Arena Resources developing core assets in Permian basin

EDITOR’S NOTE: Founded in 2000, Tulsa-based Arena Resources has aggressively sought to acquire long-life properties, primarily in the Permian basin of West Texas and eastern New Mexico. In the past couple of years, Arena has made the transition from acquisition to development and enhancement of assets in this core area. CEO Tim Rochford recently took time from his schedule to talk with OGFJ.

OIL & GAS FINANCIAL JOURNAL: Arena Resources grew significantly during the past year. Fourth-quarter and year-end financial results look very good. Are you satisfied with the progress the company has made, and what are your goals for 2008?

LLOYD T. (TIM) ROCHFORD: Oh, absolutely. Not only for the fourth quarter but for the entire year. We’re very pleased. We sustained growth in areas of production, revenues, earnings, cash flow, and reserves. And our profitability index has far exceeded what our initial expectations were in the early part of the year and we now have a PV10 value just under $2 billion.

2007 has been not only a year of growth, but also one of transition. Whereas in the past, much of our emphasis has been on acquisition as well as development, clearly now the emphasis has shifted to the development side of the ledger. That’s not to say that we’re not evaluating opportunities, because we are, particularly those that complement our existing core properties. That said, we’re now in full-scale development and enhancement of the assets we own.

Our first full year of operation was 2001. If you look back at the posture of the company, the first few years were really about acquiring good, key assets. Not really developing – we did short-term enhancement – but development really never kicked in until late ’04 and early ’05. As a matter of fact, as we started ’05, it was the first year we has a true, formalized capex program.

So the first few years, we were focused on acquiring solid assets. Since then we’ve really been doing both development and acquisitions at the same time. But ’07 really was a transition year because it was the first year we’ve been in a full-bore development mode.

I’ll share with you some of the things we accomplished during the year. We started the year with two drilling rigs operating at our Fuhrman Mascho property in Andrews County, Texas. We began acquiring these Permian Basin leases in West Texas late in ’04, and moved in our first drilling rig, a contract rig, in April of ’05, and now we have three rigs running, two of which are company owned.

Last year we drilled 133 wells, and this year we’ll drill close to 220 wells, so this is a key project for us. It has been just amazing how this property has evolved. As we finished ’07 and started putting together our budget for ’08 and we looked at the development potential at the Fuhrman Mascho, we had somewhere in the neighborhood of 1,600 potential primary drilling locations of which we’ve booked less than one third. That is, fewer than one-third have been booked as PUDS. So you can see there is an enormous amount of upside as far as future growth

We will probably add a fourth rig and accelerate work in Fuhrman-Mascho, but even then it will take years to complete the development in our current properties.

OGFJ: Are these long-life properties?

ROCHFORD: Yes. The Permian basin has a history of long-life properties. The wells we acquired in ’04 were producing about 200 to 300 bbl/day and are an average of 20 to 30 years old, so you can appreciate that they are truly long-life.

But, to sum up ’07, I couldn’t be more proud of the results we achieved and when you look at the opportunities lying ahead for Arena, it’s pretty bright.

OGFJ: How important a step was Arena’s listing on the New York Stock Exchange? Can you explain how this enhanced shareholder value, stock liquidity, analyst coverage, etc.?

ROCHFORD: It was a very important step; it increased our exposure. It really gave us the opportunity to open the door to additional institutional investors. It’s increased our daily volume and as a result our liquidity has increased as well. And the credibility of being listed on the NYSE just speaks volumes. We couldn’t be happier with the results so far. Our specialist there has done a great job. Our analyst coverage really expanded since we made the move. At the end of the day, when you look at a market cap that now exceeds $1.5 billion, we think going to the NYSE had a lot to do with that.

OGFJ: How many analysts follow your company?

ROCHFORD: Currently we have nine.

OGFJ: You say that you have evolved into a $1 billion-plus company. In your view, does that take you out of the small-cap category and into the mid-cap?

ROCHFORD: That’s a very good question. My knee-jerk reaction to that is no – we’re still small cap. However, I think in certain groups that $1 billion is sort of the measurement, and in others it’s $2 billion or greater. So it depends on who you’re talking to. I continue to think of Arena as small cap.

