The heady days of drill-and-flip A&D are gone, finally capsized by the rogue waves of commodity crashes. But now that the demand drought has ended, some E&Ps managed to find a way to keep from being pulled to the bottom.
Tulsa, Okla.’s Canyon Creek Energy is one of them. Led by president and CEO R. Luke Essman, the company was founded in March 2017 with the idea of quickly building up a demonstrable production base and then selling. Canyon Creek, backed by Fort Worth, Texas-based Vortus Investment Advisors LLC, now finds itself on an island of 35,000 acres in the nearly forgotten Arkoma Basin, churning out production and cash flow to its investors and considering its options.
Darren Barbee: You were in kind of the last class of the drill-and-flip companies. How did you adjust as the world crashed around us?
Luke Essman: Survival is an appropriate and sometimes overused term, right? To that point, we would not be where we are without good partners and good partners in our capital stack. The benefits of being a public company is there’s plurality and most times lack of control. In a private company, you end up having pretty material decision makers that are part of your investment, whether that’s banks, equity holders [or] somewhere in between.
“We’re able to develop out of cash flow coming off our existing production and off our existing investment decisions.”— R. Luke Essman, president and CEO, Canyon Creek Energy
I think we saw a lot of forced consolidation because they were maybe mismatched with management’s expectations for either duration or expectations for what their investment thesis was and be able to run that out. And for us, we have benefited from having really good investment partners on the debt side and the equity side of our company.
DB: When you formed the company, what was the business model you pitched versus what you had to morph into as circumstances changed?
LE: It’s the narrative of our company. We’ve lived it. We were started like any private equity-backed company in the sense that it was a build-and-flip model. There was no perpetuality to our business. That wasn’t the idea. And that’s just by virtue of our investors having term limitations on how long their investment period can be. It’s in the nature of the business.
But the idea was to go to a basin that we saw was overlooked and try to increase production, increase the investment thesis of it and then try to sell that to somebody else that could take the company through development or take the asset through development.
We saw the collapse in the industry. We saw the collapse in the acquisition side of the industry where there was no more need to be able to own PUDs or development opportunities. It was about cash flow. Public companies got marked to cash flow, sometimes marked below we’d expected to cash flow. And so, the amount of capital available for acquisitions went to zero.
And so, we were faced with the decision of saying, “Look, our thesis needs to change if we want to stay in business. How do we build and support this company from a capital standpoint, from a technical standpoint, repeatable operations, development, mentality, cost monitoring? These things maybe don’t live with a build-and-flip idea because it’s a short duration. Do we want to invest in that infrastructure, capital infrastructure, personnel infrastructure, to be able to have a thesis for continued development?”
And that’s where I go to the conversation and say we had good partners willing to pivot and willing to think that we do have a good platform. We have a good asset. The market changed on us, and we want to be able to hold through it. And so, we went out and hired development personnel. We increased our capitalization, both on the debt and the equity side, to be able to give us some longer duration on our investment and have been really a development company for two years now.
DB: Did you have the team you needed to do that?
LE: We had the backbone we needed to do that. We had really qualified technical personnel. In a small company, a lot of those people end up wearing multiple hats. There’s a lot of crossover between geology [and] engineering, [and the] land department is doing all kinds of functions, anywhere from permitting all the way up to the leasing to actually the strategy side of it.
What we needed to bring in and supplant our team with was the mentality of, “Hey, I’ve run five or six rigs; I’ve drilled 40 wells a year.” These kinds of things instead of us just being very lumpy in development, where we may drill a pad and watch flow back. And we may manipulate what we do in the next one based on historical results.
We need to bring in that continued development mentality. So, we hired three people that were pretty instrumental to our company. Again, we’re a company of 15, so three is pretty impactful to that and still asking them to wear multiple hats in a small company but bringing another set of experiences and ability to our team to be able to kind of supplant the backbone that we have.
DB: In the public space, there’s obviously been this push for free cash flow generation. Are you now at that point where you are fully oriented toward that, and are you able at this point to be able to say, “Oh yeah, we’re able to throw off free cash; we can do that,” or is that on the horizon?
LE: No, we’re there, and we’re proud to say it now. We think of free cash flow a little differently than public companies, in the sense that when I discuss free cash flow, I mean that we have no more needs for debt. We have no more needs for equity investment. We’re able to develop out of cash flow coming off our existing production and off our existing investment decisions. And so, we’re recycling. At this point, it’s going to be a majority of our free cash flow because of where commodity prices are that makes sense to be able to pull resource out of the ground.
But we’re no longer in the capital markets. We’re no longer increasing our equity investment or increasing our debt. In fact, we’re forecasting de-leveraging through pay downs and building our balance sheet back to help the company.
