiple times. There was a lot of interest."

So who is signing confidentiality agreements? The most dominant group seeking oil is private-equity-backed E&Ps and other privately funded buyers. Together, says Richardson, they account for 50% of data-room visits.

“Every private equity fund has $1 billion-plus and they would love to be exposed to oil,” says Randy King, managing director with Bank of America Merrill Lynch in Houston.

According to one president of a private-equity-backed E&P, sponsors are more willing to be aggressive on an oil acquisition today than a gas acquisition, and are telling its management teams to "stretch" the numbers to secure oil assets. "My private-equity sponsor said they would be much more willing to ‘lean into the wind' on an oil deal than on a gas deal."

Further driving the private buyers is a mountain of latent capital amassed since the Great Fall of 2008, the largest hoard to be deployed yet seen in the industry, according to King.

"Not only do they have unspent what they raised in the past two years, but they have unspent residuals from their prior funds. Everybody's got $1 billion-plus and they would love to be exposed to oil."

Conventional public E&Ps—those not solely focused on gassy resource plays—make up another sector of oil-focused buyers that are primarily targeting the Permian Basin. Companies like Apache Corp., Concho Resources Inc. and Occidental Petroleum Corp. have established positions there and have been acquiring more. Others, like Berry Petroleum Co., are moving in.

Jack Aydin, senior managing director for KeyBanc Capital Markets Inc., confirms that most companies and investors are focused on oil and liquids. "Given the Btu disparity between oil and natural gas, there remains a focus by companies, as well as investors, on ‘oily' plays, as well as natural gas plays that have higher liquids components."

A clear sign the oil market is healthier than gas is verified by another sector pouring acquisition dollars into oil assets: upstream master limited partnerships (MLPs).

"MLPs are back in the game," says Subash Chandra, managing director for Jefferies & Co., "and they are buying oil assets."

The ultimate acquirers, MLPs returned to the marketplace in mid-2009 as more aggressive bidders than in previous years targeting oil assets. The reason, says Chandra: "MLPs cannot buy gas assets because they cannot finance gas assets."

MLPs must sell units to finance acquisitions, and selling units on a gas acquisition at present is a tough sell. "It's more trouble than it's worth," he says. "They can't sell units based on a gas business right now, so they are reinventing their businesses toward oil."

“Essentially, we’re buying cash margin, and right now there is a lot more cash margin on the oil side,” according to Mark Ellis, Linn Energy LLC president and chief executive.

Margin mindset

One such MLP is Houston-based Linn Energy LLC, which in second-half 2009 announced three strategic and sizeable acquisitions in the Permian Basin totaling $268 million, thus establishing a new core position and one that is decidedly oil. Combined with several natural gas-asset divestitures in 2007 and 2008, the portfolio restructuring tilts the company's reserve base to oil and gas liquids. Why the migration? "Essentially, we're buying cash margin," explains Mark Ellis, Linn president and chief executive, "and right now there is a lot more cash margin on the oil side. When you take that into consideration, even with the cost of doing a transaction, there is still enough margin to be accretive."

The shift, he says, is not derived from a stated corporate strategy to become a more oil-dominated company, but instead is driven by the current commodity environment dictating what will best compete for capital investment.

"There's just not as much margin in a $5-gas world on the more mature gas plays. I'm not totally agnostic to commodity, but we're really just looking for that cash margin. And right now oil investments are generating favorable economics to gas investments."

The Lariat Services crew prepares for a bit change during reentry at the #7 Davidson Rab in Upton County, Texas.

A notable exception is the company's position in the Granite Wash in the Texas Panhandle and southwestern Oklahoma, a natural gas play in which some 60% of revenues comes from the associated liquids produced, carrying much of the economic load of the wells through a soft gas market.

"That's what is really attractive to us in that development. If you could buy a gas property right now, given the current commodity prices, that tends to be richer in liquids than an area that's dry gas, your ability to pay might go up for those assets because of the liquids content."

The second reason Linn targeted oil acquisitions is simply the ability to get the deals closed. Because its capital structure requires distributions to investors, "everything must be accretive," Ellis says. And that, in a nutshell, comes down to seller expectations.

