M&A action heats up thriving Kansas-Missouri CBM play

Sept. 1, 2004
Coalbed methane production in Kansas has been quietly expanding and prospering in recent years because of escalating US prices for natural gas.

Sam Fletcher
Senior Writer
Oil & Gas Journal

Coalbed methane production in Kansas has been quietly expanding and prospering in recent years because of escalating US prices for natural gas.

The burgeoning play is attracting independents large and small alike—and even spawning new companies.

Early drilling activity was primarily in the Cherokee basin and adjacent Bourbon Arch (OGJ, Dec. 23, 2002, p. 36), but the play now has expanded into the previously ignored Forest City basin.

In 2001, Oklahoma City-based Devon Energy Corp. drilled 125 CBM wells in the Cherokee basin, which stretches from southeastern Kansas into southwestern Missouri and northeastern Oklahoma. Since then, annual unconventional gas production in Kansas has doubled to just over 9 bcf in 2003.

"That kind of production attracted a lot of attention, and some of the biggest players in coalbed methane quickly moved into the play, leasing up large land positions in the Cherokee and Forest City basins," said analysts at NaturalGasStocks.com, an online stock research portal that's part of ECON Investor Relations Inc. "Three years on, the land rush is largely over, but the mergers and acquisitions rush is in full swing."

Click here to enlarge image

Two independent producers, Heartland Oil & Gas Corp., Vancouver, BC, and Petrol Oil & Gas Inc., Las Vegas, Nev., were created in recent years specifically to focus on development of CBM in the Forest City basin of eastern Kansas and western Missouri.

Early entry

Heartland was an early entry, acquiring 252,000 acres around its Soldier Creek project in what is believed to be the thickest part of the coal fairway in the Forest City basin at lease costs as low as $1/acre, said Richard L. Coglon, company president.

Heartland began operations in spring 2001 when Adriatic Holdings Ltd., a publicly listed Nevada firm, completed its analysis of the prospective Soldier Creek project. Adriatic subsequently advanced $1 million to Heartland, with an eye toward making it a wholly owned subsidiary.

Heartland and Adriatic also raised more than $2 million for the Soldier Creek project through sale of shares and a convertible debenture. In 2002, the two completed a reverse takeover through a stock exchange. The new company, Heartland Oil & Gas Corp., oversees the operating subsidiary Heartland Oil & Gas Inc.

Heartland concentrated its leasing activity along a fairway containing a thick section of lower Cherokee coals, which are the primary producing coals throughout the basin. It acquired more than 167,000 acres before the play "attracted some interest from bigger players," Coglon said. "Because of our early entry, we picked up the best acreage. Later participants spent up to $100/acre."

He said, "Evergreen [Resources Inc., Denver] picked up 500,000 acres that wrapped around us." As a result, Heartland is not pursuing additional leases. Instead, its focus is to develop aggressively its existing CBM leases. "Our short-term goal is to complete the dewatering and get production from our first wells," said Coglon. "Long term, we want to prove up our assets and find some major interested in taking us over."

Heartland has drilled and is completing three pilot programs consisting of 15 CBM wells and three saltwater disposal wells. It also drilled two additional CBM wells on its initial Engelke five-well pilot program in Nemaha County, where it earlier encountered some of the thickest coal sections in the basin. As they are completed, wells will be tied in immediately to disposal wells to begin the dewatering process.

With no production as yet, Heartland incurred aggregate losses of $1.7 million from inception through 2003, including a $1.2 million loss from 2003 operations.

"There is no assurance that we will operate profitably or will generate positive cash flow in the future," the company said in its annual report. "If we cannot generate positive cash flows in the future or raise sufficient financing to continue our normal operations, then we may be forced to scale down or even close our operations. Until such time as we generate revenues, we expect an increase in development costs and operating costs. Consequently, we expect to incur operating losses and negative cash flow until our properties enter commercial production."

It added, "Our stock is a penny stock. Trading of our stock may be restricted by the SEC's penny stock regulations, which may limit a stockholder's ability to buy and sell our stock."

As of July 31, Heartland had working capital of $6.5 million with $2 million allocated for completion of the recently drilled 17 new production wells.

The balance will be used for ongoing development of the Forest City basin project and for general working capital.

Heartland valuation

With no publicly traded peers focused solely on CBM in the Kansas area, Heartland did a share price valuation on its web site comparing itself with Pennaco Energy Inc., which was acquired in 2001 by Marathon Oil Co. for $500 million in cash and debt.

"In July 1998, Pennaco was at a similar development stage as Heartland Oil & Gas," the company said, although natural gas prices at that time were much lower, trading at $1.61-2.72/Mcf on the New York Mercantile Exchange. "Like Heartland is now, Pennaco was in the midst of a major CBM lease acquisition program" in Wyoming's Powder River basin, to which pipelines "had yet to be built," the company noted.

By the end of 1999, said Heartland officials, "Average reserves per well for Pennaco's Powder River area were projected to be around 300 MMcf, with a drill-and-complete cost of $50,000 on an 80-acre spacing. This figure does not include the cost of water disposal or operating costs, as does the Heartland estimate.

"In comparison, Heartland's reserves, according to the Schlumberger [Ltd.] model, are projected to be from 761 MMcf (base case) to 1.9 bcf (potential case) with a per-well cost (including water disposal) of approximately $200,000-250,000—with substantial downward revisions anticipated as actual development is rolled out. Drilling and completing costs are roughly $100,000.

