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Executives

Louis Baldwin – EVP and CFO

Vaughn Vennerberg – President

Keith Hutton – CEO

Bob Simpson – Chairman and Founder

Analysts

Scott Hanold – RBC Capital Markets

Subhash Chandra – Jefferies

Tom Gardner – Simmons & Company

Brian Singer – Goldman Sachs

David Tameron – Wachovia

Joe Allman – JPMorgan

XTO Energy Inc. (XTO) Q1 2009 Earnings Call Transcript May 6, 2009 12:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2009 XTO Energy, Incorporated Earnings Conference Call. My name is Jasmine and I will be your operator for today. At this time, all participants will be in a listen-only mode and we will conduct a question-and-answer session towards the end of the conference. (Operator instructions)

Before we begin, the company has asked me to read the following statement. Management will be making forward-looking statements during this call. Risks associated with such forward-looking statements have been outlined in our latest 10-K, 10-Q, and news release. Actual results may vary materially. The company undertakes no obligation to publicly update or revise any forward-looking statement.

I would now like to turn the presentation to over to the host for today’s call, Louis Baldwin, Executive Vice President and Chief Financial Officer. You may proceed.

Louis Baldwin

I’d like to thank everyone for joining us today to discuss XTO’s first quarter results and our outlook for the balance of 2009. As usual, joining us in Fort Worth today are Bob Simpson, our Chairman and Founder; Keith Hutton, CEO; Vaughn Vennerberg, President; and Tim Petrus, Executive Vice President of Acquisitions.

I’ll start off by briefly discussing the quarterly financial results and then turn it over to Vaughn who will give you a hedging update and a quick summary on his views of the situation in Washington vis-à-vis energy legislation. Vaughn will then turn it over to Keith for an operations review and finally, Bob will wrap up and give you his macro views.

Obviously, XTO had a great quarter in the first quarter. Our adjusted net income was up 16%, operating cash flow up 40% when compared to the first quarter of 2008. Our team has been together for more than 20 years and I’ve got to tell you that this is really an exceptional performance, especially when you consider that our large cap peers that have announced to date are down 73% on net income and down 46% on average on cash flow.

If you look at what’s caused this outperformance from a financial perspective, I would ascribe it to a strategy that’s been time-tested and allows XTO to prosper through what we consider to be inevitable ups and downs in price cycles in our industry. The strategy consists of three primary components.

First of all, we seek out quality acquisitions and capitalize on them when they are available and we’ve got the operations team to improve production and reserves after those acquisitions are made. Secondly, when we make the acquisitions you’ve got to protect your balance sheet.

In 2008, we issued $5 billion of equity, half of which was given its purchase consideration to the sellers of these acquisitions. We’ve also issued in 2008 $4.25 billion of senior notes at an average interest rate of about 6% with an average term of 15 years. Already in 2009, we’ve reduced debt by about $2 billion and as of 3/31/2009 we have available $2.7 billion of undrawn credit under our commercial paper bank credit line facility.

And finally, you lock in your returns through hedging. Vaughn will give you a brief update on that, but I can tell you that our hedging philosophy has been consistent since 2001. If we look at the acquisitions made in 2008, by year-end 2010 our hedges should allow us to have a return of about 30% of that investment back to the company after our maintenance CapEx on those properties.

Looking specifically at the first quarter financial results, comparison to first call estimates, earnings per share was $0.77 and our adjusted actual earnings per share was $0.91, obviously a strong beat. If you look at GAAP net income, that’s $486 million or $0.83 per share on a diluted basis and the adjustments that we made in this quarter were the non-cash derivative fair value gain, an after-tax amount of $51 million and then a gain on extinguishment of debt of $6 million. So, as adjusted, our net income was $531 million compared to the GAAP net income of $486 million.

Just briefly, the gain on extinguishment of debt, the company did repurchase $114 million face amount of its senior notes during the first quarter and we took a $6 million gain after tax on that. The pretax amount of about $9 million is netted out of interest expense. I will also update you and tell you that we bought an additional $86 million face value of notes during the second quarter for a total of $200 million and at this time, we’d expect about a $7 million gain to be recognized after tax on that in the second quarter.

Looking at production and prices, gas production, 2.228 Mcfe per day, up 30% oil production, almost 66,000 barrels a day, up 27%, and these are all comparables to first quarter of 2008. Natural gas liquids, 18,300 barrels a day at – up 15%. So, on Mcfe basis, XTO’s production was up 29% first quarter of 2009 compared to first quarter of 2008. If you look out on breaking this out between acquisitions and development growth, of the 29%, 20% of the growth came from acquisitions, 9% from development.

We had more than a 3% quarter-over-quarter increase in production and all of this, about 3.4% increase, came through our development efforts. Looking at average prices, we did benefit from our hedging program as I mentioned before. Natural gas prices were $7.24; this was a 6% decline from same quarter of last year. Obviously, the reference price declined far more rapidly.

Oil prices averaged $104.59 and NGL prices, $23.84. So, it was a quarter on prices and we have these hedges that go through the end of this year, as well as a substantial hedge component of production for 2010.

Looking at revenues, total revenues, $2.161 billion, up 29%. As I said operating cash flow, up 40%. That’s $1.485 billion. Importantly, our cash flow margin, looking at the ratio between operating cash flow and total revenues, was 69%. That compares to 63% in the first quarter of last year and cash flow per Mcfe, another way of looking at that cash margin, was more than $6 per Mcfe. That compares to $5.50 for the similar quarter of last year.

Looking at operating cash flow per share on diluted basis, $2.57 compared to $2.10 last year. That’s a 22% increase. If you look at the gas gathering, processing, and marketing margin, that’s $25 million for the first quarter of 2009.

Turning to our unit cost analysis and guidance, production expense continues its downward trend, $1.04 per Mcfe and that compares to $1.12 in the fourth quarter of last year and compares to $1 to $1.10 in guidance. For the remainder of the year, our guidance has been reduced from $1 to $1.05, from $1 to $1.10.

Looking at the breakout in LOE per Mcfe, the biggest decreases have come from maintenance and workovers and power, fuel, and CO2 category. Specifically, labor and overhead, $0.25 per Mcfe; maintenance and workovers, $0.61 per Mcfe; power, fuel and CO2, $0.13 per Mcfe; and compression and other, $0.05 per Mcfe, for a total LOE of $1.04.

