Not all drillers piling up fortune in shale, some pile up debt

Asjylyn Loder (c) 2014, Bloomberg News. Floyd Wilson raps his fingertips against the polished conference table. He’s just been asked, for a second time, how he reacted when his Halcon Resources wrote off $1.2 billion last year after disappointing results in two key prospects.

Wilson once told investors that the acreage might contain the equivalent of 1.2 billion barrels of oil. He fixes his interlocutor with a blue-eyed stare and leans forward. At 67, he bench-presses 250 pounds (110 kilograms) and looks it. Outside the expansive windows of his 67th-floor executive suite, downtown Houston steams in its July smog.

He responds, unsmiling, with a one-syllable obscenity: “F- –.”

Wilson has reason to curse, Bloomberg Markets magazine will report in its October issue. On the wall behind him hang framed stock certificates of the four public energy companies he’s built in his 44-year career. The third, Petrohawk Energy, discovered the Eagle Ford shale, now the second-most-prolific oil formation in the country. He sold Petrohawk three years ago for $15.1 billion.

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Then came Halcon. Since Wilson took over as chairman and chief executive officer in February 2012, the company’s shares have dropped by about half, trading at $5.67 on Sept. 5.

Halcon spent $3.40 for every dollar it earned from operations in the 12 months through June 30. That’s more than all but six of the 60 U.S.-listed companies in the Bloomberg Intelligence North America Independent E&P Valuation Peers index. The company lost $1.4 billion in those 12 months. Halcon’s debt was almost $3.2 billion as of Sept. 5, or $23 for every barrel of proved reserves, more than any of its competitors.

Wilson is undeterred. “What do you do if you’re wrong? You go home and cry?” he asks. He shakes his head. “Uh-uh.”

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A decade into a shale boom that has made fracking a household word and Wilson a rich man, drillers are propping up the dream of U.S. energy independence with a mountain of debt. As oil production hits a 28-year high, investors and politicians are buying into the vision of a domestic energy renaissance.

Companies are paying a steep price for the gains. Like Halcon, most are spending money faster than they make it, an average of $1.17 for every dollar earned in the 12 months ended on June 30. Only seven of the U.S.-listed firms in Bloomberg Intelligence’s E&P index made more money in that time than it cost them to keep drilling. (Results for two companies included only the first six months of 2014.)

These companies are plugging cash shortfalls with junk- rated debt. They owed $190.2 billion at the end of June, up from $140.2 billion at the end of 2011. (Six of the 60 companies that didn’t have records available for the full period weren’t included.)

Standard & Poor’s rates the debt of 41 of the companies, including Halcon’s, below investment grade, meaning some pension funds and insurance companies aren’t allowed to invest in them. S&P grades Halcon’s bonds CCC+, which the rating company describes as vulnerable to nonpayment.

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Money manager Tim Gramatovich sees disaster looming in the industry.

“I have lent money to nobody in this space, and I don’t plan to. This thing is absolutely going to blow sky-high,” says Gramatovich, chief investment officer of Peritus Asset Management in Santa Barbara, California. The firm manages investments of about $1 billion, including the debt and equity of oil and gas companies that aren’t drilling shale.

Halcon’s recent lousy run shows how quickly a bright future can dim. Like many of its peers, Halcon uses two sets of numbers to describe its outlook. To the Securities and Exchange Commission, the company reports what’s known as proved reserves.

The SEC requires an annual tally and limits these calculations to what the firm is reasonably certain it can extract from existing wells and other properties scheduled to be drilled within five years, based on factors such as geology, engineering and historical production.

To investors and lenders, Halcon also highlights a much higher figure that it calls resource potential. These estimates, while loosely defined by industry guidelines, don’t follow the SEC rule or timeline, as Halcon discloses at the beginning of its presentations. In fact, as Halcon notes, the SEC forbids companies from making resource-potential claims in official reserve reports. The agency doesn’t regulate what companies say at investor conferences, in press releases or on their websites. No one does.

Discrepancies between proved reserves and resource potential are common in the industry, and investors can get duped, says Ed Hirs, a managing director at Houston-based Hillhouse Resources, an independent energy company, who also teaches energy economics at the University of Houston.

