From majors to minnows, producers aim to find company-making fields. But for small E&P companies that lack the liquidity to develop these projects, the best discoveries have proven at times to be a curse, rather than a blessing. Developing the discoveries may be difficult, expensive or time-consuming. It can be years before shareholders know if their patience, and investment, will ultimately pay out. Three years ago, Natchez, Mississippi-based small-cap Callon Petroleum Co. (NYSE: CPE) embarked on this journey in the deepwater Gulf of Mexico. No one doubted the potential of its prospects, which were operated by Murphy Oil and Shell, but as the development schedule was pushed further and further, some well-timed financings and asset sales were required to keep the company going. "In hindsight, these delays were a bad combination of worst-case scenarios thrown at Callon. For larger companies, that's not an issue. But for smaller companies, it is an issue," says Stephen Smith, founder of Natchez-based independent research firm Stephen Smith Energy Associates and formerly an E&P analyst with RBC Capital Markets, Dain Rauscher Wessels and Bear Stearns. "It certainly tested management in terms of its ability to pull it off." Callon did pull it off. In November, the Murphy-operated Medusa Field, in which Callon has a 15% interest, came online-a year behind schedule-and is producing 25,000 barrels of oil and 25 million cubic feet of gas a day. And the Shell-operated Habanero Field, in which Callon has an 11.25% interest, has also begun production-23,500 barrels of oil and 65 million cubic feet of gas a day. This year, with some of its major deepwater goals behind it, the company is looking to explore again-an activity that took a back seat during the recent liquidity crunch. Its conventional exploration program will be on the Gulf shelf, and it has launched a new deep-shelf exploration program. "Everything on the Gulf shelf will be reserve-additive," says John Weatherly, Callon senior vice president and chief financial officer. "We're looking at about a five-fold increase this year in reserve-additive spending versus last year." In May 2001, Callon planned a refinancing that would have addressed all of its spending needs for the foreseeable future: its share of expenses toward developing Medusa, delineating Habanero and delineating another deepwater field, Boomslang; drilling on the Gulf shelf; refinancing $100 million in debt that was due in 2002 and 2004; and refinancing its outstanding bank-line balance. In a combination debt-equity plan, it was to sell $225 million of high-yield senior notes due 2008, and it had already priced 4.5 million shares for $11 each. At the 11th hour, the debt deal fell through, primarily because development of Medusa and Habanero was in such an early stage, Weatherly says. Callon called off the equity deal. "We were not going to get credit from the market or from the rating agencies for what was supposed to happen with those fields," Weatherly says. When the financing fell through, some perceived the company had a $225-million shortfall to fill, but that wasn't the case, he says. The company focused on its immediate needs: cash to continue to pay expenses toward developing Medusa and delineating Boomslang and Habanero, and to pay $36 million in debt that was due in 2002. At the time-July 2001-Murphy's plan was to bring Medusa online in the fourth quarter of 2002, and Callon expected to use the cash flow from that production to pay its share of costs for development of Habanero. Its immediate need: $95 million. Duke Energy's newly launched producer-finance unit, Duke Capital Partners, stepped in. Callon issued $95 million of 12% senior notes to Duke Capital, along with warrants to purchase more than 265,000 common shares, and an overriding royalty interest equal to 2% of its net interest in four deepwater discoveries-Medusa, Habanero, Boomslang and another find, BP-operated Entrada, in which Callon has a 20% interest. (Murphy-operated Boomslang was later deemed non-commercial.) It was the inherent quality of Medusa and Habanero in particular that allowed Callon to find the capital it needed, but it was expensive capital, says Subash Chandra, an E&P analyst with Morgan Keegan in Houston. "Many parties were willing to finance the developments, but they were charging astronomically for the privilege." Going into 2002, it became apparent that Medusa would not be producing by year-end. There were construction delays on the spar platform, and a barge that was to lift the deck onto the hull got tied up in a Gulf eddy and arrived at Medusa two to three months late. These events added up, and pushed production from Medusa into late 2003. "We knew we hadn't quite covered it with the $95-million Duke Capital deal," Weatherly says. Callon had expected Medusa to produce $40 million in cash flow, net to Callon, in its first year of production. So in July 2002, Callon pieced together what it needed through four transactions. It added a $30-million Tranche B to its bank credit facility, increasing its borrowing base to $75 million. It negotiated an extension on $23 million of the $36 million in debt that was to become due in September 2002. And, it sold its North Dauphin Island pipeline for $7 million and its hedging claims against Enron for $2.5 million. Every dollar mattered. "A million here and a million there was the difference between survival and disaster," Chandra says. But in late 2003, having to fund both Medusa and Habanero without cash flow from either, "it got real tight," Weatherly says. Approximately $1 million remained available on its $75-million bank line. The $23 million in 2002 notes that had been extended were due in July 2004. Some $40 million of debt was due in December 2004. And, its bank line was up for renewal. If the company survived all of this, it would be greeted next by the $95 million in Duke Capital notes due in March 2005 and $33 million in subordinated notes due in December 2005. "Medusa and Habanero weren't going to generate that much cash flow," Weatherly says. On top of this, the company knew it had to fund an exploration program in 2004. Callon added no