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Approach Resources Inc. (NASDAQ:AREX)

Q1 2008 Earnings Call

May 7, 2008 11:00 am ET

Executives

Curtis Henderson- Executive VP and General Counsel

Ross Craft- President and CEO

Glenn Reed- Senior Vice President Operations

Steven Smart- EVP and CFO

Ralph Manoushagian- Sr. Vice President Land

Analysts

Wade Suki- Round Rock Investments

Irene Haas- Canncord Adams

Mitchell Wurschmidt- KeyBanc Capital Markets

Jeffrey Engle- JP Morgan

David Heikkinen- Tudor, Pickering, Holt & Co. Securities

Scott Moore- Kornitzer Capital Mgmt.

Tim O’Toole- Delta Mgmt.

Operator

Good morning everyone and welcome to Approach Resources first quarter 2008 earnings conference call and audio webcast. Today’s call is being recorded. A replay of the earnings conference call will be available on the company’s website immediately following the call. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session at the end of today’s call. At this time I would like to turn the call over to the Executive Vice President and General Counsel of Approach, Mr. Curtis Henderson. Please go ahead, Sir.

Curtis Henderson

Thank you, good morning everyone and thanks for joining us today. Our remarks today will include forward-looking statements. These subjects are subject to many factors that could cause actual results to differ materially from our expectations as expressed in those forward-looking statements. Those factors are described in our SEC filings and I refer you to our website, or the SECs website to review those filings. We undertake no obligation to publicly update or revise any forward-looking statements. Also during this call we will refer to certain non-GAAP financial measures. Reconciliations of these measures to the most directly comparable GAAP measures are contained in our first quarter 2008 earnings release, which is posted at our website at www.Approachresources.com. Now I will turn the call over to Ross Craft, our President and CEO.

Ross Craft

Thank you and good morning everyone. With me on the call today are Steve Smart, our CFO; Curtis Henderson, General Counsel, EVP; Glenn Reed, Sr. Vice President of Operations and Ralph Manoushagian, Senior Vice President of Land.

Our first quarter 2008 highlights: We have several financial and operating highlights from the first quarter of 2008 to report. Production increased 46% to BCFE compared to 1.4 BCFE produced in the first quarter of 2007. Revenues increased 102% to $19 million. Net income rose $2.8 million, or $.13 per diluted share. Excluding the unrealized loss on commodity derivatives our adjusted net income was $5.9 million, or $.29 per diluted share. In our [inaudible] increased 75% to $15.2 million. Capital expenditures for drilling and development in the first quarter of 2008 were $15.5 million. For the first quarter of 2008 we drilled or participated in a total of 23 wells, 15 of which were completed as producers; 5 of which were in various stages of completion; and 3 of which were drilled and abandoned. As we reported yesterday, we increased our 2008 capital expenditure budget from $64.3 million to $80 million. That represents a 24% increase. We plan to increase capital expenditures by $10.9 million in Cinco Terry, $8.4 million in Ozono Northeast. We also plan to defer our 2008 capital expenditures in New Mexico by $3.6 million. The increased budge will allow us to add two rigs to our drilling program from June 2008 to December 31st, 2008.

In April this year we moved a rig to Cinco Terry from Ozono Northeast. We plan to begin running two rigs in Ozono Northeast in June of 2008. The addition of the two rigs in June will bring our total working rig count to five, with two running in Cinco Terry, two running in Ozono Northeast, and one running in North Bald Prairie.

In addition to the Capital expenditure increase, we increased our 2008 production target between 8.5 Bcfe and 9 Bcfe. When we include the proforma effect of the Ozono acquisition in the fourth quarter of 2007, this represents a new target of production growth rate of between 20-27%. Excluding the proforma effect of Ozono Northeast acquisition, our revised production guidance represents a targeted production growth of between 69-70%. Now I will ask Steve to review selected financial results for the first quarter of 2008.

Steven Smart

Thanks. Ross. Net income for the first quarter of 2008 was $2.8 million, or $.13 per diluted share on revenues of $19 million, compared to a net loss of $581,000, or $.06 per diluted share on revenues of $9.4 million in the first quarter of 2007. Net income for the first quarter of 2008 was impacted by $4.9 million unrealized loss on commodity derivatives attributable to high natural gas and oil prices in relation to our call receiving’s and our fixed price slots. Excluding the unrealized loss on the commodity group, these adjusted net incomes from the first quarter of 2008 was $5.9 million, or $.29 per diluted share, compared to $2.4 million or $.26 per diluted share for the first quarter of 2007.

