Using The JV To HBP

Glenn Darden, Quicksilver Resources Inc.’s president and chief executive officer, hoped that the company’s Barnett joint venture with Eni SpA would help investors realize his company’s stock was undervalued. That hope has played out.

When Fort Worth-based Quicksilver Resources Inc. bought 13,000 prime acres in the core of the Barnett shale in August 2008 from Chief Resources LLC, Hillwood Oil & Gas LP and Collins and Young LLC, for $1.27 billion in cash and stock, money was still flowing in the debt and equity markets and A&D transactions were going strong. The tumultuous downturn that followed just weeks subsequent to the closing, however, left the gassy producer highly levered in a capital-constrained environment. Quicksilver exited the year with $2.6 billion in debt.

“Our motivation was to reduce that debt and we had a plan to do that,” says Glenn Darden, president and chief executive. “Unfortunately, the markets crashed in fall 2008. We then went forward with an attractive plan as the smoke was clearing in mid-2009.”

Selling shares was out of the question. Quicksilver’s share price had plummeted 91% from its earlier high, hit especially hard by market fears the E&P would violate debt covenants if its borrowing base were reduced in the spring.

The company slashed its capital program for 2009 to conform to cash flow, simultaneously dropping two-thirds of all rigs running. Not wanting to part with a core asset if at all possible, management settled on a best-case solution to raise additional capital: a joint venture.

By May, Quicksilver had partnered with European integrated energy company Eni SpA on the same assets acquired just months previous, receiving $280 million applied directly to debt reduction. This provided ample cushion under its borrowing base, and a partner for about one-fourth of development costs going forward.

Like in Quicksilver’s case, joint ventures have become a popular mechanism for cash-strapped or acreage-laden E&Ps to jump-start languishing drilling plans in a challenged economic environment. Along with being a quick method to raise cash to delever balance sheets without giving up operational control, a joint venture is more often being used to raise capital to accelerate drilling programs when lease terms may be in jeopardy, or to bring in a more knowledgeable industry partner, particularly in shale plays where companies may lack technical expertise.

Quicksilver’s alliance

Patterson-UTI Rig #322, an Apex walking rig, drills Alliance Speedway A#1H south of Justin, Texas, as part of the joint venture between Quicksilver Resources and Eni.

In fall 2008, Quicksilver began to have informal conversations with a number of companies interested in a partnership on various assets in the company’s portfolio. These discussions, led by chairman Toby Darden and chief financial officer Phil Cook, were primarily with international players.

Meanwhile Eni, which is a leading producer in the Gulf of Mexico and holds interests in Alaska, had been studying U.S. onshore unconventional-resource basins. Attracted to the predictability of the Barnett, and Quicksilver’s cost structure and integrated model including gathering and processing, Eni made an overture.

“Eni liked the well-defined decline curve of a more mature basin,” says Darden. “They wanted to learn the shale game and take what they learned and apply it to other areas around the globe.”

Over several months, the companies built a comfortable rapport. The discussions narrowed from Quicksilver’s broader Barnett acreage position to focus specifically on the 13,000 acres in the Alliance Airport project in Tarrant and Denton counties acquired in the Chief deal. “The high-potential nature appealed to Eni,” Darden says. “It’s a very consolidated block with great rock.”

When the ink dried, Eni had taken a 27.5% stake in the Alliance project in exchange for $280 million up front and the opportunity to keep operational boots on the ground, with six technical staffers on location with the Quicksilver operations team. The deal represented 131 billion cubic feet of proved reserves and an additional 96 billion of probable and possible reserves net to Eni.

The joint venture provided a needed infusion of fresh cash to Quicksilver and a partner to carry some of the financial load in the project going forward. “This was a timely discussion with Eni,” says Darden. “We had carried a higher debt load than some of our peers, and this gave us more flexibility to execute our overall program.”

“Our alternatives were to sell down or find a partner, and we didn’t want to give up control of our position,” says Michael Radler, chief operating officer for Chief Oil & Gas LLC.

Analysts valued the deal above $2 per thousand cubic feet (Mcf), strong metrics in that marketplace, and roughly twice what Quicksilver was trading at the time. Darden hoped investors would extrapolate the sale—which represented 5% of Quicksilver’s proved reserves—across the entire asset base and realize the company was undervalued. “That has played out,” he says. “Our stock has risen 150% since that time.”

Why didn’t the joint venture involve all 192,000 acres of Quicksilver’s Barnett position, including holdings in Somervell, Hood and Johnson counties?

“Everybody’s budgets were hit hard earlier this year. It was the right size for them and for us. Their objective is to learn and get involved in a commercial project, but also to be able to transfer that technology elsewhere. This fit their pistol pretty well.”