That was one of those pivot points for us, where we had just gotten to the precipice of getting to free cash flow, and we were able to tip that last year. So that was a little bit of the bet with the investors and with our debt, is that we’re really close. This year, and probably for the foreseeable future, we’re developing out of just our existing production base.
DB: I’m sure you’re having to pay your investors. How are you balancing that with continued drilling and other expenses?
LE: It’s a fluid conversation. Our investors have investors. And so, as I mentioned, I can’t underscore more just the relationship we have with them. I think they’re in the market; there've been lots of conversations we’ve heard about between investors and management companies.
We don’t experience those. We’re having very fluid conversations about what we’re doing with incremental cash flow. How does that help them, help their business? How do we continue to build our business alongside that? But again, with $4.50 gas and $100 oil, it’s a pretty short conversation to say, “It makes sense to reinvest in resource.”
That may change as commodity prices move. We may shift that weight as we go forward, but right now, we’re all pretty locked and aligned on developing resource.
DB: One of the advantages I’ve heard about private companies in the past year has been that they don’t have the same restraints as public companies that have to demonstrate capital discipline to shareholders. Private companies have been able to just drill as they please. Have you been able to step up drilling in order to capitalize on the rise in prices?
LE: We don’t take a lot of things from the battlefield against a public company, but one of them is our nimbleness, our ability to react and our decisions that we make every day have a much higher impact on what we’re doing relative to our company’s size.
And so when we see those opportunities, exploit those advantages on the battlefield of the long gas industry, we want to hammer those. Because most of the time we’re not going to win a long duration war, we’re not going to win a war through big commodity cycles. We just don’t have the balance sheet to be able to weather those things, I’m afraid. Especially if we talk about relative to cost of operations for a smaller company.
So the purpose of a private company is to be able to react when we see these disconnects in price. When I see the public companies saying, “We’re going to do variable dividends, or we’re going to kick cash back out to investors,” that makes intellectually no sense. I understand why they’re there, because of the history, but it makes intellectually no sense that you wouldn’t put every dollar you have into the ground today when prices are delivering the types of returns we’re seeing.
But they serve a different cause, a different narrative, kind of these things that are available to them, it gives them longevity as their platform. But we have a small investor group. We have a small investment decision opportunity. And so we can look at investment opportunities very quickly. We can make decisions very quickly, and we can exploit those.
DB: Your internal rates of return have been really good. Were you impacted at all by the hedges? Pioneer Natural Resources Co. wrote off a large sum of money. Were you affected by that?
LE: Oh, sure. I mean, look, we have a pretty healthy hedge book. So prices I show in our investment is going to be our incremental dollars that we go in. But we’re always naked on new gas. That’s also the benefit of a private company. So we have a base load hedge book across our existing production that’s going to be at low current prices. But every incremental drilling decision we make is so impactful to our balance sheet that we’re getting current price exposure as we move forward.
So that process looks like we’ll go hedge our existing book and have done that over the years to be able to maintain our base load cash flow. As we drill, that’s going to be a slug of new gas that comes online, and we’ll be able to get market exposure on that. We’ll hedge into that. We’ll do the next one.
So we’re continually moving our hedge book up. If you look at it in totality, it looks like we’re well below where current prices are just because of the run-up in gas prices, for instance. But every dollar we put in, we’ve locked in a return profile with that. And then we’re very comfortable with that. And so it’s a little more nuanced than just looking at a huge company like Pioneer and seeing how they do across their base load. Everything that we’re making on an investment decision is very impactful, and it allows us to get access to the market.
DB: Canyon Creek at one point had 70,000 acres, and now you’re at about half of that. What necessitated that divestment?
LE: It goes back to your original question about business models changing. The strategy of the company was to get big and get big fast and to show availability of investment opportunities. So a lot of our acreage position, if we talk about it from that metric, was going to be on term leasehold—leasehold that wasn’t held by production as we’re expanding out of the Arkoma Basin.
So commodity prices didn’t allow us to continue developing into that acreage position we had. We had a lot of term leasehold expire. And so that’s going to be the principal driver from that drop in acreage position. If we’d have been in today’s market, or if we would have been in a continuation market where we were, we would’ve continued drilling on that leasehold, converting that term leasehold into held acreage and would’ve maintained that position.
The fortunate thing for us is while we haven’t drilled, neither have our competitors both in the basin and then across Oklahoma, across the U.S. And so that opportunity for us to expand back still remains. We still have that opportunity to continue to grow.
