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Oil and gas explorers are searching everywhere for a hint of fossil fuel: offshore, onshore, in rock, fields, coal beds, the depths of earth. Here’s one that might prefer a day at the beach: Approach Resources Inc. (Nasdaq:AREX). It’s looking for natural gas in sands and shale.

It would seem to be a good time to be a member of the explorers’ club, what with energy prices near all-time highs. But even though producers are selling at record levels, costs are rising too, and this is jeopardizing profits — particularly of smaller outfits, such as developers, who seek to expand by buying high-priced property.

Approach seeks natural gas and oil properties onshore in the United States and British Columbia, hunting mainly for natural gas reserves in known tight sands and shale gas areas. The Fort Worth, Texas-based company, with market capitalization of $391 million, operates substantially all of its proven reserves, giving it control over capital expenditures and other operating matters. Its interests are in West Texas, East Texas, Northeast British Columbia, North New Mexico and Southwest Kentucky; total leasehold interests are a net 191,182 acres, or nearly 300 square miles.

Of those interests, all of Approach’s proven reserves and production are in the Ozona Northeast and Cinco Terry in west Texas, and in North Bald Prairie in east Texas. Proven reserves were 89% natural gas. A positive sign for this year: the company increased proven reserves to 180.4 billion cubic feet of natural gas equivalent on Dec. 31, up 71% from the previous year. Proven reserve life is 21 years.

By concentrating on properties already producing, Approach in 2008 expected to increase natural gas production to 7,400 to 7,700 million cubic feet (MMcf), up from 4,900 MMcf in 2007. Oil production is expected at 120 to 125 thousand barrels (Mbbl) up from 80 Mbbl in 2007.

Those are great expectations. But then there are costs. One study by the Ziff Energy Group early this year said unit operating costs in the Permian Basin, located mostly in west Texas, have increased significantly. For oil fields, the average operating cost increased 34% in the 12 months from mid 2006 to mid 2007 — in line with the rise in oil prices — to $10.42 per barrel. For gas fields, the average rose 45% to nearly $1.35 per thousand cubic feet.

Big operators in the Ziff study had much lower operating costs than the averages, so the smaller guys have been carrying the burden. Other industry research points out the impact on explorers and developers, who must hustle for acreage and pay steeply for reserves that will produce in the future, when the price of energy may be quite different that that of today. That, too, makes it tough on the tadpoles, and easier for the portly toads.

And, in polliwog fashion, Approach is expected to see certain operating costs rise, although the company expects to cut back on general and administrative expenses. For example, exploration costs are expected to climb to $0.28 to $0.29 per thousand cubic feet equivalent, from $0.22 in 2007. Its strategy to focus on already producing sites should help to mitigate costs.

For J.P. Morgan analyst Joseph Allman, the company’s net asset value — based on gas and oil price expectations — tops rising costs. Allman calculates the NAV of Approach at $22.11 per share, valuing the proven reserves alone at $11.18 per share. Shares closed Wednesday at $18.95.

If future wells, especially in Ozona Northeast, Cinco Terry and East Texas, perform below expectations — or if costs rise enough to squeeze returns — the stock could underperform. Since natural gas makes up so much of Approach’s natural reserves, the stock is “highly leveraged” to natural gas prices, says Allman, adding that Approach has hedged close to 65% of 2008 estimated production and has little hedged beyond that. Weaker-than-forecasted gas prices could mean the stock won’t meet expectations.

At KeyBanc Capital Markets, analyst Mitchell Wurschmidt carries a “buy” rating with a target of $18. Wurschmidt said in a research note March 20 that Approach continues to ramp up production, citing a meeting with management.

In addition to potentially disappointing drilling results in the Ozona Northeast field, Cinco Terry project and North Bald Prairie field, risks include the lack of production growth and reserve additions, Wurschmidt said. The relatively low amount of public float, infrastructure issues and overhead costs, as well as higher operating expenses, could stall shares.

Approach has so far paid off for investors. Incorporated in 2002, it went public in November at $12 per share; Wednesday’s settlement shows a 58% gain since its IPO. For the year, analysts peg earnings at $1 per share, up from $0.71 in 2007. Earnings in 2009 are seen growing again to $1.14.

Certainly, there is money to be made for investors in energy. Just don’t let the costs drain your pocketbook.

Source: Approach Resources: In Search of Sand and Shale