As oil prices stabilize above $20 per barrel, the petroleum industry is once again gearing up for serious exploration. Recent surveys conducted by Salomon Smith Barney and Lehman Brothers indicate that drilling worldwide will rise about 10%-11% this year from last year's lows, with a 16% jump in the U.S. and a 25% rise in Canada. Like earlier exploration waves, this one will no doubt spawn a host of new companies and revive many "old timers." Some will succeed-a few spectacularly-but unfortunately, many will also crash and burn when the next down cycle inevitably hits. Many investors lost billions of dollars when oil and gas prices plummeted in the mid-1980s, and again in 1997-1998, so it's no wonder they are scratching their heads now. How do they choose the horse that will go the distance in this race? Ammonite Resources Co., international petroleum consultants, tried to find out what the organizational and philosophical criteria are for long-term success in petroleum exploration-and to identify the characteristics that point to ultimate failure. It defines the exploration process as "a dedicated, long-term intellectual and capital commitment to the assumption of risk and reduction of uncertainty, in looking for commercial hydrocarbons where they have previously not been found." Ammonite analyzed companies that are generally perceived by industry insiders to be successful, as well as some that are not. It sought the opinions of a number of highly successful oil and gas finders, and relied also on its own experience as explorationists. It found that E&P companies with a consistent track record of success share some common denominators: outstanding people, a focused strategy leveraged by some kind of competitive advantage, and an aggressive commitment to exploration itself. Note the key word "consistent." Even fools are sometimes blessed by luck. The most common quantitative measures used to benchmark success include finding costs per barrel of oil equivalent (BOE), annual reserve and production growth rates, annual reserve replacement ratio, and return on capital employed. However, these describe a company's past and are no guarantee of future performance. So, how can one make success happen, or at least, make it more probable? People who dream The success of an exploration company flows directly from the quality of its team. This is obvious. But Ammonite found that in the most successful E&P companies, management and technical staff exhibit certain optimal personalities and traits. (See box.) The ideal exploration staff need not be large-proven oil-finding abilities are what count. Staff should be cross-trained and up-to-date with the latest exploration technologies, including computer workstations. The initial exploration team should number five or six persons, each a proven oil finder with a minimum of 10 to 20 years' experience in different basins with different stratigraphy and structural styles. Expertise in stratigraphy, depositional environments, paleogeography, structure, paleogeomorphology, well log analysis, geophysics, and reservoir engineering is essential. Intelligence is just the starting point for a good explorationist. Success is often a function of hiring people who can visualize creatively, who are unconventional thinkers. It helps if they can recognize opportunities where others see nothing. It also helps if they refuse to give up the quest until they have figured it out, whatever "it" is. Getty Oil Co. allegedly made a study in 1980 when it needed to hire young explorationists. The company concluded that the best explorers were independent thinkers, anti-establishment types who did not color between the lines. Interdisciplinary teams organized to focus on one region work best. These should include one or two geologists, a geophysicist, a log analyst and/or reservoir engineer, a drilling engineer and a land man. Each should be familiar with the technical expertise, responsibilities and limitations of the others. Larger staffs are needed when a company is evaluating mature areas or planning extensive development activity, where massive amounts of data are typical. When specialized skills and local expertise are required, consultants must augment the team. International opportunities are another matter. Generating prospects and reviewing outside submittals do not require a large staff, as the data and level of activity is generally less than in the United States, particularly if a company does not operate overseas. Global Exploration LLC (Globex), a small private company in Dallas, has successfully used this formula. Formed in 1991 to look for international opportunities for its owners, a small group of very successful independents from West Texas and Michigan, Globex has quite a track record. During the company's first three years it participated in exploratory wells offshore Holland, in Papua New Guinea, and offshore Western Australia, farmed into development of a discovery offshore West Africa, and reviewed probably close to a hundred submittals worldwide. This flurry of activity was conducted with a full-time staff of only two: a geologist president and geophysicist exploration manager, both with more than 20 years of solid international experience. How? Globex makes extensive use of outside consultants. After exploration managers make a strategic decision to pursue a particular play, they should seek out and hire the most experienced and successful experts in that play. Calgary's Canadian Hunter Exploration Ltd. developed a reputation in the 1970s for raiding other companies for their best and brightest. John Masters, cofounder and former president and CEO, made no apologies for his raids. In his book, The Hunters, he said, "We don't just acquire competence. We go for the absolute best in the business...