Taxes, transportation and other, $0.65 per Mcfe, that’s middle of our guidance and our guidance remains unchanged. Exploration expense, $0.14 per Mcfe, slightly above guidance as we had higher dry hole expense and seismic costs. These were really related primarily to Gulf Coast onshore and Bakken shale. Looking at DD&A, we get $2.84, slightly below guidance, and our guidance is $2.90 to $2.95 going forward.

Asset retirement obligation, $0.04 per Mcfe, guidance remains unchanged. G&A, on a cash basis, $0.23 per Mcfe. That compares to guidance of $0.25 to $0.30, which will be unchanged going forward. And non-cash stock-based G&A, $0.16 per Mcfe and guidance remains unchanged.

If you look at interest expense, it was $0.51 per Mcfe. That includes a $9 million pretax gain on extinguishment of debt. Excluding that, it would be $0.55, which is still substantially below our guidance of $0.58 to $0.62. Going forward, we are expecting $0.56 to $0.60 for interest expense and that really is due to lower principal amount outstanding after reduction of debt in the first quarter. Capitalized interest for the quarter was $13 million compared to $7 million in the first quarter of last year.

Looking at income taxes, our effective tax rate was slightly below guidance, 35.6% versus our guidance of 37%, but the current portion was slightly higher at 44% compared to guidance of up to 35%. We are tweaking our guidance upward to say that up to 40% of our tax liability maybe currently payable. That may turn out to be conservative, but that’s the guidance that we’ll have at this time.

Looking at investing activities on statement of cash flow, development activities, $10.76 billion; property acquisitions, $92 million; gas gathering additions, $179 million; and other property and asset acquisitions, $30 million. So, cash used by investing activities, $1.377 billion. We would expect development costs to decrease rapidly; Keith will update you on that. And of the property acquisitions for this year, they were most – for this quarter, mostly unproved properties and/or core shale plays.

Looking at the balance sheet, long-term debt as I mentioned has been reduced from 12/31 to March 31 by almost $2 billion. If we look at our debt to total cap, that’s improved on a GAAP basis from 40.8% at year-end to 35.9% at the end of the quarter. Looking at net debt to total cap, excluding other comprehensive income, again an improvement from 44.7% to 39.8%. So, you can see the strength of the balance sheet is here and we have moved aggressively this year to strengthen the balance sheet.

With that, I’ll turn it over to Vaughn Vennerberg, our President, to update you on our hedging.

Vaughn Vennerberg

Thank you, Louis. It’s good to be here today. As you are aware and many of you have all seen, our hedging position for 2009, we have discussed previously, are 1.7 B’s at $8.79 in our oil of 62,000 barrels at $1.17.

I did want to point out that on basis differentials on that production of what we have done because we are monitoring that on a daily basis and added to that your 2009 production, all the volumes have been – the basis has been locked in at minus $0.31 through November of this year. November, December this year, we have approximately 1 B a day at minus $0.31 – negative $0.31 and we are working the balance of that as the year progresses.

On your 2010 production, 95% of your basis is locked in on the $730 million a day that we have hedged at a minus $0.23 and we are working on the balance of that (inaudible) in 2010 at minus $0.19. We have 50% of that done. So it’s always working, we are constantly adding on a daily basis. Company philosophy has been to hedge all of our gas, all the way to delivery point with the basis locked in as well.

And how that works? Just to explain to you, as you know, as a seller, to truly set your price at the point of sale, hedging a price you got to do three things. You have to sell your swap NYMEX and then sell the location basis and then sell your gas and index. And that is what XTO has done for all its hedged gas and that takes out the pricing risk.

And looking at some of the basins were we – the areas where the price point – where we sell a lot of gas, for example Houston Ship Channel, the basis is kind of locked, we do anywhere between 500 to 600 at Houston Ship. Winter months was minus $0.60, today we are looking at minus $0.20. Caltin [ph] is running at about minus $0.30.

Columbia mainline, which is the (inaudible), East Texas and Barnett gas, it usually runs about minus $0.06. Today it’s anywhere between $0.06 to minus $0.08. Caltin is minus $0.12 to minus $0.14. Again, we run about 600 to 650 a day there as well. So, those are two big areas where we transport a lot of gas to and just so you know that we are constantly working to make sure we have a fully effective hedge for the production that is coming out of our various fields on a daily basis.

To update you briefly on the lines that have come on, Fayetteville/Greenville Expansion, that’s your Fayetteville to East Coast markets. It was on service as of April 2009 around $75 million a day was our firm capacity April ’09 to September ’09 and that increases as time goes on and this is to your costing sales point, which is Texas Eastern.

Woodford, your Gulf Crossing project. It started up in April. We have a firm capacity year one of $75 million a day. That’s not at full capacity as we speak, but it will be so in the near future. And then also Midcontinent Express, it looks like it – it’s your Woodford and Barnett Shale from Bennington, about $100 million a day for XTO firm capacity and compares to $50 million [ph]. Those lines are in progress. As you can see, we are well prepared with those to transport the gas that we are producing out of our major field Woodford, Fayetteville.

To give you a brief update on what’s happening in Washington and what we see; President’s budget request including a proposal to repeal IDC deductions, neither the House nor the Senate has included it in their budget resolutions. You can’t predict policymaking in Washington, but we don’t believe is going to be any serious discussion of repealing the IDC deductions this year.

We have lots of friends in Congress, we are talking to those on how important the IDC deduction is to keep capital flowing to the industry. Our friends on the side of the issue, you have Max – Chairman Max Baucus and Senator Kent Conrad who represent the Bakken Shale and Senator Blanche Lincoln who represents Fayetteville; Senator John Cornyn of course, Texas and Barnett and – as well as others who represent oil and gas producing states.

So, many of us in the industry have been talking to them about opposing the IDC deduction repeal if it does come up and we believe they are understand the issue and will oppose it in the Senate. So, that’s a real plus side. (inaudible) real plus for the cost side in the industry.