OGFJ: Is it a fair characterization to say that Arena Resources today is primarily a development company – that you’ve moved on from being an acquisition company to development and enhancement of current properties?

ROCHFORD: Early on, Arena didn’t have the capital or the financial backing that we have today, so we had to operate very cautiously. From 2001, when we first became operational, right up through ’04, it was about building our assets and building our cash flow. By the end of ’04, our cash flow had reached a level where we thought we had the resources to start our official capex program for ’05. That kind of dovetailed into a couple of significant acquisitions in ’04. One was our Hobbs project in New Mexico and the other was the Fuhrman-Mascho that I mentioned earlier. We finally had the cash flow to start developing those properties.

Throughout ’05 and ’06 we continued to look for acquisition opportunities. We did close on a number of good assets, and as we entered ’07 we really moved into high gear as related to development. But ’07 also brought along a couple of nice acquisitions as well. In fact, we closed on a significant acquisition in Dec. of ’07.

However, in the absence of any acquisitions in the immediate future, we are well positioned for years to come to grow this company – both in reserves and production. Having the resources to do that makes it all possible.

OGFJ: A lot of Arena’s production is oil. It doesn’t hurt that crude prices are well over $100 a barrel, does it?

ROCHFORD: Boy, it certainly doesn’t. About 85% of our production is oil. The same percentage for our reserves as well. Truth be told, we followed the path of least resistance in the early years and bought the best properties available. It could have been gas or it could have been oil. The affordable opportunities at that time happened to be oil.

At the time we were acquiring properties, back in ’01 through ’04, natural gas properties were in vogue. We tried to stay in an area where we had a footprint and where we had relationships, from an operational standpoint as well as contacts. This led us down the oily path, so today we look like we are geniuses.

OGFJ: Are all your properties in Texas, New Mexico, Oklahoma, and Kansas?

ROCHFORD: That’s right. Although our company is headquartered in Tulsa, we were trying to stay in the mid-continent. We have good producing properties in all four states but are focusing more on the Permian basin, specifically West Texas and Southeastern New Mexico.

OGFJ: Is Arena engaged in any enhanced recovery projects?

ROCHFORD: We have initiated the early stages of secondary recovery through waterflood on a couple of properties in New Mexico and Oklahoma.

OGFJ: How about unconventional gas or oil?

ROCHFORD: No, we’re 100% conventional.

OGFJ: How many acres do you have under lease in the Permian basin?

ROCHFORD: At present about 30,000 acres, but by the time this appears in the May issue, we should be well north of 33,000 acres. As I said before, Fuhrman-Mascho is our main producing area and we have a great infrastructure in place, not only from a fixture standpoint but from a staffing standpoint. Hobbs, NM, right on the Texas border, serves as our operational headquarters in the area. From Hobbs, you can be on location at any of our Permian basin properties within an hour.

We had about 200 bbl per day of production when we first acquired the Fuhrman-Mascho properties. Today the company is netting well over 5,000 bbl per day in that area. Since we first started drilling in early ’05, we have drilled more than 300 wells. And we have speeded up the process. In the first quarter of ’08, we will have drilled right at 55 wells. For the year, we’ll drill about 220 wells. By comparison, last year we drilled 133 wells in the Fuhrman-Mascho. We have 500 PUDs (proved undeveloped) sites and well over 1600 potential locations. Less than one third have been booked.

OGFJ: Are you the largest leaseholder in the Fuhrman-Mascho?

ROCHFORD: We are now. Range Resources and Encore Acquisitions are also active in the area. We have now exceeded those companies in daily production as well.

OGFJ: What formations are you drilling in?

ROCHFORD: The primary formation is the San Andres, and we are drilling to a depth of about 4800 feet. At about 3000 feet, we have a formation called the Yates, which is 100% gas. But it’s a high nitrogen content gas, and until very recently, developing or producing that gas didn’t make a lot of economic sense. Recently, we entered into an arrangement with a third party that is bringing in a 40-mile pipeline from Odessa up to our project, the Fuhrman-Mascho. We’ve entered into an arrangement to develop the Yates gas and market it through their pipeline – and at very favorable prices. However, we won’t see the results of that this year. What will be taking place in ’08 is that we will be preparing wells so that when that pipeline does arrive in late ’08, we’ll be in a position in the early part of ’09 to start marketing that gas.