EBIDTAX for the first quarter of 2008 was $15.2 million compared to $8.7 million in the first quarter of 2007. Having the average realized natural gas, oil, and NGL prices of the first quarter of 2008, before the effect of commodity derivatives, were $8.93 per Mcf; $ 97.91 per barrel; and $50.95 per barrel in NGL, all that respectively compared to $6.70 per Mcf; $56.22 per barrel; and $30.12 per barrel for the first quarter of 2007.

Ross Craft

Overall we are encouraged by our results thus far in 2008 and look forward to continuing to build value in your company during the rest of the year. The increase in our capital expenditure budget and production guidance for 2008 reflects several positive highlights to our approach.

First we are operating in a favorable price environment for natural gas, oil and NGLs. In the first quarter of 2008 our production profile saw an increase in oil and liquid production as results by development in the Cinco Terry, which is a larger component of oil and NGLs as compared to Ozono Northeast field. Natural gas sales represented 78.2% of the total oil and gas sales for the first quarter of 2008, compared to 87.9% of the first quarter in 2007.

Secondly, as we recently reported, we expanded our anchorage position in Cinco Terry by approximately 9,500 per day gross acreage. The additional acreage expands our Cinco Terry project to a total of approximately 31, 400 gross acres. We are encouraged by the success we have seen in the Ellenburger, Canyon Sands and Cinco Terry to date, and additionally have sufficient pipeline capacity thus allowing for a more aggressive development of the acreage.

Finally, we are reprocessing the 3-D Seismic previously shot over Ozono Northeast which should allow us to identify the canyon sand channels with even more precision. We plan to have 3-D completely reprocessed by June, when we expect to have two rigs working in Ozono Northeast. This basically concludes our prepared comments. Thank you for your time this morning, and I will not turn it back over to our Operator for Q and A’s, and we welcome any questions or comments you have.

Question-and-Answer Session

Operator

Our first question will come from Wade Suki with Round Rock Capital.

Wade Suki- Round Rock Capital

We normally don’t say this on conference calls, but good quarter. I have a quick question for you guys on this New Mexico thing here. Wondering if you could maybe walk us through some potential scenarios on how this thing plays out. Can you declare a force majeure out here; just give us a sense of what we can expect going forward. Thank you.

Curtis Henderson

We can declare a force majeure. The lease does have a force majeure provision in it; in fact we have notified our lessor of this expected delay. The force majeure provision in a lease in the event of a government or regulatory delay, or the failure to obtain permits, which is the case we are looking at, can last up to four years. We have sixty days in effect after the delay is lifted, in order to comply with our drilling commitment, so we have in fact invoked the force majeure provision, but I think there is no question that our drilling plans are going to be delayed.

We are looking at a couple of different alternatives. One of those would be to challenge the counties authority to enact this moratorium, and on top of that to impose another local zoning and permitting process on our activities there. We are looking at those alternatives. We will come up with a game plan in the next seven days, and we will go from there.

Operator

The next question comes from Irene Haas with Canaccord Adams.

Irene Haas- Canaccord Adams

I would like to ask a question on Singletary, this is a brand new lease that you have gotten, and in addition you have grabbed some more. My question for you is that Canyon Sands, you have tons of experience with that, and Ozono fields, and right now I guess that initial spacing is at 80, just wondering if the balance spacing at 20 or 40 is feasible, as Cinco Terry is. Secondarily, I want to get a feel to Ellenburger, how predictable is the [inaudible] Have you cracked the code, and will 3-D be helpful and ultimately what is the optimal spacing to dig out the Ellenburger?

Ross Craft

Concerning the 80 acre spacing on Canyon Sands and Cinco Terry, yes, it is difficult in Canyon Sands, so it is feasible to give a down-space even more Whether we will get down to 20 acres or not because of [inaudible] I don’t know yet, but definitely a 40 acre down-spacing is in order. As far as the Ellenburger, have we cracked the code on the Ellenburger?

I guess in summary, no. We know a whole lot more about it, but we are still having to work our way through it, it is a very complex structure, or series of structures, I might add. And 3-D would definitely help us complete our model on it. I do think that we have cracked the code enough to continue a very aggressive program on the Ellenburger. But do we understand it completely; I would have to say no. It is still emerging as a study session as we move on, every well we drill, every canyon well we drill out there, we go down to the Ellenburger and the results are continuing to be favorable. But we still have a learning curve on it. We are further than we were before, but we are not there yet.

Irene Haas- Canaccord Adams

You are implying that there is quite a bit of structural component to the Ellenburger that would control the success or failure of a particular well?

