Just in case you don't know what an "oilman's gamble" is -- or you do know and don't think the real deal exists anymore is all its big-hat glory -- make sure you understand exactly what Goodrich Petroleum Corporation (GDP) is doing in the Tuscaloosa Marine Shale or TMS, an emerging play that spans the border between Louisiana and southern Mississippi. The company has assembled a humongous land position -- more than 300,000 net acres at a cost of under $200 an acre -- and then gone way out on a limb (with the little money it could raise and the little cash it generates from other production) to drill some deep and very expensive wells in the hopes of proving up the play for an impressive payoff. And for better or worse, the clock is ticking down. Since the tension is killing me (and I have only a tiny exposure), I can hardly imagine what it's doing to the Goodrich folks. But they sounded cool and confident at their recent earnings call, so it's either some of the best bluffing I've ever experienced, or they know they got the winning card face down. Call or fold, we'll likely know the outcome before New Years.
Goodrich has some operations outside the TMS -- most notably in the Eagle Ford, but also in the Haynesville Shale and in East Texas -- but these can be comfortably ignored from a current investor perspective, as the company has frankly staked it all on the Tuscaloosa and is so publicly identified with the play. Goodrich can make it through the present year and meet its $325+ million capex commitment for 2014, running three rigs in the TMS. But after that, everything depends on a new infusion of capital.
A mere handful of new well results from Goodrich and the few other meaningful players in the TMS have been trickling in, dealt like cards in a hand of stud poker, each providing new and precious public hints about the value of the play. There's time for only a few additional results before the end of the year, when GDP will have crawled to the end of its financial limb. But the company knows what it's expecting, which is that some major industry or financial partner will step in with a horde of capital and buy into a joint venture at a price of $5,000 an acre. Now E&P economics can get pretty complicated, but you don't even need a pocket calculator to know that when you grab up acreage for $200 (most purchased within the past year) and sell it for $5,000, you've made a serious profit. In this business, there is simply nothing as exciting as opening up a brand new major shale play with your own guts, brains, hard work and the pennies raised from risk-savvy believers. This is what used to be called "wildcatting," the polar opposite of picking over decline curves and spreadsheet models to squeak out increments of IRR. It's why some of us love oil and gas.
And the TMS has got a lot to make your eyes light up. It's damn near 100 percent oil -- high quality black crude qualifying for LLS (Louisiana Light Sweet) pricing, the top domestic tier. Unlike much Eagle Ford production that passes for crude, it's not condensate or "light oil" or "volatile oil" or any of the other names currently being used to describe something that creates problems for the big Gulf Coast refineries, who can use only so much of it. And unlike Bakken-Three Forks production from the Williston Basin in North Dakota, it's not hundreds or thousands of miles from major markets. The TMS is within spitting distance of the Mississippi River for barge transport to Gulf Coast refineries, so there are no obnoxious takeaway issues or basis pricing differentials. (The company says it's getting LLS less $2.) And there is so little gas content to the TMS results seen thus far, even at 14,000 ft depths, that it's geologically uncanny. In the TMS, a barrel of oil equivalent (BOE) means a barrel of oil (bo). How refreshing!
Over the past few months, each new Tuscaloosa well result has been poured over, picked apart and greeted with extremes of elation and depression, making for the wildest possible ride. The Crosby 12H#1 and Blades 33H#1 wells sent expectations soaring with initial 24-hour rates around 1,300 boe. But these were followed up in early summer with two wells averaging below 800 boe for their first 24 hours, and although these figures should have been, by any reasonable standard, considered highly respectable considering the oil "cut" (oil percentage) and its favorable pricing, they were somehow received by investors as a major disappointment in light of the earlier results. (Remember that we are talking about a tiny handful of well results with which to judge perhaps a million acres between all the players, supporting tens of thousands of potential well locations.) GDP stock, which had soared to $30 on the excitement has collapsed below $20, though it's impossible to sever the impact of these specific results from the overall hit that the E&P sector has taken this summer.
The current low stock price is important (other than, perhaps, from the buying opportunity it may represent) mostly because it rules out any equity offering by the company as a means to raise fresh capital. In fact, the current stock price might be read by some as a conclusion that Goodrich is bluffing in its apparent confidence to find a JV savior and validator before it runs out of nickels. Be that as it may, the company put its case up for scrutiny at its recent 2nd quarter earnings conference call. And while each investor is entitled to judge the merits of the message, it was, a least, remarkably clear and coherent.
Goodrich held small non-operated interests in two wells drilled by Encana (NYSE:ECA), the second most prominent player in the TMS, and was therefore able to report new results in the play that returned to the high-end of excitement -- averaging 1,400 boe for 24 hour IPs. Goodrich's own most recent well came in at 900 boe, but this was a test of the very deepest extent of the formation on its acreage, at fully 14,000 feet, and where formation thickness was thinner. Due to the extreme bottom hole pressure at such depth, the production was significantly "choked" -- by passing through a small aperture at the wellhead as a means to counter the pressure -- indicating a potentially higher flow rate on a more comparable basis.
But most important, Goodrich was able to report that at least one of the more disappointing recent wells on the basis of initial production had effectively caught up with the production rates of the better wells within a month or so, due to a slower rate of decline. Thus it was likely to end up with a wholly satisfactory EUR of 600K boe (estimated total production over the life of the well), with the only difference being a minor one of timing, almost certainly too small to impact financial rates of return.
