Approach Resources Inc. Q4 2008 Earnings Call Transcript

Mar.11.09 | About: Approach Resources (AREX)

Approach Resources Inc. (NASDAQ:AREX)

Q4 2008 Earnings Call

March 11, 2009; 11:00 am ET

Executives

Ross Craft - President & Chief Executive Officer

Steve Smart - Chief Financial Officer

Curtis Henderson - General Counsel

Analysts

Joe Allman - J.P. Morgan

David Tameron - Wachovia

Huston Netherland - First Natixis

Irene Haas - Canaccord Adams

Mitch Wurschmidt - KeyBanc Capital Markets

David Heikkinen - Tudor Pickering, Holt

Scott Moore- Kornitzer Capital Management

Operator

Good morning everyone and welcome to the Approach Resources full year and fourth quarter 2008 earnings conference call and audio webcast. Today’s call is being recorded. A replay of the conference call will be available on the company’s website immediately following the call.

At this time all participants are in a listen-only mode. We will conduct a Q-and-A session at the end of today’s conference call. Management’s remarks today will include forward-looking statements. These statements are subject to many factors that could cause actual results to differ materially from managements expectations as expressed in those forward-looking statements.

Those factors are described in the company’s SEC filings and management refers you to our website or to the SEC website to review those filings. The company undertakes no obligation to publicly update or revise any forward-looking statements. Also during this call, management will refer to certain non-GAAP financial measures. Reconciliations of these measures to the most directly comparable GAAP measures are contained in the company’s full year and fourth quarter 2008 earnings release and the company’s year end 2008 proved reserves announcement on March 2, 2009, both of which are posted on the website at www.approachresources.com

Now, I’m going to turn the call over to Mr. Ross Craft, the company’s President and Chief Executive Officer. Sir you may proceed.

Ross Craft

Hello, thank you. Good morning everyone. With me on the call today is Steve Smart, our CFO and Curtis Henderson, our General Counsel. 2008 was a very unique year as you can imagine. It was our first full year being public.

During the year we saw prices of natural gas peak around $12.74 followed by decline to around $5.30 in just under six months. We saw the price of crude equate to $145 per barrel, followed by a decline to just under $40 a barrel in the same time period. We saw a 65% increase in rig rates, 75% increase in fuel cost, we saw steel and tubular prices increase approximately 65%.

Production from our Ozona Northeast field was shut-in 23 days, approximately a third of the Bcf during the third quarter, by disruption and downstream NGL, purely due to Hurricane Ike and by the rupture of a third party pipeline locate almost 400 miles away. Like other operates, we also saw our NGL volumes curtail to approximately 40% due to the pipeline capacity issues as well as residual effects from the hurricane.

We saw our realized gas price go from $9.10 per Mcf in the third quarter to just at $5 per Mcf in the fourth quarter. It was a unique year to say at the least.

If you go a bit down, year end and fourth quarter 2008 operational results as we previous reported, our 2008 year end proved reserves increases 17% to 211.1 Bcfe. 2008 proved reserves were composed of 82% natural gas and 18% oil and NGLs. The proved developed portion of the total proved reserves at the year end 2008 was 48%.

In 2008, we increased production 65% to 8.8 Bcfe or 23.9 in Mcfe per day, compared to 5.3 Bcfe or 14.5 in Mcfe per day in 2007. Our 2008 production was 81% natural gas and 19% oil and NGLs, compared to 19% natural gas and 10% oil and NGLs in 2007. This increase in liquid volume is a result of the success we’re having in our Cinco Terry, Wolfcamp Canyon Ellenburger development.

Total exploration and development cost during 2008 were $89.2 million, which includes $3.5 million in assets retirement obligations. In 2008 property acquisition costs were $14.7 million, which includes $10.3 million for the acquisition of the deep rights in Ozona Northeast.

Our drilling program, we replaced 483% of the production, had drill bit finding and development costs of $3.11 per Mcfe. From all sources we replaced 450% of production and had all-in-all finding and development cost of $2.64 per Mcfe, not a bad year.

With that, I’m going to turn it over to Steve to discuss the financial results and then I’ll close and take some questions-and-answers. Go ahead Steve.

Steven Smart

Thanks Ross. Net income for 2008 was $23.4 million or $1.12 per diluted share on revenues of $79.9 million, compared to net income for 2007 of $2.7 million or $0.24 per diluted share on revenues is $39.1 million.

Net income for 2008 include the effects of an impairment of non-producing properties of $6.4 million, relating to drilling and completion costs of three wells in Northeast British Columbia and drilling costs of three wells in Southwest Kentucky. Also an impairment of 917,000 relating to the write-off of our equity investment in the Canadian operator of our Northeast British Columbia project and a pre-tax unrealized gain on commodity derivatives of $7.1 million.

Adjusted net income for 2008 was $23.5 million or $1.13 per share, compared to $5.3 million or $0.47 per share per diluted share for 2007. EBITDAX for 2008 was $63.2 million or $3.3 per diluted share, compared to $30.4 million or $2.71 per diluted share for 2007. LOE for 2008 was $7.6 million or $0.87 per Mcfe, compared to $3.8 million or $0.72 per Mcfe for 2007.

G&A for 2008 was $8.9 million or $1.1 per Mcfe, compared to $12.7 million or $2.39 per Mcfe in 2007. Depletion, depreciation and amortization expense of DD&A for 2008 was $23.7 million or $2.71 per Mcfe, compared to $13.1 million or $2.47 per Mcfe in 2007.

For the fourth quarter; net loss for the fourth quarter 2008 was $152,000 or $0.01 per diluted share on revenues of $14.7 million, compared to a net loss of $1.8 million or $0.12 per diluted share on revenues of $11.7 million for the fourth quarter 2007. Net loss for the fourth quarter 2008 included the effect of a $6.4 million impairment of non-producing properties and $917,000 of impairment of investment, as well as a pre-tax unrealized gain on commodity derivatives of $3.1 million.

