Energy’s Biggest Names Converge in a Tired, Old Place

Big things are happening in the Outer Continental Shelf-the shallow-water portion of the U.S. Gulf of Mexico.

Two critical-but under-appreciated-developments have just happened here. One that points to a paradigm shift in offshore development. And a second that shows how some of the world's most prominent energy investors are jumping to capitalize-even if the wider investment community hasn't picked up on the potential yet.

Event 1: We just got results for the first modern horizontal drilling campaign in the Gulf of Mexico Shelf.

You didn't hear about it, because these results came from a relatively new and unknown player in the E&P space: Energy XXI (Nasdaq: EXXI). This tiny junior drilled 13 horizontal wells in the shallow-water Gulf Shelf during the past year, completing 11.

The chart below shows why this is a critical development. Production results from Energy XXI's West Delta 73 field clearly show technical proof of concept for horizontal drilling in the offshore. The production adds from horizontal wells (shown in blue) have been significant.

Source: Energy XXI corporate presentation

The program is a technical success. But do the economics of horizontal drilling make sense in the offshore?

Energy XXI's recently-released reserves figures say yes. In fact, offshore horizontals work exceptionally well.

During the past year, Energy XXI spent $648 million on development drilling. Mainly the horizontal drill program. This spending added proved reserves of 61.8 million barrels of oil equivalent during the year. That's a very competitive $10.49 finding (and at least partial development) cost per BOE.

The company's reserve value (including produced cash flow during the year) grew by $2.7 billion -- against overall capital spending of $977 million. That means for every dollar the company spent, it created $2.76 in reserve value. That's ultra-profitable.

The success of this pilot drilling program is one of the most exciting developments in the offshore (and perhaps in the entire U.S. E&P sector) in years. But the future potential for offshore horizontals is even more enrapturing.

Over the past seven years, Energy XXI has purchased five of the largest oil fields in the Gulf of Mexico. But at the time of purchase, this wasn't nearly as grandiose an achievement as it sounds. These fields are aged, some dating to the 1960s. They weren't pumping a lot anymore, despite having a combined 3 billion barrels of original oil in place.

But horizontal drilling appears to be re-vitalizing these elderly pools.

Not only are per-well production rates better (horizontal wells are seeing initial rates up to 1,500 b/d), but recovery rates for in-place oil are growing. The chart below shows forecast future production rates for the horizontally-drilled fields (black line) versus previous estimates based on conventional drilling (red line). The increase in production looks small on the chart but-factored over the years-it adds 57 million barrels in 3P reserves. Across all of Energy XXI's properties, this includes 22.3 million BOE in proved producing reserves.

Source: Energy XXI fourth quarter 2013 earnings conference call presentation

That's a big addition, at relatively small expense.

Here's where the second big development on the Shelf comes in-and the implications explode sector-wide.

57 million barrels in added reserve isn't material to the major companies that dominate the Shelf-Chevron and Apache. Neither of these players will find it worthwhile to expend the time and effort for a horizontal drilling campaign here.

But 57 million barrels is very relevant to a junior company. A company like Fieldwood Energy-who in July announced it would pay $3.75 billion to acquire Apache's GOM Shelf portfolio.

Fieldwood is a private firm, run by people who know the Shelf well: Lord John Browne, ex-CEO of BP, and James Hackett, ex-CEO of Anadarko. Both are partners at Fieldwood's parent company, Riverstone Holdings-a major energy investment firm based in New York and London.

Both of these Fieldwood backers previously sold Shelf properties to Apache. BP completed sales to Apache in 2003 and 2006. Anadarko sold them Shelf properties in 2004.

Intriguingly, Riverstone partner Hackett's career overlaps almost exactly with Energy XXI CEO John Schiller, through a series of Shelf-focused E&Ps. Hackett was president and COO of Devon, when Schiller was VP, Exploration and Development. Before that, Hackett served as CEO of Ocean Energy, where Schiller was also his VP. Prior to that, the two served together in management at Seagull Energy.   

You can bet that Hackett's been watching his old colleague's progress at Energy XXI. And it's no coincidence that Fieldwood's multi-billion purchase of tired old Shelf assets comes on the heels of Energy XXI's successful horizontal drilling campaign. The concept has been proven-and energy insiders are sending forth their juniors to capitalize.

Keep watching this space. The next big thing for the junior E&P sector isn't going to be shale-it's going to be underwater unconventional drilling.