Mark Stoner - The Business of Building DrillCos

Congrats on-- actually, really, I think a great, great slate of speakers you put together today. I've actually not been playing on my phone all day. I've actually been listening. So for everyone who came to learn the nuts and bolts about private equity and how to try to set a business up, I think this has been a pretty good boot camp for you. So thanks for putting it together.

And when Rick called me and asked me to be a speaker, I was flattered. Then he told me that the topic was going to be DrillCo's. And I was a little bummed out because DrillCo's-- you have a, I think a visceral reaction one way or the other-- it's not quite the Green New Deal reaction. But you either love it or hate it. And so I've been kicked out of many a management presentation for pitching this. So I might need one of Storm's coloring books to get me through this but bear with me.

So, Mark Stone-- I'm a partner at Bayou City Energy. We're a Houston, Texas-based private equity group. We only do upstream investments. We formally kicked off in January of 2015, so we've been around a little over four years now. And we're now investing out of our third fund between our three funds and direct LP Dollar Co-investment.

We manage about $1.3 billion, and we've deployed that out through two very distinct, yet I think, highly complementary investment strategies-- first of which we'll obviously get into here in a second, which is DrillCo's, or what we call drilling partnerships. And the 2nd strategy is what we call "Platform Company Investing. And I'm going to touch on Platform Company Investing for a second because I want, A, you to know that we do more than just DrillCo's, and, B, I think understanding how we approach this particular type of investment helps inform how we go about making investments in DrillCo.

So with platform companies, what we're looking to do is partner with management teams. Typical to a lot of private equity, we want to take a control equity position within the entity. And we want to go and find cash-flow producing properties. We're commodity-mix agnostic, and we're really basin agnostic.

We actually did do a deal in California, which I guarantee you you'll probably never hear another guy in private equity say that. We did. It was actually, our first deal, we exited that last November-- had a great realization, and, frankly, I'd go back to California. There's a lot of value there. So we're really agnostic as to where we go.

But the overarching asset quality we want is we want the asset to be PDP-heavy and to have production. We want, as Dick Stoneburner mentioned this morning, there's the J-curve effect in private equity, and you eliminate that perhaps altogether if you're buying a cash-flowing property. You don't have to keep going back to the private equity sponsor to get dollars to drill. You have cash-flow being spun off your property on day one. And so, in a sense, you're paying back your investment on day one. And, also, importantly to us, you can hedge-out those cash-flows, so you can protect a lot of your investment.

So we're typically going to be buying tier-two, tier-three assets, and those are assets that BP, others, the larger operators are leaving behind. They're taking all their people and their money and looking after their tier-one unconventional basins, which is the absolute right thing for them to do. But we can come in and step in with a team that's solely focused on that asset and do all the things that the prior operator wasn't doing-- not because they weren't a good operator, just because it didn't move the needle for them to do a 50-barrel-a-day recompletion, or to renegotiate certain service contracts or anything like that. But for us, we can expand margins and make a private equity return doing that with the right team.

So that really gets us into a lot of, again, tier-two and conventional basins. And that's great, but 99% of the brainpower and the capital in this industry is focused on the tier-one unconventional basins. So how do we expose our LP dollars to that part of the world? And for us, that solution is via DrillCo's. And we think we can do it in the same risk-measured way because we're partnering with management teams who-- or operators who have already assembled the acreage position, they've drilled delineation wells, they've figured out how to dispose of water, how to sell their molecules, et cetera. So they're really at a point of development, and we can come in and provide the dollars to get that done. So in the same way, we think that we're doing it in a very risk-adjusted way, but we open up our LPs to really the entire breadth of the universe at that point.

So I didn't-- or Bayou City didn't make Don's slide on the private equity groups out there. So, I think, really, the reason we got-- or I was invited here is because I think we've been very active in Oklahoma. Oklahoma's been a great place for us to deploy capital. So in 2018, between our DrillCo's and Oklahoma, and our platform company investing, we actually deployed with those entities in aggregate at $1.1 billion drilling over 220 horizontal wells.

And at one point in time late last year, we had 14 rigs running. So we were pretty aggressively putting dollars to work. That's actually more capital than Newfield spent in Oklahoma last year, and it's the same amount of dollars that Continental is budgeting for 2019 in Oklahoma. So I think we do have a very nice presence here. We're looking to grow that. We're actually negotiating three purchase and sale agreements right now to grow some of our positions-- those should all close on June 1. And we've also, again, we typically end up in our platform company investing in some of the tier-two basins. We have a big position actually in the Mississippi line, which is another thing you'll probably never hear a private equity guy ever say.

