R E S E A R C H

January 7, 2014

Drill Report #1.0

Energy Positive Outlook going into 2014. Bullish AR, CRK, BCEI
** For access to our models and analysis please contact drill.research@drillcap.com

As specialists in researching the North American energy space, we have canvassed the industry
and have taken a deep dive into the companies that we believe will benefit from the boom in
shale oil and gas production. In this research piece we walk you through our views of the
industry from commodity prices to the actual shale plays we prefer and finally to the companies
we believe are best positioned to take advantage of the prevailing investment environment. Using
our ranking methodology we believe that Antero Resources (AR), Comstock (CRK) and
Bonanza Creek (BCEI) are well positioned to outperform the prevailing exploration and
production E&P indices.

Introduction
The third quarter of energy earnings reporting ended in mid-November. Since then we have had follow
up meetings and calls with several energy companies in our coverage universe. Below is a summary of
our key takeaways with an emphasis on the Utica Shale region in Ohio where our investment arm Drill
Capital is currently deploying capital. We continue to canvass various energy data points across the
sector while conducting due diligence on certain areas in order to identify future investment
opportunities. Our analysis and approach is geared towards following longer term market fundamentals
while at the same time keeping a close eye on short term developments in the space.

Commodity Price Insights

Energy management teams remain bullish on long term natural gas market dynamics with a view that a
structural tightening is setting in for the next few years while remaining bearish in the short term. We
also noted volatility in regional basis prices and the pace at which fundamentals (supply increases versus
industrial demand pickup) will ultimately dominate weekly market speculation (driven by storage
numbers and maintenance activity). At $1.00-$1.50/mcf basis differentials we could see some material
pullback in northeast production as this seems to be the price at which producers become constrained
from an economics perspective. The market appears to be focused on the pace at which the Marcellus
can grow given a historically strong track record by the likes of Cabot, Range, Southwestern, Anadarko,
EQT, Antero and Chesapeake. When speaking individually with these producers, there appears to be a
noticeable inclination for them to behave rationally in a post 2008 environment. The majority of the
sample set believes that there isnt an infinite capacity to produce in the basin (given a fixed inventory of
low breakeven core inventory and given natural well decline rates). Several producers have articulated
that the ~3bcf/d growth seen in 13 involved taking a significant backlog of wells into production and
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that you would likely not see that pace of growth going forward. If these assertions are true, then the
natural gas production growth we saw should be balanced going forward. Either way, we continue to
monitor the market - gas exports to Mexico have been growing (>15% YTD) and that is a data point to
keep an eye on going forward from a gas exportability potential.
$US/Mcf

Natural Gas Prices (Henry Hub)

$6.00

Forward Strip Prices

$4.40
$4.00

$4.00

$3.90

$4.26

$4.16

$4.19

4.25

2014

2015

2016

2017

$3.74
$2.80

$2.00

$0.00
2009

2010

2011

2012

2013 ytd

Sourced to Bloomberg Financial Markets.

Oil prices held up throughout the year, with some observed volatility going into year end. Producers
remain constructive around oil price fundamentals. Energy investors have voiced concerns around
domestic U.S. oil production outpacing the current U.S. refining system (given success in the Bakken,
Eagle Ford and Permian plays). The counter argument for this is that Permian production is lower quality
oil and will likely not be able to compete with Eagle Ford or Bakken oil in the refining system. According
to EOG (a market leader in all three plays), the rate of growth in US oil production is slowing (driven by
natural declines) normalized at 600 Mbbls/d in 2013 versus 1 MMbbls/d last year and projected to be
roughly 700 Mbbls/d in 2014. We think volatility will persist in the oil markets as the tug of war between
geopolitical risks in the middle east on one hand and strong production domestically on the other hand
continues (not to mention refinery maintenance and turnarounds). Over time we expect a reversion to
towards prices equating supply cost fundamentals.
$US/bbl

Oil Prices (West Texas Intermediate)

$120
$95.10

$100

$94.10

$97.99

$94.94

Forward Strip Prices

$88.21

$84.27

82.13

2015

2016

2017

$79.50
$80
$62.00
$60
$40
$20
$0
2009

2010

2011

2012

2013 ytd

2014

Sourced to Bloomberg Financial Markets.