You have a lot of chatter about the (inaudible) monthly bill. Our observation is that moderate democrats on the House Energy & Commerce Committee are pushing back an opposition of the bill is mounting and just recently – yesterday, there appeared to be some confusion among the committee leadership as how they intend to move the bill forward in commitment. That is not uncommon in Washington.

But we are following all of these issues closely. We do have close friends in the Congress both on the Senate and House side and we will keep you updated as things progress. We think things are very positive right now for the oil and gas industry as far as legislative issues that may arise.

And with that, I’ll turn it over to Keith Hutton.

Keith Hutton

Thank you, Vaughn. Guys, it’s always nice to be on a conference call when you have this kind of quarter. Operating expenses dropped from $1.19 in the third quarter to $1.04 this quarter, production grew through the drill bit alone 3.5% for the quarter. In fact, if we kept this pace up, we’d be at a 14% organic growth pace for this year.

Obviously into the current pricing, we are slowing down our rigs. So, let’s look a little bit at that. We averaged 81 rigs in the fourth quarter, about 70 in the first quarter and we’ll average about 55 rigs this quarter. So, it looks like our capital cost is pretty hot in the first quarter. That’s a rollover from the amount of rigs that we ran in the fourth plus we are dropping rigs 21% quarter-to-quarter.

In addition to that, you are also seeing costs for fracing and pipe that really held up pretty well in the first quarter, have dropped in April probably 30% to 35% for both of those, which will lower your drill well costs under 15% or 20%. So, we should see drill well costs go from – to about 30% to 35% drop by the end of the year, which means our capital will drop very rapidly as we get into the back half, in fact three quarters of the year, which is why we are maintaining our capital at our original budget of $3.2 billion, about $2.8 billion for drilling and development.

If we look at where our production beat came from, quarter-to-quarter, 5% growth in the East Texas region, mainly paced by the Freestone Trend, 7% in Barnett, and then in the Midcontinent it was up 13% quarter-to-quarter due to your Fayetteville and Woodford taking off.

So, if we stand back and kind of look at what we’ve done in the last couple of years, especially last year with our large acquisition budget that we ran, what we’ve done is set ourselves up for what you are seeing today, which is a lot of growth firepower from the Shale basins. If we think about what we set up for this year, we are going to pace growth in Freestone Trend and Barnett.

So, you’ll see us slow those two down a little bit as we go forward from here through the year. And then, Fayetteville and Woodford will maintain the rigs that we had at the end of the year. That will actually end up with us doubling our Fayetteville production and increasing our Woodford almost a double as well as we go through the year.

In Haynesville, we started off with two rigs, we are running to four rigs and so, we will be delineating our acreage position in Haynesville. Bakken, we are still running four rigs. Marcellus, one rig and then we may take that to two from some of the results we’ve seen.

So, let’s step through and look at area to area, first Freestone Trend, up 3.6% quarter-to-quarter, most of that just driven by normal everyday 20-acre and 40-acre wells. We did bring on a couple of (inaudible) horizontals late in the fourth quarter that we talked about the last quarter, that were $13 million a day type wells and those two wells are still making in the $8 million to $10 million a day type range. So, they helped us in our quarter.

In addition to that, South Bald Prairie, where we had a number of good wells that we talked about over the couple of quarters, we continue to have good wells down there on our extension area, which is about 80,000 net acres we picked up at the last couple of years with wells that range from $6 million to $7 million a day start rates for a capital cost of about $2.5 million.

If we flip then from Freestone to Barnett – I mean, from Freestone to the Eastern region, we’ve had a number of good wells in our Shelby County Stockland field area, ranging from $3 million to $4 million a day out of the cotton valley line, Haynesville line. We continue to do our development in the Doyle Creek, Travis Peak area, where we’ve had a number of wells in the $2.5 million to $3 million a day range.

Our second Haynesville Shale well that was in Panola County came in at $5.5 million in average, close to that for the first month sales rate, just about an IP rate. We have four other wells down and are currently completing a couple of those as we speak. So, we’ll have more data next month.

We will have rigs going into our Louisiana acreage here in the next month or so to start drilling on our Louisiana acreage [ph] and Haynesville and so, we are excited about what we’ve seen so far. Things look good and we are working on getting top line takeaway capacity so we can run hard next year.

If we flip from that to Barnett Shale – let me mention one thing on Haynesville a little bit about costs. The wells were costing in the $8 million to $9 million. We actually have drilled a well for $7.5 million and believe we can tuck that to $7 million, maybe $6.5 million by the end of the year. So, wells that are even in the 5 Bcf type range up to 7 Bcf, all of those will be good finding costs as we work our way through the year.

Barnett Shale, another stellar quarter, up 7%. We are currently running 13 rigs. 11 of those are in the core 2 in Tier 1, a bunch of $4 million and $5 million a day wells like we’ve seen before. And again, we are really having a hard time slowing Barnett growth down. So, we are trying to throttle it at current gas prices, probably won’t complete as many wells in the second quarter as we did in the first just to slow down the growth.

If we go from that to the Midcontinent region, we are currently running 14 rigs, most of that in our three shale plays, Woodford, Fayetteville, and Bakken. If we look at Woodford, we are currently running three rigs. We have had a number of wells coming in at $4 million to $5 million a day during this last quarter, spread out across our acreage position.

Woodford has jumped from some $35 million a day in the fourth quarter to currently $65 million and we expect to exit the year at $80 million, running just three rigs. So, we are getting quite a growth out of the Woodford at this point without a lot of capital being spent from a drilling standpoint.

If we flip from that then to Fayetteville, we are currently running six rigs. Fayetteville was actually at about $25 million to $30 million a day at the end of year. It is currently $60 million a day and we’ll probably exit at a $120 million a day. And to put that in perspective, it was $13 million a day in the first quarter of ’08. So, it’s been kind of a rocket ship here.

We completed 23 wells in the quarter. Imagine anywhere from $2 million a day to $3.8 million a day. If you watch the AOGC’s IP rates on our wells, I know some of you do that, a lot of our wells are actually being held back because we are building out infrastructure. And so, you will not see full tilt out of those wells. And as we work out way through the year, our production will keep coming up very rapidly as we bring our compressor stations. And so, I wouldn’t pay too much attention to what you are seeing on the AOGC IP report.

