Low-risk, high-return development wells help fund Energy XXI's ultra-deep prospects

OIL & GAS FINANCIAL JOURNAL: What is Energy XXI's core strategy? How do you differentiate yourself from other exploration and production companies?

JOHN SCHILLER: Energy XXI primarily is a shallow-water Gulf of Mexico exploration and production company. Since our start-up five years ago, we've executed a highly successful acquire and exploit strategy, which recently has been overshadowed by the high-impact exploration side of the business. So, while we consider ourselves one of the best acquire-and-exploit companies in the business, Energy XXI offers game-changing upside from our shallow-water, ultra-deep shelf joint venture, highlighted by the recent Davy Jones and Blackbeard West discoveries and the currently drilling Blackbeard East prospect. Still, we continually have to remind investors that our proven track record of low-risk, high-return oil and natural gas development should not be overlooked.

For example, take a look at our MitEnergy acquisition completed last December. In this case, we added 27 million barrels of oil equivalents (MMboe) to our proved and probable reserves at low cost, helping increase our proved reserve base 42% as of our June 30, 2010 fiscal year-end to nearly 76 MMboe, 64% of which is oil. The high oil percentage is by design, and further differentiates us from the predominantly natural gas peer group.

OGFJ: The ultra-deep shelf of the Gulf of Mexico certainly has captured the market's attention. The Davy Jones and the Blackbeard East projects represent two of the deepest wells ever drilled. Why are these projects so important, and can you provide us with an update?

SCHILLER: Each project is important for different reasons. Davy Jones is the first-ever Wilcox, or Eocene, discovery on the shelf. In February 2010, our partnership, which is led and operated by McMoRan Exploration Co., logged 200 feet of net pay at Davy Jones in multiple sands between 27,000 and 29,000 feet on a 20,000-acre structure, in only 20 feet of water. Geology 101 said these structures would be at unreachable depths on the shallow-water Gulf of Mexico shelf and that even if you could reach them, sand quality would make them uneconomic. Davy Jones is re-writing the text book and opens up an entirely new exploration frontier. That discovery well, on South Marsh Island Block 230, is awaiting completion equipment and is expected to achieve first production in October next year, less than two years from the initial discovery. That's light speed for a discovery this size, which we are estimating at 6 trillion cubic feet equivalent (tcfe), gross. We currently are drilling the offset well, which should confirm the continuity of the originally discovered sands as well as test deeper Wilcox and potentially Cretaceous objectives that could significantly boost the discovery's size. In addition, the offset well should collect all the pressure data, hydrocarbon samples, and cores needed to begin booking proved reserves at Day Jones.

Blackbeard East is part of the same ultra-deep-shelf play, but is targeting different sands, in the Miocene intervals. This prospect is syncline-separated from our very first ultra-deep discovery made in 2008 at Blackbeard West. Drilled to a total depth of 33,000 feet below mud line, Blackbeard West is the deepest oil or gas discovery in the world. Blackbeard East is part of the same "mountain range," so to speak, across a valley and up-dip to Blackbeard West, located in South Timbalier 144.

Shallow Water Facility Located at South Timbalier 21

The Blackbeard East exploration well commenced drilling on March 8, 2010, with a proposed total depth of 29,950 feet. As with Davy Jones, Blackbeard East – and in fact each of the 15 prospects McMoRan has already leased – has a pre-drill target in the multiple-tcfe range. Total potential already identified for the ultra-deep play exceeds 100 tcfe. And all of this is in shallow water on the shelf.

OGFJ: Energy XXI is a relatively small company. How did you gain access to these giant ultra-deep projects?

SCHILLER: We have a strong relationship with McMoRan, going back to my early career. Jim Bob Moffett is chairman and CEO of McMoRan, and in my opinion is one of the greatest geologists, if not the greatest geologist, in the industry today. The first venture between McMoRan and Energy XXI was in 2007 when Jim Bob called to offer an interest in the Laphroaig prospect, onshore Louisiana. His partner had abandoned the drilling effort and he convinced our team that the well was just above the intended target. We took the deal, and less than two weeks later we logged a significant gas discovery with nearly 30% porosity below 19,000 feet. That defied the text books on the quality of pay you could expect at those depths. That eye-opening experience, along with the cash flow from the well – 40 MMcf/d of gas, steady for the first 18 months of production – helped convince us to enter the ultra-deep shelf play later that year when McMoRan purchased the shelf properties from Newfield Exploration, including most of their interests in the so-called Treasure Island ultra-deep play. Our first attempt was Blackbeard West, which had previously been drilled to roughly 30,000 feet and abandoned. We re-entered the well in April 2008 and drilled it to 33,000 feet by October, logging multiple hydrocarbon-bearing sands. Just as important, the wellbore gave us the data needed to re-calibrate our seismic picture, serving as the "missing link" between the industry's many deepwater discoveries and onshore discoveries. Those seismic ties led us to the Davy Jones discovery and further validated the Blackbeard East prospect.