Energy Insights and Views

The energy industry has become more in tune with returning or at the very least taking measures to
return value to shareholders. This in turn has driven producers towards a more refined and measured
approach towards 1. Proactively hedging commodity prices to stabilize future capital programs 2.
Rightsizing asset portfolios through dispositions of non-core properties in addition to share
buybacks/dividend increases and 3. Spending capital only in the highest impact, highest return plays
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with a de-emphasis on exploratory spending. We continue to see evidence of this trend through yearend.
Producers are still expected to spend more in 2014 than in 2013 barring any material and sustained
(multiple quarter) drop in oil or gas prices. The third quarter reporting season marked the beginning of
2014 capital budget announcements for the energy sector. Based on preliminary budgets and our
discussions with corporates, overall spending is expected to be robust in 2014 relative to 2013 an
approximate 5% increase with a relatively flat rig count (an expected drop in vertical rig count offset by
a continued increase in horizontal rigs) and well count growing by 4-5% relative to 2013. It would be
misleading to look at the expected flat rig count (typically seen as a proxy for oil and gas activity) as a
negative indicator for 2014 spending as this is really a function of 1. Oil/liquids drilling requiring less
horsepower than gas wells and 2. Positive momentum in capital efficiencies (wells take less time and
therefore less capital to bring online).
The industry has taken advantage of high oil prices throughout the year to lock in a significant portion
of their 2014 oil weighted production between $87-$95/bbl WTI which bodes well for oil/liquids
activity going into next year. We continue to see a strong appetite for capital allocation away from
natural gas towards liquids rich, oil or hybrid plays in fact some producers that have been articulating
this change in their production mix over some time have now clearly made the transition from being
pure play gas producers towards a more balanced production and asset portfolio. As it relates to natural
gas, producers need to see a sustained $4.50/mcf gas price before resuming operations in the dry gas
portion of their portfolios.
Pricing in the energy services sector remains relatively soft across the U.S. - Producers have benefited
and continue to benefit from this trend. Spot pricing for rigs and completion services (with the
exception of more specialized completion product lines) is trending lower (or at the minimum remaining
flat) across various basins as the industry continues to digest the oversupply in equipment and service
providers. Labor remains a challenge in certain areas, in the Permian and Bakken specifically.

Energy Investment Climate and Positioning

We believe that capital spending in the energy sector will remain robust in the foreseeable future and
that information inefficiencies in the private space will make for compelling investment opportunities
around Greenfield businesses within plays that are expected to receive capital inflows going
forward. We think that risk reward within the private energy market sector will be lucrative going
forward. We think the Utica shale play will emerge as a top tier shale play in the US and our investment
arm Drill Capital is deploying capital to build businesses in that region.
Our view is that public market investing will continue to be a stock pickers environment with a bias
towards E&Ps (exploration and production companies) that can grow, on a debt adjusted basis, and
that are positioned in the highest return regions. We believe that on the public side, Antero Resources
(NYSE: AR) screens as a top tier oil and gas company that will provide the best leverage to the
energy sector. Both the energy integrated and large cap US firms can still provide good exposure to the

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energy sector but growth will remain a challenge given their already large production and asset bases.
On the other hand we like the domestic midsize E&P companies as their growth prospects are relatively
attractive we remain cautious though as outperformers in this sample set still have to be disciplined in
their capital allocation decisions and their exploration programs.

The Drill Portfolio

We introduce the Drill Portfolio a basket of stocks, including our top pick Antero Resources (AR),
which we think will outperform the EPX and XLE. We also like Comstock Resources (CRK) and Bonanza
(BCEI).
-

We believe AR is an enviable position with its core acreage blocks in the heart of the Utica and
Marcellus shale plays. We believe the company delivers on strong production growth over the
next few years and as a result brings forward value from its NAV. We think that Street estimates
on its midstream assets are too low and that any MLP IPO or split will be well received by the
investment community.
We believe CRK is taking the right steps in growing its base inventory while at the same time fine
tuning its current operations in the Eagle Ford where it has a core position in McMullen County.
We expect liquids growth to be strong going forward. We also believe that investor concern
around the companys lack of drilling inventory will be addressed going forward, we like the
optionality the company has in the Tuscaloosa Marine Shale where it will be drilling 2 wells this
year.
We believe BCEI has a strong balance sheet and a dominant position in the Niobrara
(Wattenburg) play where drilling economics are top tier. We think the company continues to
deliver strong production growth this year. We also like the catalysts going forward especially
the super section tests where multiple formations and various well configurations will be
experimented with; this could greatly increase the companys drilling inventory and reserve life
going forward.