Adjusted net income for the fourth quarter 2008 was $2.6 million or $0.13 per diluted share, compared to a loss of $614,000 or $0.04 per diluted share for the fourth quarter of 2007. EBITDAX for the fourth quarter 2008 was $11.6 million or $0.56 per diluted share, compared to $7.5 million or $0.49 per diluted share for the fourth quarter of 2007.

LOE for the fourth quarter 2008 was $2.5 million or $0.95 per Mcfe, compared to $1.0 million or $0.65 per Mcfe in the fourth quarter 2007. G&A for the fourth quarter of 2008 was $3.2 million or $1.20 per Mcfe, compared to $8.6 million or $5.36 per Mcfe in the fourth quarter 2007. DD&A for the fourth quarter of 2008 was $7.5 million or $2.80 per Mcfe, compared to $3.9 million or $2.43 per Mcfe for the prior year quarter.

We had $43.5 million drawn on our revolving credit facility at December 31, 2008 and $47.4 million drawn on February 28, 2009. We have a $200 million revolving credit facility with a $100 million borrowing base. Borrowing base will be re-determined on April 1, 2009.

With that Ross, I’m going to turn the call back over to you.

Ross Craft

Thanks Steve. Turning to our 2009 operations, we currently running two rigs in Cinco Terry. They are on extended contract which will expire at the end of March of this year. We have no plans on renewing that contract for the time. With the commodity prices being what they are right now, and the uncertainty of where they’re going, it makes good since to do this at this point.

We’ll continue to monitor the prices and the cost and determine what our next step is going to be on this, but right now I think the most important think we can do is preserve our financial flexibility and take this excess cash flow that we’re going to realize in 2009 to pay down debt. I think that’s the prudent thing to do.

I don’t think anyone in this office or anyone on the phone call and tell me where the natural per gas prices are going to go. So, we’re going to sit back and again just watch it. We have a full inventory of things to do, so we have a lot of flexibility.

Despite the current low commodity prices and reduce drilling operations, we still believe that we’re going to be able to achieve moderate production growth in 2009. We’ve had the two rigs running as I said on Cinco Terry, good results from that. We have revised our production guidance from a range of 9.4 Bcfe to 9.9 Bcfe; that was when we discussed our $43.8 million budget. We revised that down to 8.7 Bcfe to 9.4 Bcfe based on the drop in the drilling rates.

In conclusion, during 2008 we continued to increase our reserve base primarily through our drilling program compared to the F&D cost. This was challenging considering the price environment we’re in and the cost escalation of the service sector. Our West Texas, asset Cinco Terry, Ozona Northeast are a long life, low risk, reverses properties, which gives the flexibility to drive several price cycles and that’s important when we’re looking at these low commodity prices right now.

We believe, reducing our operations now will preserve liquidity and put us in a position for long term growth of the shareholders. We believe that this year is going to open up a lot of opportunities for this company, the balance sheet’s clean, we’re going to keep it that way. I think mid-year we’re going to see a lot of opportunities present itself, both from a drilling standpoint, as well as a acquisition standpoint.

That really concludes our comments. We’ll take question-and-answers now. I appreciate you all.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question will come from the line of Joe Allman of J.P. Morgan.

Joe Allman - J.P. Morgan

Thank you. Good morning, everybody.

Ross Craft

Hey, Joe.

Joe Allman - J.P. Morgan

Hey, Ross in terms of not renewing the rigs effective April 1, I mean is the issues there, I mean is it that the rig rates haven’t dropped enough or is it really just concerned about the gas price and also concerned about the differential that seem to be pretty wide out there?

Ross Craft

The rig rates are definitely coming down, although these rigs are on a 2008 contract, which is $15,500 a day. We can get the same rigs right now or less than $10,000 a day. So costs were down considerably, but our biggest concern is the short term year, maybe 15 month gas price, where is it going to go.

Remember we’re fortunate that we have a fairly attractive hedge positions still out there, but what really gets us is tight gas and the way these wells operate, you pay out of these projects, but these low prices are extended out to three to four years and so looking at it, I just wanted to get a grip on where we are as far as gas prices.

Today for example, I think we sold gas for $3.14 in the WAHA index and $3 and $2.99 on the El Paso index today. That’s pretty low numbers and the differential was blown out, but it now looks like it’s coming backing. I think NYMEX closed yesterday at 384.

So, the differential is coming a little bit. Now the old differential still fairly high about $5 a barrel out there, but our projects are going into the Cinco Terry project for a typical Canyon well. Cinco Terry right now will give you about a 24% rate of return and that’s a typical Cinco Terry Canyon well, but well under 600 million cubic feet of gas Mcfe and that’s pave of about 2.6, 2.8 years.

We find the Ellenburger is going to be a pay out of less than a year and in the Ozona Northeast you’re talking about rate of returns right now under there price scenarios, about somewhere around 18% with a four year payout. Obviously, East Texas doest not work at these prices. Although, it is a positive rate of return, it’s like 14%, it’s just not worth going after.

So, the thing I really want to do right now is take this short term approach and reduce the drilling, and by reducing the drilling rig it doesn’t mean we’re going to start doing re-completions or the work-overs out here. It just we’re going to take a sabbatical right now.

We will see production decline a little bit, although I don’t think it’s going to be that significant and the beauty above what we have out here is, if we want to reengage the rigs in three or four months, we can theoretically be bag up to our original budget of 43.8 by the end of year, if we saw a substantial increase in natural gas prices, which I don’t think we’re going to see.

I’m running internal models right now using 350 for NYMEX to see where it stands, because I truly believe that we’re fixing to see some pretty nasty gas prices. There’s nothing on the horizon that supports anything other than that. Likely, it looks like crude has stabilized a bit, so that’s going to be helpful.