If you look at Bakken Shale, we currently have four rigs running. We will drop to three in May. Bakken is actually running at 700 barrels a day, net above our forecast. That’s one of the reasons our oil forecast has been upped as our Bakken wells are doing very well. In fact, we brought in the best Bakken well we’ve drilled so far, the Boucher 41X-21. It was 20,000 barrel a day plus Three Forks/Sanish well. Actually, it’s better than the two, the Angelus and Crater that we’ve announced over the last couple of quarters. We are actually choking that well back and making probably 800 barrels a day of oil at this moment. No reason to pound it at current prices.

And then we completed a couple of (inaudible) wells at over 400 barrels a day equivalent. One of the things that’s kind of exciting for us, we’ve had a rig sitting on a super pad. And what that is, is a large pad we have built in South basin area that has four wells drilled off of it and that all will be completed here in the second quarter. Two Three Forks/Sanish and two Middle Bakken, the wells in that particular area are very good; some of our offset guys had 1,000 barrel a day plus Three Forks wells, as well as Middle Bakken. So, we should see a nice bump in oil out of the Bakken in the second quarter here.

Last but not least, Marcellus Shale. We are running one rig. We are currently completing our first horizontal and drilling our second, we’ve almost tidied our second and they look good, shows look very good, we are excited about them. And so, we think we’ll get our 10 to 15 horizontals drilled and if we can, we will bring a second rig into the Marcellus in the back half of the year and take it up to Northeast Pennsylvania.

We are setting up to try to do that. That will delineate Marcellus for us a little more rapidly than we had originally thought about it. So, we are excited about what we are seeing in the Marcellus well. No well data at this point, but you should see something in the next quarter.

Other than that, I won’t talk much about Permian or San Juan. We are running only one rig in Permian. San Juan, no rigs at the moment and Gulf Coast, no rigs. We did a good offshore well come online at $6.3 million a day and about 200 barrels of oil a day on South Marsh Island platform. Other than that, most of our capital is being pushed into the shale plays.

A little discussion then about production. I noticed that February production, the EIA 914 was up slightly. That does not surprise me given that everybody was running more rigs in the third and fourth quarter of last year. You haven’t seen the production decline show up and it won’t until May and I think you’ll see the back half of the year production falling off at some 10% to 12% cliff if rig count keeps coming down.

I think your natural gas rig count is at 740, it’s kind of flattened for a couple of weeks, but I doubt that holds. I know we are going to drop a couple more rigs and some other people will as well. So, I think you’ll see the rig count continue to decline and get under 700 barrel in the next couple of weeks. And so, I think we will be set up for a price rebound as we get into late ’09, early ’10 as production begins to fall off and demand begins to pick back up.

With that, let me turn it over to Mr. Simpson to wrap it up. Bob?

Bob Simpson

Thanks, Keith and welcome everybody to our first quarter conference call. As Keith pointed out, it’s an exciting quarter. A little bit about the history of it. Last year was the year of volatility to say the least both in our industry, in the world, and somewhat at XTO given our growth activities that were underway last year.

We did about $11 billion in acquisitions last year and we are seeing the fruits of that work sort of coming into play. If you look at the concept, it was to put into place a property base that could lead to a doubling in size of the company; doing roughly 2.5 B’s a day, which is a daunting task if you look at it sitting in our chairs. Those of you who were following the promotions last year of Keith and Vaughn probably wonder given this quarter why we didn’t do those sooner. But – be it as it may, they’re off to a good start and I congratulate them.

Actually, the evidence of our team strength of our properties is shining through and the old XTO strategy is steady as she goes, keep anticipating and keep building is what you see happening. And on the personnel decisions, we simply recognize and document what the talent was doing within this company and let you know more about it.

So, we are excited about all the changes and all the work done last year and the stock has been trading at a – kind of a price where you get all that for free – a lot of work and a lot of potential that went into those times, but be that as it may, that’s the opportunity that the markets present here from time to time.

If you look at our strategy, the XTO strategy of aggressive yet conservative, you can see that it serves you well in times that you didn’t anticipate how much you need it that conservatism built into your strategy. We started doing that about a decade ago, as Louis pointed out, learned a lot in ’98, made some changes and abided by them.

Our strategy of hedge half to two-thirds, keep the balance sheet strong, buy the best properties, hire the best people has served the owners very well during this, I’ll – in Texas terms I call it a 100-year flood we went through. There was a real serious and actual risk of systemic meltdown of the world’s financial system. We were in a position that if that’s what we are going to be, we were fine.

We had our debt turned out, our equity plays, and our balance sheet strong, went down and cashed down some hedges to make it even stronger. And so, the overall strategy, although it didn’t proceed being that imminent last year, was put in place and protected the owners and the employees and served us very well.

But out of that comes strength and you are seeing it. The XTO, I would make an analogy, it’s like a great thoroughbred. If you look at it for the last ten years, it’s used to be a racehorse. It’s in the top five of performers in the S&P 500 and it’s in a depleting industry, very anomalous outcome for stock in this industry. So, it’s been a racehorse and I’ve always said the oil and gas industry is more suited for plow horses because it’s sort of as steady as she goes best you can do replace production. It’s not meant to be a racehorse.

So, we’ve always been somewhat anomalous and you can see where we are today, where we are restraining this great thoroughbred and it’s still outperforming. It’s ready to grow, you can see in the numbers and we’ve got it set up to grow at double digits. It did a double-digit pace organically in the first quarter and we are restraining it. Wells are outperforming and that’s great.

The theory last year was we positioned ourselves in every great shale resource plays, play known in size and in the best areas we believe and you look at them individually, all of them could be another Barnett Shale in terms of impact to XTO, which the Barnett Shale is doing over half a feet a day. And so, four or five of those is how you double this company. It’s just that simple and so, that’s what we were about. And I think as the dust has cleared, it’s obvious what we were doing now and we are proud of it and hold it up for all to see.

So, I’m going to label XTO Man o’War, which is one of my favorite horses, but that may date me. You can Google it if you’ve never heard of Man o’War. Anyway the – for XTO, race is ahead. We are restraining production. Our 16% new growth target, same capital budget, just stated simply that’s the first quarter held flat. And even that is an understatement actually. We’ll have to restrain that. That’s certainly a very conservative projection, but who wants to grow gas production into a $3 sales price? We don’t, we are 80% hedged.