But we’ve also changed our directive for our company to be more developed. If we put a dollar down a hole, we want to get $2 back. And we want to be very purposeful about that. We don’t want to put money into fixed costs. We don’t want to put money into option value that may come with leasehold. We want to make sure we churn profitability from each incremental dollar we spend.
And so I’m less worried about acreage size. I’m more worried about what I am going to do in the next 12 months. What am I going to do the next 24 months? And making sure we can capitalize that, scale that out for profitability generation. Because that terminal value of an asset sale, which was our original investment thesis, we’re not making that anymore.
We’re looking for every incremental dollar we put in the ground, we bring two up, by example. Not looking for some buyer at the end. And it’s actually a very healthy business model. So if prices contract, we’re not waiting on a terminal value that can collapse our company. We’re looking at just incremental growth with that, and we’re actually running an oil and gas company.
DB: There was a point in late 2019 when many people were looking at the Midcontinent and not really seeing a great deal of value here. Did you feel like at certain points people have just completely forgotten about the potential that the Arkoma held?
LE: I think it still lives today, right? I think what we fight with is there’s been misinformation presented from public companies about how great every basin in the U.S. is and not being intellectually honest about what the variability and how much technical expertise needs to go into optimally developing basins.
So we were caught up in the narrative of, “Let’s just take a big hand across a small map and say there’s oil and gas everywhere, and it’s awesome.” And what we’re really finding out is whether it’s a midcon or more specifically the Arkoma Basin, it’s nuanced. There are going to be results that are variable from time to time.
We’re drilling 6,000 or 7,000 ft into the earth, and we’re spinning a couple miles from out there. And you tell me what guys got eyes on the end of that drill bit down 15,000 ft away. You don’t know. There’s so much variability in what we do every day.
If we would’ve been intellectually honest about the way we develop resources in the U.S., we’d understand that there are appropriate ways that may not always be a lay down to another basin about how they’re drilling shallow depths, along laterals. We would not apply that to another basin.
The way we’re completing wells, you wouldn’t necessarily apply to another basin. The Arkoma, it was like a first girlfriend for a lot of guys, right? And they drilled a lot of wells within that basin. I mentioned it’s the second horizontally developed resource in the U.S. behind the Barnett Shale.
And so you had a lot of guys learn how to kiss. You had a lot of guys learning how to date during that. And they have those histories on it. It’s like, I always hear the conversation that says, “Oh man, I remember my time in the Arkoma Basin, I drilled this well, I did that.” And they stopped in time. That was their memory of their girlfriend, and that was their memory of that experience. And they set it on the shelf and they walked away.
And so when you have those conversations with people, and those people are a lot of times now upper little of managers, they’re running companies and they carry that history with them. And instead of looking at what could be done today, they’re looking at what their historical experience is with that.
And so we don’t have a public company that’s out there, hitting every 10Q, talking about the results they are having with the Arkoma Basin. One, it’s not a big basin. But then secondly, there’s no publics that are touting the results within it. So it’s left up to the private companies.
On one side, I don’t want to talk to you about it because we’re having good results. But on the other side, it’s like, “Look, it’s okay you had a history here. That doesn’t mean that’s what’s going on today.” And I’m not going to tell you it’s great everywhere. We’ve had our learnings during it.
But we figured out a way that we can generate a really nice rate of return for our investment. When prices move with us, we can generate an exceptional rate of return. Does the market want that? I don’t know. We’re not set up really to ask what the market wants right now. We’re able to generate resource out of our development right now and generate that for our shareholders.
It’s really a pretty fascinating pull together of convergence of events, in the sense that people know the basin, there’s a general excitement about it because there’s a lot of early horizontal teeth cut in here. But the understanding of where we are today is so much further advanced than where the basin was when the lights were kind of turned out in ’07 or ’08.
DB: Let’s turn to A&D. Do you see yourself as potentially an attractive target or that you could go back in and acquire additional acreage? Do you think that that would be something that your capital providers would be interested in?
LE: We’re candidly today oscillating between are we buyers or sellers where prices are. The market’s moving that quick right now.
And we’re seeing the capital markets open up a little bit. Maybe “open” is the wrong word, but we’re seeing guys walk into the door about ready to flip the open/close sign. Like there’s momentum that way. And so we’re in a commodity business. I’m telling you about my assets today. I may have more or less assets tomorrow in a different basin than we were. We’re commodity producers, right? And so we can’t fall in love with our rock. Just try to make the most of it as we can.
But I think probably back to your question about where are we on the A&D market? It makes no sense for me to go acquire production at, let’s call it, a PV-10 basis. So 10% discounted future production at $4.50 gas, which takes your opinion on where gas is. I don’t know. I mean it feels really good right now versus I can take those same dollars and put them into a well and generate a 200% rate of return.
