Steven R. Williams, president of Bridgeport, West Virginia-based Petroleum Development Corp., entered the public-drilling-fund business just as this investment strategy, which had made small fortunes for petroleum-naïve doctors and tennis coaches, succumbed to uneconomical commodity prices, bankrupting many "When I came in, we had close to $20 million in obligations and gross revenue of about $10- or $12 million a year," Williams says. "We spent the rest of the 1980s digging out...But we honored our obligations." The company still organizes public drilling funds-four a year-and successfully for itself and for fellow investors. The lessons of the 1980s were not lost. "That background tends to make us fairly careful in terms of financial structure and debt." Petroleum Development (Nasdaq: PETD), public since 1969, has seen its share price improve from less than $1 eight years ago to more than $7 recently. Its sales have grown 37% and its earnings per share 31% on average each of the past five years. Recently, Forbes named it one of the best small companies in America. Production in the first nine months of 2000 totaled 4.6 billion cubic feet of gas equivalent (91% gas), up 89% from the same period in 1999 and already more than the 3.5 Bcfe in all of 1999. At year-end, it will report its 11th consecutive year of positive net income. Alex Montano, E&P analyst for Irvine, California-based C.K. Cooper & Co., says 2000 will prove to be a watershed year for Petroleum Development, and this strong growth will continue at least through 2001. He has a long-term Strong Buy and short-term Buy on PETD with a target of $8. "In large part, the acquisitions of producing fields and acreage positions in Colorado are driving production volumes at the company to record highs. PDC is also experiencing very strong sales of its partnerships, suggesting that this key indicator to revenue growth in 2001 continues to take shape," he says Williams was introduced to Petroleum Development in 1982 by way of a fellow Stanford University MBA student's father, who was organizing public drilling funds. Petroleum Development was one of the funds' driller-operators. In 1983, Williams, whose undergraduate degree from Carnegie-Mellon University is in engineering, joined the company. "The people who were putting the partnerships together were taking bigger and bigger pieces and the investors got less and less." Petroleum Development survived by eliminating the middleman, which was the position his friend's father held. Williams explains in the following interview with Oil and Gas Investor. Investor How do public drilling funds work? Williams Basically we're offering investors an opportunity to participate directly in the drilling of oil and gas wells by investing in a drilling partnership. They invest from $5,000 up to whatever amount they choose-our largest investor right now has $1 million in one fund. We provide about 20% of the total partnership capitalization, and we drill the wells and share in the proceeds. One of the advantages to the investor is some initial tax savings, because we allocate to them all of the intangible drilling costs, so they have a significant deduction that is available in the year in which they invest. Then, they benefit from the future cash flow stream. Investor For five years? Ten? Williams Each fund is set up with a 40-year life. We've been doing this since 1984 and all of our partnerships are still sending checks to investors each month. The wells that we've drilled historically, and the wells we're drilling in the Rockies, tend to be long-lived. They're in relatively tight formations, which by their nature tend to give up their product relatively slowly but over a long period of time. So, we're anticipating investors will continue to receive checks from these partnerships for 25 years or more, and ultimately we'll reach a point where we'll sell the properties in the partnership or we'll plug the wells. Investor Have you had a fund that was not successful? Williams We have a range of success. It depends on how good the wells are and what the prices were, particularly in the first few years that we're selling from the wells, because those are their best producing years. Certainly, we have some that we're not real proud of, and we have some that we think have done a very good job for investors. The partnerships of 1996-97, given the gas prices in those years, have not been particularly exciting. As prices improve, it makes a big difference to what the investors are getting, even several years into a partnership. A 50% increase in price can result in a 100% or better increase in partners' distributions. So, it's a combination of commodity price and drilling success. On average, a third to a half of our investors in each of our partnerships have invested with us before. I think that is an indication that they're happy with what we've done and they realize this is a business that has risks. The latter is true if you're investing in oil and gas stocks, as our shareholders do, or in the properties directly, as our partners do. Investor Yes, let's discuss that-potential investors can also simply get in on your 20% in each partnership, by investing in Petroleum Development itself. Williams Yes, in one case you're investing through PDC in the partnerships, and in the other case, you're investing in PDC itself, by buying the stock. Partnership investors own no part of PDC, unless they have purchased stock. Investor Your shareholders and partnership investors were disappointed recently with your gas-price hedging, which was done at less than $3 per thousand cubic feet (Mcf) while spot prices were more than $4. Williams We did hedge a majority of our production through the summer, which is April through October in our business. The price at which we hedged was the highest in eight summers. A lot of other producers also hedged a substantial part of their summer production. Given the same scenario, we would probably