"On oil deals, we can meet sellers' expectations and it will still be accretive, while hedging off the financial risk," but expectations for sellers of gas assets "are still a bit lofty. Sellers' expectations on gas may be higher than what we can potentially pay, given the current commodity prices and where we can hedge that exposure."

Establishing a position in the Permian Basin was "an obvious choice" for the MLP given the plethora of mature assets and the overall predictable performance of cash flow. Combined, the acquisitions gave Linn 21 million barrels of oil equivalent (BOE) of proved reserves across more than 30,000 net acres in the basin. It plans to drill 31 wells by year-end.

"Being in the Permian exposes us to a wealth of opportunities going forward," says Ellis. "It was a strategic shift of selling assets that don't fit our business model and putting ourselves into a basin where the bulk of the assets would fit our model. We'd love to grow it."

Where's the oil?

The favorite basin for bathing in U.S. onshore oil has been and continues to be the Permian, where some $2.5 billion of interests have changed hands since the beginning of 2009. Rather than the reserves getting old and tired, the super-long-lived production ages like a fine wine.

"The Permian is ripe," says Global Hunter Securities' Bodino. "If a company can bring scale to a project, rates of return can be improved even for some lower-return projects."

Other long-lived oil basins such as in Oklahoma and conventional Rockies oil, while not trading quite as competitively as the Permian due to more volatile basis differentials in those areas, are still seeing "pretty good valuations," according to Richardson. "Most of the activity we're seeing in the Rockies is oil. It is dominating the story."

Some examples include Denver's St. Mary Land & Exploration Co., which sold two mature Wyoming packages, one to GE Energy-sponsored Sequel Energy LLC and another to the MLP Legacy Reserves LLC, marking that company's first foray into the play. Likewise, Denbury Resources Inc. paid handsomely to gain control of Encore Acquisition Co., specifically for its mature Rockies fields, to establish a new core area for enhanced oil recovery.

"I would not be surprised to see more oil buyers move into the Rockies," says Richardson. "We see the Rockies as an area to attract new-entrant buyers for oil."

One of most active oil plays in the U.S. at present is the Bakken shale in North Dakota's Williston Basin, but while a significant amount of capital is being spent on acreage and development, not many assets are trading hands. Instead, the transactional dynamics in the Bakken today more reflect those of gas-resource plays: joint ventures and acreage deals.

"A lot of companies in the Bakken are long acreage and short capital," Bodino observes. "Bakken economics are robust enough to attract capital, so you're seeing some drilling deals get done there." And for those in known fields where acreage is held by production, "companies are less willing to monetize it now."

With pure-play operators like Brigham Exploration Co. receiving robust valuations from the public market, Richardson surmises private operators in the Bakken may have an ulterior motive.

"The Bakken is so hot that some of the private producers that normally would sell are actually looking at IPO'ing through the capital markets to get premium valuations."

Currently, an arbitrage exists in the public markets regarding the Bakken in which some private producers could get more through an IPO than a private sale of the properties, he believes. "Private-equity companies in the Bakken are pursuing the IPO as a monetization to receive similar valuations." (At press time, Bakken-focused Oasis Petroleum Inc., Houston, filed to do an IPO of up to $350 million, via UBS Securities and Morgan Stanley.)

Another area rich in oil reserves but quiet on the A&D front is California, likely because a handful of producers have the region locked up.

"When you talk about getting oil," King says, "you have to scratch your head." Outside of the Permian, California and the Bakken, "it's hard to find concentrated oil areas. There's not a huge amount of these targets in the U.S."

The new frontier for oil exploration is the Rockies cretaceous shales, which have triggered a mini-land rush. And while the science is still young for extracting crude from shale rock, basins such as the Big Horn, Wind River, Powder River, Green River, Red River and Paradox have oil-prospecting E&Ps rushing in.

Even shale-gas giant Chesapeake Energy Corp. is getting its drillbit oily. It recently paid $49-million for American Oil & Gas' Fetter Field project in Wyoming's Powder River Basin, targeting the Frontier and Niobrara trends. Known to be actively acquiring acreage in the play, the Oklahoma City-based producer has drilled a well adjacent to its new position that some analysts believe is the mysterious 1,000-barrel-a-day well the company referenced at a recent conference.