reserves in 2003, as it was preoccupied with Medusa and Habanero. It was critical to reverse that trend. The company considered turning to the high-yield markets again, as it had tried to do in May 2001. But the issue was one of timing. After coming online in late 2003, how much could Medusa and Habanero produce in order for Callon to secure a deal by the time its debt came due in July 2004? Relationships came into play. In December 2003, a significant money manager who had stayed close to the Callon story for many years helped arrange a $100-million private placement of seven-year senior notes, with a single buyer. That addressed the entirety of Callon's 2004 maturities, and allowed the company to pay down $24 million on its bank line. More buyers eventually came in, and another $100 million was raised in follow-on offerings. Callon paid off its $95 million in Duke notes. Also in December 2003, Callon created a limited liability corporation to hold its interest in the Medusa spar, which allowed it to get back $25 million of its investment in the production facility. Callon used the money to pay down its bank line to a total of $30 million. In a nutshell, at September 30, 2003, Callon had $268 million in debt, every bit of it due in 24 months. By March 31, 2004, it had $17 million outstanding on its $75-million bank line, $33 million of subordinated notes due in late 2005, and the balance of its debt-$200 million-due in December 2010. Total debt has not been reduced much-from $268 million to $250 million. But liquidity is no longer an issue, Weatherly says. Medusa and Habanero are online, and cash flow this year for the company is expected to be between $75- and $90 million. Chandra will be watching to see how Callon spends that money. "The biggest issue now is that they never resolved their debt problems-they just deferred their debt problems." Between now and when that debt comes due later this decade, the company's most obvious production will have been had, he says. "That's the curse of it. Once you have it, you have to replace it." Callon will have to take on higher-risk exploration and look for elephants. "They're going to have to redeploy this capital effectively," Chandra says. Stronger gas prices have helped Callon's efforts, he notes. "That was probably as important to get them to first production at Medusa and Habanero as anything else." However, he also credits management with some smart maneuvering during the lean years. "Management has been quite nimble and I applaud them for staying afloat." Prior experience This wasn't the first time management has led Callon out of a liquidity crunch. In the 1980s, it went through a much more severe crisis. Callon, like many other companies, had taken on some debt to form limited partnerships for drilling and acquisitions. The company was in the midst of consolidating these 27 partnerships into a single entity when oil prices collapsed in the mid-1980s. The Federal Deposit Insurance Corp. (FDIC) took over Callon's banker, and called the company's notes. Callon paid off its debt to the FDIC, avoiding bankruptcy. Through the course of consolidating these partnerships, Callon went private in 1988 and entered a rebuilding phase. In 1994, it went public again. Today, Smith says he can see the light at the end of the tunnel for Callon. Its Gulf shelf program should generate some quick cash flow, and its Medusa and Habanero projects have upside thanks to smaller, satellite fields that can be quickly tied into the existing infrastructure. "Callon has sort of paid its dues, in a way. By doing these big projects, now it has these satellites," Smith says. "I would say it's over the tough part, and the exploration potential around these discoveries is attractive." Callon's stock price averaged $5.19 in 2002 and $6.53 in 2003. It was trading at $11.58 in late April. He calculates that its asset value at year-end 2003 was $14 a share, using a price deck of $4 for gas and $25 for oil. "The company's shares are still selling at a discount to, I think, a reasonable asset value," Smith says. "But now that Callon has turned the corner here and is starting to address liquidity issues, as well as getting an exploration program going again, it's not going to sell at that kind of a discount for long, I think." Callon has a $65-million capital budget for 2004, Weatherly says. After $11 million for overhead and interest, that leaves $54 million, which will be evenly split between Gulf shelf and deepwater prospects and projects. In deep water, Murphy Oil will finish tying in additional wells at Medusa, and Callon hopes to drill a delineation well at Entrada, where it hopes to assemble partners to buy out BP's interest. But Callon is particularly excited about its Gulf shelf program, says Fred Callon, chairman, president and chief executive officer. "We think we've put together a nice inventory of prospects." Two prospects on the deep shelf were being drilled at press time-High Island 119, operated by Westport Resources, and West Cameron 295, operated by Magnum Hunter. Callon has approved seven shelf prospects for drilling this year, but may bump that up to 10 or 12 before the year is over. Half of those will be in the deep shelf, and half in the shallow shelf. GAMBLER The degree to which Callon stands out as a small-cap that tossed the dice is shown by data from a recent Howard Weil study of finding costs and reserve replacement for 46 public companies. The benefit of jumping into the Gulf of Mexico's deep water to find big reserves is clear, as Callon ranks fourth among the 46 companies in terms of posting the best reserve replacement through drilling alone for 1999-2003, at 346%-without acquisitions. But it has paid a price for going deeper. Callon's all-sources finding and development (F&D) costs for the five-year period averaged $13.37 per barrel of oil equivalent, well above an average for the 46 companies of $7.38. Only two of the 46 companies had a higher five-year average F&D. In another measure, Callon ranked first for having the highest percentage of total costs incurred for exploration alone, devoting an average 52% of its budget to exploration during the five years.