do this again. Meanwhile, we'll maintain some part of our production unhedged, and ultimately that will prove to be the wrong decision. Gas prices are going to change tomorrow and the next day, and some times they're going to go up and some times they're going to go down. Any hedging policy or price-stabilization policy you have is likely to not be the optimum one, but it is a fair and sensible one. Investor You're self-funding for the most part, through the partnerships and cash flow? Williams The company has been public, since it was formed in 1969. But we did our first public offering in 1997 for net proceeds of $23.6 million, to increase our participation in our newer drilling partnerships, principally in Michigan, and to take advantage of some acquisition opportunities, including two in Colorado, at least one in Pennsylvania and some in Michigan of existing producing wells. In the last year we used about $14 million in debt-we have a $20-million credit facility with First National Bank of Chicago-for acquisitions and participation in new wells. We have a focused effort currently to increase the company's production, and to make production income a bigger and bigger part of the corporation. If you look at the universe of oil and gas companies, most of them are just production companies. We're sort of unique in that we drill and complete wells for our partnerships. For a company our size, we're the most active driller in the U.S. We've been working on growing the other side-the conventional oil and gas company side. Eventually the production business will become our primary business, rather than the second business, and not because the partnerships will get smaller. Investor Is your stock, currently at about $6 a share, fairly priced? Williams No. It's discounting some really positive aspects of the company. Our hedges start to roll off this month, leaving a significant amount of our gas unhedged, and what we still have hedged is at significantly higher prices. Over the next six months, a majority of our production is hedged at $3.37 an Mcf. And only 20% is hedged after March. Also, due to the increase in gas prices, we closed our second partnership this year at twice the level at which we closed our second 1999 fund. Assuming that trend continues, that bodes well for the drilling part of our business. So, I don't think our prospects are fully recognized by the market. There's certainly some upside potential in our stock during the next 12 months. What we've been able to accomplish during the past five years is essentially a share-value appreciation that is greater than that of all but a very small handful of our peers. That's a record we are proud of and, more importantly, we can continue to achieve in the future. The partnerships are an integral part of that. They generate additional cash flow that we can use to invest in additional producing properties, which results in greater growth. Investor Why don't more sell-side analysts cover PETD? I count just one. Williams It's a reflection of new market realities, to some degree. Nasdaq says more than 50% of Nasdaq-listed companies have one to three analysts covering each stock and there are a number that don't have any coverage. So, we're certainly not unusual in that respect. Analysts are paid by the brokerage firms for which they work. The discount brokers are taking over and there's been a squeeze in that area. Fewer and fewer analysts are available in terms of the number of companies out there. Of course, one way to get coverage is to do deals with investment banking firms. But, I would prefer to not let my business be driven by trying to get analyst coverage; I'd rather go to investment bankers when we have a good idea that needs funding or when we need their services in another way. More analyst coverage is something we're interested in, but the lack of coverage is a concern that is not easily addressed or answered in today's market paradigm. Investor Do you solicit potential investors in-house? Williams We distribute our partnerships through a nationwide network of NASD broker-dealers. About 120 different broker-dealers have our product as part of their arsenal of financial products that they offer to investors. That comprises firms that may consist of one or two brokers or that have 3,000-plus brokers. Our product is for brokers that are actively involved in financial planning practices-not just selling a mutual fund but looking at investors' entire portfolio and saying our product is a piece that makes sense with the other pieces they're putting together for their clients. Investor The 120 reflects growing confidence in your funds? Williams Yes, it has been growing virtually nonstop for the past 10 years. We did have a bit of a drop in our sales last year in response to the low oil and gas prices but we're running on a record sales pace this year. Investor How did Petroleum Development survive the 1980s, especially given the investor discontent with public drilling funds coupled with declining commodity prices? Williams It's really interesting. We got into the business of offering partnerships (when we took over from the middlemen) when partnerships had the worst name-not just oil and gas partnerships but real estate and the others. The people who were putting the partnerships together were taking bigger and bigger pieces and the investors were getting less and less. Prior to 1984, we acted as driller-operator for partnerships that were formed by outside general partners. In looking at that scenario, we came to the conclusion that if we wanted to continue to access individual investor capital, we needed to be able to offer a better product-essentially get rid of a majority of the middleman load. With our success over time, we've overcome that negative. Investor Surely there are those who still refuse to participate, nevertheless. Williams Even today, it is difficult to interest some potential investors who remember the 1980s and