Our philosophy of half to two-thirds, we stretch every now and then when we think we know something and last year, we thought we could see a downturn coming, certainly not what happened, but a downturn nevertheless and that turned out to be correct. Right now, we are about 30% or so hedged for next year.

Our job will be to take that up to the half to two-thirds by the time we get there and we’ll try to do that opportunistically. So far, opportunistically means nothing. You have the opportunity to go fishing right now. If you believe in what we believe and this is our prices next year, now the strip is closer to six than three for next year. So, the world says you got the right direction and time will tell how far that direction goes. We think it’s probably going to be higher than that next year. We’ll get more data as the year goes along.

We think by the first quarter of next year, natural gas production in the United States will be shrinking at a rate of 10%. That will make all the difference in the world when you see it. The markets will tend to act all together and all at once when they get the first data of the shrinking. And right now, the data stays still cresting, maybe crested in February. I think last quarter I said I thought that gas prices would be – hit the low in February until we got to March and that’s been correct.

We are in the quadrant of bottom in here. The markets will see the data points when they get and tend to react. I suspect it will be violent when the data hits and the real world sees it. Right now it’s like, oh, yes, it’s going to grow. I mean, yes, sure. That’s not what we’ve been seeing and that’s fair because world hasn’t seen it.

But the rig count has gone from 1606 to 1742 and it’s more than half down, roughly half from a year ago to today, down almost 500 this year and so, it will respond. And it’s probably not quite done. We think it bottoms somewhere around 650 for a number, so we are getting close or close. And that’s been done already to shrink natural gas supply. It’s a question of how much. We’ve speculated about how much, but it is going to shrink and that’s going to make a lot of difference.

The economy, we are going to get through this thing for – for those of us who have been working a little longer, this felt like ’74 to me, which was the year of Watergate and the whole world went to hell and it was all over including crisis in government. And I think this is pretty analogous to that. Stats might be a little tougher, probably not a whole lot.

If you live in Texas, you've seen Barnesville before, and we survived. And so, we are getting through this. It’s hard to factor in what that does to gas price in terms of this recession certainly didn’t help it, but shrinking gas supply will do wonders for the self correction of the surplus and so, that’s coming, something to look forward to.

You can’t invest in it when it gets here because the market is smart, it will have moved in advance. So, one has to guess sooner than when you actually see it. I think the market has taken a little stab at it. Lately, you’ve seen the group is stronger. We think that gas supply – in America, the big change that we’ve seen in our career is a good deal of it. We could shortages on horizon and no real fix.

With the advent of the shale plays and technology therewith, what I would tell you is that we now have the good news, there is abundant gas in America and the good news for us is – by the way, it’s going to be probably $7 or $8 clearing price because of lower than that you can’t attract enough capital to develop it and we are witnessing that now. I mean that’s to be attested to by watching what happened to rig count.

I don’t think the industry has enough money to keep production flat from its own cash flow as a whole as an industry. We study the publicly held independents, they tend to try to grow or grow more than others because of the pressures they are under to grow. But the little guy and the majors aren’t even trying and they are probably already shrinking.

And so, the – but as a group, including the publicly owned guys, we think it takes the cash flow from a $7 or $8 gas price; and to fund it – and certainly, low gas prices don’t attract outside capital to fund it. And so, we’re going through that correction process and the markets are starting to discount it somewhat, not totally, but there’s been – there is some recovery underway and the expectations of the stocks of natural gas producers as you’re witnessing.

And so, with our growth and what we own and our prospects, and then the recovery, I think, is the last piece that we’ll – you’ll see our equity recover along with it. And so that last piece is patience, run your company smart and efficiently, and set yourself up for the resumption of growth at a more dramatic rate.

And so, right now, we are setting it up for live smart within your 80% hedges, set yourself up and study your place, hold on to your acreage, understand your better areas, and prepare for the resumption of dynamic growth of XTO; and the tremendous news for the size company it is, is we own that growth now.

It’s just a question of execution and as those who had been with us a long time at XTO, and owners for a long time, execution at XTO over time is excellent, so that is our other strength. We know how to acquire. We know how to execute. So, the two together have resulted in one of the most dynamic ENP companies ever built.

So if you look at sort of in summary where we’re going from here, we’ll be biting our time waiting on the recoveries of the markets, doing what’s smart, and preparing for that day when shareholder value is dramatically returned to those who are patient.

With that, we’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes to the line of Scott Hanold of RBC Capital Markets. Please proceed.

Scott Hanold – RBC Capital Markets

Thanks. Good morning.

Vaughn Vennerberg

Good morning.

Bob Simpson

Good morning.

Scott Hanold – RBC Capital Markets

Keith, looking at that Bakken result, it was pretty strong at over 2,000 barrels a day. Is there any thought on getting a little bit more aggressive there? I mean, oil looks like its sustaining $50 plus per barrel. I was kind of a little bit surprised here you’re holding that well back a little bit.

Keith Hutton

Well, we’re just – we could. I mean, if process keeps coming, we probably will stop.

Scott Hanold – RBC Capital Markets

What do you think the right price of the Bakken is and from your perspective to get more aggressive there? Do you need to see a fixed handle on it?

Keith Hutton

Yes. I mean, right now, what we’re doing is just basically delineating. We really need three rigs to delineate the acreage we have; and so, we’re just trying to hold our capital down at the moment and we’ll be able to jump on it if prices start coming. So it’s just a steady as she goes type maneuver.

Scott Hanold – RBC Capital Markets

Okay. And then those super pads, can you tell us about how you’re orientating those well bores? Are they going to be – basically, almost testing the concept whether the Three Forks in the Bakken are separate and all? I mean, are they going to be effectively within the same section?

Keith Hutton

They are not. There are four different – 12 80-acre units going north and south, but you’re getting in to the answer is we’ll be testing to see if we think we’re breaking those Three Forks wells up into the Bakken or not. We don’t think it is in this particular area, so what we’re hoping to do here that is come back and drill both in three forks. On the section, we’re drilling Bakken; and Bakken on the sections, we’re drilling Three Forks.

Scott Hanold – RBC Capital Markets

It has to be done on the same path as well?