There’s no math that tells me that those two things equal each other. So I’m also conflicted on that. I like size. Everybody likes size. There's stability with size. Generally with acquisitions comes more debt. I don’t like debt because I’ve felt debt, and debt’s painful.
“We’re candidly today oscillating between are we buyers or sellers where prices are. The market’s moving that quickly right now.”
And so right now, we’ve got enough inventory and enough development opportunity that I can drill at very robust returns for our company. So it’s that, coupled with where are prices at? I don’t know. We’re price takers every day. We don’t actually make the market. And so it feels good right now. And so we’re pretty nosed down on developing right now because if we needed to expand our position for additional inventory, there may be an acquisition that needs to be made, but we’ve kind of already done all that.
DB: Are you active in the ground game such as swaps?
LE: Oh yeah. We’re very active with our partners. I mean, Calyx, we’re in multiple areas with them. We work very well with them. Other operators are Marit Energy [and] Foundation Energy—these companies are our neighbors. And once you kind of go to war together, and at bad prices, you realize that there’s more in life than fighting about every nickel and dime everywhere and how to be collaborative. We like to think of ourselves as good partners, whether we’re on the nonoperated side or the operated side or how we strategically develop a certain area. We try to be good partners in all that.
And so a very collaborative mentality across that basin. It’s a band of brothers of sorts coming out of there.
DB: And bolt-ons?
LE: Probably the comment on all that is we have an internal threshold of what we think we can risk just to spend money within our company. And we’re like any other company; we’re making a determination that where should we spend our incremental dollar? We’re no longer kingdom building, and I think it’s important.
We were kingdom builders before because we’re going to try to flux on the public market or on the auction market, sales market and try to look big. Now we’re about putting a dollar in the ground, getting two out. How do we do that? And where’s the best place to do that?
DB: How do you see the market evolving as prices improve and potential buyers begin to look at upside versus PDP? Or do you see a larger consolidator eventually acquiring in the Arkoma?
LE: Yeah. It’s a nuanced question. It’s hard to hit it with one point. What my talking points on that would be, it depends who’s the buyer. So I think there’s going to be a lack of interest from a public market standpoint on the Arkoma Basin. Prove me wrong. I can be wrong with that, but again, who are they serving? What is their ultimate game? They want to be able to sell stock.
And so are they going to sell stock with an Arkoma platform? Maybe if they can get it big enough and they can show there’s really a reason to stand up an investment team or technical team and an investment into this basin. We’re fairly fragmented. There’s been a lot of consolidation through NextEra [Energy], through Foundation, through Merit. Putting that position together would probably be difficult right now without getting a few parties in the room.
So that kind of, in my mind, removes a public company acquisition opportunity within this area, especially with the contraction in the Anadarko as well. There’s a lot of opportunity across Oklahoma if you’re willing to take a bite of Oklahoma. And that’s a separate conversation about how short-sighted that is that people aren’t investing in the state.
But then we come back to who is the buyer of a smaller private ... So, not public, comes back to a private buyer. We’ve seen Merit, and the Foundation, NextEra, Trinity, who’s a subsidiary of NextEra, the power generation company, buy and they’ve historically bought off PDP values at low prices.
They think they’re going to be big winners on just timing when they bought and the value they bought at. Most of those PDP heavy buyers that leaned in really don’t have development arms associated with them. They’re not going to be heavy growth vehicles with them. So I don’t see them, as the market starts expanding and we start seeing values expand, being really active in the acquisition side because they’re going to have to put more into this upside bucket however you attach that value to it.
DB: You were a company that initially was looking to drill, to prove up and drill and eventually sell. What’s an exit look like for you now?
LE: I like cash. That’s a simple answer to a good question, but look, there’s always a number. I’m not a good manager for my stakeholders if we’re not always considering that. That sounds canned, but it’s absolutely true. If we’re not always considering the best way to maximize shareholder value, we’re not doing a good job as managers. That said, we would also not be good managers if, when we entered this down period, we didn’t stabilize the company to not have to require an exit. To not have to rely on an exit. That’s also not a good manager, is that we don’t create that optionality. And so we focused really hard on making sure we had time and the capitalization to be able to [say], “Hey, we like the price. We’ll take it.” We’re price takers every day.
But if we don’t, we’ve got a continuation plan of what we’re doing. So yes, absolutely. Whoever reads this, if they want to come buy us, give me a phone call. That’s absolutely true.
But we’re also not in that bucket that we’ve got to sell now, or we’re going to be forced to sell because of some of these other outside influences that are typical of a private equity-backed company.
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