“There’s a lot of ways to make money in the oil and gas business, and not all of them involve drilling for oil,” he says. “You just drill investors’ pocketbooks. When investors are willing to throw money at you, you can just make money on that. It’s a time-honored tradition.”

Halcon’s August investor presentation for EnerCom Inc.’s Oil & Gas Conference in Denver illustrates how far apart the figures can be. The company told investors it had resource potential equal to 1.3 billion barrels of oil. That’s almost 10 times the proved reserves it reported to the SEC at the end of 2013.

Asked in the July interview how much faith investors should put in resource estimates, Wilson says: “They shouldn’t put hardly any in them. They should just put in the idea that there’s some upside there. And if the practitioners are good at what they do or lucky, that upside might get turned into value.”

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It would be easier to dismiss Halcon’s optimistic estimates if Wilson hadn’t succeeded so spectacularly in the past. Born on a U.S. military base in Georgia, he earned a bachelor’s degree in engineering from the University of Houston and started in the oil business in 1970.

Wilson struck out on his own, selling the first company he took public, Hugoton Energy, to Chesapeake Energy for $326 million in 1998, SEC records show. His second, 3TEC Energy, was bought by Plains Exploration & Production for $417.6 million in 2003, SEC records show.

Wilson moved on to Petrohawk in 2004, confident he’d sell the company in three years. When he didn’t, he led Petrohawk into new and untested shale plays. The gamble paid off.

In 2008, while under shareholder pressure to cut spending and reduce debt, Wilson and his team made the discovery of a lifetime: the Eagle Ford formation, now pumping 1.5 million barrels of crude and 6.5 billion cubic feet (184 million cubic meters) of natural gas every day.

His sale of Petrohawk in 2011 to BHP Billiton was the second-largest transaction in North America’s oil and gas industry in more than five years, trailing only Exxon Mobil’s $35 billion purchase of XTO Energy in 2010, according to data compiled by Bloomberg.

“I’ve done really well for all the shareholders every single time,” Wilson says. “Those numbers are out there in the public. I don’t have to prove it.”

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Buoyed by the Petrohawk triumph, Wilson and his partners put up $55 million and took over Tulsa, Oklahoma-based RAM Energy Resources in February 2012. A further $550 million came from EnCap Investments, a private-equity firm that had previously backed Wilson. In honor of their recent success, Wilson and his partners renamed the company Halcon, Spanish for hawk.

Six weeks later, in April 2012, Wilson told investors attending the Independent Petroleum Association of America conference at the Sheraton Hotel near New York’s Times Square that Halcon’s companywide resource potential was 1.4 billion barrels. The number was striking because it was 66 times higher than the proved reserves Halcon reported to the SEC in March 2012.

The Halcon slide show outlined the two biggest prospects: 875 million barrels in the Utica shale, which stretches across Pennsylvania, Ohio and West Virginia, and a further 306 million in the Woodbine in East Texas. Footnotes say Halcon had yet to drill a single well in either location.

Investors were eager to back Halcon. It raised $2.1 billion in bonds in the 12 months following the April presentation. The Canada Pension Plan Investment Board, a $227 billion fund that manages retirement assets for 18 million Canadians, paid $300 million for an 11.4 percent equity stake in October 2012. Mei Mavin, a spokeswoman for the pension board, declined to comment.

As the months passed, Halcon had trouble turning the potential into proved reserves. Wilson sounded optimistic. During an August 2013 conference call, he says, “We’re really excited about our Utica/Point Pleasant asset.”

Wilson says a Halcon well was one of the most important in the play and, though some of its acreage was “goat pasture,” the company was preparing for full-scale development of the Utica.

Three months later, the company reported a write-off of $1.2 billion, largely related to the Utica and Woodbine plays. Halcon sold its Woodbine acreage for $450 million in February 2014. After almost two years of drilling, Halcon reported to the SEC in March 2014 that it had 16.4 million barrels of proved reserves in the Utica and Woodbine — the same acreage that Wilson had said in April 2012 contained the potential for 1.2 billion. The estimated bonanza had simply evaporated — eliciting Wilson’s four-letter obscenity.

