Shelf mini-boom triggered as majors disgorge hundreds of leases

Independents, turnkey drillers see windfall

As competition for deepwater plays drives up lease prices, and ultra-deepwater drillships receive up to $250,000/day, operators are making tough decisions on where to focus capital. When one considers the cost of producing hydrocarbons in these water depths, it is no wonder that at least one major has publicly stated it is not interested in any finds under 200 million bbl. As majors rush to divest themselves of on-shelf properties, independent oil companies find themselves the recipients of a large number of shallow water fields the majors no longer consider core assets.

Because of the investment involved, some producers have shifted all or most of their resources to deepwater and ultra-deepwater exploration. At the same time, these companies hold hundreds of leases in shallow waters under existing five-year contracts. Once the lease expires, the operator loses the option of developing the property. While these shelf properties are less valuable to the majors than deepwater prospects, they still represent a large investment.

As a result, many major operators are either selling off shallow water prospects or entering agreements with other companies to explore and develop the fields for a percentage of the equity. This is what Curtis Burton, President of TOPS, calls "Harvard MBA thinking."

"You have core and non-core assets. You went from noone being in deepwater to everybody being in deepwater," he said. For this reason, "15 years ago, it was very economic to get a deepwater tract and uneconomical to get a shallow water tract. That's all flip-flopped now. Now you have the majors saying that shallow water is a non-core asset and instead of getting rid of them in ones and twos, they are getting rid of them in 80s and 100s, and the independents are suddenly finding themselves with exposure to a great number of tracts."

Shelf mini-boom

This means a huge amount of offshore property is shifting ownership - from majors to independent operators. For their part, the majors get to focus attention on deepwater, while the independents get a once-in-a-lifetime opportunity to take over hundreds of fairly good prospects and increase their portfolios several hundred percent. It is commonly accepted that the more fields a company can participate in, the more successful it will be, since this spreads the risk over more prospects.

From this standpoint, the boom in deepwater has fostered a minor boom on the shelf. And activity levels provide the proof. Exploration activity levels for the independents is skyrocketing, while the majors recorded some of the lowest exploration levels in history. It was really a one-two punch that dragged down exploration drilling for the majors, according to Burton. The majors were preoccupied with merging into super-majors. Those who had merged were divesting properties, trying to define the assets they thought most worthy of retaining, while those not involved in a merger focused on evaluating why and making changes, such as divesting shallow water properties, to make themselves an attractive target.

In the midst of all this repositioning and restructuring, the last thing on anyone's mind was drilling for new reserves. Add to this oil prices that, when adjusted for inflation, were the lowest ever, and there was just not a lot of work offshore.

Shell, Texaco bail out

Independent oil and gas companies make their money by taking risks and developing projects the majors cannot afford. They have small staffs, low overhead, and focus a great deal of attention on each prospect in their portfolio. It is a formula that works well - to a point. Because margins are narrow and staffs are small, an independent has to focus very closely on each prospect. It is in the details that producers find success.

The current ingress of viable prospects has upset the balance of this formula. The independents have more viable prospects than they ever dreamed of. The shift began in 1998, when Mobil sold 23 shelf fields to Vastar. In 1999, Shell followed suit and sold 22 fields and 16 undeveloped blocks to Apache. Later that year, Texaco joined the trend by selling 82 blocks to Anadarko. Most recently, McMoRan cut two deals that increased their gross acreage almost five-fold:

(1) In December of 1999, McMoRan signed an agreement with Texaco for the right to explore all or parts of 90 of Texaco's outer continental shelf tracts, including seven leases in state waters off Louisiana. Under the agreement, McMoRan will spend $110 million over three and a half years on exploration drilling. In turn, Texaco will have an option on participation.

"I would call it a master farm-out agreement," said Chris Sammons, Vice President of Investor Relations for McMoRan. "There is a list of 89 properties that were included in the agreement and we have kind of a master farm out agreement over those under which it identifies the properties and the overall terms under which we would do exploration on those properties. We committed to doing a certain amount of exploration on those properties and an option to participate in a number of different ways, either as a working interest owner, generally from 35-45%, or as an override owner. We handle all the costs and they get an override and they retain an option on how they want to participate."