Keith Hutton

Yes. So we just set up a big pad to be able to drop some of our cost to drill pads and so forth. Work with landowners up there to tip down our footprint where we were drilling and then you put a big tight battery all in one spot. It just kept some of your costs from that standpoint.

Scott Hanold – RBC Capital Markets

Okay. On the – going to the Haynesville, the New Horizons well, do you have a current production rate on that? It seems to be, initially, I think holding there on the 8.5 million a day. Where is that at right now?

Keith Hutton

It’s a little over $5 million.

Scott Hanold – RBC Capital Markets

Okay.

Keith Hutton

And then – well, I’ll tell you what we’re doing guys is we’re choking these wells back. There is a lot of chatter about whether in Haynesville you have embedment or crashing problems with your profit. We see no reasons to be pounding those in the $3.70 gas price. So, I give this an option to see if our decline rates look different than other people who have opened them up pretty full tilt, and whether in the long run that actually makes sure yours is better.

Scott Hanold – RBC Capital Markets

What kind of propping are you using in some of those wells and is that going to differ in what you use over in Louisiana considering that it’s a little bit over pressured relative to Texas?

Keith Hutton

It’s really not. I mean, look, our wells in Texas are pointing out the (inaudible).

Vaughn Vennerberg

A lot more pressure.

Keith Hutton

So it’s just pretty close to what Louisiana is. I know there’s been some chatter that Texas doesn’t have the bottom well pressure. I don’t think that’s necessarily true, at least not on where we’re drilling. So we’re using proppants – ceramic proppants basically and a mix with some sand to go with it.

Scott Hanold – RBC Capital Markets

Okay. And the – quickly on Fayetteville, you indicated that you’re obviously – the data that’s reported in the AOGC is different than what you’re seeing due to the – you’re holding back to the – I guess – the compression and what not. Is that ever going to change or do you think that’s going to be sort of an ongoing thing we just got to be aware of?

Keith Hutton

It’s probably an ongoing thing until we get the system built out; and then, if you look at the wells that have showed up well for us on AOGC, it’s because they go into somebody else’s system that’s currently at 50 pounds. We are building our own now, and right now, we’re flowing in the 900,000 pound line pressure.

So – you’re looking at oils and we’ve got them fall in the 15,000 pounds and when you compare (inaudible) they’re flowing at 150 pounds by giving pressure. So just to give you an idea as we brought some of these wells that maybe at $1 million a day; in decompression, they have hopped to three-and-a-half.

And so, obviously, the AOGC might – it looks like a million a day, but the well is actually making $3 million today; so, I just want to make that aware and you’re particular scope could have a report that shows look like we’re drilling worse wells, and I just want to make everybody understand it; until we get most of the system built out, which probably takes us through most of this year, you’ll see some of those kind of things.

Scott Hanold – RBC Capital Markets

No, I appreciate it.

Keith Hutton

It’s not a good measure of what we’re really doing.

Scott Hanold – RBC Capital Markets

Yes, I appreciate that. And one last quick question maybe for Louis is, is severance tax went – when I look at severance tax and do it on sort of a percentage of pretax revenue, it looks a little bit high on the quarter. Is there anything to that?

Louis Baldwin

Well, again, I think that you do have some pieces that are sticky. The compression pieces are typically, relatively non-variable as our Europe ad valorem taxes. Obviously, the severance taxes do come down, so I’d expect it would be at the lower end of the $0.60 to $0.70 guidance, given the prices that we’re seeing. You’re still using $4.50 in your guidance for a benchmark, so – as your actual prices through the summer are lower, you can be towards the lower end of guidance there.

Scott Hanold – RBC Capital Markets

Okay. I appreciate that.

Operator

Your next question comes from the line of Subhash Chandra of Jefferies. Please proceed.

Subhash Chandra – Jefferies

Hi, good afternoon. I guess the first question is for Louis. I think you guys are sort of early; at least it appears to us, in recognizing some of the bank problems. Has there been any change in tone here recently, willingness to lend or – I guess for the sector and for the guys that you deal with?

Louis Baldwin

Well, it – we’re getting and mostly second hand because we’re not renegotiating with our banks; obviously, with our investment grade credit and balance sheet, we’re not having the issues that some are. I think my view has always been for – with the exception made in the last bottom 25% quartile, the guys that have borrowing bases are generally going to be in relatively good shape. What they’re going to have to do is pay more for their facilities. They’re going to be limited in the capital can expand to drill until they get the banks in good shape, but the majority are not going to have force liquidations. Now, we have seen some that do.

So my view is that the banks are there and they’re renegotiating the borrowing bases when they need to be. You could have further issues come up as you get into the fall when hedgers are running out or you last hedged for companies in 2010 and you may have additional issues there. But I think what I see for the majority of the public companies that you’ll be looking is that they’ll be really facing higher borrowing cost and may continue to have constraints on their ability to drill until they bring either additional equity in, or until they sell properties.

Our view is that it’s a tough market to sell properties; although, you’re starting to see a few things fall in that case. So, I think the banks are there. They’re just going to make more money than they have been. And if the assets are good they’ll be relatively patient but they’re not going to let you drill in preference to reducing your facility if you’re at or above your borrowing base number.

Subhash Chandra – Jefferies

Got it. Thanks. And time for Keith, in the Haynesville there has been buzz, of course, in the south west part of the play and (inaudible) around that area shale be perhaps. Have you seen any difference in the logs or how you’re looking at the Haynesville play between the northern part and the southern part in East Texas?

And also, generally speaking, do you think – we just – the operation just need to gets used to IP rates, adjust IP rates in the 5 to 10 a day range for East Texas overall or do you think that there’s a big shift coming with additional development to something that maybe is not Louisiana but closer to?

Vaughn Vennerberg

Subhash, there had been a total of – I don’t know – 15 or 20 wells in Texas. There’s probably 2 million acres for people to drill on. What I would say is we don’t know that much, as an industry. You’ve got people drilling shorter laterals trying Packers Plus versus Cemented.

Obviously, the stuff in Harrison County is a little tougher and that’s probably because you’re getting more into a liquid’s window than you’re gas window and that’s part of the problem. But as it gets out, there is not enough data down there to know. In fact, I don’t really want to comment on it. Yes. Just wait until we get some more well performance. It will happen. It will happen.