The Niobrara shale in the Denver-Julesburg Basin, typically a gas target, is also heating up for its liquid content in the northern portion of the play as operators apply horizontal techniques. The oil-prone nature of the play is believed to be the reason Noble Energy Inc. paid some $494 million for Petro-Canada Resources/Suncor Energy's Rockies assets in March, including 200,000 acres in the D-J Basin.
"Industry activity has been heating up as companies chase the oil-prone Niobrara," says Wells Fargo Securities senior analyst David Tameron. Jefferies' Chandra categorizes the play as "exceptionally promising, oily and in the very initial stages."

“On an equivalent-barrel basis, our gross profit on oil is about two and a half times higher than the equivalent in gas,” says Phil Rykhoek, chief executive officer, Denbury Resources Inc.

Westward ho

Enhanced oil recovery (EOR) specialist Denbury Resources Inc. in Dallas was oil-focused before oil was cool. Ask chief executive Phil Rykhoek if being oil-centric in today's marketplace gives the company an advantage, and he responds, "We love it."

He says, "I can remember 10 years ago when oil wasn't quite so popular. We look to the future and we think oil is going to remain strong, and we struggle with seeing a big increase in gas prices. We're bullish on oil. We really like our oil focus."

That focus is a subset of its core mission to use CO2 to flood old oil fields. Last year it made two significant asset acquisitions—Hastings Field south of Houston and Conroe Field north of Houston—both natural extensions of its Mississippi and Louisiana Gulf Coast oil properties. Conroe alone will provide the company with an additional 130 million barrels of recoverable oil potential, making it Denbury's largest EOR asset.

Its CO2 Green pipeline is set to be completed to Hastings by year-end and to Conroe in two or three more years. The cost to develop the 130 million barrels at Conroe is estimated at $750 million to $1 billion, and the company expects to realize a 30% rate of return on that project at today's price environment. "On a finding-cost basis, that's not too bad."

On a BOE basis, Rykhoek says, oil-weighted properties have much better economics in today's environment, with oil trading over gas at 15 to 1. "On an equivalent-barrel basis, our gross profit on oil is about two and a half times higher than the equivalent in gas."

Denbury's coup d'état was its surprise company-transforming $4.5-billion merger with Fort Worth's Encore Acquisition Co., another oil-focused E&P. The acquisition doubles Denbury's inventory of oil reserves and gives it a new core EOR area in the Rockies in three legacy fields with over 250 million barrels of potential oil recoverable with EOR. Plus, it establishes a strategic foundation for growing beyond the acquired properties.

"It was these legacy oil fields that initially attracted us to Encore," Rykhoek says. "The collection of properties was big enough to justify the infrastructure and the capital required to start an EOR flood. There aren't that many places in North America where there is a big collection of oil fields and sources of CO2."

Combined, the deals make Denbury one of the largest oil-focused independents in the U.S. with exposure to more than 1 billion barrels of oil. Rykhoek says the event takes the company to a new level as it leapfrogs peers.

From the perspective of an investor, Wall Street first recognizes growth and opportunities, he says, but too, "they have to take into account the economics of our properties versus natural gas. I think we receive some premium in that sense. Most of our peers are focused on gas plays, so if you want to invest in oil, we feel Denbury is a company to look at."

A frac tank captures fluids from SandRidge Energy’s recently drilled and completed #1 Montalvo, a test targeting the Clear Fork and Tubb formations in Gaines County, Texas.

Oil sellers

Shale players are rotating out of old conventional assets into resource plays, and Bank of America Merrill Lynch's King believes most asset sales in today's marketplace are designed to bring capital to an unconventional story.

"It's the driver of capital flows right now in the industry. Transactions are generally designed to provide capital for that flow, either via joint ventures or these asset sales."

BAML represented two such companies doing just that. The first, Petrohawk Energy Corp., sold its Permian assets to privately held Merit Energy Co. for $376 million to concentrate more capital into its Eagle Ford and Haynesville shale operations. Forest Oil similarly sold its Permian position to SandRidge to concentrate its funds into the Granite Wash, Haynesville and Canada Deep Basin.

"Both were designed to redeploy capital into higher-return projects," says King.

Having gone for nearly two years without a liquidity opportunity, many private-equity portfolio companies are seizing the moment to monetize oil projects as well. "Oily private-equity companies are getting pressure by sponsors to sell because valuations are so good."