“Resource potential, which means ‘Who knows?’ ” he says in the July interview. “But it’s possible. Resource potential down in the Eagle Ford of south Texas increased 10-fold over time. So our business can be rough. It can go either way.”

Halcon’s latest prospects lie beneath the oak woods and blackland prairies north of Houston, in its El Halcon prospect, and under the arid plateaus of western North Dakota, where the company is drilling the Bakken shale. The two plays account for most of Halcon’s production.

Wilson’s biggest gamble is on 315,000 acres (127,000 hectares) of unproven Tuscaloosa Marine Shale, known as the TMS, a layer of rock stretching from Louisiana’s western border to southwestern Mississippi.

“It has to work for them,” says Leo Mariani, a senior analyst at RBC Capital Markets in Austin, Texas. “If the acreage doesn’t work out and they can’t get the costs down, they’re going to be in big trouble.”

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Squeezing oil from the TMS is an engineering challenge. The formation is 2 miles underground through rock interlaced with rubble and sand. On a humid July morning, a sign in the red clay of Wilkinson County, Mississippi, announces Halcon’s Fassmann 9H-1 well. A Helmerich & Payne Inc. Flex3 rig rises above the clearing. A monitor in the air-conditioned supervisor’s trailer shows the drill bit has reached a depth of 12,000 feet (3,660 meters).

Progress is slow. In the rig operator’s cabin 30 feet up, one man steers a circulating bit screwed to the end of 2 miles of pipe, monitoring progress on a bank of flashing screens. The bit must pierce the TMS horizontally in the right spot. His margin of error: 5 feet.

He misses. Frustration is thick as the temperature climbs to 91 degrees Fahrenheit (33 degrees Celsius). The hours slip by, measured in feet of pipe. As a near-full moon rises, a relief crew dressed in fire-retardant jumpsuits emerges, already sweating, from bunkhouses at the edge of the clearing. Heat lightning flashes in purple clouds to the south. It’s after 9 p.m. when a supervisor gets a message. The drill has veered off course. It’s time to try again.

At more than $13 million apiece, Halcon’s wells in the TMS are the company’s most expensive. Halcon abandoned its first well, the Broadway H1, after an underground casing failed. It has two producing wells in the play. Three others are in progress.

Wilson says Halcon has enough cash to keep trying and no imminent debt payments. Funds associated with Apollo Global Management, a New York-based private-equity firm, committed as much as $400 million in June to help Halcon pay for drilling in the TMS in exchange for a 12 percent return and a 4 percent royalty on what’s produced. That’s reduced to 2 percent after a threshold return has been met, Apollo says.

“I don’t know how many times you can be wrong,” Wilson says. “I’ve never been wrong that many times. If your concept is that the Tuscaloosa Marine Shale might work or might not work, there’s a lot that feel that way in the industry. But there’s also quite a few that think it will work.”

Wilson doesn’t need to look far to see what happens when things go wrong. His office used to belong to executives of once-bankrupt electricity wholesaler Dynegy, which emerged from Chapter 11 in 2012. The custom wood paneling has been papered over with colored maps of drilling prospects.

Taken together, Halcon’s 1 million acres could cover Rhode Island. Wilson asks a visitor not to look closely; he doesn’t want to give away his next move.

Wilson says proved-reserve numbers aren’t as important as the company’s resource potential.

“It’s what’s in the future that really matters to us,” he says. “So the resource potential is what we’re all about.”

If the TMS works, Halcon predicts an enormous payoff. In September 2012, a presentation for the Barclays Capital CEO Energy-Power Conference showed the resource potential of Halcon’s TMS properties equaled 373 million barrels of oil. Wilson says the estimate is much higher now. The company says it no longer gives resource estimates by play.

With the U.S. bent on energy independence and investors chasing riches from the fracking boom, there’s one other number to consider. Halcon’s proved reserves from the TMS reported to the SEC: zero.

— With assistance from Isaac Arnsdorf and David de Jong in New York, Joe Carroll in Chicago and Olubukola Alao and Hyuliya Hasanova in Princeton, New Jersey.

bc-fracking (TPN)