The companies have a 270,000-acre area of mutual interest around the Alliance assets, and have added some 1,300 acres since the closing with an emphasis to expand. The companies expect to run two rigs in 2010. “We have our heads down working on execution at this point. We’ll ramp up volumes very nicely.”

As the majority of Quicksilver’s asset portfolio is 100% owned and operated, Darden says bringing in a partner is “a bit outside of our fairway.” But he thinks the mutual technical exchange could be beneficial to both, as the Eni team is as strong in geophysics as the Quicksilver team is in drilling and completion technologies. Too, Quicksilver realizes the potential of working with Eni on other projects as well.

Quicksilver holds some 127,000 net acres in British Columbia’s promising Horn River Basin, a large and long-term project. Might the company JV again?

“It’s all about value,” says Darden. “It looks like we’re in the middle of a very large gas field up there. At the proper time and the proper value, a joint venture makes a lot of sense.”

Equity for capital

After selling most of its Barnett shale portfolio for $2.6 billion in 2006, privately held Chief Oil & Gas LLC turned its attention to the emerging Marcellus shale the following year, acquiring a 540,000-acre swath along the trend in Pennsylvania and West Virginia leading into early 2009. But as it began drilling and seeing promising results, the Dallas-based company realized the prolific and immature play would soon be a budget buster, especially as its appetite for more acreage grew.

“We recognized the cost it was going to take to develop this and realized we needed additional capital,” says Michael Radler, chief operating officer for Chief Oil. “As a private company, we had a finite amount of money that we could spend on this, and we didn’t have the same access to capital markets as did public companies.”

Private E&Ps typically tap bank financing for funds to drill and acquire, but in late 2008 and early 2009, traditional energy lenders were missing in action. Plus, Chief did not have any significant production or reserves to borrow against, so “going down that road was not an option.” Chief considered approaching private-equity sources to fund the project as well, but they too were holding tight to their cash at the time, and the terms were not attractive to Chief.

The alternative was to sell off a piece of its position.

Management at Chief took notice when European producer StatoilHydro bought a 32.5% equity position in a joint venture with Oklahoma City-based Chesapeake Energy Corp.’s Marcellus position for $3.375 billion in November 2008. “We saw what Chesapeake did and it looked very attractive,” says Radler. Utilizing a joint venture, Chief saw that it could retain control of its position, pick its partner and spread out the tax impact. “All of those pieces looked very attractive, and that’s when we started the process of looking for a JV partner.”

Joint ventures have become a popular mechanism for cash-strapped or acreage-laden E&Ps to jump-start drilling plans in a challenged economic environment.

And yet it was the worst time in modern history to offer an asset. Chief was unfazed, and hired Bank of America Merrill Lynch in March to oversee the process. “We felt like we had a good property set that would be attractive to a potential partner. Also, Chief has a tremendous success history in shale through the Barnett. That was a big attraction.”

More than 22 suitors from foreign nationals to private-equity firms were invited into the data room, and others were turned away.

Chief chose to partner with Canadian royalty trust Enerplus Resources Fund, headquartered in Calgary. The company’s strong financial position and resource-play experience in the Bakken shale were key factors in the decision, but “at the end of the day it was the culture that we liked the most—we liked their approach and how they looked at things.”

Chief knew its Marcellus position was still immature and that it would take some time to get all the logistical pieces into place, including people, infrastructure, rigs and pipe. A potential partner needed patience and to understand the risk involved.

“We are going to be tied at the hip for quite a while and wanted a partner that would be able to work with us to mutually develop this play. That’s what we found in Enerplus.”

Enerplus took a 30% nonoperated position in some 540,000 gross acres, or 116,000 net, with most concentrated in the northeastern and southwestern portions of Pennsylvania. Most of Chief’s leases are “five and five,” with an initial five-year term and an option to extend for five more. The Canadian firm paid $162.4 million up front and committed an additional $243.6 million to carry 50% of the drilling and completion costs, which it expects to be expended in about four years. It estimates it paid about $3,500 per acre.

The companies additionally established an area of mutual interest in which counties that include acreage in this initial set of assets are deemed “core” areas, and anywhere else in the play is noncore. For acquisitions going forward in the core area, the joint venture will recognize the same 70/30 split with Chief operating. In noncore areas, the initiating party will have majority control of the 70% split, satisfying Enerplus’ desire to establish itself as an operator in the play. Since the deal in September, the companies have added approximately 25,000 gross core acres.

To date, Chief has drilled 39 wells in the play—11 vertical and 28 horizontal—with seven more to be down by the end of the year. In 2010, the companies have allotted $325 million toward the joint venture and currently have four rigs running with three more to be added each in 2010 and 2011. About 70 horizontal wells will be drilled in the coming year, many utilizing multi-pad drilling.