But we're really happy. They were running two rigs. We're running three rigs in the second half of last year. And we really like that, and we're looking to grow that position. And if you look at what we've done since our first DrillCo in Oklahoma back in January of 2016, we've drilled about 115 wells via DrillCo's. And within Kingfisher County, in particular, if you went back to 2016 to today, and you considered that DrillCo entity as an operator, we'd be the third-most active operator in Kingfisher County-- so very active there. And I'm not sure if I'm complaining or bragging, but we did pay about $30 million in production taxes last year to the state of Oklahoma. So, again-- big presence here.

So what is a DrillCo? There's a million different varieties. Everyone cuts and slices them a little bit differently. But in typical, this box to the right is the usual structure. So a financial partner and an operator come together and create what's called a Joint Development Agreement, or JDA, which lays out the who, what, when, where, why, how you go about prosecuting a development program on a specific amount of wells.

Those that the financial partner brings the capital-- typically, anywhere from 80% to 100% of the capital. The operator brings the know-how and the locations. The locations get drilled. Cash-flows go through a waterfall. The operator receives a promote-- typically, up to about 20%. And once an IRR hurdle is hit, typically, mid-teens IRR hurdle-- there's what's called a "reversion" where the bulk of the interest goes from the financial partner back to the operator. So instead of being a 10% to 20% working-interest owner at the get-go through the promote, once the IRR hurdle is hit, the operator can be back to 90%-plus of the program. So it's a pretty effective structure for an operator to get wells drilled. And this is, typically, an off-balance sheet structure. So it's not-- it doesn't show up on the balance sheet as debt or anything like that.

Again, I said there's a lot of different ways to do this. I'd point out a couple of the unique things, or perhaps unique things to Bayou City in terms of how we approach this. One, we will be wellbore only, which I think not a lot of people are willing to do that. So we live and die by how each wellbore produces. We don't-- it's not a carte blanche dilution of the operator's footprint in the basin. We're not taking working interest in a drilling spacing unit. We're not getting interest in PUDs. We're getting nothing outside of that wellbore. So there's really absolutely no bail-out zones for us. So we have to have a high degree of confidence in the drilling program and the operator's capabilities when we set into-- when we set the Joint Development Agreement plan into motion.

That the quid pro quo there that we look to do is put in place-- AFE caps, so we will look to fund 100% of the program. We'll lay out all the AFEs, and we'll agree that we'll fund 100% of that amount. Some wells will be over. Some wells will be over, and at the end of the day, the concept is, we'll fund 100% of the program. But this does insulate us from train wreck after train wreck after train wreck with the operator. And because we're wellbore only, it's protection that we need.

Also, unique to us is we can be small, but scalable is how we put it. So we're perfectly fine starting off at a 15-well, 20-well program. We don't need hundreds of locations or a $500 million bogey to hit with an operator. We can start small, and I think that that should resonate with operators. We're happy to start big, but I think starting small in this environment where the president can wake up, send out a tweet that moves the oil markets one way or the other, the power goes out in Venezuela, there's a whole list of things that can happen. I think the operator wants to maintain as much optionality in terms of their drilling queue as they can. So by piecemealing in locations over time, I think is a pretty friendly way to get this structured.

Obviously, we're happy if the operator, for whatever reason, wants to start with 200-- we're happy to start with 200 locations. But, again, we can be smaller than most of our peers. And we do view this as a true partnership. And we're not trying to structure this like it's a MES product or a credit product. So there's no what we call unilateral off-ramps. If the first set of wells don't turn out like the type curve we underwrote to says they will, we're not going to just walk away from the program.

We understand that entering into this is an important part of putting together your development program-- an important part of putting together your budget. You're going out and getting long-term service contracts, marketing contracts, et cetera. So we will agree to stick it through with you. Obviously, I think if we both sit across from the table from each other, and we agree that it doesn't make sense to do it anymore, we're happy pushing the pause button or stopping altogether. But there's no speed bumps that we insert into the document where prices hit X, or if type curve is Y minus a percent where we can walk away. Again, we think that that's a pretty friendly approach there.

So in terms of what we look for, it's really pretty simple. We look to partner with an operator who has drilled wells, who has demonstrated that they can drill wells to AFE, and they can drill wells over time within a relevant sample size-- they can hit type curve. And we're not looking to be dollars that help you come up with a learning curve.

By the time we want to partner with you, the operator's figured out what's the right completion design. Where do I want to lay my lateral? And we're not training wheels trying to get the operator to a point where they can hit Eject. We want to make sure that it's a bona fide operator who has a track record. For the wells to hit reversion, you really need wells that are 30% plus IRR. That was harder to do at $55 oil. Today, at 62 or 63, it starts to-- the map starts to light up a little bit more. So you typically want that because I think both parties are incentivized to see the reversion occur.

On number 4, we view the presence, or we expect that the presence of a DrillCo is something that should expand margins and drive down costs for the operator in general-- so adding that incremental rig, or locking up a service provider for a 20-well program should, at the margin, help you with your cost. And so we view that as helpful within the program as we deploy dollars and, again, helps both sides.