NGL restrictions are no longer an issue right now, so we are processing and we’re backup to full speed on our NGLs on Cinco Terry, but its really more so of uncertainty of where the gas price is going and these projects, I don’t have to drill right now and its still offers a lot of flexibility for the rest of the year. We can always prank up any time we want to and that’s the beauty about having these West Texas properties.

Joe Allman - J.P. Morgan

Gotcha and Ross, previously you were planning on I think adding a rig in the second half at Ozona Northeast and another one at North Bald Prairie, do you have any obligations to any of those rigs and what’s the plan at this point?

Ross Craft

One I’d say everything we’re very fortune. We don’t have many if any; I think well we do have a couple of small leases that are going to expire if we don’t drill on them. We can pay rentals on it, but that’s a very small amount of acreage and this is an acreage that’s normal year-to-year like we’ve always done, and it doesn’t amount to much at all, so we have another drilling obligations we have to keep up with to speak up. We don’t have any rig obligations. We don’t have to pick those rigs up that were never contracted, so we’re pretty flexible with what we can do.

Joe Allman - J.P. Morgan

Okay and lastly and then I’ll get back in queue. The price realizations, the gas differential counts a lot. If just look at the four quarters of 2008, you really widened a lot in the fourth quarter; it was pretty wide in the third quarter and it looks like a premium actually in the first two quarters. Could you guys explain the bouncing around of the differential?

Ross Craft

Yes, what happened; anytime you have a sudden jump in the prices that we saw; I think July is when all the product prices peaked out; natural gas was above 12, oil was 140 and whenever you start seeing that, the differential gets blown out pretty hard. We also had a shoulder month coming in the fall, which we haven’t typically seen for the last three or four years.

We had a hard shoulder month on natural gas, less the West Texas gas market, both WAHA and El Paso was hit pretty hard and so we saw unusually large differential out there. The differential remains a little bit higher than what it historically has been right now. It’s running close to $0.90. Today it kind of narrowed up a little bit, but if you go back and look at the five year average, six year average on differentials out there, we believe it’s going to narrow back down and get back into it’s $0.70 or $0.78 number.

Now we do have the differential hedge; on about three bcf of gas out for 2009, it’s $0.69. So, that’s helping us out a little bit as well, and that helped us out for sure in 2008, but the differential definitely has been blown out, but I believe with the slower prices it’s just coming back into line.

Joe Allman - J.P. Morgan

Okay very helpful thank you.

Operator

Our next question will come from the line of David Tameron of Wachovia. Please proceed.

David Tameron - Wachovia

Thanks, good morning Ross. Can you talk about what triggers the decisions to go back in? If you said you’ll get an 18% rate of return today, what changes do you have to see as far as pricing or returns in order to put another rig back to work?

Ross Craft

Well I would like to see NYMEX. Ideally anything above NYMEX at 4.50 or 5 would be something that you don’t want to see as preferred, NYMEX at five. Now these projects out here, even at NYMEX at 3.50, they still give you a positive rate of return, but my concern right now is I don’t know how long this gas price is going to stay so low.

So I want to watch my cash flow, because these projects, obviously the low prices, the payout term on these things are anywhere from three years up to five years and so that’s what I’m more concerned about right now. I don’t want to drill a bunch of CapEx numbers. We use a lot of CapEx dollars to drill in the slow environment, but anything around NYMEX 4.50 to 5, we’ll definitely go back and start looking.

Its not to say even though, let’s just assume we shift the rigs down, which we are at the end of March and we still have these re-completions, small amount of re-completions and work overs through the years. That what suggests that our CapEx would be somewhere, just slightly south of $12 million for the year of 2009, if we don’t do anything; and that will still give us a production growth, because of what we’ve done the first quarter of the year, but we still have plans and have the flexibility.

If we see that we need to bring a rig in, we can do that and drill a couple of wells and release it again, because one thing we also have to do and it’s very important when you’re looking at tight gas and the development of tight gas, you have to look at what you do this year or what you don’t do this year will affect you three years down the road, especially on the cash flow projections, on growth projections, because you get behind the curve a little bit on this development.

Especially when you have fields such as Cinco Terry that’s in its early stages of development, that field is still in a high decline rate mode. So, if you let it get too far down, then you’re going to be spending 2010, which means the price is coming back catching up. So, we have to balance this thing out and we’ll be watching it throughout the year.

I’m still not to say that, if gas prices rebound strongly; let’s say in mid-summer, we had a weather related issue and we see gas prices rebound nicely, then by all means it will bring the rig back in and as I said earlier, we theoretically could achieve still our $43.8 million budget by mid-year if we wanted to and we saw that kind of price increase, but I don’t think we’re going to see it, I really don’t. I think we’re going to see pretty ugly pricing at least till mid-summer.

David Tameron - Wachovia

Okay. Did you have any obligations in North Bald Prairie? You said your going to be drilling obligations; is that just Cinco Terry or is that kind of company wide?

Ross Craft

That’s really company wide, that’s the beauty about what we have. We have lease terms on our three producing areas; for the most part our Cinco Terry, Ozona and Bald Prairie, we have a very little lease retirement obligation to 2009 and what little we are going to have, we’ve already taken care of it. So, we really don’t have to do anything.

David Tameron - Wachovia

Okay, I’ve heard that the cost and oil plays on the Wolfcamp etc., the service costs up there come down quicker than gas plays. Are you seeing that in your areas, service cost pressure on the downside?

Ross Craft

Yes, we’ve seen a huge reduction in cost. Overall the whole thing; I mean from work-over rigs, to drilling rigs, to labor, to trucking. The only thing that we haven’t seen a reduction in a big reduction in is transportation of our oil and we’re still seeing about a $5 differential, $4 of that being trucking and the rest being just the cushion differential and we haven’t seen that.