(2) A month later, in January of this year, McMoRan signed another deal with Shell in which the company purchased Shell's interest in 56 exploratory leases containing approximately 260,000 gross acres, located primarily in the Louisiana offshore Gulf of Mexico area. As part of the deal, Shell retained an overriding royalty interest of 8.33% in each of the properties.

These two package deals represented a total of 600,000-650,000 gross acres and increased McMoRan's inventory from 125,000 gross acres to 750,000 gross acres. "The acreage positions that we took from Shell and Texaco, were a substantial portion, if not all, of their unexplored on-the-shelf acreage. It wasn't that they picked a group of leases and let us have that. We didn't want them to give us only what they didn't want; we wanted the whole package. These guys (Shell, Texaco) have really turned over all of their on-shelf opportunities to us. And, they think we will be successful or they wouldn't have given us this big acreage position," Sammons added.

To help with the monumental task of developing so many properties, some on or near deepwater, McMoRan signed a subsequent deal with Halliburton Energy Services. This alliance not only provides McMoRan with Halliburton's service equipment, and industry expertise, but also helped with the funding.

Marginal profits

While many of the prospects the majors are selling have proven reserves in the ground, there are always wells that do not live up to expectations. In many cases, it is not realized until a wildcat is drilled that the reserves are not what was expected. In these situations, the majors, and possibly the independents, often look to cut their losses and get out of the prospect altogether.

There is a lot of up-front expense in drilling a wildcat. If a dry hole is drilled, or a well produces in sub-commercial volumes, many times the operator will sell out of the project, preferring to recover some of the investment and move on to a larger more promising field.

As more on shelf fields are explored, thanks to the recent deals being made, it is a safe bet that not all the wells drilled will be producers. With the majors focusing on deepwater elephants, and the independents under the gun to explore as many of their new found prospects as possible, the definition of a field that is sub-commercial is broadening. It is this niche that companies such as ATP Oil & Gas fill.

Assistance for majors

Oil companies call ATP when they want out of a project, or just don't have the time to spend on a discovery that is smaller than anticipated. Sometimes ATP buys out the operator, sometimes it just takes over ownership and pays out a percentage, but it is a safe bet that the market of prospects too small for anyone else to worry about is growing.

Paul Bulmahn, President of ATP, said his company is observing an increase of activity and expects the number of wells the company operates to continue increasing. ATP has established relationships with operators and frequently receives calls with offers to take over fields that just didn't live up to expectations. Bulmahn said the company may offer to buy such a prospect outright, or offer cash and participation. "We become very creative on the deal terms and, in turn, try to be creative with the development scenario," he said.

ATP can evaluate a prospect and offer the operator an answer within days, sometimes hours. Bulmahn said there are specifics ATP's engineers look for in a prospect to determine if it is viable.


Independents spread risk, get financing from contractors as access to capital dries up

One of the things that keeps independents small is access to capital. When oil prices fell two years ago and major oil and gas producers began to merge, something even more dramatic occurred on the US and European financial landscape. Internet companies were changing the way banks viewed returns on investment.

Suddenly, the return for risk taken in the oil industry was not nearly as attractive. As a result, much of what is considered traditional financing sources for oil and gas producers dried up. Banks that had traditionally invested in the energy sector tied up their resources in the high tech sector and the result was a scarcity of capital. In addition, independent oil companies, which historically spent every penny of revenue and then some, on new exploration, had to change the way they did business.

Bob Rose, President and CEO of Global Marine, said these independent producers started to hold onto their capital and limited their risk in the area of exploration. Rose said these companies began to participate in drilling programs, taking on more partners, and spreading their risk around. In this way, they could realize a better return on the same level of investment. Independent oil companies do not have the resources to pay up front for a drilling program.

