Kinder Morgan's (NYSE:KMI) Tall Cotton project, located approximately 15 miles northwest of Seminole in Gaines County, Texas, is a pilot study to demonstrate the effectiveness of injecting carbon dioxide (CO2) in order to economically recover oil and gas from an otherwise unproductive residual oil zone (ROZ).
More specifically, the project is a greenfield project targeting a portion of the San Andres Formation which up to this point in time has not experienced any primary oil production (for reasons discussed below). While at first glance this project may not sound particularly exciting, it is, in fact, revolutionary because it is the first time CO2 technology (normally reserved for secondary or tertiary recovery) is being utilized for primary production. More importantly, if this project proves successful, it could lead to the recovery of many billions of additional barrels of oil from the San Andres Formation throughout the Permian Basin.
The Unique Origin and History of the San Andres Residual Oil Zone
Residual oil zones (ROZ) are not uncommon. Indeed, a typical producing zone is usually surrounded to some extent by a ROZ. Figure 1 diagrams the basic structure:
In the Figure 1 example, we can see two "oil traps" (a.k.a. "main pay zones" or "MPZs") and an oil-water contact zone with ever increasing water saturation the deeper you go. Normally the MPZ is where conventional drilling takes place, followed by secondary waterflooding and then, where feasible, tertiary CO2 injection. In Figure 1 the area between the two oil traps would be considered unproductive "goat pasture," as some old-timers might put it. At least that was the conventional wisdom until recently.
In October 2001 a research study presented findings of a thorough examination of the oil-water contacts in a portion of the Permian Basin. Its conclusion: the San Andres ROZ exists from an original oil trap which was then subjected to an uplift in New Mexico (west of Artesia and Roswell, New Mexico) which then exposed the San Andres to an infiltration of metoric water resulting from the Chicxulub meteor impact in Mexico's Yucatan Peninsula. (See: Technical Oil Recovery Potential from Residual Oil Zones: Permian Basin, 2006 p.1-5); "Significant San Andres play emerging amid ROZ fairways," Midland Reporter-Telegram, June 21, 2015.)
As depicted in Figure 2, this flow of water from west to east (which has been called "Mother Nature's Waterflood") literally swept the hydrocarbons from the pre-existing accumulations in the San Andres and deposited them elsewhere in the Permian Basin. What remained was the oil traps from which present-day oil fields are producing as well some left-over oil in the ROZ (as depicted in Figure 2).
Source: Trentham, B., Residual Oil Zones: The Long Term Future of Enhanced Oil Recovery in the Permian Basin and Elsewhere), 2011.
In the mid-2000s, additional research was conducted which concluded that the San Andres tilted oil fields (as well as the leftover oil in the ROZs) could be grouped together into three distinct "fairways." As illustrated in Figure 3, these fairways are: Slaughter (named after the large Slaughter oil field in Hockley and Terry counties), Roswell (which begins near Roswell, New Mexico), and Artesia (which begins near Artesia, New Mexico).
Source: Seminar on the Origins, Processes and Exploitation of Residual Oil Zones, p. 36; presented 12/9/2015 CO2 Conference Week, Midland, Texas (annotated to show cities of Roswell & Artesia, New Mexico).
These fairways carry over into West Texas. Figure 4 shows the overall sweep of the San Andres ROZ fairways (shown in light blue) from New Mexico and West Texas, as well as some of the better-known oil fields.
Source: Trentham, Robert et al., Identifying and Developing Technology for Enabling Small Producers to Pursue the Residual Oil Zone (ROZ) fairways in the Permian Basin San Andres, p. 5, December 2015.
How Much Oil Is There In The ROZ Fairways?
Research presented in December 2015 at the Annual EOR Carbon Management Workshop analyzed the resource potential of the San Andres ROZ fairways in a four-county area of the Permian Basin: Yoakum, Gaines, Terry & Dawson. Figure 5 shows the four-county study area and ROZ fairways as they traverse through these counties west to east.
Source: Kuuskraa, Vello A., The Residual Oil Zone (ROZ) Expands the Potential of CO2 Utilization and Storage, p.13, December, 2015.
Figure 6 summarizes the findings of the four-county study. The study concluded that over 27 billion barrels of oil are technically recoverable from the San Andres ROZ fairway within the four-county area of West Texas. That is a huge number if it is anywhere close to reality. To put that number in some perspective, over the past 90+ years of development, the Permian Basin has produced 29 billion barrels of oil and 75 Tcf of natural gas (Railroad Commission of Texas, 2015). So even though there is a big difference between oil that is "technically recoverable" and "actual production", the study strongly suggests that the resource potential of the San Andres ROZ fairways is enormous.
Source: Kuuskraa, Vello A., The Residual Oil Zone (ROZ) Expands the Potential of CO2 Utilization and Storage, p. 17, December, 2015.
Recently the four-county ROZ study was extended to eight additional counties: Andrews, Martin, Winkler, Ector, Midland, Ward, Crane and Upton. Figure 7 shows the eight-county study area and the San Andres ROZ fairways.
Source: Kuuskraa, Vello A., The Residual Oil Zone (ROZ) Expands the Potential of CO2 Utilization and Storage, p. 26, December, 2015.