Ross Craft

It appears at this point that there are a couple of issues. It depends on where you find the Ellenburger. Is it in the lower portion on the down-thread side, has it been eroded off the top for the producing zones, were the eroded off before they were deposited or thrown downward. That is the big issue right now. We are in a very good position from the studies we have done. We are in an extremely good position to find the structure we need. But there are some complex issues here, for example one location to another location offsetting it going back to the west, and you might not have it. You might not have the proxy, you have the zone, but you might not have the proxy. Then you move over to another location and you have it. There is a certain amount of hit or miss, but the beauty about this, and what makes it so attractive, is that you have a canyon zone above you that will give you a nice rate of return. As we said before, in our reserve report that we prepared earlier this year, we only booked six PUDs in the Ellenburger. We instructed D and M to do that based on the fact that we were still on the middle of our study and we didn’t want to get overly aggressive on the Ellenburger.

Irene Haas- Canaccord Adams

What you have said that is even structurally, once you determine the presence of Ellenburger, there are still other issues such as probably diogenesis that can mess with the porosity. So is that aspect of it another layer of complexity over this [inaudible]?

Ross Craft

Yes, that is exactly correct. Based on our drilling scenario that we have done to this point, all of the northwestern four sections that we have picked up the last time before this most recent; we have pretty much concluded that the Ellenburger is due out those four sections. What is different is the quality of wells between one well to another well. And that is where the structural difference comes in. We are still finding a very attractive well. We just brought one on yesterday and the Ellenburger well came over about like we expected. So it is still a very good play for us. We are still very excited about the play but we still need to do some more homework on it.

Operator

The next question is from Mitchell Wurschmidt with KeyBanc Capital Markets.

Mitchell Wurschmidt- KeyBanc Capital Markets, Inc.

On Ozono Northeast, can you talk a little bit about your plans beyond the Canyon Sands development? Are you looking at anything deeper over there?

Steven Smart

We always are looking at the deeper horizons where we have rights to. Obviously on Ozono Northeast the way the format agreement was, we only have rights to where we operate at down to the top of the line. But we are working and trying to identify deeper structures, and we should be able to talk more about that as we move forward.

Mitchell Wurschmidt- KeyBanc Capital Markets, Inc.

Also, can you give me an update on what is going on in Canada right now? Are you looking at anything on additional leases, or your drilling up there?

Steven Smart

We just got back from Canada last week from a meeting with the operator, and we are not as far along in Canada as we would like to be, or as [inaudible] would like to be, but remember, we don’t operate it. We have drilled three wells in Canada, of which none are online right now. We are caught into the road band thaw process in Canada, the ground is thawing out, it is muddy, and we can’t move any type of heavy equipment until they lift the road band. We are waiting to get a pipeline connection for those first three wells we drilled.

The first three wells targeted the Montney and the Doig we have stimulated the [inaudible] in the other two wells, we are waiting on the pipeline connection so we can flow test these wells. The play continues to be robust in that there are a lot of players out there paying extremely high prices for acreage, but until we get this pipeline in we can’t really flow test these wells, and that is where we are at a disadvantage. If you look at the spring thaw and when we think that we might have these pipelines connected, and this is a best-case scenario, would be end of June, it could be longer, there is ample capacity right now to get into lines. How long this capacity will last because of the amount of drilling that is out there that is in question.

One of the good things about where our acreage position is, being north of the Peace River, we don’t have to cross a river. That becomes problematic with environmental issues out there as well. But we should have some information late second quarter or first of third quarter to talk about the performances of these wells. The Montney structure in itself looks good. One thing about the Montney in this area is nothing more than a tight gas plate. It is just like our Ozono Northeast plate, except it has a little more pressure to it, it has variability’s just like a normal [inaudible] would have, porosity variability’s, permeability variability’s, you can look at the development around the core fields, the Dawson Creek Field, where Douvenet is working, where Ark is working, and they are working on core areas that have higher porosity. As where we move up in our area we are in a good area as well. We are still very high on the play, again, we are not as far along as I would like to be, I was hoping we would be further along than what we are. That is just how it is.

We are still working to acquire additional acreage and we have some bids going out soon that hopefully will be successful in picking up acreage. The cost of this acreage is going up drastically. It is a very competitive environment.

Mitchell Wurschmidt- KeyBanc Capital Markets

Just a final housekeeping question. What is your current level of production running right now, your net production for the entire company?

Steven Smart

Net production for the entire company for April was running at about 22.4 a day.

Operator

The next question comes from Jeffrey Engle with JP Morgan.