those partnerships. Some want to know what's different between what we do and the partnerships they were in. In those days, most of the partnerships that were offered were essentially tax shelters with multiple tax write-offs that were generated basically through some kind of borrowing, and when one combines leverage with declining product prices, a really ugly situation results. That's true for corporations too. The newer partnerships, the ones we're offering now, because of the changes in tax structure, don't have any leverage associated with them. They're cash investments, so the relative impact on the investor is not magnified by the impact of the leverage, of having to pay interest on borrowed money. Investor Ever consider getting the company or partnerships involved in high-risk, but high-return-potential, plays? Williams Our wells are a good base on which to build a company over a period of years. It's not flashy but it's good, it's steady-it's a building-block kind of approach, instead of a home-run approach. In some ways, when I look at other oil and gas companies out there that are valued more highly than ours, it appears they have some sort of flashy big prospects that are going to "make" the company. Frequently, when we look back a year or two later, those developments never materialized and that company is back down to a valuation more in line with where we are. Investor What were Petroleum Development's darkest days? Williams Anywhere in the 1980s would probably qualify. We were hanging on by our fingernails through the '80s. Prior to myself and the current chief financial officer joining the company, PDC made investments based on continuing escalation of already-high gas and oil prices. We spent the entire decade digging out of debt, paying it off in 1990 or thereabouts. Investor What have you learned from that? Williams That background tends to make us fairly careful in terms of financial structure and debt. We're not going to take the biggest position in a drilling program. We're going to continue to stay focused on not trying to be everything to all people, but to build on our experiences in tighter formations and shallow natural gas and being able to drill a lot of wells pretty efficiently. We think there are some plays where those skill sets fit very well. That's not offshore Gulf of Mexico and it's not in 20,000-foot wells in Oklahoma, but it certainly is a good fit with what is available in the Rockies, Michigan and the Appalachian Basin. THE EXPLOITATION STRATEGY Eric R. Stearns, Petroleum Development Corp.'s vice president, exploration and development, joined the company in 1985, from wellbore analysis firm Core Laboratories and reservoir engineering analysis firm Petroleum Consultants. Here, he talks about Petroleum Development's exploitation strategy. Investor Are your decline rates remarkably different in each of your operating areas-the Appalachian Basin, Michigan and the Rockies? Stearns Each basin has different reservoir rocks. Wells have their own unique decline curve types and ultimate reserves depending upon the area in which they are drilled. Wells drilled in each of the areas that we're developing have somewhat similar production profiles. The wells produce a significant amount of their ultimate reserves in the first 10 years and then tail off into the future at relatively lower decline rates, and can last quite a long time. These areas have the production profile we're looking for, that make the economics attractive, but have the added benefit of long-lived production. You don't know what the ultimate life of these wells will be, but you know that it will be many, many years. Investor So, you're not experiencing anything like what is occurring on the Gulf of Mexico shelf, such as three-year depletion rates? Stearns No, no. Most of the reservoirs we're developing are considered tight sands-the wells have to be fractured or stimulated to achieve their full production potential. The tighter rocks have fairly predictable declines-the first couple of years ranging from 20% to 50%, then flattening out to between 2% and 10% during its remaining life. When you look at a lot of the rocks in the Gulf Coast area, you're dealing with reservoirs much more porous and permeable. The rocks deliver the reserves very quickly to the wellbore and then they're depleted. It's really just the nature of the rocks. Investor What drew Petroleum Development to the Rockies, a new area for the company, last year? Diversification, or are you seeing fewer opportunities in the Appalachian region or in Michigan? Stearns We're always looking to find the best places we can to spend our drilling dollars and we've been looking outside Appalachia and Michigan the last several years. It was only recently that we found the right opportunity. It's a combination of looking over the fence to see what other successful companies are doing that might be more attractive as well as developing our own new ideas, and moving projects to the front burner based on improved commodity prices. In years past, Rockies gas traded at a significant deficit to Nymex and now, with new pipelines and available take-away capacity, many more Rocky Mountain plays are attractive. Also, in the past 10 years, there have been technological improvements in drilling and completion methods, allowing access to reserves more cost-effectively than before. So, it's really quite a few events that have made the Rockies attractive to us. Investor Are you looking at other new areas as well? Stearns Right now, we're concentrating on developing additional properties in the Rockies, now that we've got a significant foothold there, from in production we've purchased and from wells we've drilled. We're going to expand on that operation. Certainly, several years down the road we'll be looking at opportunities outside the Rockies, but right now it's where our main focus is, other than in our other core areas-Michigan and the Appalachian Basin.