Buysiders attending presentations for the first public offering of an E&P company usually expect to hear how an operator plans to grow from a start-up position in a particular niche area. But that's not what they heard from Denver's Pennaco Energy on its road show last October. Pennaco, already listed on the American Stock Exchange under PN, had grown like Topsy in the hot Powder River coalbed methane gas play. Now it wanted cash to turbocharge that growth. And cash it got. Lead-managed by Bear Stearns & Co. and comanaged by A.G. Edwards & Sons; Howard, Weil, Labouisse, Friedrichs.; and Hanifen, Imhoff, the offering was oversubscribed-raising $28 million after expenses. Not bad for a company that had originally hoped to raise $20 million in its public-offering debut. But then again, Pennaco had a lot going for it, in terms of inspiring buyside confidence. "For one thing, we had already built a strong acreage position in the Powder River Basin," says Paul Rady, Pennaco's chairman, president and chief executive officer. That's an understatement. Just six months after its January 1998 start-up by a group of geologists and London Taylor-a San Diego venture capital firm-Pennaco had grown its coalbed leasehold position to 200,000 net acres in the northern fairway and northwest flank of the Powder River Basin. This $10-million investment was just the beginning, however. Enter 20-year oilpatch veteran Rady in June 1998, who was asked to head the new entity, and Glen C. Warren Jr., an experienced investment banker with Lehman Brothers and Warburg Dillon Read, who took over as executive vice president and chief financial officer. "I was familiar with the Powder River coalbed play and recognized that Pennaco was a jewel in the rough that still needed to acquire a lot of acreage," says Rady. Familiar, indeed. It was Rady who just 18 months earlier had helped highly regarded Barrett Resources Corp. get involved in the same play. That's another thing buysiders liked about PN last fall-seasoned management. Pennaco borrowed $4 million through a bridge loan from Venture Capital Sourcing in Liechtenstein, and within two months, built its leasehold to 500,000 net acres. Still, more capital was needed to grow the company. "In August 1998, we hit the road-show circuit, hoping to raise $30 million of equity through a private Reg D offering to institutions," says Rady. "Instead, amid falling stock market prices, a Federal Court decision that cast a dark cloud over the industry's ownership of coalbed leases, and environmental concerns that restricted coalbed drilling permits, we ended up raising only $3 million. That was barely enough to keep our lights on and the doors open. We had to change our strategy drastically." The following month, Pennaco elected to sell down its acreage position in the Powder River coalbed play by bringing in a working-interest partner-CMS Oil and Gas Co., the Houston-based wholly owned subsidiary of CMS Energy Corp., the giant Michigan utility holding company. It paid $28 million cash for a 50% interest in 492,000 net acres-almost all of PN's leasehold at the time. The paring made sense for three reasons. CMS had a lot of experience in shallow gas due to its exposure to Antrim Shale production in northern Michigan. Second, it had a midstream affiliate that could increase gas pipeline take-away capacity in the Powder River. Third, the corporate cultures of the two companies were a good fit. Both were growth oriented and willing to share ideas and cooperate technically. Says Warren, "This was the transaction that capitalized the company and allowed us to go forward-drilling aggressively and building reserves and production." How aggressively? In 1999, the company drilled 550 gross wells, or 418 net wells, in the Powder River coalbed methane gas play, operating as many as 17 rigs at a time. As a result, its coalbed gas reserves over the year increased from 18.1 billion cubic feet to an estimated 90 Bcf. Also, net daily working-interest production climbed from 11 million cubic feet in May 1999 to about 37 MMcf by year-end. Moreover, the company achieved this spectacular growth at a meager finding cost of 17 cents per thousand cubic feet (Mcf). "We're dealing with shallow 300- to 1,500-foot coalbed methane gas wells that take two to three days to drill, and that cost $35,000 to $45,000 to drill and complete," explains Warren. "On a gross basis, these wells typically hold reserves of 350 million cubic feet; on a net basis, 275 MMcf. So we're getting quite a bit of bang for our buck." (For more on coalbed methane action in the Powder River, see this month's cover story on Wyoming.) Pennaco also benefitted last year from increased take-away capacity in the basin, which allowed it to ramp up production. Last September, two new pipelines opened up-the Fort Union and Thunder Creek-each with an initial capacity of 450 million cubic feet per day. Also boosting infrastructure in the basin was the late-1999 completion of CMS' Northern Header pipeline and Wyoming Interstate Gas Co.'s Medicine Bow Lateral pipeline. Given this kind of growth, it is not surprising that Pennaco's first public offering went off so well. "From the $28 million in proceeds, we repaid about $14 million in bank debt to U.S. Bank National Association in Denver; the remainder will go to drilling and lease acquisition in the Powder this year," says Warren. With zero debt going into 2000 and $20 million of borrowing capacity from U.S. Bank NA, Pennaco has tentatively set a capex budget this year of about $42 million-on par with 1999's spending. With that financial flexibility, it expects to drill some 800 gross wells, or about 550 net wells, on its current 350,000 net acres, 290,000 of which it holds 50-50 with CMS. Says Rady, "We plan to spend a lot less on land this year-$10 million versus $22 million last year-and a lot more on drilling. As a result, we should be able to significantly increase reserves and production, be cash flow positive going into 2001, and begin repaying any bank debt drawn down to fund this year's spending." The biggest challenge facing Pennaco? "Keeping a significant inventory of available drill sites in front of us," says Rady. "Right now, we feel pretty good about our 1,400 to 1,800 net drilling locations on