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Play by Play Insights

Below we walk you through our takeaways and views across select oil and gas basins that we monitor in
North America:
Utica (Ohio)
-

Activity remains strong, capital continues to flow into the play. Carroll County continues to
dominate incremental drilling and permitting activity levels followed by Harrison, Noble,
Belmont and Guernsey. You are starting to see an accelerated shift from the wells
drilled/drilling category (i.e., wells that were drilled and awaiting pipeline connections) towards
the wells producing category as gathering and processing capacity is brought online across the
basin.
Ohio Utica Shale Activity Profile - March 2013

200
160
120
80
40
0
Carroll

Harrison

Columbiana

Wells Permitted

Noble

Monroe

Belmont

Jefferson

Wells Drilled / Drilling

Guernsey

Mahoning

Wells Producing

Sourced to Ohio Department of Natural Resources.

Ohio Utica Shale Activity Profile - August 2013

200
160
120
80
40
0
Carroll

Harrison

Columbiana

Wells Permitted

Noble

Monroe

Belmont

Wells Drilled / Drilling

Jefferson

Guernsey

Mahoning

Wells Producing

Sourced to Ohio Department of Natural Resources.

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Ohio Utica Shale Activity Profile - December 2013

200
160
120
80
40
0
Carroll

Harrison

Columbiana

Wells Permitted

Noble

Monroe

Belmont

Wells Drilled / Drilling

Jefferson

Guernsey

Mahoning

Wells Producing

Sourced to Ohio Department of Natural Resources.

Some Notable Utica Developments include:

-

As at December 7, 2013, 48 rigs were running in the Utica shale, up from 18-20 rigs earlier in the
year. 1,015 permits have been issued compared to 858 permits in our previous update in August
(and 548 permits in March). Of these total wells permitted as at December, 627 wells have been
drilled to date compared to 547 wells drilled in August and approximately 250 wells drilled in
March. All these data points are all strong indicators reflecting capital spending increases in the
area
Antero Resources went public during the third quarter. Another Utica player, American Energy
Partners, led by ex-Chesapeake CEO Aubrey Mclendon has filed for a public offering to raise up
to $2bn proceeds will likely be used to accelerate development of the companys Utica
acreage recently acquired. There is also chatter around Rice Energy (a private Marcellus/Utica
operator) going public in 2014
Utica processing and infrastructure projects continue to come online:
o MarkWest and Energy & Minerals Group started up their first cryogenic gas processing
plant at the Seneca complex in Noble County. The initial plant capacity is 200 MMcf/d
with more capacity additions going into next year. It is important to note that the plant
is supported by long term, fee based contracts
o Marathon Petroleum (one of the largest domestic refiners) plans to increase its total
crude plus condensate processing capacity in its Canton and Cattlesburg refineries from
25 Mbbls/d to 60 Mbbls/d. This will include over $640 mm of projects including
condensate splitters, pipeline connections and truck and barge connections. Also of
note in this package is the $140 mm Cornerstone pipeline that will run through Carroll
County and is expected to be completed by 2016
o Kinder Morgan announced the signing of a letter of intent with NOVA Chemicals to
develop a pipeline running from the Utica shale (Harrison County) to Ontario, Canada.
The pipeline is expected to transport (NGLS) natural gas liquids this is a positive sign
for getting takeaway capacity out of the growing liquids basin

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According to Ohio State University Professor Chris Penrose the energy activity driven by the
Utica shale industry has created approximately 550 millionaires out of landowners in Carroll
County since drilling has begun
Drill Capital investment view: Very positive. Drill Capital is deploying capital in the play.

Duvernay (Alberta)
-

Incrementally positive data points from industry well results, operators are moving towards pad
drilling into the winter drilling season
Midstream configuration is underway to facilitate a full development scenario
Capital continues to flow into the play evidenced by tightness in the domestic services space
Waiting for Encana to declare commerciality on the play (although field condensate data points
and well costs reductions are encouraging to date)
Drill Capital investment view: Positive. Economics are strong and rig count is expected to
grow. Drill Capital is actively exploring investment opportunities in the play while monitoring
well economics / midstream build-out and various energy data points.

Tuscaloosa (Louisiana / Mississippi)

-

Increased capital allocation by industry players Encana and Goodrich driven by supporting
Crosby well result also seeing entry into the play by Comstock, Sanchez and Halcon
Starting to see several midstream companies looking to negotiate gathering / compression lines
and associated infrastructure with producers in the region
Need to get comfort around well costs below $12.5-13.5 mm to justify longer term development
economics looking for spud to casing days to go down
Drill Capital investment view: Positive, cautious. Drill Capital is actively exploring investment
opportunities in the play while monitoring well economics / midstream build-out and various
energy data points.

