Falcon’s COO describes financial milestones since inception in 2000

Edmund A. Knolle, Falcon Gas Storage Co. Inc., Houston

Falcon Gas Storage Co. has grown rapidly over the past five years by selectively acquiring high quality reservoirs in strategic locations to become the largest privately-held owner and developer of natural gas storage facilities in North America. Recently completing an equity recapitalization, the company now is in the process of fully developing these assets in response to strong market demand for storage services.

Falcon was founded in 2000 on the belief that the domestic natural gas infrastructure was not keeping pace with the growth in the weather-sensitive gas load. In our view, the market would demand a greater amount of operational flexibility, and these types of assets would command a premium in the market over the next 10 to 15 years.

By 2000, it was becoming clear that North American natural gas production was lagging behind the rapid growth in gas demand as gas emerged as the fuel of choice for space heating and new electric power generation. Increased consumption by residential and commercial end-users meant that the marginal demand for natural gas would become increasingly sensitive to short-term changes in weather patterns.

The predicted result was significantly greater price volatility and increased demand for storage and balancing services from high-deliverability, multi-cycle (HDMC) facilities that can more closely follow these rapid changes in load swings and commodity price movements. To be competitive, these facilities must offer customers the right balance of price, performance, and location.

There are significant physical and economic barriers to developing these types of assets. Storage reservoirs and HDMC reservoirs, in particular, must meet an exacting set of geologic criteria. A geologically suitable reservoir located near major pipelines, close to market centers, and downstream of transportation bottlenecks is a rare and unique asset that is difficult, if not impossible, to replicate for a competitive cost.

In our view, these barriers create a significant opportunity. Our primary objective was to quickly identify and acquire development options on unique prospects and operating facilities that could be expanded in a phased approach as demand for services increased in our respective markets.

Company history

Falcon was capitalized on Oct. 3, 2000, with a $5 million convertible note from Energy Spectrum Capital Partners. This seed capital would be used to evaluate and acquire previously identified HDMC prospects in the Northeast, plus additional prospects identified over time.

Our business plan anticipated raising additional equity capital as we achieved development milestones. Additional equity investors and debt financing would be required when funding needs grew beyond the $30 million investment available from Energy Spectrum. This would present the company with some interesting financing challenges as we continued to acquire additional assets during the turbulent energy market of 2002-2004.

Shortly after closing the initial round of funding, Falcon completed the purchase of the Worsham-Steed storage facility from Texas Utilities Fuel Company (TUFCO). TUFCO had recently sold the generating assets, which were served by Worsham-Steed, and was in the process of selling the remaining base gas.

Worsham-Steed was an attractive acquisition opportunity to us for a number of reasons. The reservoir is an old oil field that had been operated by TUFCO as a gas storage facility for over 20 years, and its geology makes it suitable for HDMC storage development. At 20 bcf, it is a sizeable reservoir with around 15,000 unitized acres, in what has now become the western flank of the prolific Barnett shale play.

Approximately 1,400 megawatts of newly built gas-fired generation is located within seven miles of the facility. All surface facilities and wells necessary to resume seasonal storage operations were in place and operational.

Finally, at the time of purchase, the reservoir contained approximately 1 bcf of base gas - not enough to support HDMC storage operations, but enough to pay for the acquisition and holding cost until market demand justified expansion to HDMC operations. Higher commodity prices and increased production of base gas and remaining oil reserves have paid for the acquisition several times over.

Second acquisition

In 2001, Falcon completed its second acquisition, purchasing the Hill-Lake storage facility from Lone Star Pipeline. Located in Eastland County, Texas, Hill-Lake has been operated as a storage facility since 1962 and is well suited for HDMC development. It is 16 miles north of two major transmission lines connecting the Waha Hub to newly built gas-fired generation serving the Dallas-Fort Worth area.

Falcon funded the Hill-Lake acquisition with an additional equity investment from Energy Spectrum and began the Phase I expansion immediately thereafter. Phase I expansions were funded with a combination of equity and an $8 million sale-leaseback transaction used to construct a 16-mile, 300,000 Mcfd, high-pressure pipeline connecting Hill-Lake to the 36-inch Lone Star Line “X” (now Atmos Energy Line “X”) and the 36-inch Gulfterra/TUFCO (now Enterprise Products/Energy Transfer Partners) North Texas pipelines.

The Phase I expansion was completed in early 2002, and capacity was fully subscribed by the winter. In October 2001, Falcon completed a $10 million “contango” credit facility with Bank One that allowed Falcon to purchase gas for resale on a fully-hedged basis.

In July 2001, the company successfully negotiated an option agreement with National Fuel Gas Supply Co. to evaluate, permit, and develop the depleted Wyckoff reservoir in Steuben County, New York. Wyckoff is a 10 bcf Onondaga reef and Oriskany sandstone reservoir located near several major interstate pipelines serving the Northeast market. The option agreement gave Falcon exclusive rights to evaluate and permit the reservoir for HDMC storage development.