Jeffrey Engle- JP Morgan

I had a couple of questions. One on Cinco Terry area, and the other on New Mexico. Quickly on New Mexico. How much do you guys have invested in the leases there? Just dollar amounts at this point.

Steven Smart

In New Mexico it is $2.4 million. Does that answer the question completely?

Jeffrey Engle- JP Morgan

And on Cinco Terry, the new acreage that you picked up there. What is the expectation on Ellenburger in that area, just on the top level? What are your thoughts on the number of locations that could be in the new acreage?

Steven Smart

Obviously the twelve sections that we have picked up we have modeled that based on our geological model where we think this Ellenburger trend goes, so we have a lot of hopes for this new acreage. It also is modeled after where the canyon channel sands go as well. On Ellenburger right now, this is just an internal guideline, we don’t want to drill any closer than 80 acre spacing now. Glenn, correct me if I say anything out of line here.

Glenn Reed

I would probably agree with that. Eight acre spacing.

Steven Smart

On the canyon obviously we are going to be drilling at a lot close spacing, forty acre spacing on the canyon and maybe even down-spacing to twenty acres at some point. But I think that the development phase, if you look at the 9500 acres that we picked up, I don’t know if all of it is productive, I would like to believe that it is. But I think that there is a good possibility that this play will expand across the new acreage, so I have pretty high hopes for it.

Jeffrey Engle- JP Morgan

When are you going to actually start drilling that new acreage?

Steven Smart

We will start drilling that new acreage probably really quickly. We are drilling around to prove up the northern acreage that we have right now previously under lease. We have it pretty much proved up and from that point forward, with two rigs out there, will allow us to start moving in and start the initial stages of development of this new acreage. It is going to happen immediately.

Operator

The next question comes from Irene Haas with Cannacord Adams.

Irene Haas- Cannacord Adams

One more question on the Montney. I am looking at Canada’s description of it, the upper and the lower. It is turbidite, shoal face type sand, so it does have that sand consistency and configuration that you were talking about, much like the canyon sand. Can you give me a little color on the Doig shale? Is that kind of a blanket type formation, and can you give me some insight on how often can you hit both cells and can it be co-mingled?

Steven Smart

The Doig phosphate is a shale sequence, a true shale sequence, and again I will go back to comparing it to the Barnett shale sequence. It has the same characteristics as the Barnett shale, and it is sitting right on top of the Montney. In the area that we are exploring in, the Doig is present, especially above the Peace River; the Doig is present in every well we will be drilling. The key on the Doig is, it is full of gas, the saturation is fairly high, the TOCs are fairly robust as well, and it looks like from the early work we are doing on core analysis that it does have the right component to be able to fracture and connect the fracture systems in it. So we are still pretty high about the Doig, especially seeing that to go down to the Montney you have to go through the Doig, so that is always a great addition so you get it behind pipe. We don’t have any specific Doig stand-alones right now projected by everything we are doing is targeting Montney and the Doig, but it is true shale type clay.

Irene Haas- Cannacord Adams

Can it be co-mingled, or do you have to produce them separately?

Steven Smart

I am not sure, and I apologize, but I am not sure if the authority in BC will let you co-mingle the Doig with the Montney. Let me get back with you on that when I do some checking. It hasn’t been but that is not to say that it can’t be.

Operator

The next call is from David Heikkinen from Tudor, Pickering, Holt & Co.

David Heikkinen- Tudor, Pickering, Holt & Co. Securities Inc.

A couple of questions on Cinco Terry: how much of your production increase in your guidance is related to Cinco Terry?

Ross Craft

I would say on the production increase on Cinco Terry it is probably going to be a good 30% to 40% from Cinco Terry.

Steven Smart

But on the overall guidance it is going to dominate. We would say north of 60%.

David Heikkinen- Tudor, Pickering, Holt & Co. Securities, Inc.

And you have 31.4 thousand gross anchors in [inaudible] in Cinco Terry. What is that anchorage position? You added 9,000+.

Ralph Manoushiagan

We added about 52% net interest in that amount of [inaudible].

David Heikkinen- Tudor, Pickering, Holt & Co. Securities, Inc.

One more question. You were previously in 24 wells planned in 2008 for Cinco Terry, was the increase in CapEx in two rigs now, does that change, has it gone up, what is the new number?

Steven Smart

We are hoping with the new CapEx increase to drill 42 wells this year in Cinco Terry with the two rigs.

David Heikkinen- Tudor, Pickering, Holt & Co. Securities, Inc.

And the break down between Canyon and Ellenburger?

