There is hardly another horizontal oil play in North America that would have caused so much controversy and polarized opinions as the Mississippian Lime.
In a noteworthy recent development, Royal Dutch Shell's (RDS.A, RDS.B) confirmed that it found a buyer for its entire Mississippian Lime position in Kansas. Acquiring the estimated 600,000 net acres of leasehold and 45 producing Mississippian wells is Tom Ward's new company, Tapstone Energy LLC.
The transaction is the result of a six-month divestiture process. Shell put the properties on the block after its strategic review concluded in July of last year that the assets did not meet the company's targets. The acreage is located in Barber, Harper, Kingman, Pratt, McPherson, Sedgwick, Sumner, Rice and Reno counties in Kansas. The transaction is expected to close this month.
Notwithstanding all the turmoil surrounding SandRidge, in the area of deal-making and capital raising for the Mississippian, Tom Ward has an unmatched track record. The transaction is worth a closer analysis.
Shell In The Mississippian Play - The Background
To understand Shell's decision to exit the Mississippian, one needs to look more closely at the history of the company's involvement in the play and specific well results.
Shell entered the Mississippian at the peak of the play's boom in 2011 by acquiring a large acreage position from Woolsey Petroleum, a privately held E&P operator based in Wichita, Kansas (the price was not disclosed).
Shell was not alone seeking exposure to the promising new horizontal oil play. Several large independents, including SandRidge (NYSE:SD), Chesapeake (NYSE:CHK), Encana (NYSE:ECA) and Devon (NYSE:DVN), were competing for acreage, each accumulating hundreds of thousands of acres via massive leasing campaigns. Of note, each operator early on planned to use the "JV technology" to offload portions of their leased acreage at much higher valuations (SandRidge, Chesapeake and Devon in fact succeeded in that).
In parallel, dozens of smaller private operators were aggressively leasing acreage, often in the hope of flipping it for a quick profit to larger entities or financial sponsors.
No surprise, land was in high demand. Areas that had not seen a drilling rig for years all of a sudden were courted by armies of landmen. Lease bonuses increased substantially.
Leasing in the play ran far ahead of its evaluation. By the end of 2011, well over four million acres have been captured throughout the play and over 400 horizontal Mississippian wells have been drilled. Importantly, most of the horizontal wells were concentrated in select areas within the play's original core. The vast majority of the Extension acreage was essentially unevaluated with horizontal drilling. Nearly half of all wells in the play had been drilled by SandRidge Energy.
During 2011-2012, the Mississippian was enjoying the spotlight. Capital was flowing in via the public market, private equity channels and JV transactions.
The peak of the gold rush in the Mississippian was marked by four high-profile capital raising transactions successfully executed by SandRidge - two Joint Ventures, with Repsol YPF SA (OTCQX:REPYY) and Atinum Partners, for total consideration of $1.5 billion and two royalty trust IPOs for total proceeds of over $0.8 billion.
Both SandRidge's JV deals were characterized by stellar valuations:
- In the Repsol JV, SandRidge sold a 25% interest in ~1,000,000 net acres in the Extension Mississippian play in Western Kansas and a 16% interest in ~710,000 net acres in its original Mississippian play for $1 billion in aggregate ($250 million in cash and $750 million in drilling carries). No existing production was included in the deal. Assuming that 50% of the transaction price was allocated to the Extension acreage, and taking into consideration the timing of the carries, the transaction implied a valuation of ~$1,800 per undeveloped acre in the Extension and ~$4,000 per undeveloped acre in the Core.
- In the JV with Atinum (South-Korean private investment firm), SandRidge raised an additional $500 million by selling a 13.2% interest in ~860,000 net acres in the play's Core in Oklahoma and southern Kansas. The transaction implied valuation of ~$4,000 per undeveloped acre.
The per-acre valuations achieved in both SandRidge's JV transactions represented staggering 15x-20x multiples of the going leasing rates just one year earlier (SandRidge disclosed that it had spent $200 per acre on its leases, on average, across its entire ~2 million acre position).