Click here to enlarge image

"Significantly, unlike Pennaco, the gas price environment for Heartland is far more positive in terms of both futures markets and locally as Forest City basin pipeline access is readily available and gas markets (Kansas) are close by."

Petrol Oil & Gas

Petrol is drilling in areas that are cost-efficient and in proximity to existing production to reduce economic risks.

Paul Branagan, president, CEO of Petrol Oil & Gas Inc.

Paul Branagan, president, CEO of Petrol Oil & Gas Inc.

Click here to enlarge image

"We identified CBM early on as an area that was gaining recognition as a viable source of natural gas and was experiencing above-average growth. We focused our attention on the Western Interior basin, a CBM and shale-rich basin that is one of the largest CBM basins in the US," said Paul Branagan, Petrol president and CEO.

Branagan is a physicist who spent 30 years developing new technologies and techniques for unconventional gas production. He was recruited by the founders to head Petrol.

New technologies, some of which Branagan helped create, are making CBM production more practical and profitable, said company officials.

In 2001-02, Petrol leased 165,000 acres that "cover 9-10 counties from Kansas City on south and slightly west into Woodson County, with some acreage also in Missouri," Branagan said. "We put ourselves around interstate pipelines so that we can sell the gas as the wells begin to produce."

Click here to enlarge image

Of its acreage, 145,000 acres are in eastern Kansas and 20,000 acres are in western Missouri. Most of the Kansas leases are located in and around Coffey County, with additional acreage in Anderson, Osage, Lyon, Douglas, Franklin, Woodson, and Greenwood counties. Petrol also acquired leases in nearby Bates and Cass counties, Mo.

Click here to enlarge image

With CBM well spacing of 80 acres, Branagan said, "We currently hold enough acreage to drill and complete in excess of 1,700 gas wells."

Petrol recently drilled five 900 ft exploratory wells in Missouri with good gas shows in several Cherokee coals. Completion costs averaged about $40,000/well.

In July, Petrol's Coal Creek project in southeastern Kansas became commercial with a multiyear contract for sale of CBM and other natural gas to Big Creek Gas Field Services LLC.

"Most of our field efforts this year have focused on establishing the gas reserves within our Coal Creek project," said Branagan. "Petrol is now in the process of transforming from a start-up company looking to prove up its play to a true production and development company."

"Petrol's initial private placement did not provide sufficient cash for extensive drilling of production wells. To raise money for additional drilling, the company is looking to sell working interests in the results of wells to be drilled," said analyst Joe Blankenship at Source Capital Group Inc.

Moreover, Blankenship said in an April report, "Our modeling of prospective results of target wells in the area of development indicate that the economics of drilling would support the partnerships favored by the company or the issuance of additional equity. The low cost of drilling and completion and the close proximity of transmission pipelines indicate that individual well economics would provide for a return of capital within 12-18 months, and the resulting cash generation would provide a substantial return to investors."

Branagan sees $4-4.50/Mcf as the new price floor for natural gas. But Petrol's CBM operations in Kansas and Missouri "could still survive" on prices of $2.50-2.75/Mcf and even "squeak by on a shoestring" at $2.10/Mcf, he said.

'Great play'

The Forest City CBM play "was really undervalued back when the price of gas was depressed, so there was not much leasing. At $2/Mcf, this is not a great play, but at $5-6/Mcf, it's a great play," said Branagan. "Everything indicates that we have as good a play as the producing CBM areas to the south. Coal beds are there, gas content is there, dewatering is there, and infrastructure is there."

What's more, he said, "This country is beginning to understand the need for the US to reduce its reliance on imported petroleum products and is now willing to support companies that can show a way to do that from relatively untapped domestic resources, such as CBM."

Heartland lists several economic factors favoring CBM production from its Soldier Creek project:

Major gas lines in the area are operating at 50% capacity, translating to a ready market for Forest City basin gas, often at premium prices.

The area's flat and sparsely populated ranch and farm land makes transportation and access inexpensive, and property owners are receptive to development, minimizing surface access costs.

Less than 1% of the area is Indian or federal land, resulting in minimal federal regulation.

An equipment surplus and competitive business environment further reduce drilling and completion costs.

An abundance of depleted wells simplifies and reduces the cost of water disposal from dewatering coals, as wastewater is often reinjected into depleted wells.

Local CBM is "sweet" (low in sulfur), requires minimal processing, and can go straight into the pipeline.

An "excellent" royalty structure is typically 12.5%.

Other participants

In 2002-03, Denver-based Evergreen Resources Inc., a leading developer of CBM in Colorado, acquired more than 700,000 gross acres of prospective unconventional natural gas properties in the Forest City basin.

Evergreen drilled and completed 18 CBM and 3 water disposal wells on that property in the fourth quarter of 2003, but pursued a more moderate exploration and development program in that basin in 2004.

Evergreen and Pioneer Natural Resources Co., Irving, Tex., recently approved a strategic merger valued at $2.1 billion, in which Evergreen will become a subsidiary of Pioneer. Completion of the merger is expected by October.

"But for some reason, Evergreen's massive CBM land position in Kansas is being spun off prior to the merger," said the NaturalGasStocks.com report. "Rumors are flying that Evergreen's CEO [Mark S. Sexton] still wants the play."

Quest Resource Corp., a small, experienced CBM operator based in Kansas, acquired Devon's Cherokee assets last December. The cash price of $126 million for Devon's total proved reserves of almost 96 bcfe meant Quest spent an average 89¢/Mcf, after allowing $40 million for undeveloped acreage and the 200 miles of pipeline that were part of the deal, said NaturalGasStocks.com analysts.