When the Yates comes on line it will have a significant impact on our total production, as well as add substantial proven reserves.

One of the things that will happen is that it will boost production immediately in addition to what we’ve already established there. And, secondly, it will add to the reserve component substantially.

When people ask me about Fuhrman-Mascho, I tell them it’s a gift that just keeps giving.

OGFJ: Who will you market the gas to?

ROCHFORD: Our arrangement is with a company called Aspen Pipeline, which is based in Houston. They have entered into a contract with an end user, which is a power plant that is 100% gas fired.

OGFJ: Have you slowed down on the acquisition front, or will Arena continue to look at new opportunities?

ROCHFORD: Well, we have turned the corner and entered into a stage where we will concentrate on the development of our assets. By no means will we walk away from the right opportunities on the acquisition side, especially those that are in our back yard, so to speak, compliment our existing properties. So we continue to look at other assets. Right now, I’d say that we are taking a close look at half a dozen projects that are potential acquisitions for us. Fortunately, there is no sense of urgency on our part. We have ample properties to develop right now.

OGFJ: You mentioned that you are currently running three rigs in the Fuhrman Mascho – two company-owned and one leased. Considering all the upside potential you just mentioned, do you plan to increase the number of rigs?

ROCHFORD: As I mentioned before, it is likely we will add a fourth rig at our Fuhrman Mascho property before year end. This year we will have four, five – even six rigs running company-wide at the same time.

OGFJ: Are you partnering with anyone anywhere?

ROCHFORD: We haven’t, but that isn’t to say we aren’t open to it, particularly now that the company has grown and matured. We’re going to be looking at partnership opportunities, such as on the exploratory side. We’ve become open-minded about this.

OGFJ: Would you be the operating partner in such a venture?

ROCHFORD: In most cases. We’ve been approached by some groups with good acreage and good positions in the Permian basin, but they don’t have the operations experience that we have. We’re considering involving ourselves in something like that. Under the right circumstances, we’d also be open to participating in the right project as a non-operator.

OGFJ: Can you provide a little information about your management team and their experience?

ROCHFORD: The team that we have assembled is just outstanding. Let me begin with Phil Terry, our President and COO. He’s been with us over five years and just this past year we added “President” to his title. Phil has over 37 years of industry experience, primarily in the mid-continent, covering everything from engineering and drilling to property evaluations and corporate management. I can’t say enough about the job Phil has done for us. Randy Broaddrick, CFO, was the first person we hired in September ’01. Randy has done a great job managing our financial needs and reporting.

In the latter half of ’07 we were very fortunate to have Craig Gaines, VP of reservoir engineering and acquisitions, Tom Wahl, VP of our land department, David Ricks, VP of operations and Pat McConn, VP of geology and exploration join our Tulsa-based management team. All of these gentlemen have 25-35 years of industry experience in the mid-continent and Permian basin and are outstanding additions. H. D. Haston is general manager of our drilling company, Arena Drilling Company. H.D. has decades of drilling experience in the Permian basin and has done an excellent job overseeing the operations of our two company-owned rigs.

A very key individual for our field operations is Danny Palmer. Danny heads up our Hobbs, NM office and services all our Permian basin assets from there. Along with these great people, we have a wonderful support staff. We wouldn’t be where we are today without this outstanding group.

At year-end ’07, we were right at 86 employees. As we speak, we are into the 90s, so we continue to be highly selective and are bringing on board highly competent people.

OGFJ: What is your capex budget for the coming year?

ROCHFORD: We actually announced our initial capex budget of $218 million in January. It does not include any funds for future acquisitions. If you look at our history, you will see that it wouldn’t be unusual to see us adjust that as time goes on. So we’re starting off at $218 million, and that includes the budgeting and drilling of 275 wells, 222 of those specifically in the Fuhrman-Mascho. In addition to that, another 65 workovers of existing wells – converting some of those wells to water injectors in specific areas. We’ll be converting existing wells to water injectors in some areas, for example. Also, this includes some infrastructure upgrades and finally, we’ll also be re-completing another 90 existing wellbores in preparation for our Yates project that will begin production and marketing in early ’09.

OGFJ: How liquid is the company’s stock?