private and state lands. That should serve us well for at least two years. However, about half our drilling acreage is federal, on which an environmental impact study (EIS) is about to begin. We would hope this EIS concludes on schedule while we're drilling up our non-federal acreage." Adds Warren, "We're very early on in this play. To put that in perspective, when we've finished drilling those upwards of 1,800 net well locations, we'll have only developed 20% of our total prospective acreage in the Powder River coalbed play." For Frank Murphy, St. Louis-based vice president and director of the energy investment banking group for A.G. Edwards & Sons, it was no surprise that the buyside bit big on PN. "First, the company is involved exclusively in what has become one of the hottest onshore natural gas plays in the U.S.," he explains. "Second, it has a strong, aggressive management team led by Paul Rady, in whom investors already had confidence from his days at Barrett Resources." Third, several months prior to its first public offering, Pennaco brought in CMS Oil and Gas as a 50-50 partner on a large portion of its leasehold. "That was important for two reasons," says Murphy. "It validated Pennaco's strategy by showing the market that a highly regarded and successful company like CMS was willing to invest with and participate alongside the new company in the basin's coalbed methane gas potential. Also, the entrance of CMS into the picture resolved another important issue for Pennaco-better access to gas pipeline capacity out of the basin." Layered on top of all this, the company's large prospect inventory allows for a very aggressive, sustained, low-risk drilling program that could yield significant reserve and production gains. Observes Murphy, "Investors tend to be very favorably disposed to emerging-company stories with significant growth potential." One major West Coast institutional investor that is so disposed is the Franklin Templeton Group in San Mateo, California, a mutual fund manager controlling about $235 billion of assets. Steve Land, oil and gas E&P analyst for the $10-billion Franklin Advisors Small-Cap Growth Fund and portfolio manager for the $80-million Franklin Advisors Natural Resource Fund, explains why these two funds bought into the Pennaco story last fall. "In mid-1999, we were looking for more natural gas exposure due to our bullish outlook for this commodity," he says. "At the time, we were already large shareholders in Barrett Resources and Devon Energy Co., both active in the Powder River coalbed methane play. So we were familiar with Pennaco. But it had always been a little too small, with respect to the size of companies in which we usually invest." However, by the time of its first public offering, Pennaco had gained critical market size, says Land. "That, coupled with the company's 100% natural gas exposure, its large acreage position in the Powder River coalbed play, and my colleague Ed Perks' prior dealings with Paul Rady and Glen Warren, made Pennaco's stock a very attractive buy." Land says that although the stock trades at high current multiples of earnings and cash flow relative to its peer group, it has an immensely better outlook than its peers. "The company's wells are comparatively low-cost with very high success rates. So, for Pennaco, it's really a matter of drilling up its acreage and growing reserves and production at substantially higher rates than the overall industry." Ellen K. Hannan, New York-based managing director and oil and gas E&P analyst for Bear Stearns & Co., also sees significant growth ahead for the company. "Pennaco's early investment in its large acreage position, its 588 gross wells drilled to date, and the start-up of Fort Union and Thunder Creek should bear fruit in early 2000, in terms of earnings and cash flow," she says. "In addition, we look for the company to grow its net asset value exponentially over the next several years, essentially converting its undeveloped acreage into proved reserves. Already, PN has identified 1,800 net drilling locations on less than 20% of its acreage, giving it a three- to four-year drilling inventory." While development of coalbed methane production in the Powder River Basin is very low-cost, relative to more conventional, shallow gas plays, it's not exactly a walk in the park for operators, however. Says Hannan, "Due to the extensive gathering and compression needed to move the relatively low-pressure gas out of the basin, it's a relatively low cash-margin play as well. As such, the key to success for all players in the basin will be to keep operating costs low and maintain efficiency by amassing contiguous blocks of acreage." She looks for Pennaco's earnings to grow from 39 cents per share this year to $1.16 in 2001 as cash flow rises from 92 cents per to $2.25. Her 18-month price target for PN: $15.50. "Since investors are focused on rate of return in the upstream, they have to like the economics of Pennaco's coalbed methane projects in the Powder River," says Greg L. McMichael, vice president and senior energy analyst for A.G. Edwards & Sons in Denver. "Its finding costs are below 20 cents per Mcf versus an estimated average of $1.10 for the rest of the industry. Also, taking into account the company's all-in costs in the play, its projected internal rate of return on wells drilled to date is in the range of 50% to 70%." In addition, the buyside has to like the size of Pennaco's Powder River acreage position-which represents roughly 15% of the total play-and its large number of drilling opportunities there, says McMichael. By his estimates, the company has an eight-year inventory of drillable coalbed methane gas wells, each with the potential of adding gross reserves of about 350 million cubic feet; 260 MMcf net. He thinks the biggest challenges facing Pennaco are getting its wells hooked up to a pipeline, and getting the permits necessary to discharge water from the wells on the surface. "That's a major environmental issue in the area because some of these wells generate 800 to 2,000 barrels per day of water." McMichael sees PN's cash flow moving up from 83 cents per share this year to $2.20 in 2001 as earnings rise from 34 cents per to $1.20. His 12-month price target for the stock: $20.