Niobrara (Colorado)
-

Industry is drilling longer laterals (9,000 feet versus 7,500 feet) and trending towards 40 versus
80 acre spacing. Focus is around getting comfort on spacing results
Still seeing production shut-ins due to highline pressures
Coddell performing relatively better than expected, the plays eastern boundary is expanding
Greenhorn well tests are to be followed
Investment view: Positive, improving well economics.

Woodford/SCOOP (Oklahoma)
-

New play within a legacy field. Continental leading the way in terms of ramp up, planned 6 rigs
addition over the next 12 months
Discovery wells will be defining the ariel extent of the region, resource potential appears to be
present
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Play is under delineation / derisking mode

Investment view: Positive, monitoring data points.

Permian (New Mexico / Texas)

-

The basin continues to be a key focus for U.S. energy operators seeing an increased amount of
capital and rigs going into the basin and planned for next year. Geoscience work continues as
various intervals within the basin are being delineated
Delaware basin and Bone Spring seeing incremental capital (and excitement) on a relative basis.
Delaware basin still underappreciated relative to Midland but returns could compete as the play
gets delineated Concho leading the initiative
Operators are high grading their acreage and comparing economics across intervals (Wolfcamp
vs. Joe Mill vs. Spraberry and Tier 1 vs. Tier 2 within these intervals)
Pressure pumping and completion service costs continue to come down. Labor in the basin is
generally tight but improving at the margin
Investment view: Positive however investment opportunity set is relatively crowded at
present.

Eagle Ford (Texas)

-

Overall operating success continues across the basin - the play continues to attract capital and
operators are accelerating the pace of their programs
Service costs are coming down and pad drilling is driving cost savings
Look for Upper Eagle Ford well results going forward to confirm early well results from Penn
Virginia and Pioneer. Success could add a substantial amount of drilling locations to existing
acreage portfolios as this could be an entirely separate reservoir in some areas of the play
Investment view: Positive however investment opportunity set is relatively crowded at
present.

Bakken (North Dakota)

-

The majority of private operators have been taken out, the play is in a high grading phase, the
acreage grab is also largely over basin is focused on pulling value forward by accelerating well
count and production (despite a drop in the rig count) and focusing on cost cutting initiatives
EOG is leading the way in terms of best practices and well testing results using close to double
the average quantity of sand than the industry (on a per frac stage basis) with a relatively similar
decline curve and 30% more cumulative production. On the flipside there is an industry concern
of sand supply if every operator where to follow in EOGs footsteps
The service pinch is largely over. Producers have the ability to get the equipment they want. It
takes a day to get a pressure pumping crew. Labor is still an issue however
Barrels are not getting stranded there is ample takeaway capacity in the basin. The volatility in
differentials continue, ultimately differentials will be dictated by transport cost fundamentals
and not mere quarter to quarter market speculation

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The fringe parts of the play are starting to get access to infrastructure, so we will likely see
improving economics outside of the Core
Investment view: Neutral investment opportunity set is crowded.

Marcellus (Pennsylvania)
-

The marginal gas operators are now largely out of the basin, larger operators have the majority
if not all of their acreage held by production
Incrementally positive quarter from a production growth and well results perspective
o Although spacing tests remain county specific there is a downward trend across the
play, more specifically Cabots recently announced 10 well pad
o Upper Marcellus initial results are positive and to be followed
Basin wide basis differentials continue to be a challenge for operators; looks like we will see a
big pinch going into the summer of next year from a basis pricing perspective
Service costs (frac crews, drilling) continue to get negotiated down
Drilling efficiencies continue to drive overall well costs down
Investment view: Neutral Basin pricing differentials dampen an otherwise robust production
growth trajectory.

Mississippi Lime (Kansas, Oklahoma)

-

Drop in activity given Chesapeake and Sandridge portfolio rightsizing both companies are only
focused on the core of the play
Trend is to move in the northwestern part of the play and from upper target to middle and
lower target horizons
Infrastructure control and access to gathering will continue to dominate ability to command the
best economics in the play, marginal acreage holders will likely give up / have given up
Spot pricing for services is going down
Investment view: Negative Seeing capital outflow from the basin.

Fayetteville (Arkansas)
-

Basin is declining at 30%, with Southwestern the only operator with rigs in the basin
Both BHP and XTO are down to zero rigs
Investment view: Negative Seeing capital outflow from the basin.

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Best Regards,
Farid
Farid Guindo,
Managing Partner
farid.guindo@drillcap.com

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