OGFJ: What's next on your ultra-deep-shelf agenda, and what other projects are you working on?

SCHILLER: The Lafitte prospect is next on our list, with a very similar set-up to Blackbeard East, and is scheduled to begin drilling within weeks. What we learn from those two wells will help determine where we go from there. While our ultra-deep projects generate a majority of the headlines, Energy XXI's low-risk producing properties in South Timbalier 21 and the Main Pass and South Pass areas continue to be our bread and butter assets. About $190 million of our $250 million fiscal 2011 capital program, which began July 1, is targeting our core producing properties. The program is well underway, unhampered by the regulatory issues stemming from the Macondo blowout, with about 4,000 boe/d of production already pending start-up in the coming months. Production growth this fiscal year should exceed 25%, none of which relies on exploration success, and most of which is targeting oil. We do, however, have a portfolio of exploration prospects identified on our core properties that we plan to test in the coming months, including the exciting sub-salt Crete target at South Timbalier 21, which we estimate could hold as much as 100 MMboe of recoverable hydrocarbons. Energy XXI has a 100% working interest in the prospect, so it clearly could be a meaningful event.

OGFJ: Does new technology play a significant role in your drilling efforts?

SCHILLER: Actually, the techniques and technology used in both our core program and the ultra-deep-shelf efforts haven't really changed much during the past decade. What has changed is the interpretation of the seismic, which has changed our basic view of the geology. We're re-working the geological picture below 25,000 feet on the shelf, and what our McMoRan-led partnership has learned in that effort is also being applied to Energy XXI's core properties, particularly in relation to our modeling against and below salt. That's not to say drilling ultra-deep wells is easy. It's not. But our partnership has proved that it can be done, it can be done safely, and the economics appear to be robust. The Gulf of Mexico shelf may be about to re-assume its historical position as the lowest-cost natural gas producing region in North America.

Shallow water facility located at Main Pass 61.

OGFJ: How much do the ultra-deep wells cost, and what are the project economics?

SCHILLER: These projects and wells are not for the faint of heart. Our costs to drill and complete each well are initially expected to average $150 million, which should drop as we enter full development, with each yielding approximately 150 bcfe. Importantly, facilities costs are minimal, since most infrastructure is already available on the shelf and whatever else is needed is easy to add in shallow water. Our break-even gas price at Davy Jones is estimated at $2 per Mcf if it's dry gas, and well below $1 per Mcf with even a modest amount of condensates.

OGFJ: How are you funding these projects?

SCHILLER: Great question, since too many people believe a small company like Energy XXI can't internally fund such a high-profile project. But the fact is, our oil-focused development program continues to drive strong results and deliver industry-leading margins and cash-flow that is expected to be sufficient to fund the entire capital program, including ultra-deep, with discretionary cash left over. As currently set, our interest in each ultra-deep prospect will be 20% or less, which is manageable from a funding perspective yet large enough to have a big impact on future reserves and production.

OGFJ: With so much on your plate already, is Energy XXI out of the market for additional acquisitions?

SCHILLER: Absolutely not. There are some very attractive property packages coming to market right now. We will look at all the ones that fit within our wheelhouse and do our best to continue our streak of highly economic acquisitions. We would like to maintain at least a 50% oil weighting, which means we will need to acquire oil properties if we start significantly boosting gas reserves through the ultra-deep-shelf program. Ideally, we prefer to give shareholders a chance to see initial results at Blackbeard East and the Davy Jones offset wells and would have positive results at both wells before year-end and could then issue stock with something higher than a 2-handle on it in order to fund a material low-cost, oil-weighted producing property acquisition. That's how I would draw it up if I could plan the future. That is our vision for the future.

Thank you for taking the time to talk with us.

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