David Tameron - Wachovia

Where are mostly your re-completes there?

Ross Craft

We have re-completion in Cinco Terry; we have re-completions in Ozona; remember the deepening project that we were talking about a couple of quarters back, we have those projects that are earning a reserve report, because we didn’t want to put them in there in Ozona, but then we have some re-completions from the Ellenburger, to the Canyon and Cinco Terry.

We’ve also got some Wolfcamp re-completions to do. We’re having pretty good success at locating Wolfcamp up to the North on our properties on Cinco Terry, up in the University acreage, so we’re pretty pleased about that. So, little projects like that that will really impact just because they’re cheap to do and they really like drilling the well.

David Tameron - Wachovia

Yes, and all of it being equal, is Wolfcamp today better economics which don’t give you the best economics for where oil and gas prices are at?

Ross Craft

Yes obviously finding a strong Ellenburger is the best, but let’s say at Canyon zone; re-completing up to the Canyon zone and Cinco Terry gives you good economics. I mean you’re chasing about 450 million cubic feet of gas and about 33,000 barrels of oil and then when you put the processing upgrades on it, it’s very attractive.

Wolfcamp is pretty much an oil play and it’s depth, it’s only about 6000 feet; at that depth its attracted as well and those are safe low cost projects that we can do and we don’t have very many of those built into the reserve report, only because we say “hey we got them out here, we don’t really want to put them in the reserve report. Lets just leave them, in case we have a rainy day and we need to do something” and that’s how we treat them. Those are our projects we’ll comeback in and utilize when we don’t want to utilize drilling those.

David Tameron - Wachovia

Okay, alright and just come back to the Canyon and Ellenburger. When you book these at year end, with the DNM digit you reserved report, is that right?

Ross Craft

That’s correct

David Tameron - Wachovia

Yes, when you did that, what did you get per location; what did you get on a per well basis?

Ross Craft

On the Canyon, let’s just take it by drill, like Cinco Terry on the Canyon. DNM gave us basically 300 million cubic feet of gas on a typical Canyon well and 33,000 barrels of oil.

David Tameron - Wachovia

Okay, that’s right and 500 is kind of what you’re targeting right, 500 equivalent?

Ross Craft

Exactly and I’ll just say this, our actual are more or like 400 million cubic feet of gas and about 38,000 barrels of oil.

The Ellenburger, which we again tell them not book many, I think we have four Ellenburger location booked in the reserve report, four or five. I think you gave us on those, right at about three quarters that would be per well and again we have wells that have projected Bcfe recoveries of 2.5 to almost 3 Bcfe of the Ellenburger right now.

Ozona; on the reserves in Ozona it’s still half a B per well in Ozona. The re-completions in Ozona from the Ellenburger to the strong, we’ve got them in the reserve report at about 300 million per re-completions as far gas. The average out there we’ll go back and look at the average of the strong production that’s going to be closer to a half a B per well.

Bald Prairie; actually Bald Prairie was interesting. They gave us 1.3 to 1.5 B’s per well in Bald Prairie. We actually asked them to really look at Bald Prairie hard, because obviously our production doesn’t support that. The wells issued with our other 50% interest owner on this is not proving projects and because the join operating agreement states if the well’s economical you can’t work on it unless we have 100% approval, so we have wells that are loading up.

DNM went back and looked at the Bald Prairie field results that XTO and all those guys to have and all the wells surrounding our least and they said, “No, we don’t want to drop reserves. We like the reserves where they are. This is the good play. It just doesn’t work at these gas prices.”

David Tameron - Wachovia

Alright, one last question and then I’ll let somebody else. Actually two questions; your accounts, any indication what they intend do with their 30% plus ownership stake?

Ross Craft

No, historically they’ve been distributing about a little over 900,000 shares per quarter. We haven’t heard this quarter what they’re planning of doing, don’t really know, should even look at it from the value standpoint as well. Obviously our stock price is fairly suppressed right now. So, I’m not really sure what they’re going to do. Steve?

Steve Smart

We haven’t heard a word from them about anything after the earnings here.

David Tameron - Wachovia

Alright and the last question, New Mexico, I think previously you had talked about the regulatory process are going to begin first part of this year. Any update there or can you refresh us as to where that’s at?

Ross Craft

David, so the County, Rio Arriba County recently published a draft ordinance that would divide the County into an exploratory basin and a development basin essentially. We obviously would be in the exploratory basin or district and read the draft regulations are broad and would be difficult to comply with.

We are working with the County and some other operators out there to get the best thing we can past, but we’re still looking at probably three months before we see the final ordinance. In the meantime, the County’s drilling moratorium remains in effect.

Even in our $43.8 million budget that was approved in December; we didn’t allocate any CapEx to New Mexico for 2009. We continued to do ’09 as a time to lay the best ground work we can for our future drilling out there, but nothing in ’09.

David Tameron - Wachovia

Alright and has the clock stop ticking or do you have clock ticking on your New Mexico?

Ross Craft

The clock under our lease, we have of course insured provision in our lease to the landlords who have essentially four years to battle the kind of enforcement issues. So we’re a year into that now, we’d have another three years of clock remaining. The drilling commitment actually would come into play in April of this year, but for the force measure. We’ve got another three years to fight it out.

David Tameron - Wachovia

Alright, thanks for that all the Q-and-A.

Operator

Our next question will come from the line of Houston Netherland of First Natixis [ph]. Please proceed.

Huston Netherland - First Natixis

Good morning.

Ross Craft

Good morning.

Huston Netherland - First Natixis

Just to understand the timing a little bit better on Cinco Terry rigs, when do you guys think the latest you could reinitiate your drilling program and still sort of hit that guidance, your new guidance that you issued?

Ross Craft

I think by mid-year end of July, if we haven’t seen any appreciable increase in pricing, obviously at that point it would be tough to meet it.