ROCHFORD: Our liquidity has continued to improve since we’ve moved to the NYSE. However, what I think was really important for us was the stock split last year. Our volume. . .our 30-day average is greater than half a million shares. Before we moved to the NYSE, it was 150,000, maybe 200,000 shares.

OGFJ: What could happen to prevent Arena from meeting its objectives this year?

ROCHFORD: Well, there are areas that you can’t control, such as the availability of services, costs related to that, and certainly commodity prices. There is the possibility of regulatory changes that can always influence how well we do. However, that said, I don’t see any element out there that will have a major negative impact. If oil were to fall back to, say, $50/bbl, that could have a dramatic impact, psychologically if nothing else. But our fundamentals are so strong, Don, I don’t foresee anything in the immediate future that could have a serious negative affect.

“Without a heavy debt component, we aren’t required to hedge our production, allowing us to sit back and evaluate. However, when you can lock in a $112 ceiling and a $90 floor through ’09, it’s tempting. As attractive as that looks now, $112 oil may be something we’re looking back at in a few months.”
– Tim Rochford

OGFJ: Has Arena been affected by the current economic downturn or by the so-called credit crunch that has impacted some business segments?

ROCHFORD: As an oil and gas producer, we’ve benefited from the escalating commodity prices, particularly oil. The current credit crunch hasn’t had an impact on us right now, but that’s a possibility in the future. We have a strong banking group. We have a credit facility that’s in place -- $150 million with a $100 million base. And it is likely that will increase because that was based on our year-end ’06 reserve results. With our outstanding ’07 reserve results, we expect that both these amounts will increase. We have developed some excellent banking relationships over the years. If we need capital, we will first go to the credit facility, but if needs continue to grow, we know that we have the investment banking opportunities as well.

With the $218 million we’ve budgeted this year for capex, we could accomplish this with our cash flow and credit facility without raising further equity. I’m not suggesting this is what we want to do, but if need be, we could.

OGFJ: Do you hedge any part of your oil or gas production?

ROCHFORD: We implemented a small hedge in ’07 that runs through this year. It represents less than 20% of our overall production. We saw an opportunity to have an $80 ceiling and a $65 floor, and we thought it would be prudent to hedge a portion of our production based on this. At the time we did it last August, prices were going down, so it seemed like the right thing to do.

I guess the next question is – would we do further hedging? Without a heavy debt component, we aren’t required to hedge our production, allowing us to sit back and evaluate. However, when you can lock in a $112 ceiling and a $90 floor through ‘09, it’s tempting. As attractive as that looks now, $112 oil may be something we’re looking back at in a few months. We’re watching it very closely, and as we move along, we may put in another component of hedging. We’ll just play it by ear for now.

OGFJ: Do you have an advisor on this?

ROCHFORD: We talk closely with our banking people – both the traditional banking side and the investment banking side – and we lean on them for advice. We also talk to the analysts, and we’re all ears. We’re not the experts. We have a lot of expertise in the fundamentals that we do, but the bankers and analysts are tuned in to commodity prices. That’s why we’re more than willing to listen and benefit from their advice.

OGFJ: Looking ahead, can you gaze into your crystal ball and tell us what Arena Resources will look like a few years down the road?

ROCHFORD: With our inventory of great assets, we have an image of what we think is possible in terms of properties to exploit and develop. In addition to our Fuhrman-Mascho properties, which I have already discussed in some detail, we have another half a dozen great quality assets within the Permian basin. None of them are the size of the Fuhrman-Mascho, but they all have great growth opportunities, not only for primary development but for secondary development as well.

When we look at an acquisition opportunity, we try to look at it in different stages – primary as well as enhancement. Beyond that, we look at secondary recovery through waterflood, possibly even eventually CO₂. Every asset we own in the Permian basin is a candidate for secondary opportunities.

So as I look at the broad picture, I see continued growth for the next several years. We should grow our production by another 40% to 50% this year with a 15% to 20% growth in net proved reserves. I think we will continue to post numbers comparable to this for at least the next three years. The result: I think we could be looking at a company three years out that could more than double its current net asset value.

We’re very transparent right now, and it’s pretty easy to see where we’re headed. I see good things for years to come.

OGFJ: Thanks very much for your time, Tim.