Figure 8 summarizes the findings of the eight-county study:
Source: Kuustraa, Vello A., The Residual Oil Zone (ROZ) Expands the Potential of CO2 Utilization and Storage, p.28, December 2015.
Looking at just the "higher quality ROZ resources" in the top 4 counties (Andrews, Martin, Winkler & Ector), the study concludes there are 49.6 billion barrels of "oil-in-place" (OIP). Assuming a recovery factor of 24% (the percentage used for the northern four-county study) an additional 11.9 billion barrels of oil could be "technically recoverable" from this area. Again, a significant number which is further evidence of the potential importance of the San Andres ROZ as a future resource.
Can The San Andres ROZ Fairways Make Money?
The 2015 four and eight-county studies provided evidence that there is a lot of oil left in the San Andres ROZ. However, there is a huge difference between oil that is "technically recoverable" and oil that is "economically recoverable." KMI's Tall Cotton project hopes to help answer the latter question. So let's take a closer look.
As illustrated in Figure 8's plat map, the Tall Cotton pilot project (Phase I) consists of 16 producing wells and 12 CO2 injection wells. Each injection well is surrounded by four producing wells in a five-spot pattern.
Source: Seminar on the Origins, Processes and Exploitation of Residual Oil Zones, p. 121, presented at CO2 Conference Week, Midland, Texas, December, 2015.
Figure 9 also shows the location of the Tall Cotton project as it relates to Occidental Petroleum's (NYSE:OXY) West Seminole field and Hess Petroleum's (NYSE:HES) Seminole field. Both are conventional San Andres fields. It is starkly obvious just from this slide how much potential "running room" there is for additional ROZ projects.
KMI spud the first well in the project in April 2014, and CO2 injection started in November 2014. The field began to produce oil in May 2015. Figure 10 shows the production from the field through April 2016.
Source: Texas Railroad Commission
To date the ROZ project has produced 146,829 barrels of oil and 624,720 Mcf of gas. This equates to total production of 250,949 boe.
Figure 11 provides a summary of the projection forecasts for Tall Cotton Phase I and Phase II (which is substantially larger and still in the planning phase). According to KMI's projections, Phase I should reach peak production later this year.
Source: Kuuskraa, Vello A., The Residual Oil Zone (ROZ) Expands the Potential of CO2 Utilization and Storage, p. 19, December, 2015.
Source: Kinder Morgan 2016 Investor Conference, p. 26.
However, one has to keep in mind that KMI owns 100% of the mineral rights in the Tall Cotton project area which obviously helps with the rate of return. Another recent study projected that 17.5 billion barrels within the San Andres ROZ in the 4-county study area (discussed above) was both technically recoverable and commercially viable at $80/barrel oil and $1.92/mcf gas. (Trentham, R.C., Melzer, S.L et al., Identifying and Developing Technology for Enabling Small Producers to Pursue the Residual Oil Zone (ROZ) Fairways in the Permian Basin, p. 414, December, 2015.)
Kinder Morgan divides its business into five segments: Natural Gas Pipelines, Products Pipelines, Terminals, CO2, and KM Canada. Last year the CO2 segment contributed 15% of the company's earnings, second only to the Natural Gas Pipelines segment (see KMI's Q4 2015 earnings release).
So although the CO2 segment is not huge, it is not insignificant either. That said, the success or failure of the Tall Cotton project is important for a couple of reasons. First of all, as shown on in the discounted cash flow (DCF) chart on Figure 13, Tall Cotton is expected to be an increasingly important contributor to DCF in about five years as production from KMI's other CO2 projects (especially SACROC) decline. Should Tall Cotton not meet expectations this would be a concern because KMI does not appear to have any other CO2 E&P projects on the drawing board.
Source: Kinder Morgan 2016 Investor Conference, p.27.
The second reason the Tall Cotton project is important is that its success could foretell the beginning of a whole new area of growth for KMI's CO2 business. If KMI can prove the viability of economic oil recovery from the San Andres ROZ, then other producers are going to need alot of CO2 to recover that oil -- which KMI would be happy to supply.
So what should KMI investors do now? After all, any significant impact of Tall Cotton on earnings is years away and any serious development of the San Andres ROZ will have to wait for higher oil prices. My plan is to listen to the next earnings conference call (which will probably coming between July 13th and July 18th) to see if KMI discloses any information on the progress of the Tall Cotton project. I want to see if Tall Cotton is meeting production goals. If it is, that portends well for expansion of the project into Phase II and will encourage other producers to at least start thinking about their own projects. If not, it could call into question any near term growth opportunity for KMI's CO2 business.
One final macro comment: the discovery of the San Andres ROZ is both exciting and sobering. It is exciting because it will open up entirely new areas of the Permian Basin for exploration and production, especially in the four-county area of Gaines, Yoakum, Terry and Dawson counties. On the other hand, the discovery is sobering because, if and when the price of oil approaches $80/barrel, many billions of barrels could come into the market, helping to keep a firm lid on higher prices. So do not make any long-term bets on $100 oil.
Disclosure: I am/we are long KMI, OXY.
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.