Although, the beauty about what we’ve got now is, the availability of rigs is pretty good obviously. I think you can get a rig just about in each three corner you want one and so if we want to bring in four rigs, our plan was to have two rigs working in Cinco Terry. If we want to bring in four rigs in mid-year, we should theoretically be able to hit the target of number of wells we project.

Obviously, mid-year we can do both East Texas and Ozona Northeast. So, I’d say mid-year and to the second quarter, first and third quarter would be a point that we’d have to really seriously look at it.

Huston Netherland - First Natixis

Okay, thanks for that and then on the impairments at Montney and New Albany, can you speak to those a little bit? Are those a result of non-economic drilling, what’s behind the impairments there?

Ross Craft

The impairment let’s just say Canada first, okay. We drilled; remember we’re at 25% working at the Southern Canadian project. We drilled two wells in 2008, one horizontal and one vertical. One horizontal Montney well, one vertical Montney and Doig well. Those wells are cased and had been completed, but economically wise I would say they’re uneconomical right now. So, we elected to write that off, write that drilling cost off on that area.

Our New Albany Shale Kentucky play, we had drilled those three test wells in 2007 and we have set 7-inch case and we haven’t completed any of those wells, but we decided it would be healthy if we went on and wrote the actual cost of those wells off. We like the New Albany Shale play, as well as that we still like the Montney play. In fact the New Albany Shale, there’s a lot of activity just our East going on right now, but it was not a function of ‘do we now like the play, have we seen anything that discourages,’ the answer would be no.

Unfortunately, the Canadian play, we haven’t operated that we feel probably went over his ahead and New Albany we just want to do a little house cleaning.

Huston Netherland - First Natixis

Okay, any comments on the higher production taxes you guys are seeing in the fourth quarter?

Steven Smart

What we’ve seen in the last year is the state of Texas, once a year they re-determined the different levels that it takes to get to the different lower severance tax rates and we noticed that in 2008 when everyone’s were getting back, we’re more above 5%, but we think it will gravitates us up slightly between the 5% to 6% on a weighed basis.

Huston Netherland - First Natixis

Okay and just one final question, how much stock comp do you have in that G&A number?

Steve Smart

It’s probably about $1.2 million.

Huston Netherland - First Natixis

Okay that does it. Thanks very much guys

Operator

Our next question will come from the line of Irene Haas of Canaccord Adams. Please proceed.

Irene Haas - Canaccord Adams

Yes, I have two questions, firstly is the re-determination coming up. You actually did grow reserve by 17% in ’08, however the TB-10 went down because of pricing, much like everybody else or do you have sort of any feel of what would happen on April 1? So, that’s the first question.

The second question is directionally what’s going to happen to your cost structure? You think its going to be sort of overall 25% decrease in ’09?

Steve Smart

I’ll take the first one. Irene this is Steve Smart. The banks as we said are set to re-determine our borrowing base on April 1. We have some things that are working in our favor that might counter the price. We won’t know for sure until we get to that date that the things that will counter is earlier like in the mid year re-determination. We know that we could have had a higher borrowing base in $100 million, we were told that. We just elected not to go there because we didn’t need it so much.

The other thing of course is we added reserves in the second half of the year, so it’s difficult for me to say how we’re going to really come out, time will tell, but we don’t have any early indications that the $100 million borrowing base will necessarily go down. Ross do you want to talk about that cost structure?

Ross Craft

Yes, Irene good morning. The cost structure, what we’re seeing right now and I think it’s a pretty good indication of what we will be seeing is going to somewhere between 20% and 25% I think is a fair statement and that would be on the drilling side and the work on the completion side as well, so it’s going to substantial.

For example; I’m just giving an example. Where last year we projected on our; let’s just take Ozona for example; we had drilling cost in Ozona of 820. I think our drilling costs are coming in closer right now. These lower prices if you project it that far will be somewhere around 680. So, that’s a pretty big difference in numbers now.

Now, also in our Cinco Terry, that’s what we are actually doing right now, Cinco Terry, so let’s talk about that one. We have our Cinco Terry numbers; last year I think we had an average re-completion, our average drilling cost of Cinco Terry was somewhere around 920, 950 and inclusive pumping unit. We are seeing those same costs somewhere around 750 to 800.

So, it’s coming down nicely. I don’t know where bottom is yet. I think we are close to it, because these service companies, they have to make a little money to stay in business. So, I would hope that it comes down. Casing cost is a big component; casing costs has come down considerably, still it has a lot of room to go. Fuel costs went from $4 and it’s now around $2.45 per gallon. So I mean its all light and sound.

Steve Smart

And we’re working also towards trying to cut our lease operating expenses as well as we look forward into ’09. We have some ideas that we think will bring that down as well.

Irene Haas - Canaccord Adams

Okay, that’s great. Thanks.

Operator

Our next question will come from the line of Mitch Wurschmidt of KeyBanc Capital Markets. You may proceed.

Mitch Wurschmidt - KeyBanc Capital Markets

Hey guys. Actually all my questions have been answered. Appreciate it. Thanks.

Ross Craft

Thanks, Mitch. How you’re doing this morning?

Mitch Wurschmidt - Keybanc Capital Markets

Good, thanks. How are you?

Ross Craft

Well, thank you.

Mitch Wurschmidt - Keybanc Capital Markets

Good.

Ross Craft

Tell Jack hi.

Mitch Wurschmidt - Keybanc Capital Markets

I sure will.

Operator

(Operator Instructions) Our next question will come from the line of Joe Allman of J.P. Morgan.

Joe Allman - J.P. Morgan

Thank you. Hi again everybody. So Ross, in terms of British Columbia and Kentucky, have you written all of your cost off for those two plays?