Subhash Chandra – Jefferies

All right. Well, the two to four rig count, any idea or could you tell us where the additional two rigs would go?

Vaughn Vennerberg

I don’t really want to comment. I’ll tell you will be shipping some to Louisiana because we got some pretty good Louisiana acreage, so you’ll see us propping up with some more Louisiana wells here in the third and the fourth quarter; but other than that, we just delineate, and then there is some things you rather keep under our hat.

Subhash Chandra – Jefferies

Okay. Marcellus, have you – any thoughts on sort of the water they’re seeing there? There’s been a more concern about that and if he – if you heard it yourself and had an independent opinion?

Vaughn Vennerberg

The disposal of or the core eyes and so forth.

Subhash Chandra – Jefferies

Yes. Well, I think first water, sort of frac fluids showing up and water aquifers and/or producing more out of well bore when it shouldn’t have.

Vaughn Vennerberg

I haven’t heard that much about that. I heard a little chatter about it until we get our own wells online, Subhash. You always got to think that (inaudible). We’re really looking to try and do deep well bore disposable wells like you do in a lot of these other plays. And I think the industry will be able to do that with time.

Subhash Chandra – Jefferies

Okay, got you. And one final one, Bakken, what is your sort of the transportation setup right now? And at the super pads, is that – are you drilling that off the river in that acreage you have down there, and is that the type of configuration in order to deal with that type of access?

Vaughn Vennerberg

No, it’s not. It’s actually not on the river. If we just decide that it was a better thing to do as far as you could place all your equipment in one place. You could actually access four units with a single pad. It’s actually a smart thing to do. So, now – and differential-wise, we’re probably at $4 or $5 a barrel right now. So, you’ve more than doubled your actual price since the fourth quarter even though oil has only gone from $44 to $54 because your differential was $15 or $18 a barrel in December and it’s $4 a barrel now.

Subhash Chandra – Jefferies

Any way to be more specific on the rail versus which pipelines and –?

Vaughn Vennerberg

We don’t rail anything, so I just – we either truck it or pipeline it and honestly, there’s not all that much difference between the two, which should not be a surprise.

Subhash Chandra – Jefferies

Perfect. Thank you.

Operator

Your next question comes from the line of Tom Gardner of Simmons & Company. Please proceed.

Tom Gardner – Simmons & Company

Good evening, guys.

Louis Baldwin

Hello.

Tom Gardner – Simmons & Company

Keith, I believe you mentioned you may not complete as many wells in the Barnett in second quarter. Can you walk us through what your drill bit uncompleted inventory was at year-end, where it is now, and where it’s headed?

Keith Hutton

Yes, Tom. It’s probably in the 150 range or so. And what you’ve got an option to do here is slow down your drilling a little bit, and then just sit on your inventory some and not try to pound it in the 370 gas. It’s not going to change the overall world as it goes to natural gas production, it’s not. It’s just – well, there is no reason for us to try to bring those wells on into this current environment. We can hold them back, see if it’s higher gas price in the fourth quarter, which we believe, and then we’ll set up our completion percentage.

Tom Gardner – Simmons & Company

Got you. And I appreciate your comments on when supply is likely to roll. I found that one of the key assumptions there is the delay between when you move the rig off to – when you place it on sales. Do you have an idea what that number is industry-wide or per XTO?

Keith Hutton

Well, it really differs from play to play. And what I’d tell you is if you’re in something like Barnett or one of these shale plays where you’re waiting for pipeline infrastructure to get there, it may be a little longer. If you’re in mostly convectional plays, you got a pipeline sitting there, so convectional plan may be rig moves off; 60 days later, you got no production.

The shale plays may be 90 to 120 days. That’s why I’m saying I think you’ll run out of your inventory. In the March/April timeframe that we built up, you might see production still build at that point and then start to fall as rig count’s falling now. I think a good way to look at that, Tom, to give you an idea is frac costs did not drop until April.

So, all of these frac companies held their margins until April, and all of a sudden, we saw them start coming in and dropping their prices 30% or 35%. What that said is they’re going to let frac crews go. We now a shortage of – we have too much freight crews to the number of wells that are being completed, which I read that into, oops, we’re running out of all that backlog of wells. They used to be sitting there.

Tom Gardner – Simmons & Company

Interesting thought. One last question. I believe it was Louis that mentioned you’ve been actively leasing in 1Q. I just wanted to see if I could get any leading-edge lease rates out of some of these major shale plays primarily possible.

Vaughn Vennerberg

Good question, but no thanks. Sorry, pal.

Tom Gardner – Simmons & Company

Well, thanks anyway.

Operator

Your next question comes from the line of Brian Singer of Goldman Sachs. Please proceed.

Brian Singer – Goldman Sachs

Thank you, good afternoon.

Vaughn Vennerberg

Hey, Brian.

Brian Singer – Goldman Sachs

In the Woodford shale, looking at the map in your operations report, it looked like a success since you highlighted where – in various different portions of your acreage. Can you say what that does to how you think about the prospectivity overall? And it looks like the White 1-34 well right there in the north at the edge of your – the area that you play with the core, does that have any implications on potentially expanding the area that could be in what you regard as the heart of the play?

Keith Hutton

Could. Need a couple more wells to find out. Those wells scattered through our acreage positions are still pretty much inside the core outline that we had before. I don’t know how much changes it Brian, but we are drilling some wells outside those core areas right now, which might lead us to expand, but we believe the core area a the Woodford play. Don’t have that data at the moment.

Brian Singer – Goldman Sachs

Okay. Thanks. And secondly, can you talk about capital spending and acquisition trajectory over the coming quarters relative to the $1.3 billion to $1.4 billion that I believe was spent in the first quarter and how you’re thinking about the acquisition market here?

Bob Simpson

The capital was low. The acquisition market is – we don’t have any plans for a major one this year. We’ll do selective bolt-ons as they come along, but obviously, to get to the $3.2 billion between infrastructure and development, you can sort of divide that by three and subtract the first quarter, and get where we’re headed pretty quickly now. So, it’ll be coming down in terms of dollars pretty rapidly.