The McMoRan deal (farm into 90 shelf leases from Texaco and 56 shelf leases from Shell) shows how creative financing can be applied to expand a company's access to capital. Halliburton provided additional financing to McMoRan as part of this alliance, making the purchase of these leases possible. In the case of the Texaco deal, the up-front cost was $110 million over three years, and $38 million for the Shell deal. There are participation agreements built into the deal as well, but the cash up-front was clearly substantial. In addition to this out-of-pocket expense, there is the cost of exploring and developing the properties. When a company expands its holdings five-fold, it needs good access to capital.

While these were good leases, backed up with seismic data, very little drilling had been done. From that standpoint, McMoRan will be starting from scratch.

Chris Sammons, Vice President of Investor Relations for McMoRan, said the company's competitive edge is the expertise in structural geology it will apply to target the most promising of the leases. The goal is to have a number of wells drilled by the second quarter of 2001. The clock is ticking on these properties.

One of the things that motivated the majors to divest shelf properties in bulk is the short lease terms. While ultra-deepwater prospects have 10-year terms, on-shelf leases are for five years. Because McMoRan acquired existing leases, they have to move quickly to explore these properties.

It is such a focus and specialization that allows ATP to make money on fields others can't be bothered to develop. Bulmahn said his company specializes in operating and developing fields, but does no exploration. The company focuses on reservoir data and evaluates the mechanical risks of a prospect. ATP looks at the contracts on the well, the cost of the rig on site, the contracts with service companies, the crews, data expenses, and other items.

If they like a project, they acquire the block. ATP's financing comes from banks, private investors, and internally generated cash flows. Bulmahn said ATP's ready access to capital is critical to the company's rapid growth. While the company will subcontract, much of the ongoing engineering is in-house. ATP takes over the mobile rigs drilling on leases it has bought, and through efficiencies, specialized expertise and streamline operations, will try to increase production levels and hopefully turn a profit. "We academically understand the complexities and problems of these projects," he said.

While ATP continues to evaluate a growing number of prospects, Bulmahn said it is the quality of the projects that has changed. He credits the growing focus on deepwater with this windfall in higher quality fields. By specializing with a focus on marginal fields, Bulmahn said ATP has substantially built its stock of proven reserves.

Turnkey turnaround

Independent oil companies do not have the resources to pay up front for a drilling program. Partnering with a turnkey company not only eased the financial strain, but provided the expertise needed to make the most of these smaller plays. While many of these fields have proven reserves in the ground, it takes a certain level of expertise to recover reserves in a profitable way. While a smaller independent operator may drill 1-2 wells a year, drilling is all turnkey companies do. Bob Rose, Chairman, President, and CEO of Global Marine, said ADTI, the company's turnkey division, drilled 75 wells last year.

TOPS also took a similar position. While the majors were tying up ultra-deepwater drillships as fast as they were coming out of the yards, Burton said R&B Falcon, which owns TOPS, was sitting on a number of stacked smaller rigs it needed to put back to work. Many of these were shallow water jackups and barge rigs. Assessing the situation, Burton said there were small oil companies holding what many would consider valuable assets with no means of realizing them.

He said many of the properties the majors unloaded had proven reserves. When one adds in the advantages of new 3D seismic and enhanced recovery technology, there were profitable fields in the cards. The key was getting these property owners together with R&B's stacked rigs.

Evaluation

Before turnkey drillers take a stake in a well, they must assure themselves that the prospect can be drilled profitably. This takes a broad skill set. TOPS has geologists on staff who review seismic data submitted to the company. Rose said ADTI has another Global Marine subsidiary, Challenger Minerals, which acts as a marketing arm of ADTI, evaluating prospects and determining whether the company should put turnkey profits at equity interests in projects. Global has investors they refer to as overhead paying partners that pay the company a fee to view prospects obtained by Challenger. Many times the investors will take on the participation themselves without a Global interest, in which case ADTI simply drills the well on a turnkey contract.