Ross Craft

No, just the drilling cost. The acreage cost is still there and so they actually, the acreage cost what we have is much cheaper than what the current rate is on the acreage. So, we just want to clean up the house a little bit and get these things cleaned up. That’s only the reason for doing that.

Ross Craft

Yes, let me add to that. Under the accounting rules, we had to determine what the reasonable associated value, could be associated to these wells and given our price market, the market for gas and what have you, the price is out there, we couldn’t associate a lot of value to this. So, that’s what we wrote it all the way down on the well cost. It was partly SFAS 144 driven.

Joe Allman - J.P. Morgan

That’s helpful, Steve. Then Ross where did you say there is some good activity to the East, which play there?

Ross Craft

On our New Albany play in Kentucky; there is a couple of counties that’s to the West, just directly to the East of our position that have been doing horizontal New Albany Shale wells that had fairly decent success, at least once reported, which very much mirrors what we were telling you guys about two years ago.

So, we don’t have anything planned in Kentucky this year with these low price, I can tell you that right now. There’s nothing that we need to do there. Our leases are five years, majority of them are five year; five year options, so we are in good shape there. We’re going to let the price rebound a little bit.

Joe Allman - J.P. Morgan

And Ross on British Columbia, your partner was looking to sell the asset there I think; any update there?

Ross Craft

He’s still looking to sell. I think they want to do something fairly quickly obviously, so there’s no development on that front. They’re still trying to sell their interest. We’re looking at the play in-depth now and we like the play probably more now than we did before, especially in the shallow horizons as well as the deeper Montney.

Storms have been offsetting our Mercury lease, they’ve been offsetting within four miles of our Mercury lease and storms had some very good results from the lower Montney wells. I think up to 15 million a day and that play is moving towards, but this is in lower Montney and then down of the rent, our geo play, there’s a lot of production coming in, shallower production around us that has very nice reserves. We still like to play a lot; we just have to get this operator removed and get somebody in there that can do the job.

Joe Allman - J.P. Morgan

That’s helpful and then also on CapEx, you didn’t give any really guidance on CapEx, at least understood. I mean what are you thinking you might spend and I know there’s a lot of uncertainty; what’s the tentative plan for picking up rigs. I mean in your model right now, do you expect to take a rig up in Cinco Terry, July 1 and you plan to spend $25 million for the year; I mean what are you thinking?

Steven Smart

Well, what we did is we have modeled this thing in-depth, but we went back and looked at different scenarios based on different pricing and there was about six different models we came up with and there was all kinds of rig movements and stuff. We finally settled on two models.

When you keep two rigs busy out in West Texas, we see the prices improve and we see a light in the tunnel in 2009. If we don’t see any improvement in natural gas price or commodity prices to speak of, we can take the conservative approach and then just shut it down at the end of the contract on the drilling rigs.

If you did that and just projected thus far what your CapEx is, just going to be slightly into $12 million, somewhere between $11.5 million to $11 million and like I said earlier, we could go as high as 43.8 like we originally said; that’s where we are in at this point dropping the 43.8. We just are saying we’re going to take a conservative approach.

So, I know this doesn’t help you very much, but looking at it from a conservative standpoint, say $11.5 million; looking at it from an optimistic standpoint, say somewhere around 25 to 43.8, somewhere there, remember that these fields, even at these low prices, fell off a huge amount of free cash.

So, if we did go into our no drill mode at the end of March, we are going to be chunking off somewhere around to just north of $20 million, somewhere around there, $20 million, $24 million in free cash flow and that’s pretty good in today’s time, because that along with our clean balance sheet is going to help us position ourselves for a couple of strategic deals, which we think will be popping up in the mid-year range.

Joe Allman - J.P. Morgan

Okay and then I guess you said in your press release that you had 10 gross wells, five net wells that are not completed at year end, and subsequently you completed those and so what’s the status of any wells that are drilled, but not competed at this point and when you wind up with two rigs in Cinco Terry, how many wells you’re going to have not completed?

Ross Craft

Well in Cinco Terry we’ve caught up on our completions. With just two rigs running we’ve caught up on all the work that was residual from the year end and we’re caught up on completions right now. So we’ll finish out the quarter and we’ll have all those wells which should be somewhere around, you’ll look at three quarters; 12 wells we should have on line at the end of the quarter, new wells.

Joe Allman - J.P. Morgan

Okay and then how about production right now. What are you looking at right now for overall company production?

Ross Craft

Overall company production, we are running a little bit less than what I’d like to see. We’re running somewhere around $26.5 million to $27 million in that range right now, that’s equivalent per day. That number is coming back up.

We’ve had some winter related issues with compression in our Cinco Terry facility. We’ve had some winter related issues in Ozona Northeast; not many, but enough to where you lose $0.5 million a day. So that’s turning the corner, so like I said $26.5 million to $27 million a day.

Joe Allman - J.P. Morgan

And then in terms of production, I mean if we look at your guidance and we hit maybe the midpoint of your guidance, your fourth quarter production ramped up quite a bit from the third quarter. I mean it looks like fourth quarter of ’08 to fourth quarter of ’09 you could see a decline of like 25% to hit the mid point of your guidance? Is that what you’re modeling or?

Ross Craft

Yes actually let’s address the fourth quarter ramp up and production. We came off remember in October. We had a huge month of production because we are coming off to shut in, Ozona being shut in for 23 days because of the hurricane and so that jacked up the weighted averages a little bit. We had lot of wells coming online. We come into the 2009 and we’re starting to tell off a little bit.

When you look at it, if we take the ‘do nothing’ mode, shut the rigs down, I think it’s reasonable to expect that we could easily still grow production, but yes, it’s going to decline somewhat. We’ve had these fields such as Cinco Terry that’s in the early life; they’re declining at around 54% right now. They’re going to have to come on downing and slow the decline rate a little bit as also I guess wells do, but you could be down to $25 million a day and finish up the year around $25 million a day, if we do nothing.