On the 5th point here, obviously, we'd like to expand, so we want to make sure that there is inventory. If we agree we want to expand that there's something we can do there. And on 6 and 7, this is an IRR-driven product, so that means that you don't want to have chronic delays or systematic delays built into the development program. You want to be able to drill a well, get permits, and get gathering and flow-lines set up so you can get it to sales as quick as possible.

Some of the-- DrillCo's two, three years ago we were really a stigma product. If you were an operator looking for one of these, that meant something probably pretty bad was going on in terms of your finances. I think that's fundamentally changed starting in 2017. Seeing EOG, Diamondback, and other really blue-chip operators start to embrace this strategy. And the reasons for that, I think are pretty apparent. But the upside is ultimately going to go to the operator, at least within the Bayou City structure.

So promoted cash-flow, PUDs, the HBP acreage, et cetera, the efficiencies that you get through an expanded program-- that all goes to the operator. This is something that is off-balance sheet and nonrecourse, so it's credited creative to the operator. And you're creating value. You're creating reserves. You're creating cash-flow out of otherwise long-dated, dormant inventory. And, again, that's something that, as the wells come on-line, you can hedge volumes. You can book reserves. If you think about what the curve looks like once reversion hits, you're going to pop up from that 10% to 90% or whatever that number is. And so the DrillCo's-- once you revert, it synthetically flattens your decline curve and smooths out your cash-flow. And in a world where as everyone's mentioned today-- it's all about dividends. It's all about creating sustainable cash-flow. I think that's a pretty appealing piece of the structure as well.

And then lastly, there's the ability to refocus capital. A lot of operators are multi-basin-- doesn't make sense to continually drill your tier-two stuff just because you have MVCs or drilling commitments. So we can free up your capital, so you drill all tier-one stuff. And we're happy to come drill your tier-two stuff as long as you hit that 30%-ish IRR.

And then lastly, it's not on here, but DrillCo's really worked well in Oklahoma because you can use it as a really offensive weapon to go out and HBP and force-pool a lot of acreage, which the operators we partnered with have done this pretty well. So, Alta Mesa-- we closed this in January 2016-- it actually took us about 35 days to negotiate and put the JDA in place, which is faster than I think most people even get to in LLY. So we were able to put together a pretty friendly playbook. And we funded the first well in January of 2016 when prices were, I think, $27.

So, again, we're not-- we don't create outs for ourself. We'll do what we say we're going to do. And Alta Mesa has been textbook in how they've used this. They've been able to HBP a lot of acreage, and they've expanded the number of tranches within the DrillCo handful of times now. So we've been happy with that exposure.

And then lastly, with respect to Oklahoma, we've also created a partnership with Chaparral in Canadian County and in Garfield County. We had the concept for Chaparral is they had a clean balance sheet. They wanted to accelerate development as much as possible and delineate Garfield County, which I think not many people draw on the map of the stack. So they wanted to create a presence there.

And so we put 17 wells in Canadian County and 13 wells in Garfield County and kind of married the way we viewed risk around that to come up with the structure there on the right. And we've now funded all 30 wells. We started this program in September of '17, so pretty quickly got through it. And with that, I guess, stop for questions or go sit down.

[APPLAUSE]

Thanks a lot, Mark. Questions? Right here.

So thank you, Mark, we're still in transition.

[LAUGHTER]

It seems like there should be another arrow of what happens when you don't hit the IRR, and what happens when things don't go right?

When things don't go right, we never get to that IRR box. And so, in this example, we'd be 85% working interest owner in a lot of wells that were poor performers. And, ultimately, there's no reversion that happens. But you know there's nothing beyond that. There's no acreage collateralization or hooks into existing PDP or other treasures within Chaparral that we have recourse to.

Any other questions?

Question then about since a lot of these happend on the tier-two and tier-three acreage, and in light of just unconventional service company intensive tech work, have you guys noticed any service-quality related issues with the service companies? Because a lot of those tend to be devoted to the larger customers on tier-one acreage. And we found that an AFE max really mitigates that for you. Do you see AFE for lats above the AFE max?

I think the fact that we can cobble together-- a lot of times, you're partnering with someone who episodically has drilled-- has never had a fulsome development program of multiple rigs. So by being able to put out that two-year drilling commitment or rig line, I think that that helps get you the better quality service providers. And, yeah, we really haven't seen-- at least to my knowledge-- that any deterioration here versus there on DrillCo wells based on what I'd call poor service providers, or B service teams.

How do you control AFEs when they start to overrun?

How do we control AFEs?

Yeah, when you get AFE overruns. Do you step in and tank? You start setting limits. You start tightening the strings. What do you do?

We set limits. So we'll fund 100% of what we all sit across the table and agree that the well will cost. And the operator will take overages.

Overruns are on the operator?

Yeah.

OK. Thank you.

You know there's never any overruns. You know that.

If there ever was an overrun.