Shell does not disclose the total cost of its investment in the Mississippian, but it likely was substantial, given the timing of the acquisition from Woolsey Petroleum (although clearly not nearly as high as SandRidge's JV transactions).
Shell's Well Results
In addition to the large acreage position, Shell's acquisition from Woolsey included approximately ten Mississippian vertical delineation wells that had been drilled by the seller. In 2012-2013, Shell followed up with an additional approximately 35 Mississippian horizontal wells before making the decision to put its entire 600,000 acre position and associated production on the auction block.
Having painstakingly reviewed the performance of each of the 45 Mississippian wells on Shell's acreage, I must conclude that the major's decision to abandon the play was the only logical outcome.
Let's start with the results of the ten original vertical wells drilled by Woolsey Petroleum. Average cumulative production per well, over an average 3-year life, was ~9,500 barrels of oil and ~16 MMcf of liquids-rich gas, or ~12.2 Mboe on a two-stream basis. The result is in on the weak side, even for a vertical program. Of the ten wells, three wells had performed poorly and were taken off-line after less than two years on production. The remaining seven wells are currently producing - at an average rate of 6 barrels of oil and 16 Mcf of gas per day.
Nonetheless, Woolsey's vertical program did demonstrate the producibility of the Mississippian on the Core portion of the acreage. It also showed very high oil content of the production stream. Of note, the extrapolation of vertical production data on to horizontal results was likely one of the sources of the initial overestimation by operators of oil EURs in the play - horizontal wells turned to be gassier and often had much higher water cuts (SandRidge's infamous oil EUR revision in 2012).
The majority of the horizontal wells drilled by Shell were concentrated in the play's original core in Southern Kansas (the map below).
(Source: KGS, Zeits Energy Analytics)
I have reviewed in detail production data for 26 wells located within the play's original Core in the southern portion of Shell's acreage by the Kansas-Oklahoma border (townships 33S-35S). While some wells show encouraging results, their percentage in the total number is low.
I estimate that less than half of the 26 wells have a chance of achieving oil EUR of 100 Mbo. (In my opinion, ~100 Mbo EUR is the economic viability threshold in the Mississippian.) Only three wells of the 26 appear to have potential to deliver strong EURs, perhaps in the 100-150 Mbo range. One can get an idea of these three wells' performance from the following metrics:
- The best well, the Koblitz 3409 #28-1H delivered ~34.6 Mbo in the first 10 months and was producing at a solid 85 bopd rate in November 2013 (month 10), the latest month for which data is available. Of note, a "sister" well, the Koblitz 3409 #33-1H, failed to replicate the success, producing only 1.3 Mbo in the first five months.
- Schupbach Ranch 3510 #3-1H had peak 30-day production rate of over 400 bopd, the best rate among the 45 wells. In the first 11 months, the well produced 39 Mbo and 97 MMcf of gas. The production rate has declined substantially, however: after ten months, the well was producing less than 40 bopd. Of note, another well located in the vicinity, the Schupbach Ranch 3510 #6-1H, produced only ~6,500 Mbo in the first 11 months online.
- The Knorp Farms 3410 #34-1H produced 32.8 Mbo in the first 8 months. The well was producing at less than 50 bopd during its month 8.
On the other hand, the percentage of poorly performing tests among the 26 wells was high. I would characterize at least 11 wells of the 26 as weak - unlikely to produce more than 25 Mbo over their economic lives. These 11 wells had average cumulative production during the first year of just 6.5 Mbo per well.
Shell also drilled several step-out evaluation wells on its acreage further north. Of the five wells that I reviewed, four wells produced very low amounts of hydrocarbons and were plugged. One well, the Morrow Land 3007 #28-1H, is currently producing (~20 bopd during the month of November, 2013); cumulative production from this well was ~7 Mbo for the first nine months.
Who Is To Blame, Shell Or The Mississippian?