Joe Allman - J.P. Morgan

Okay, and then in terms of LOE and G&A increase in the fourth quarter and despite a higher rate, what were the reasons for those increases?

Steve Smart

Joe, we had a lot of costs as Ross pointed to when we came off the Hurricane Ike reconnection. We had a lot of cost on getting those wells back on-line, compression back up and running at full speed like before and I would say that was the primary reason.

Joe Allman - J.P. Morgan

Okay, that’s helpful and then Ross you mentioned early on, interesting acquisition opportunities. I mean are you actually looking at acquisition opportunities here?

Ross Craft

We are not seriously looking at anything at this point. We’ve got a couple of deals we’ve been watching. We could probably get them right now if we wanted to, but I feel there’s still a lot of room left. To ask and bid is way too different and I think the time to go out and really be effective is going to be somewhere around the beginning at the end of the second quarter. A lot of these coming have to go through the re-determination period again at that point.

A lot of companies aren’t going to make it through that re-determination period whole and that’s where we’ll come in; that’s why I want to get my Worchester cash built up, because at that point I think that we’ll be able to come in and be very effective through joint venture drilling opportunities such as the Marcellus, we love the Marcellus. We think it’s a good play for companies to capitalize like we are. That would be one of our primary targets.

Then acquisitions of course; always the acquisition market and the strategic properties in our core area, we would definitely look at that, but I think it’s a way too premature right now or it’s a little way too early. They’re going to get a hell of a lot cheaper before they go up.

Joe Allman - J.P. Morgan

Okay, and then lastly on rate return. When you gave your rate of return numbers, what pricing were you using; were you using like a five years strip or a three year strip and what kind of differentials were you assuming there and what kind of cost basis?

Ross Craft

On our rate of returns, we were using a quasi bank case, 450 for NYMEX or 450 for 2009, escalating to 550 for 2010 and flat at 650 for life on gas; and oil was 45 for 2009, 60 for ’10, and 70 flat for life. That’s kind of the models we were running.

Joe Allman - J.P. Morgan

And what kind of differences are you seeing there Ross, just normalized differentials?

Ross Craft

Yes, what we did, we assumed the average differential like in our reserve report. We said $0.70 on the WAHA index and $0.78 on the El Paso Permian index.

Joe Allman - J.P. Morgan

And the costs you’re assuming are kind of current costs or a reduction from here or what?

Ross Craft

No, the cost reduction we were looking at, we assumed, that’s one thing we ran in the reserve report, that’s a good question you ask. The cost we used in the reserve reports are all based on the higher costs that we realized in 2008.

So, quasi mixtures of these costs are somewhat between what we expect on where we were for example. I think it’s Cinco Terry run at about 850 per well, somewhere around there on the Canyon’s. 700 per well on the Ellenburger’s, and in Ozona, it’s close to 700 in Ozona. East Texas we still are running at about 1.9 million per well in East Texas.

Joe Allman - J.P. Morgan

What was Ellenburger again, give me that cost again?

Ross Craft

Ellenburger is about 700.

Joe Allman - J.P. Morgan

Alright thanks for time everybody.

Ross Craft

Thanks.

Operator

Our next question will come from the line of David Heikkinen of Tudor Pickering Holt. You may proceed.

David Heikkinen - Tudor Pickering, Holt

Good morning Ross.

Ross Craft

Hi David, how are you doing?

David Heikkinen - Tudor Pickering, Holt

Doing alright. As you think about costs in today’s commodity price, can you give us the same thing by area, where cost would have to go for you to resume drilling if commodity prices don’t recover by area?

Ross Craft

Well yes, let me just go a little bit beyond that even. What we’re looking for right now is a stabilization in the decline. If I could get a bottom to this thing, I wouldn’t be opposed to drilling at even these lower prices, if I could see a bottom in it. I don’t have the bottom. As soon as I see the bottom, then I’m going to crank back up, because then I can project where I need to be on it. The costs like I said, the costs right now are being what they are, say NYMEX at 450.

David Heikkinen - Tudor Pickering, Holt

No, no, not commodity price here, it’s service, your per well completed well cost is what I’m…?

Ross Craft

So, well I think we are there. I mean obviously I’d like to see it get cheaper, but Ozona Northeast, theoretically we can drill at the same price that we took the same over in 2004 and it worked in. So we’re there; although the rate return is not that great, its still would work.

East Texas; obviously East Texas it’s just too much risk of money at this price and so you’d like to see those prices drop into the $1.5 million to $1.7 million range per well and I don’t know if that’s going to happen, it might. So, we’re getting real close on the prices. I’m more concerned of projecting my cast a little forward out and as soon as I can see a bottom in this, then it’s going to be a lot easier for me to utilize, crank the rigs back up.

David Heikkinen - Tudor Pickering, Holt

Okay and kind of following on Joe’s question. Can you talk a little bit about it Cinco Terry? What is your base decline rate with no activity?

Ross Craft

In Cinco Terry, my base decline rate, if you look at mid-year to mid-year just like that, Cinco Terry being the newest one we have it’s about 54% to 50% decline rates. Hyperballis went down for just year-to-year and we do nothing more in Cinco Terry. It’s going to drop off pretty fast.

David Heikkinen - Tudor Pickering, Holt

And Ozona?

Ross Craft

Ozona is running right now about 12%, it’s still falling off a little bit at 12%. So when you look at Ozona, Cinco Terry and the rest of them combine and this has just taken a production plot and said “okay, let’s decline it like we see it.” It will work out somewhere between 25% and 30% decline company-wide.

David Heikkinen - Tudor Pickering, Holt

Okay and then thinking about the bank re-determination, you’re proved developed value as a percentage of your overall PV-10, do you have that?

Ross Craft

Yes, I should, let me see. Go to the next question, I’ll give it to you.

