The Prospect Quality Issue Takes Another Turn

Abstract: To hear most E&P firms talk, the North American natural gas industry is prospect poor these days. But those same firms want you to invest in their stock because their portfolios contain really good prospects.

Analysis: With apologies to the late, great Waylon Jennings, this prospect thing has done got out of hand.

To review briefly, the prospect issue--meaning questions over the availability of attractive exploration or development targets typically in association with natural gas--first surfaced in 2001, largely promoted by the large independent exploration and production (E&P) companies in their discussions with the investor community.

As an abstract issue, no one cared about prospect quality until the last few months when colder than normal weather in gas-consuming regions of the country siphoned away the natural gas surplus, placing the industry in a potential short supply scenario for next winter.

Like the natural gas markets, the prospect quality issue has undergone evolution over the last two years. Initially, E&P companies cited prospect challenges as a euphemism for lack of access to potential natural gas resource areas in the Rockies and the restricted offshore areas in the eastern Gulf of Mexico or along the Pacific and Atlantic coastlines.

Subsequently, the "lack of quality prospects" issue morphed into a challenge facing larger independent E&P firms who found themselves in the same position as the major oil companies a decade earlier. Namely, once companies reach a certain critical mass, typically through mergers and acquisitions, it becomes difficult to generate anything more than single-digit returns on capital investment. In the late 1990s, this was a scarlet letter for corporations seeking investors who believed that a 15 percent return on capital was the norm in business, regardless of scale.

The majors solved the problem by divesting U.S. properties and high-tailing it overseas. Now the large independents appear as though they may be forced to do the same because of "lack of quality prospects" in the North American natural gas market.

Most recently, lack of prospects was one reason E&P firms weren't drilling for natural gas in 2001 even though commodity prices were quite high.

Obviously, the prospect issue is one of continuous permutation. This was evident in two events held in New Orleans last week. The first was the 31st reenactment of the venerable Howard Weil Energy Conference. The second took place across Canal Street from the Howard Weil conference where the Gulf Coast Energy Marketplace--essentially an exposition for oil and gas prospects--was taking place. Each forum focused in its own way on the prospect issue.

It was apparent at the Howard Weil conference that what was termed "lack of quality prospects" last summer has now evolved into the phrase "prospect poor." And while many companies alluded to the oil and gas industry as being "prospect poor" in general, the message to the 358 institutional investors at the 31st Howard Weil conference was that each E&P company represented a golden investment opportunity because that company was undervalued in relation to commodity prices and "prospect rich" in a tightening natural gas market. E&P company CEOs presented a mind-numbing parade of slides detailing proved, undeveloped properties that had undrilled locations in the aggregate mounting into the thousands, literally, over the next five years. Indeed, several companies alluded to being in the sweet spot--the industry's latest buzzterm--either through the macroeconomic trends in the natural gas industry or because of a company's geological or technological prowess in an individual play.

The underlying message at Howard Weil echoed the old Prairie Home Companion radio program about Lake Wobegon where all the children are above average. Operators were almost giddy in noting large increases in free cash flow from the current commodity price environment, a beneficial circumstance that would allow them to increase capital spending for E&P work and direct funds towards balance sheets that wobbled out of kilter because of mergers, acquisitions, or related reasons when the last cycle expired.

The message was a little different at the two-day Gulf Coast Energy Marketplace across Canal Street from the Howard Weil conference. That event, sponsored by Houston-based PLS, Inc., is one of several regional expositions held each year to bring together buyers and sellers of oil and gas properties and present a forum for prospects. Here the issues involved the wide gap between an abundance of prospects in oil and gas and potential purchasers/underwriters.

Discussions with expo attendees reveal there are plenty of quality opportunities, though many languish because of marketing challenges. It seems that prospects are the orphans of the oil and gas industry. There is no clearinghouse in the industry to screen prospects for technical merit. Nor are there methods for generating data for capital markets that track the success rates for prospects and thus open the doors to financing. As a result, quality prospects remain in a state of suspended animation because of credibility issues and capital constraints.

Prospect marketing also takes a distant back seat to the acquisition and divestiture business where more than 40 firms nationwide handle packaging, marketing, and sales for oil and gas properties.

Currently, the major method for marketing oil and gas prospects involves the traditional shoe leather approach where prospect generators go door-to-door with projects. The other method involves the oil and gas exposition forum, which gained momentum in the 1990s. Today, exposition forums include entities such as North American Prospect Exposition, sponsored by the American Association of Professional Landmen, as well as privately organized regional gatherings such as the one PLS, Inc. hosted in New Orleans. Expositions tend to be restricted to certain time slots on an annual basis while prospect marketing remains a 24/7 reality in the oil and gas industry.

Clearly, the prospect issue is rife with complexity. There is little doubt after visiting both events that there are plenty of prospects out there. On the other hand, the natural gas industry faces accelerating decline rates and smaller reservoir sizes for newly drilled gas wells--essentially an erosion in prospect quality. Taken as a whole, the industry experienced a phenomenon in 2001 where vastly increased rig counts and capital investment produced the smallest of incremental impacts on the natural gas decline curve.

So how does the industry reconcile the opposing trends? It may be a case of defining optimists and pessimists. It appears North America may be arcing over the top of the parabolic natural gas production curve. As such, peak production represents the point in the long-term cycle where approximately half the resource volume remains. So an industry can be growing prospect poor from a macroecnomic standpoint--essentially a glass half empty--even while it appears to be prospect rich--or a glass half full--in the eyes of the individual entities who seek entrepreneurial ways to monetize the remaining resource.