I have heard more than once from industry practitioners that the primary reason for Shell's lack of success in the Mississippian is the major's high operating cost structure. Having reviewed the results of Shell's evaluation program, I actually see the situation from a different angle:
- There is no such realistic cost structure that would make these well results look commercial. To continue drilling, any operator would need to have the confidence that well results will substantially improve.
- Production data show lack of performance consistency expected of a resource play.
- The data do not lend support to the concept of a "sweet spot" within which wells would be reliably economic. The variability of results is very high not only from township to township, but often between wells separated by very short distances.
- Finally, the discouraging step-out tests effectively curtailed the position, limiting it to the southern portion of the acreage. As a result, Shell acreage no longer provide the scale that the major likely initially hoped for.
The bottom line, it is hardly a surprise that after drilling ~35 appraisal wells Shell decided to draw a line.
Shell is not alone in its decision to scale back in the Mississippian:
- Similar to Shell, Encana decided in 2013 to exit the play after drilling a number of disappointing tests and failing to secure a JV partner for its large acreage positions, most of which were in Extension areas.
- In mid-2013, Devon re-prioritized its drilling from the Mississippian to the underlying Woodford.
- Early in 2013, Chesapeake sold 50% of its Mississippian Core position in Oklahoma (which consisted of 850,000 net acres) via a JV transaction with Sinopec. The deal was priced at an estimated $800-$1,000 per acre, a far cry from the ~$4,000 per acre achieved by SandRidge in its JVs. Chesapeake let many of its leases outside the JV expire.
- Apache, who had accumulated a 500,000+ net acre position in Norwestern Kansas, never scaled up its drilling program.
Why Is Tapstone Energy Buying Shell's Assets?
Perhaps a more relevant question is: How much is Tapstone Energy paying for them? The terms of the transaction were, obviously, not disclosed. However, two circumstances may help in making a guess.
The first consideration relates to lease expirations. The majority of Shell's leases likely date back to the 2011-2012 period and therefore are close to the end of their primary terms (some may have already expired). According to SandRidge, the current going rate for new leases is $100-$150 per acre in the play's Extension and $300-400 per acre in the play's Core, which is similar to the pre-boom period. It is very possible, therefore, that extension bonuses on many of Shell's leases are higher than the current market rate for new leasing. As a result, potential buyers are unlikely to see much value in the vast majority of Shell's leases, unless they are held by production or have been extended.
The second consideration is the lack of competition in the play for acreage. With the departure of several heavy-weight participants and failure by certain large JV offerings to find investors, there is more acreage in the play than capital. Many operators, particularly those who purchased land for re-selling but have been unable to attract outside capital, are now facing a tough choice of paying additional cash to extend leases or release their acreage back in the market.
As a result, it would be difficult to imagine that competition for Shell's assets was very high. It would not be at all surprising if Tapstone won the assets by bidding close to the market value of the existing production.
- In November, gross volume from Shell's 45 wells producing wells was ~660 barrels of oil and 10 MMcf of gas per day. Even assuming 100% working interest in the wells, the market value of the existing production is likely less than $40 million and should be partially financeable via bank borrowing.
The acreage that is close to the end of the primary term may have little value to operators - it is cheaper to lease new acreage. However, for a capable capital-raiser, expiring acreage may be an enabling commodity if acquired at a right price.
The acquirer gains the ability to control - for a short period of time but at a very low cost - a large acreage position while marketing deal packages to capital providers. In the event funding is secured, the acreage can be extended, with the buyer paying the extension price (and then some). If no investor materializes, the acreage expires with relatively little loss.
One observation comes to mind, however: with over 2,000 horizontal wells drilled, the Mississippian is no longer in its infancy as a play. Having seen many disappointments, both operators and investors have learned many painful lessons and now have a much keener ability to discern operating results and evaluate future drilling economics.
The Mississippian deal-making bonanza of the 2011-2012 period involved re-sales of massive amounts of super-cheap acreage, the demand for which was fueled to a great degree by the lack of production histories in the play. That environment is not returning to the Mississippian Lime anytime soon.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.