David Heikkinen - Tudor Pickering, Holt

Then kind of the final question, I’m just thinking about; built into your guidance, it sounds like you’re somewhere between the no improvement and the $25 million for CapEx. I’m trying to think through what we would expect? Is that a fair way to think about it now?

Ross Craft

I think so.

David Heikkinen - Tudor Pickering, Holt

Okay. So you don’t get back to 44, but you’re probably somewhere in the 20s, and then if you didn’t have the winter downtime, what would today’s production be? The compression downtime with Cinco Terry particularly it sounds like that’s the bigger impact.

Ross Craft

Yes, I think if you look at from that standpoint it would be closer to the 27.5. Hang on just a second; I just about got your number. Of the PW-10 value which was $221 million, just the approved portion of it’s going to be 179.

Steve Smart

PDP would be $168 million, David.

Ross Craft

Yes, when I used the 179 that was PDP plus PDNPs.

Steve Smart

Yes, that’s right. I let the PDNP, that’s good.

David Heikkinen - Tudor Pickering, Holt

Okay and maybe just thinking about that bank re-determination question, banks are lending kind of 40% to 50% of PDP as a kind of a reasonable number. It’s kind of the lower worse case that I’ve heard. Have you’ve heard with that said that you’re probably in the $70 million to $80 million of borrowing base to be the lower end range from the 100 where you were if your looking at worse case.

Ross Craft

I don’t actually have color on the other three banks. I only have what Ross highlights are and they’re higher than that, but I’m sure in this climate, there are some banks that are going there, I agree with you.

David Heikkinen - Tudor Pickering, Holt

Okay, when you think about your current borrowing capacity and then on the acquisition side generating free cash, did you ever think about it makes more sense to buyback your own stock than to buy somebody else?

Steve Smart

I mean obviously buying somebody else versus buying our stock, we know our stock is well and know our reserve base better than anybody; that would be a well placed investment, but I’m seeing a lot of opportunities coming on the radar screen that would allow us to increase our overall position in certain areas, get into new areas that have a huge amount of upside potential down the road and so that’s kind of what we’d like to do.

As far as the board buying back stock, we’ve had several discussions about that, including this recently. So in special where the stock packing is right now, it makes a lot of sense and we look at every thing.

David Heikkinen - Tudor Pickering, Holt

I’m just thinking about kind of how the history and the relationship you guys have had from an operating standpoint with your work down; I mean is every a case where you start combining assets or does that provide a strategic advantage to you with any of the other investments?

Ross Craft

Well, there’s always an opportunity out there, especially in an economic environment like we are right now, to combine assets with the other worked down entities. The problem you have with that is kind of like, you’re negotiating with your cousin and so its always a difficult task to reach an agreement on a value, but there are opportunities out there and Brian and I have talked about it, certain opportunities and they also have to fit in our area that we feel is our expertise area and so there will be discussions, but I would say that’s probably a long shot to grow within to get one of their companies into us.

David Heikkinen - Tudor Pickering, Holt

Alright, thanks, guys.

Ross Craft

Thanks.

Operator

Our next question will come for the line of Scott Moore of Kornitzer Capital Management. Please proceed.

Scott Moore- Kornitzer Capital Management

Hi, guys. How are you doing? Hey, jus want to get a little more clarification. I guess I’m little a confused still on the CapEx side. What does your current production guidance imply for CapEx? Is that the low end of what you were talking about, like the $11.5 million to 12 million or…?

Ross Craft

Yes.

Scott Moore- Kornitzer Capital Management

Yes. Okay, so current guidance implies $11.5 million to $12 million in CapEx.

Ross Craft

That is correct.

Scott Moore- Kornitzer Capital Management

Okay and then you were saying, obviously if conditions improve you can ranch that up if you need to?

Ross Craft

That is correct.

Scott Moore- Kornitzer Capital Management

Okay, and as far as previously you had given a break out, I don’t if this was back in December, of the $43 million budget. So how does the budget look with the $11 million or $12 million right now? I guess it sounds like it’s mainly re-completion they are deepening in Cinco Terry and Ozona Northeast, is that correct?

Ross Craft

Yes, the bulk of its going to be spent in Cinco Terry, and that’s with our existing drilling equipment we have right now and then the next remaining balance will be spent between Ozona and Cinco Terry on these re-completions and small work loads.

Scott Moore- Kornitzer Capital Management

Okay. So, how many wells do you think you’ll drill and complete, just I guess through the first quarter which is when you’ll lay down the two rigs in Cinco Terry, because previously you’d said you’re going to drill and complete 48, so what are we looking at now?

Ross Craft

We’re looking at, should have 12 wells.

Scott Moore- Kornitzer Capital Management

Okay and you already said that, I’m sorry. Then you said earlier that the production will drop there maybe a little bit, but it shouldn’t be too much and then you went onto say that the base decline rate was 50% to 54%. So, obviously what you’ve drilled so far and any re-completions are basically going to keep that flat to a little bit down?

Ross Craft

Yes, now the 54% was for Cinco Terry and so yes, now is that ‘do nothing’ case, so what we have now is these are all re-completions and conversions for Ellenburger up into the Canyon, and we’ll be the flat net out even more.

Scott Moore- Kornitzer Capital Management

Okay great. That’s all I had for today. Thanks guys.

Ross Craft

Alright, thanks.

Operator

Ladies and gentlemen this concludes the question-and-answer portion of today’s conference. I will turn the call back to management for any closing remarks.

Ross Craft

No, I think we’re good. I want to again thank everybody for taking your times to listen to us. I think we still have a good story. Stock value obviously as I’ll like to see is a little bit better, but concerning the time I think we’re whether this thing pretty well and again thanks for your support and thanks for your time.

Operator

Thank you sir and thank you for you participation in today’s conference. You may now disconnect. Have a great day.

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