On the acquisition market, we haven’t seen a lot of activity in general, but usually, when you go through something like we just saw, Brian, you’ll see the bidding has moved quite a ways apart because the new buyer is looking at, gosh, I hope you’re broke, for the seller. And the seller said, gosh, I remember when I was at 140 last week and it seems like last week to me, so that changes.

We’re not particularly in that market anyway, but I really haven’t seen a lot of producing properties change hands and it would – my guess, it would be because of that phenomenon that I’ve seen historically when you have that rapid a change. Works both directions, by the way, whether it’s going straight up or straight down. The bidding as it gets the spirit, but we’ll – but there’ll always be some bolt-ons we’d see.

One thing that’s a little different than in times past is acreage can be a bolt-on now, more than ever in the history of this company because, as you know, some of these plays, the acreage can approach a pud value or at least a pud risk in terms of the risk that’s virtually gone.

And so, that will probably be more available this year than production. And, of course, in general, I’d have to say that we don’t need to buy anything, certainly, after last year, but the one thing that you all will have to think about a little differently for producing property acquirer is that perhaps you will have more bolt-ons in the acreage category. And it’s not – we’re all conditioned to think of that as something that – it may not be anymore, at least, for XTO. It could be a pud, and so that will be more available. We did, in the first quarter about $90 million of that and a good deal of that would be in pud pack acreage that we’re filling in drill size and that kind of activity.

So, I suspect the producing property market itself is still frozen. Probably will unlock by the fourth quarter somewhat because that’s sort of in my career experience. And whether or not – we’re very active whether or not, certainly will depend on a lot of things. We won’t be active in size for a lot of reasons, including this last year and our current goals and our current vessel plan. So, it has to be an extraordinary opportunity to even – to get me to spend $100 million on it at the moment.

Brian Singer – Goldman Sachs

Thank you.

Operator

Your next question comes from the line of David Tameron of Wachovia. Please proceed.

David Tameron – Wachovia

Hi. A lot of detailed questions have been asked, but also, this is to whoever wants to take it, but can you talk about – like obviously, Chesapeake (inaudible) some production. Can you guys talk about what level in which you’re in production or how you think about that strategically, obviously realizing you are hedged in Chesapeake wells as well. So, can you comment on that?

Louis Baldwin

In general, as a company, we generally don’t shut in production unless it’s a very unusual circumstance where bases fall out and then the price ends up being about zero, but that’s with our hedging and we rarely see that. Now, on a PV basis, one thing that happens when you’re in oil and gas business is when you don’t produce it now, and so, you were going to get 250 net or three.

It then moves to the tail-end of the PV-curve. As a financial guy, it’s hard to get to a price where you can justify the financial impact, but – and then, I wonder at times, if people are shutting in or just messing their estimates and failing or shutting in, as a side comment, because of that financial knowledge.

David Tameron – Wachovia

All right. I’ll leave the – I’d let that side comment fall to the wayside for now.

Louis Baldwin

That’s where it should go.

David Tameron – Wachovia

And one more question, I guess for you, Bob. If I think about big picture, everybody tells me and I’m right there with it. We need $7 to $9 gas longer term to incentivize capital, et cetera, et cetera. How – can service costs drop enough that the margins, work at $5 rather than $7 and that will attract capital to? Why is the number seven versus five, versus three versus 10?

Bob Simpson

It’s a good question. So how far can service costs drop? And you’d say, well, you have to go analyze each variable in the equation and how low can labor go in the drilling business, how low can steel go. I mean, there’s a lot of things to analyze. Obviously, it – in theory, if prices could be completely elastic, then the answer to that is price can be whatever price is going to be without a constraint. Reality, that’s not true. They have their finite limits as well because labor can only be so cheap and metal and so forth.

So, we think for there to be a free exchange of capital and then they also – you also have to have some reinvestment capital for those guys to replace their equipment that wears out as well. So, just an all-in equation to us suggests for the long term that number, now, it can be obviously within any – short period, it can be anything as witnessed today as 3 something.

So – anyway, that would be our thought, is to go analyze their businesses and see what number they go out of business or shut in is the analogy would be for us. But we think, for there to be a healthy business over time that supplies America, there has to be rates of return available to everyone at the trough.

David Tameron – Wachovia

All right. And congrats on a nice quarter everybody. Thanks.

Bob Simpson

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Joe Allman of JPMorgan. Please proceed.

Joe Allman – JPMorgan

Thank you. Good afternoon, everybody.

Vaughn Vennerberg

Hey, Joe.

Joe Allman – JPMorgan

Did – I’m looking at your overview page and your operations review. Did your Permian gas production drop a bunch?

Keith Hutton

No. Actually, we pulled Permian out of – pulled Gulf Coast and offshore, we’re out of Permian. It was – they were lobbed together last quarter.

Joe Allman – JPMorgan

Okay, got you. All right. Very helpful. Thank you.

Louis Baldwin

You bet.

Operator

You have a follow-up question on the line of David Tameron of Wachovia. Please proceed, sir.

David Tameron – Wachovia

Just a quick follow-up on that. Is that just you guys are going to ready this asset for sale at some point and, therefore, you’re pulling it out? Is that the split between the Gulf Coast and Permian?

Keith Hutton

Actually, we just did it because they’re actually two different operating areas now. At the time, when we first bought on, we actually had our South Texas being run by our guys in the Permian division. Now, we actually have a Houston office that runs South Texas and Gulf Coast and offshore together. That’s the reason we broke it out.

David Tameron – Wachovia

Okay. All right. Thanks.

Keith Hutton

You bet.

Operator

And there are no further questions at this time. I’d like to turn the call back to Louis Baldwin for closing remarks.

Louis Baldwin

Well, once again thank you for listening. It was a great quarter for the company. Again, we expect record cash flows for the year and I would emphasize, it’s not just the hedges, it’s the whole strategy that we’ve employed; protecting the balance sheet, making the acquisitions at the right time, and looking for the long run. So, that’s going to continue to advantage XTO versus the peer universe this year and going into next year as well. And as Bob says, we’re preparing to be able to grow when prices come back as we know they will.

Thank you very much.

Bob Simpson

Thanks, everybody.

Operator

Thank you for attending in today’s conference. This concludes your presentation. You may now disconnect. Good day.

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Source: XTO Energy Inc. Q1 2009 Earnings Call Transcript
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