Radler says he feels good about the decision to bring in a joint-venture partner, and in particular about the relationship established with Enerplus, which will have three members of its technical team working with Chief in the Marcellus project.

“Our alternatives were to sell down or find a partner, and we didn’t want to give up control of our position,” Radler says. “We’re pleased with the people at Enerplus and their view on development. With their experience in the Bakken and shallow production in Canada, they understand oil and gas. They are good partners for Chief.”

Leveraging man and money

By the end of 2008, Appalachia-focused Rex Energy Corp. had accumulated a large acreage position in the Marcellus shale in Pennsylvania. To drill out such a sizeable position was daunting to the company in terms of available capital and manpower. To preserve its low debt levels, a priority, Rex thought it wise to spread out the capital and the risk through a joint venture.

“We’re a relatively small company,” says Ben Hulburt, president and chief executive. “We were looking at 70,000 acres spread over three major project areas. We wanted to bring in a larger company that could accelerate the drilling as well as to bring additional expertise into two of those areas. That would allow our operations team to focus on the third area.”

“From our analysis, accelerating the drilling with a bigger company—which increases the present value of the acreage substantially—well outweighs any future upside that you’ve given up,” says Ben Hulburt, president and chief executive, Rex Energy Corp.

State College, Pennsylvania-based Rex invited 20 companies into the data room, narrowing the list of interested companies to those of significant size, those that had shale experience and those with more human capital that would allow it to run several more rigs than it could internally staff.

“We needed more manpower. We’ve put together a very good shale team and have a good understanding of the Marcellus. What we didn’t have was the staff to run 20 rigs at once. We wanted a bigger company that could provide that.”

Tulsa, Oklahoma-based Williams Cos. rose to the top, impressing the Rex team as conservative and cost conscious, “which is always a concern when you’re our size teaming up with a bigger company.” The deal marks Williams’ upstream entry into the Marcellus.

Williams’ established midstream capabilities in the Marcellus, while not a part of the deal, are an added benefit. “If there are going to be market restrictions in the future, having a company like Williams with such a large midstream presence is certainly an advantage.”

In June, Rex farmed out a 50% interest in its Clearfield and Westmoreland projects involving 44,000 gross acres, with Williams carrying the first 90% of the total costs to drill and complete up to $33 million on Rex’s behalf and $74 million total in a drill-to-earn structure. Hulburt says that will equate to 15 to 20 wells in which Rex is obligated to pay just 10%.

Avoiding debt was a “huge” part of the decision to seek a partner, he emphasizes.

“In the early stages of the horizontal drilling, where it’s certainly riskier, we are carried in most of the costs. It has allowed us to keep our balance sheet at an extremely low debt level.” Rex’s debt stands at about $15 million, or a 3% debt-to-cap ratio. Hulburt estimates Rex’s debt would have ballooned to $60- or $70 million had the company drilled these wells at 100%, putting it “perilously close to having a real problem.”

Instead, he points to the 400% year-to-date increase in the stock price as affirmation of the decision. “I think the investment community has realized we have a low-levered balance sheet. Absent the JV, it would have grown substantially or we would have had to raise equity at prices we weren’t very happy with.”

Midway into the fourth quarter, the joint venture had drilled five horizontal wells with three completed and two more under way, “and our debt level hasn’t changed one dollar.”

But what of the downside of giving up some 20,000 net acres of its position in two core projects? “Our Marcellus upside was 20 times the size of our current proven reserves before the Williams deal, and afterward probably 16 to 17 times. From our analysis, accelerating the drilling with a bigger company—which increases the present value of the acreage substantially—well outweighs any future upside that you’ve given up.”

Besides, Hulburt is confident in Rex’s ability to make up any lost ground—literally.

“We’re actively leasing additional Marcellus acreage every day. We can replace that acreage fairly quickly, and at this point at a cheaper cost than what we brought Williams into the deal for. We’re leveraging our capital to expand the acreage back to where it was.”

While continuing to grow the area of mutual interest with Williams, Hulburt is enthusiastic about the company’s third area of focus—not included in the joint venture, but given new life because of it. The day after signing with Williams, Rex bought out its 50% partner, privately held, Pennsylvania-based Vista Resources, in its Butler County property and now holds 100%.

When Williams takes over operations of the joint venture January 1, Rex’s technical team will be wholly focused on the Butler project, in which the company holds some 22,000 acres. It has 20 landmen scouring the region.

“We wanted to have one area that we own and operate by ourselves,” says Hulburt. “We picked the one we liked the best. The capital that we would have spent drilling we’re instead using to add additional acreage, and we think we can expand pretty significantly. We’re keeping this one to ourselves.”