The company’s strategy is not necessarily to reduce its holdings of gas assets as much as to bolster its oil footprint, according to Matt Grubb, SandRidge Energy Corp. chief operating officer and executive vice president of operations.

Shifting strategy

"For some time now we have recognized the disparity between oil and gas," asserts Matt Grubb, SandRidge chief operating officer and executive vice president of operations. "Natural gas prices plunged in 2009, and we feel they will remain depressed in the near term due to the current supply of gas that's on the market and the amount of gas that can be brought on very quickly."

With the proliferation of high-initial-potential gas wells coming online due to horizontal drilling in the shales, Grubb anticipates supply can come on quickly as market conditions dictate and cap prices in the near term. "We recognized that we needed more exposure to oil and to have a better mix of oil and gas assets in our portfolio."

Weighted about 85% to gas at year-end 2008, and despite being comfortably hedged at $8.42 per Mcf, SandRidge entered 2009 levered as gas prices sank. To improve its balance sheet, the company reduced capex by slashing its rig count from a high of 47 in 2008 to a low of four in 2009. The company additionally raised more than $1.8 billion of capital through issuances of stock and notes and by monetizing its East Texas deep rights and West Texas midstream assets.

When done, it posed the question, What should we do to prepare for the future? The answer: Diversify.

"We have been proactive in looking for the right acquisition that fits our corporate strategy, which includes low-risk upside drilling opportunities in proven producing basins," says Grubb. And it was crucial that an acquisition establish an oil platform for the company.

SandRidge already had a 50,000-acre footprint in the Permian Basin, where since 2007 it had quietly drilled more than 125 wells on the Central Basin Platform targeting the Clear Fork formation—shallow, vertical, low-risk oil wells that fit the company's conservative, conventional model. At $700,000 to $800,000 per well, this oil play in Ector County, Texas, produced the highest returns in the company. Nearby were Denver-based Forest Oil's producing assets and a position in the Permian that comprised about 100,000 acres—"an asset we coveted," Grubb says—and when the package became available, SandRidge was positioned to make a preemptive offer.

The acquisition nearly tripled SandRidge's proved oil-reserve base, which jumped to about 105 million barrels of oil at year-end 2009, tripling its acreage position in the Permian.

"This enables us to expand and reallocate more capital to oil and make a material change in our company to produce a higher-value product," Grubb says. "Additionally, along with this acquisition we have hedged approximately $1.1 billion in oil revenues through 2010."

Following the transaction, SandRidge exited 2009 with PV-10 reserves weighted 50% to oil and with about 40% of 2010 revenues projected from oil sales. More importantly, the company now has the flexibility to switch investment into oil or gas as market conditions dictate.

"As we move forward, we have the flexibility to implement a drilling program that will maximize the value of our company, whether from oil or gas or a combination of both."

Before its sale to SandRidge in late 2009, Forest committed very little capital to the Permian Basin. This translated to opportunities, according to Grubb. SandRidge quickly ramped up to a six-rig schedule and expects to spend up to $200 million in the Permian Basin in 2010. In addition to Lariat Rig #20, SandRidge also currently has five active rigs developing the oil-rich San Andreas and Clear Fork formations in the region. Production should top 26,000 BOE per day by mid-2012.

"We continually evaluate our drilling program and will remain flexible in our decision-making process. If gas prices firm up, we can certainly ramp up more rigs and accelerate development of our gas resources.

Grubb emphasizes that its strategy is not necessarily to reduce its holdings of gas assets as much as to bolster its oil footprint.

"We are rapidly transforming from a company that was primarily natural gas to one that now has investment opportunities in both natural gas and oil."

Even with such demand for oil assets, supply to satisfy whetted appetites remains short."There are not a lot of oily assets for sale," observes King. He warns that if a producer's strategy is to buy oil in the U.S., "you're not going to have many shots at assets to buy. It's a limited field."

Richardson agrees with the assessment, but anticipates more oil assets coming to market beginning in the second quarter, with announced large divestitures by Petrohawk, Denbury and ConocoPhillips.
"We're seeing such strength in oil valuations that public and private companies will continue to sell their oil properties into the 2010 market," he says. "It's going to be an active year with oil deals."