McMoran Exploration: Shallow Water, Deep Oil Drilling, Long Odds
Though its natural gas production is in decline, McMoran Exploration (MMR) remains convinced that there are still good ultra-deep oil and gas prospects at shallow depths in the Gulf of Mexico. That exploration is still in its infancy, though, and it's far from clear that these high-risk, sub-salt reserves can ultimately be recovered at economically attractive costs.
McMoran has staked its future on relatively mature Wilcox prospects abandoned by most of the majors, including ExxonMobil (XOM). Annual production of natural gas pumped from these shallow fields of the Gulf of Mexico -- in less than 150 feet of water -- have been in decline for years (see chart below left; click for a larger version).
Simply put, management believes companies like Exxon just didn't dig deep enough. McMoran's drilling strategy is focused on extracting reserves thought to exist below the "salt weld" -- specifically, hydrocarbon-bearing sands in the "deep gas plays" (depths of 15,000 to 25,000 feet) and "ultra-deep gas plays" below 25,000 feet.
McMoran's woes: Falling production, growth by acquisition
Management believes its successful strike at Flatrock -- discovered in mid-2007 and brought online the following year -- demonstrates the validity of its "deep gas" model. Drilling almost four miles down, producing wells pumped out, on average, 272 MMcfe/d gross in the fourth quarter of 2009 ( 25 percent working interest).
But by December 2010, production from prolific Flatrock gas field operations had fallen to 165 MMcfe/d (31MMcfe/d net to McMoran), due to persistent wellbore and remedial work-over issues.
Furthermore, McMoran has been slow to convert proven, undeveloped reserves into production. For example, only 6 percent of proved undeveloped reserves in 2009 were extracted through development drilling activities, according to regulatory filings. Aggregate reserves totaled 276.1 Bfce in December 2010 (66% gas).
Total production is expected to average approximately 175 MMcfe/d in the first quarter of 2011 and 160 MMcfe/d for the year, up from 144 MMcfe/day in fourth-quarter 2010, according to McMoran's co-chairmen, Jim Bob Moffett and Richard Adkerson. This impressive boost in average daily output, however, is being driven by acquired shallow-water Gulf of Mexico Shelf assets -- not from successful, internally generated exploration activities. Properties purchased in a recently completed $1 billion deal with Plains Exploration & Production (PXP) pumped in, on average, 43 MMcfe/d to aggregate fourth-quarter 2010 production rates.
Big bets not yet paying off
Recognizing that reserve and production growth potential out to 2014 depend on exploratory success in shallow-water prospects, Moffett admitted on the last earnings call that McMoran was "doubling its bet." For example, Plains' working interests in ultra-deep exploration programs progressing in the shallows on the GOM shelf, including Blackbeard East and a 27.7 percent in well-publicized Davy Jones discovery wells, could add more than 10 trillion cubic feet of natural gas stores to McMoran's reserves.
With spud activities situated in only 10 to 20 feet of water, McMoran and its partners figure break-even costs on Davy Jones could be less than $1.50 per thousand cubic feet. Drilling at depths as much as five miles below the sea floor, however, is still in its infancy. In the last two decades, only a handful of such ultra-deep wells have been drilled, according to Offshore magazine.
Working at such depths beneath the sea floor presents a plethora of technological challenges. As explained by geologist Art Berman:
Bottom-hole pressures may be as high as 25,000 pounds per square inch, by far the highest pressures known in Gulf of Mexico wells, and almost 10 times the rocket engine chamber pressure required for spacecraft liftoff. While not specifically mentioned, reservoir temperature is probably considerably more than 400 degrees Fahrenheit. Gas has never been produced at these temperatures and pressures, and may present engineering obstacles. In addition, gas reserve volumes will shrink at surface conditions. There is also a possibility that the gas will contain carbon dioxide, which will reduce the volume of commercial gas and present a disposal problem.In a recent interview with Oil & Gas Financial Journal, John Schiller, CEO of minority partner XX I (EXXI), downplayed the technological complexities, preferring to focus on reservoir potentials, improvements in seismic imaging and assessment tools, and past successes, such as Flatrock. He admitted, nonetheless, that ultra-deep drilling wasn't for the "faint-hearted" and was capital-intensive:
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.Schiller's comments are misleading -- and do not represent actual recovery costs: production and delivery (including gas gathering charges and other transportation) expenses totaled almost $3.00 per Mcfe last year for McMoran, according to regulatory filings. Depreciation, hurricane-related damage, and work-over maintenance -- throw in these additional expenses and break-even margins triple!
McMoran is downplaying other critical risks associated with this "swing for the fences" drilling strategy:
- In 2010, dilution to existing shareholders increased almost 19 percent to 102 million shares of common stock outstanding. To date, the company has spent more than $260 million for Blackbeard and Davy Jones ultra-deep prospects -- just on appraisal activities.
It's no secret the company needs money to develop its leased holdings. Although McMoran threw off $98.2 million in cash last year (average selling price for gas, $4.77 per Mcfe), the energy firm bled $205 million in red ink due to exploration and development activities. An internal cash-flow sensitivity analysis reveals that each $1 move in the price of gas would impact McMoran's EBITDA by (at least) $50 million.
"You can hype a questionable product for a little while, but you'll never build an enduring business." ~ Former Remington Products CEO Victor Kiam (1926-2001)Looking ahead, McMoran will need to book gas discoveries into reserves (assets) as quickly as possible. Save for outright lease sales, the company could find it difficult to monetize unproven prospects.
The Energy Information Association (EIA) Agency recently warned the current natural gas supply glut could last to decade's end -- with average natural gas wellhead price remaining under $5 per thousand cubic feet through 2022. Should Davy Jones, Blackbeard and other ultra-deep plays prove more hype than hope, McMoran may not find much on the Gulf shelf but a shallow grave -- dug by itself, for itself.
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