With The Cabot Oil & Gas/Osaka Joint Venture, Pearsall Shale Joins The Horizontal Oil Race

| About: Cabot Oil (COG)

The Pearsall Shale, a deep hydrocarbon-rich source rock formation in South Texas, has received relatively little attention in the industry press flooded with recent developments from the North American horizontal oil and liquids plays. This may begin to change.

On June 22, Cabot Oil & Gas (COG) announced a Pearsall Shale joint venture with Osaka Gas of Japan. The transaction implies a staggering price of $14,300 per acre and may have caused some executives in the industry to call emergency meetings with their geological teams. The valuation is particularly impressive as it relates to a high-risk prospect with very little production history, technical complexities associated with the target zone's depth, and unproven economics.

Under the agreement, Cabot would sell to Osaka Gas a 35 percent non-operated working interest in the deep mineral horizons, which include the Pearsall Shale, in COG's approximately 50,000 net acres in Atascosa, Frio, La Salle and Zavala counties, Texas. The total price of $250 million consists of $125 million in cash at closing (on June 26) and an additional $125 million to carry 85 percent of Cabot's share of the joint venture's future drilling costs. The drilling carry is expected to be fully utilized by year-end 2013 based on the current drilling plans. Initial plans call for two rigs to operate under the JV with drilling commencing in July 2012. A third rig will be added to the drilling program during 2013 and a fourth rig will be added in 2014. Osaka receives interest in all zones below the Buda formation (the primary objective being the development of the Pearsall Shale) while Cabot retains 100% of its lease rights above the Buda formation, including the Eagle Ford Shale.

According to Cabot, well results to date from neighboring peers have been very encouraging. Cabot provided the initial production data for four wells drilled in the Pearsall by other operators in the immediate vicinity of COG's Buckhorn operating area:

740 b/d of condensate and 6.2 Mmcf/d of gas
451 b/d of condensate and 4.4 Mmcf/d of gas
720 b/d of condensate and 4.4 Mmcf/d of gas
552 b/d of condensate and 6.2 Mmcf/d of gas

While no information regarding the NGLs content of the produced gas and production decline rate was made unavailable, these data points alone are impressive enough, particularly given the very early stage of the Pearsall horizontal development, to explain the surprisingly high price paid by Osaka Gas for the acreage.

The Pearsall Shale has a vast areal extend in South Texas and lies at depths of 7,000-12,000 ft, with a thickness of 600-900 ft. The better known Eagle Ford Shale overlays a large portion of the Pearsall formation and is typically few thousand feet shallower. The Pearsall play has received some interest for its natural gas potential in the Maverick Basin, which is near the Texas-Mexico border, during the period of high natural gas prices several years ago, well before the Eagle Ford discovery by Petrohawk in 2008. TXCO Resources, who filed for bankruptcy protection during the latest recession, held a large Pearsall position in the Maverick Basin and was a vocal advocate of the play's rich potential. Some larger operators, including Anadarko (APC), Encana (ECA) and Shell (RDS.A), also held interests in the Pearsall in that area, although the drilling activity never gained true momentum. In addition to the Pearsall's natural gas promise, it has been also known that the play had liquids potential in its eastern part. Still, very few wells have been drilled in the play outside of the Maverick Basin until recently. The bankrupt TXCO eventually sold its assets to Anadarko and Newfield Exploration (NFX), and the Pearsall opportunity got overshadowed by the success of the shallower Eagle Ford.

Cabot's acreage contributed to the joint venture with Osaka Gas consists of two operating areas, the Powderhorn area with 10,740 net acres in the Zavala county by the Zavala-Maverick county line, and, further east, the Buckhorn area with 39,122 net acres located mostly in the Frio, La Salle and Atascosa counties.

In the Powderhorn operating area, the Pearsall zone is 600-700 ft thick and lies at depths varying from 8,000-9,500 ft. Cabot anticipates a high liquids content of the hydrocarbon mix to be ultimately recovered with 25%-30% condensate, 35%-40% NGLs, and 35%-40% dry gas. The Company estimates it has 75-100 drilling locations in this area assuming 1,000 ft well spacing and 3,000-6,500 ft laterals.

In the Buckhorn operating area, the Pearsall is thinner, 500-600 ft, and deeper, with a depth range of 8,500-11,500 ft. The estimated liquids content is also very high, with 25%-30% condensate, 30%-35% NGLs, and 35%-40% dry gas. Cabot sees 250-300 drilling locations in the Buckhorn, assuming 1,000 ft well spacing and 4,000-7,500 ft laterals.

In the event the play shows positive results, many E&P companies may find themselves well endowed with the Pearsall acreage as the leasing activity driven by the Eagle Ford success has been very strong over the past several years. Companies such as Chesapeake (CHK), EOG Resources (EOG), Conoco (COP), Pioneer Natural Resources (PXD), BHP Billiton (BHP), Forest Oil (FST), SM Energy (SM), Rosetta Resources (ROSE), Talisman (TLM), Marathon Oil (MRO), Hess (HES), and many others have been active in the Eagle Ford. It should be noted that shallow mineral interests may at times be leased separately from the deep rights, and interests in the Eagle Ford Shale leases do not automatically translate into interests in the underlying Pearsall rights, however the correlation should be high. In the past, several operators, including Anadarko, Newfield and Chesapeake, have publicly stated their intent to assess Pearsall potential over time. Many more are likely to join. While Cabot's 50,000 acre position is relatively small in comparison to the Pearsall leaseholds controlled by the larger Eagle Ford players, Cabot's drilling results will be closely watched. In the event of a success, the Pearsall leasing and drilling activity may kick into a high gear. It is too early to draw any conclusions about the technical and economic viability of this play, but it seems that the Pearsall Shale has just been officially nominated for the "New Hot Horizontal Oil Play" category.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.