While one of the motivating factors for TOPS to become involved with drilling turnkey wells in shallow water was to bring the company's rigs back into the market, Rose said ADTI rarely uses Global Marine rigs in its projects. The real problem, according to Rose, is finding qualified people to man the rigs. This is another area where turnkey companies have an advantage.

Rose said because ADTI drills so many wells, its drilling engineers gain a great deal of hard experience. Such experience is what attracts many of the company's workers, who sign on to gain expertise and look forward to lots of drilling. An independent cannot afford to keep such people on staff if they are not working constantly, but a turnkey company can maintain a core staff of experienced workers who can apply their cumulative skills to whatever project the company is hired to complete.

Rose said he has seen growing interest in turnkey contracts, not only from independent oil companies, but from the majors. Although the clear emphasis of these companies is in deep-water, Rose said they are several who are contracting ADTI to drill their promising shelf properties, rather than selling these properties off.

Burton said his company is seeing the majors sell off hundreds of good shelf prospects to clear portfolios and free up capital for deepwater exploration. He said this follows the classic business school model of focusing on core competencies.

The result has been that independents are inundated with more properties than they can handle. In the past, these companies would use the strength of such prospects to secure capital from banks and ramp up their exploration efforts. This time around though, they are looking for partners instead.

For TOPS, these shallow water prospects, many with proven undeveloped reserves, represent a perfect opportunity to put idle rigs back to work and make a low-risk investment. Because the cost of drilling in these depths is so low, and the new seismic and recovery technologies are so advanced, TOPS can justify many types of creative financing, including pay from participation and taking an equity stake in the well.

For their part, Burton said the independent oil companies are eager to work with a turnkey company. He said the oil companies recognize that this is the fastest and most efficient way to get prospects onstream.

Extending turnkey services

Turnkey is taking on a broader meaning for many of these contracts. In addition to evaluating and drilling the prospects, many turnkey companies, including ADTI and TOPS, are offering extended services. Both now offer completion services as well. TOPS even handles development hardware, installation, and abandonment activities.

For such a project, it is necessary to have a multi-well program, Burton says. This helps to spread TOPS' risk around, in case some of the exploration drilling results in dry holes. TOPS has a group of companies it regularly works with to put together these turnkey deals. Burton said TOPS would like to develop a short list of oil companies to work regularly with, fielding deals that come in on potential projects. This would provide the opportunity for discounted single projects and a closer relationship. Burton said his company could handle more projects, but is initially looking to align itself with about five independent oil companies working on 10-well turnkey packages.

Turnkey a threat?

While turnkey drilling seems to offer many things to independents and major producing companies alike, Burton says not all producers are quick to embrace the concept. At the highest producer executive levels, turnkey is a very popular concept, but for those on the operations level, turnkey is a threat to job security. These staffers are concerned that outsourcing drilling operations, and possibly completions as well, could make their jobs redundant.

This is not so, according to Burton. Regardless of the extent of a turnkey contract, there will always be a requirement for producer personnel to supervise all activities. No one is going to sign a turnkey contract, then sit back and wait for oil to flow. To protect the producers' interests, these contracts are heavily monitored. Burton said this may be a little different role for production staffers to play, but it is certainly not a threat to careers.

"I see a transformation in the way our companies do their business," he said. "There has been a focus among the major oil companies to outsource many activities over the past decade. With broad layoffs and cuts in research and development funds, oil companies have become more and more dependent on service providers to come up with the solutions needed for economical development of resources. The turnkey trend is just an extension of this."

History repeats itself in the oil business. A few years ago, majors and large independents made offshore the core asset and divested onshore properties. Now they have moved one step further from shallow water to deepwater.

As for turnkey operations, Curtis Burton summed it up: "The ultimate end point for every major producer is this: In 1960, they (the producers) owned their own drilling rigs; by 1975, none of them did. They are not in the drilling business. They are in the oil finding business. That is (also) where they are going with field development and production."

More in Company News