Steven Smart

The Canyon and Ellenburger right now, every well will be targeting the Ellenburger that we drill. In our reserve report we have only six Ellenburger wells as PUDs projected, and that is because we wanted to take a look at before we got aggressive on the PUDs. But every well is targeting an Ellenburger.

Operator

The next question is from Scott Moore with Kornitzer Capital Markets Management.

Scott Moore- Kornitzer Capital Management

Just wanted to get an update on service costs and rig day rates with you guys adding a couple of rigs and with the strip at $11 or above for [inaudible] gas. What are you guys seeing with service costs, and day rates, and also how much of your CapEx increase might be due to just cost inflation?

Steven Smart

We had talked about two rigs for $13,000 a day for two contracts prior to this increase in gas prices. The additional two rigs, we will probably be looking at an additional $15,000 a day for those. Somewhat of a small increase, but stimulation we had locked up for a year contract, so we don’t anticipate any increase there, but we are going to see some increase in our tubular costs are going up pretty rapidly. We are trying to lock in as much as we can into that, so we can control that expense, but [inaudible] really is the unknown factor right now.

Ross Craft

In our modeling, for example, on Ozono Northeast, even though we were drilling for about less than $750,000 per well we kept the $750,000 in our model, so that is already based in for anticipated cost increase and then further out we have even raised it to cost a little more. Cinco Terry likewise we are in the same position. We modeled a little higher as far as cost wise with the anticipation that there could be a slight increase in costs. But everything is already baked into our numbers. As far as what percentage of the CapEx budget is related to cost, nothing, because we have already added it in. It is all related to drilling.

Scott Moore- Kornitzer Capital Management

Also, how much are the wells in Canada cost you guys in total?

Steven Smart

I can attest that they are very expensive. The good thing about them is the horizontal wells should cost around $4.5 - $5.5 million. And as we get more drilling up there, we are going to see those prices slide down a little more, I would think. But it is expensive. A vertical well for example can cost around $2 million. And remember, this is not deep stuff. It is deep for Canada, but not deep here. This is like the deepest well is 6,000 feet and normally our Montney is located around 5700 feet, and then we go out on a horizontal well about 3500.

Our first well cost us quite a bit more. The bill for our first horizontal well was somewhere around $6.2 million. To date, which we have projected for a little less than that, so it is expensive.

Ross Craft

Those numbers are gross, by the way. We have a 12-25% interest depending on the particular area.

Operator

The next question is from Tim O’Toole with Delta Management

Tim O’Toole- Delta Management

A couple of unrelated things. You had mentioned that coming out of last year in the reserve report you had only booked 6 PUDs for the Ellenburger, but you have been targeting that as you have been going along this year. How many successful wells have you actually completed into that zone so far this year?

Glenn Reed

Six. We are pretty well there the first quarter.

Tim O’Toole- Delta Management

Were they the same drilling locations as what you had booked as PUDs, or do they not necessarily have to be?

Glenn Reed

They were not necessarily the same ones because we were stepping out based on what we could prove up.

Tim O’Toole- Delta Management

And then, to complete a thought, you mentioned that you are looking to do forty two wells this year in the Cinco Terry. You said your net working interest across that was 52%, so does that imply that essentially half of that number of wells would be your net wells for the year approximately?

Glenn Reed

That is correct.

Tim O’Toole- Delta Management

And the other question is related to something that was in the press release, but I did come on late, which I apologize for. Around the borrowing base increase, my question there is, that that gives you some capital and some running room this year before you would have to raise either equity or debt capital. You had a lot going on through the end of the year, and you put up a reserve report, but when you came through Boston a few months ago, it sounded like that was a fairly conservative report. Was the borrowing base increase based on the reserve report coming out of last year, or was there an update to that, and is there some chance still that by the middle of the year that you would do an interim reserve report after certain things have settled down, after you get some more data on Cinco Terry and the Ellenburger, to support that borrowing base increase. I don’t know whether that was baked into the increase, or whether there is another incremental opportunity to increase that reserve base.

Steven Smart

That $100 million borrowing base redetermination was an annual redetermination that we do and it is based on the D & M report issued at year end. And then we will have a required mid-year redetermination, and we will prepare an internal report at a minimum and provide that to the banks for an update. Yes, if we have additional reserve findings of course that will be [inaudible].

Tim O’Toole- Delta Management

So that would be a natural kind of timing and opportunity if you do decide to do an interim update publicly to kind of look at that.

Operator

We have no further questions at this time.

Steven Smart

Thanks for joining us, and if you have any follow-up questions feel free to call us and we will be glad to talk to you about any questions you might have that you didn’t ask today.

Operator

That will conclude today’s call, we do thank you for your participation.

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