Greyhawk JV formed

A month later, Falcon formed Greyhawk Gas Storage Co., a 50/50 joint venture with a Canadian utility to develop the Wyckoff and Jasper reservoirs in New York. Falcon contributed its development rights to Greyhawk, and its partner contributed $2.5 million in capital for 3D seismic acquisition and permitting. Greyhawk shot nine square miles of high-resolution 3D seismic across the reservoir in 2002 and filed its application for a Certificate of Public Convenience and Necessity with FERC by the end of the year.

During this same time, we continued to pursue other storage prospects in Texas, Colorado, Mississippi, Alabama, and the desert Southwest. We avoided competitive bid situations and instead focused on finding high-quality reservoirs in the best locations. In a two-year period, management screened more than 50 potential reservoir candidates including more than a dozen in the Southeast.

In 2002, Falcon identified four producing gas fields in the Mobile Bay area that are uniquely qualified for development as HDMC gas storage reservoirs. The reservoirs are located in approximately 12 feet of water in the Mississippi Sound between Dauphin Island and Coden, Ala. Initially discovered by ARCO in the early 1990s, the reservoirs had been substantially depleted and were being offered for sale as part of a mid-sized independent’s divestment package.

The asset package also included two offshore platforms, the largest of which was built for ARCO in the early 1990s to survive Category 5 hurricane conditions. The main platform is approximately 17 miles due south of Coden, where four major interstate pipelines serving the Southeast and Northeast converge, including Gulfstream, Gulf South, Florida Gas Transmission, and Transco (Mobile Bay Lateral). MoBay presented the opportunity to develop the largest, most easterly HDMC storage facility on the Gulf Coast and the only storage facility directly connected to the Gulfstream Pipeline.

Like Worsham-Steed, MoBay’s existing cash flow provided the company with the flexibility to develop the asset based on market demand, regulatory timelines, and funding availability. Falcon completed the acquisition in December 2002 with a $4.5 million term loan facility with Bank One.

Challenging times for midstream

By early 2003, the company, along with many others in the midstream sector, faced some challenging times as it sought to raise additional capital following the collapse of the energy merchants. Dealing with its own challenges, Falcon’s partner in Greyhawk elected to exit the storage development business.

Confident in both the long-term vision of the company and the ultimate potential of its assets, management responded by reducing costs, increasing oil and gas production, and incrementally expanding Hill-Lake’s capacity as cash flow and borrowing capability allowed. During this time, Falcon obtained FERC permission to develop the Wyckoff project and bought out its Greyhawk partner.

In January 2004, Falcon sold Greyhawk to SemGroup in order to raise cash and increase debt capacity for further improvements at Hill-Lake. The sale generated a 5 to 1 return on our investment in Greyhawk. Falcon also continued to benefit from increased demand for storage services, higher storage rates, and higher commodity prices. The company established a new contango facility with Bank of Texas.

In March 2005, Falcon used a portion of the Greyhawk proceeds to repurchase half of the Cisco Pipeline lease. The following month, the company expanded the term loan and the contango facility with Bank of Texas to $7.5 million and $12 million, respectively. In addition to a stronger balance sheet, Falcon now benefited from the investment community’s growing interest in storage assets.

Arcapita recapitalization

In early 2005, the company retained Simmons & Co. International to help recapitalize Falcon and raise the additional funding necessary to fully develop its North Texas assets and MoBay. In July 2005, the Arcapita investment group acquired 100 percent of Energy Spectrum’s ownership interest in Falcon and also invested an additional $35 million in common equity for expansions and new development.

The Arcapita transaction is truly a transformational event for Falcon. Arcapita provides Falcon with the financial strength necessary to fully develop our asset portfolio in order to meet the growing demand for the company’s services. Since 1996, Arcapita has completed transactions with a total value in excess of $8 billion, including more than $4 billion in the United States.

This winter, we will complete the Hill-Lake Phase II expansion, increasing injection and withdrawal capacity to 300,000 MMcfd. At Worsham-Steed, we will start a pilot waterflood program to test the feasibility of extracting an estimated 7 million barrels of recoverable oil reserves remaining in the oil leg of the reservoir. At the same time, we are ready to accept storage injections and will continue to closely monitor market demand for storage services in the area.

At MoBay, we are in the process of negotiating precedent agreements and plan to file our permit applications with federal and state authorities by early 2006. Storage service is planned for summer 2007.

Over the past five years, the company has benefited from the valuable expertise of its engineering, legal, accounting, and investment banking advisors. Our relationship with several key customers has also played a significant role in our success. Management is grateful for the support received from Energy Spectrum as we dealt with opportunities and challenges, and as we grew from concept to reality.

The company has a talented and dedicated team of managers, field employees, and staff supported by a large controlling shareholder that shares our long-term vision of the company and strongly endorses our growth plans. We are now well positioned to execute our business plan in full and look forward to working with Arcapita and our customers on new projects and future expansions. OGFJ

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