A case study in early-stage financing of an E&P company

P. Mark Stark
The Exploration Co.
San Antonio

Here are the parameters:

• You are an emerging public company with 23.5 bcfe in reserves as you complete your 2002 fiscal year.
• Your company has an extensive drilling inventory that will take years to drill up and therefore a huge appetite for capital.

• Your growth strategy is primarily organic and oriented toward focused exploration rather than acquisition and exploitation.

•  The company's tolerance for financial leverage is low given the nature of its assets and growth strategy.

•  The task at hand is to provide financing to grow the company while also growing shareholder value.

That was the assignment I accepted in 2003, when I joined The Exploration Co. of Delaware Inc., a San Antonio-based independent operating in the Maverick basin of Southwest Texas.

The challenges

The assignment raised several challenges.

Because the company is publicly held, with a large number of shareholders, its financing options differ from those of a private firm.

Private companies have ready access to private equity funds, which employ various holding-period strategies. Capital providers of that type look for an exit strategy-typically a monetization of assets through a strategic sale or a capital-market event such as taking the portfolio company public. Already being public removes one of those potentially strategic events important to private equity funds.

Size also is an issue. With 23.5 bcfe in proved reserves (28.4 bcfe at yearend 2003), a company can find itself too big for small-capital providers yet too small for large-capital providers. This is true for the whole array of prospective capital providers - from commercial banks, to equity funds, to investment banks. The trick becomes matching the capital provider to the size of capital seeker.

A third issue is business strategy. The acquire-and-exploit model is probably the easiest business model to finance. The starting point is a significant base of proved, developed, producing reserves with which to secure a senior bank credit line. There are many ways to support the expansion-exploitation phase through mezzanine financing, equity financing, and hybrids such as convertibles.

In our case study, however, the growth strategy is organic and exploration-oriented, albeit focused in a way that makes drilling more like development than pure wildcatting.

A fourth challenge is that the company's tolerance for financial leverage in the form of senior bank debt is relatively low. While this issue is largely self-imposed, I have never believed in subjecting an organization with such operational risks and operating leverage to the compounded risk of financial leverage. This may be largely because I am a survivor of the tumultuous 1980s. What is more, enthusiasm from financial institutions, especially senior bank lenders, has been tempered over the years. Senior bank lenders are becoming more aggressive in the current environment, but their approach is still case-by-case.

Appetite for capital

Into these circumstances comes a company with an extensive inventory of drilling targets that will take until the next decade to drill up and put on line - a company with a huge appetite for capital. How does such a company fuel growth at the least cost and to the greatest shareholder benefit?

I maintain that equity and hybrids such as converts, even though they represent a higher cost of capital, are the way to go.

In 1998, the company entered into a $4 million mezzanine financing arrangement with the independent- producer finance arm of what was then Domain Energy Corp. It used the funds to repay bank debt and to supplement capital for development drilling. Strong production growth and favorable product prices enabled it to retire this piece of financing a year ahead of schedule.

In early 2000, the company initiated one of its first private equity placements, selling 1.33 million shares in a private offering to a Swiss investment group. The offering carried warrant coverage of approximately 93% and a strike price premium of 33%. It generated approximately $3 million, which the company used to accelerate its Maverick basin exploration and development program.

The year 2002 encompassed two significant financing events. First, the company entered into a multiyear senior bank credit facility with Hibernia National Bank. The initial credit facility called for a master note amount of $25 million and an initial borrowing base of $5 million. This borrowing base grew to $14 million within 15 months of the facility's origination.

Next, the company was able to raise $15 million through another private equity placement. It sold about 2.5 million shares and used the funds to acquire a 70-mile gas pipeline system crossing the company's lease block. In addition, it used funds exceeding the purchase price of the pipeline to continue the drilling program.

Success and credibility

Operational success yields financial success, which builds credibility with the capital markets. The company had successfully raised capital a number of times when I joined it and earlier that year had announced its most ambitious capital expenditure program ever. It was again seeking capital - this time looking into the convertible preferred market.

After an extensive search, the company entered into a letter of intent with Kayne Anderson, a preeminent fund whose business strategy is, as it describes it, to "play in the middle of the balance sheet somewhere between debt and equity." This deal called for a private placement of redeemable preferred stock as well as 2.13 million common shares in return for $16 million. This allowed the company to finish its aggressive 2003 capital expenditure plan and prepare for 2004.

As we entered this year, we scaled capital spending down to a level that could be covered by expected cash flow. But as we implemented the 2004 plan, we completed processing new 3D seismic data on a 12-mile swath through the middle of a recent lease addition. The seismic identified 15 reef targets in the Cretaceous Glen Rose formation, on trend with similar reefs that provided a successful gas play for several years. We estimated we could expose the company to as much as 28 bcfe of reserves potential, and this was risking the projects by 50%.

These projects were too good to pass up, so we returned to the capital markets. By the end of May, we completed a private placement of stock and warrants. We were able to place 4.27 million shares of stock with 30% percent warrant coverage with a strike price premium of 13%.

Later, we completed a new senior bank credit facility. In this process, we were able to meet needs into 2007 with a master note amount of $50 million. This new facility, through the energy department of Guaranty Bank, provides interest as much as 0.25 percentage point less than our former credit agreement.

With these financings and capital raises in place the company is solidly capitalized and executing its plan. Our market capitalization exceeds $100 million now, compared with approximately $32 million in the 1998-99 timeframe - affirmation from our shareholders that the company has been correctly financed.

The author