EXCO and Comstock Resources: Two Cotton Valley E&P Long Plays

Includes: CRK, XCO
by: Trey Wasser

For those following Boone Pickens and his new venture EXCO Resources (NYSE:XCO), the news just keeps getting better in the Cotton Valley Trend.

First, no news from CEO Doug Miller regarding the Company’s East Texas assets since the postponement of the MLP filing. However, Melissa Davis at theStreet.com and Harry Chernoff of Pathfinder have provided an update on the horizontal drilling activity in the Cotton Valley. According to Davis, Chernoff is a little put off with Comstock Resources (NYSE:CRK) for not being more assertive with their acreage and developing a more aggressive horizontal drilling program. After all, companies like GMX Resources (GMXR) and Goodrich Petroleum (NYSEMKT:GDP) are commanding much higher multiples. Devon (NYSE:DVN) is currently reporting great initial success in its first two Cotton Valley horizontal wells.

Chernoff insists that Comstock, with its huge acreage position should be selling other assets and changing their cap-ex budget to immediately start horizontal drilling in the Cotton Valley Trend. Clearly Chernoff is an analyst and not an oilman.

The Devon well in Panola County, Texas is certainly proving to be a monster. Initial flows seemed to grow with every account, but the well has been producing 10Mmcf/d for the past thirty days. Results from GMX, Goodrich and other operators should start flowing in the next few weeks.

Typical Cotton Valley drilling is very low risk, but it covers a very large area. While older wells are still producing economically, newer vertical wells are being completed into multiple zones providing much better results. However, the geology can be erratic. So, there is no guarantee that every identified location will produce a horizontal well worth the increased drilling costs. (A horizontal well will cost about three times a typical vertical well). It will be at least another year before the overall impact on the reserve base is calculated and verified.

It is my opinion that GMXR and GDP are “overplaying” their Cotton Valley acreage. They have already “fully engineered” their leases and have established drilling locations based on a 40-acre (or less) spacing for vertical wells. Horizontal drilling could easily expand spacing to over 100 acres per well. If so, much of the GMXR and GDP acreage may not produce the advertised production/reserve increases. Finding costs may drop, but so will drilling locations.

GMX has a relatively small acreage position in the Cotton Valley, about 15,000 net acres. In fact, this acreage accounts for 99% of all GMX operations. They have only 5 years of drilling locations based on 40 acre spacing. If spacing increases with horizontal drilling, GMX acreage could be drilled out in just a few years. Not exactly a long term growth story.

GMX has a very technical presentation (pdf file) on their website regarding their CV play. They are experimenting with longer lateral lines and up to 8 stage completions, pretty risky business. They call their acreage, “the hole in the donut.” If GMX is the “hole,” then Comstock is the “donut” with acreage surrounding GMX. Actually, the real “hole” at GMX may be a $50MM shortfall in their 2007 cap-ex budget.

Goodrich has a much larger acreage position, but has significant problems with saltwater in many of their wells. Acreage with water disposal problems may not be amenable to horizontal drilling, at all.

As Ms. Davis points out, Comstock’s acreage has been significantly “under engineered.” It has mostly been developed (or has locations identified) on much larger spacing per well. So horizontal drilling would not reduce their potential drilling locations. The same is true for EXCO’s acreage. In addition, older producing wells in some areas could be candidates for re-entry using horizontal drilling or other re-completion methods. By using existing bores, drilling and connection costs could be reduced substantially. Comstock acreage also has little or no saltwater disposal problems.

So, is there really a problem with Comstock taking a wait and see attitude towards horizontal drilling, as Chernoff claims? Is this a “lack of focus” or just a conservative approach to long-term development in East Texas?

Boone Pickens and Doug Miller at EXCO apparently don’t think so. They are taking the same view as Comstock.

EXCO and Comstock have experienced management teams that produce long-term results for shareholders by balancing risk with reward. Both companies have over 150,000 net acres in the Cotton Valley. It is far from certain that all of the Cotton Valley will produce economical horizontal wells. Some expensive mistakes will likely be made. The service companies are providing the technology and will share their results with all their customers. So, this is clearly an acreage play. The fact that XCO and CRK are letting other companies do the early horizontal drilling and prove up the completion methods hardly seems imprudent. At $5-6MM or more per well, miscues will be costly.

For those looking to play the Cotton Valley, go with the acreage and the better management at EXCO and Comstock.

XCO-CRK 1-yr comparison chart:

XCO-CRK 1-yr comparison chart

Disclosure: author is long XCO and would be a buyer of CRK at $30. He has no position in any other stocks mentioned in this report.