Natural Fractures and Matrix Quality
This conclusion intersected with a more general and perhaps more important one for the Tuscaloosa as a whole. Goodrich management is now speculating that the wells with the higher IP's were assisted by natural fracturing in the zone that juiced results at the very front end. But they are coming to believe that all of the TMS shares positive matrix qualities.(See Note on Matrix Porosity and Permeability at bottom.) These uniform matrix properties should support EURs of 600 to 800K boe from 6,000 ft laterals across the entire acreage position based on existing data. Wells currently producing from acreage where the TMS is found at 11,000 to 13,000 ft -- roughly two thirds of GDP's acreage -- enjoy higher initial flush production in excess of 1,000 boe/day due to natural fracturing, but this is only a short temporary advantage over deeper wells on the remaining one-third of the land position. After a few weeks, the deeper production -- commencing at a lower rate but declining more slowly because it is producing entirely from the fracture-stimulated uniform matrix and not from pre-existing natural fractures -- catches up with the production decline curves of the shallower wells, and the cumulative production remains the same. At least that's the argument, and it sounds credible at the current state of knowledge.
Moment of Truth
Goodrich is promising five or six more well results of its own in the next couple months, and there will likely be other results from Encana , Halćon (NYSE:HK), and perhaps some other less prominent TMS players. All of this will be exciting or disappointing to investors, but it hardly matters what we make of it. All that really matters is whether GDP will have managed to convince a potential joint venture partner that the whole kit and caboodle is worth $5,000 an acre, because GDP has definitely drawn a line in the sand with that figure. Given that management feels that all available evidence indicates -- or at least does not disprove -- the uniform quality of their entire acreage based on matrix assumptions, any deal that would cherry pick a core or fairway would demand a significantly higher per-acre valuation. While not ruling out anything, they would prefer a "cash and carry" deal, that is, a combination of cash paid for the fractional interest in acreage acquired and a commitment to "carry" or pay GDP's share of its drilling expenses to a certain maximum. This will both assure that full development takes place and put some cash back in GDP's treasury.
The company is stressing the informal natural of the solicitation and negotiation process at this time. At the conference call, my prickly ears heard expressions of cautious confidence for a deal within months, and surely before the end of the year. At their pitch two weeks ago (a few days before this writing) at an EnerCom conference, however, I sensed perhaps a less confident tone. GDP stock is jumping around like crazy on a day-to-day basis, moving up and down in 5 percent increments, which makes sense given what's at stake and the power of rumor over such a thinly traded equity. The one-third overall decline in the stock over the past two months is hard to read, given the bear market for all E&P stocks in that period, but cannot be viewed as a positive. The biggest question may be why Sinopec has not stepped up. Sinopec is already a one-third partner with Goodrich with respect to the 185,000 net acres in the TMS that GDP purchased last year from Devon. It surely has the means and is in the best possible position to assess whether developments since last year justify an additional, much larger commitment at GDP's desired price point. And they would be an ideal partner because Goodrich is reluctant to enter into any deal that involves turning over operations to the JV partner. It would prefer either a purely financial partner or someone like Sinopec, a big E&P that can help and has strategic interests to serve, but would not interfere in the exploitation of a play that GDP justly may believe it created for itself.
Goodrich talks as though the sale of a non-core asset, namely its Cotton Valley properties that have meaningful value but are on developmental hold in GDP's hands, would make a reasonable back-up plan to raise incremental capital. And this would certainly buy more time to build a stronger TMS case toward the desired JV. But there is simply no denying that this outcome would be a disappointment to both the company and the market, as both have been gambling on a big JV validation and payout in the current time frame. If the latter comes through, the resultant revaluation of the acreage should assure a big step-up in the share price and literally "make" the company. If it doesn't, the whole house of cards could collapse in a shakeout of investor disappointment -- at least until we all get over it and wait for another hand.
Note on Matrix Porosity and Permeability:
The term "matrix" refers to the pore space and structure of the rock -- in this case, shale. The amount of pore space as a percentage of a given rock volume is called porosity, and represents the space that can be filled with fluids, whether hydrocarbons or water. But for fluids to move readily under pressure through the rock matrix toward a well bore, the pores must be interconnected, a quality called permeability.
Most people with any interest in the industry know that shales are "tight" formations, that cannot produce without the man-made permeability created by hydraulic fracturing or "fracking." (Note that I'm deliberately abandoning the ancient industry practice of spelling this word without a "k," thereby making it unpronounceable to the uninitiated. This weird insider spelling was perhaps acceptable when the no one used the term outside the industry and fracking was far from a universal practice. But it's absurd today when the concept is everywhere in public discourse and the media. I trust I'll be forgiven by hard-core E&P nerds.) What may surprise people, at least at first blush, is that shales (despite their tiny particle size, and therefore density) can be remarkably porous, even in comparison with sandstones, the standard for conventional hydrocarbon reservoirs. Indeed, they have to be to contain as much oil and gas as they obviously do.
A strong case for the uniformity of the TMS across a huge acreage position comes from the data derived from very extensive vertical drilling. Well logs -- those trains of long squiggly lines that result from lowering sophisticated devices down the wellbore after drilling-- produce a reliable signature for the zone based on what is called the Passey Method. Zones that report high levels of electrical resistivity indicate the absence of water, as brines are highly conductive. Thus high resistivity means either low porosity (solid rock) or porosity filled with hydrocarbons, which are not electrically conductive. But formation porosity can be separately estimated by methods such as sonic ones, because the speed of sound through rock is affected by pore space. Thus if a formation is logged as porous and also as electrically resistive, it's a good indication of hydrocarbons. The TMS is striking on logs for the coincidence of resistivity and porosity.
Disclaimer: The author of this article is not an investment advisor and the article itself does not constitute investment advice. This article provides information about the covered company that has been obtained exclusively from public sources, including the company's public communications, and does not address more than a limited range of issues necessary to a decision to invest in its stock.
Disclosure: The author is long GDP.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.