[and they] come into the company ready for immediate responsibility and trust." Ammonite also has found that it is important for the staff to be involved in the engineering, geological and geophysical societies. In particular, presenting technical papers keeps staff current with the latest exploration plays and technologies. It also shows others that the company is progressive and competent, thus suitable as a joint venture partner. Exploration strategy Once the exploration team is in place, the successful exploration company must have a modus operandi and strategy. The first step is to define strategic play areas. This is a function of the greatest reserve potential at the least finding cost; areas of maximum potential for new discoveries; the availability of leases; best economics; risk diversification; markets; and special knowledge which might provide a competitive edge. Development, operating and marketing costs must be carefully considered. From the standpoint of risk diversification, a portfolio of five or six different plays is a good number. Pursue a portfolio with diversified risk, ranging from low-risk/moderate-reward, to modest-risk/moderately high-reward, to high-risk/high-reward. Avoid the safe low-risk/low-return play-it is merely an opportunity to trade dollars. A conservative budget allocation would be 50% lower risk, 35% moderate risk, and 15% higher risk. Where do you look? Among the best places to find new plays is around and under established producing areas with operating infrastructure. Focus on new play areas where the existence of mature hydrocarbons is already demonstrated. Look for multiple play possibilities. Look for large reserve potential (greater than 100 million barrels in aggregate). Choose a play where good seismic can be acquired, the market is readily accessible, and where one or more staff members have direct knowledge of the area. Avoid areas where there is only a single exploratory play, or where new information could kill your exploration concept. Avoid areas if the play is sensitive to oil and gas prices, where costs could easily exceed estimates, leases are hard to obtain or are not available, and where there is no end in sight to political and economic instability. Once a play is targeted, acquire as complete a database as possible of nonexclusive and proprietary geophysical, geological, well, production and engineering information. This is not the time to try to save money by cutting back on geology and geophysical costs. Develop a competitive edge in a new play by utilizing a new technology. Thoroughly assess risk by reducing or eliminating uncertainty in your evaluation of each play element. This does not mean one must eliminate risk, just understand it better. Naturally, timing is everything. It's always preferable to get into a new play in the early stages, when the largest reserves are generally found. Lease new plays as quickly as possible before competition drives up acreage costs. Develop a play orientation to a new area rather than a single prospect approach. Originate most of your play concepts in-house, but always look at submittals from other companies on a regular basis. Keep current of competitor activity and new opportunities in your play area; good scout data is essential! Always perform a detailed post-mortum on dry holes. Be disciplined. Do not cut and run after the first or second dry holes in a new play, or exit because oil and gas prices have declined. The exploration budget must be adequate to accomplish this, and to handle any unforeseen contingencies. It can easily take five to seven years of assessment before a successful new play begins to generate revenues. Exit the play when you no longer have a rationale for being there. A rule of thumb is that the exploration budget should be in the range of 0.5 to 1.0 times the development budget for an established company. If the exploration budget of a mature company exceeds this guideline, then the exploration effort is not being successful in setting up development situations. Establish a regular procedure for peer review of play concepts and matured prospects; weekly technical staff meetings are one way to do this. Include geologists, geophysicists and reservoir engineers in the process. Finally, spend only what you can afford to lose-serious exploration must not be done with high debt levels. Several case studies that typify what can result by applying winning strategies follow. Gulf of Mexico subsalt Major new oil discoveries have been made since the early 1990s beneath the regional salt sheet of the Gulf of Mexico. Phillips Petroleum Co. pioneered the way, with partners Anadarko Petroleum and Amoco. A highly focused team effort of geologists, geophysicists and drilling engineers used every bit of existing data, innovative geological concepts, modern seismic technologies-and vision. The team was thus able to define a viable play concept in a geological frontier that industry had written off as "nonprospective" and technically inaccessible. The team convinced a supportive and open-minded management to take the bold step of testing its revolutionary theories with the drill bit. The Mahogany Field discovery proved the concept by testing up to 7,256 barrels of oil and 9.9 million cubic feet of gas per day. Yegua Sand in Southeast Texas The Eocene Yegua Formation in Southeast Texas, considered a mature play, yielded a string of important oil and gas discoveries in the early 1990s. In 1993, Anadarko Petroleum drilled 16 Yegua wildcat prospects and had 11 discoveries, for an exceptional success rate of 69%. The company attributed its track record to the use of an interdisciplinary team approach in studying the complex stratigraphy and structure of the Yegua, and utilization of state-of-the-art technologies such as amplitude versus offset (AVO) seismic. Anadarko strives to reduce prospect uncertainty by thoroughly defining every element of geological risk prior to testing a prospect with the drill bit. Elmworth Deep Basin gas in Alberta In the early 1970s Canadian Hunter defied conventional wisdom by discovering the Elmworth Field in Alberta and generating the Deep Basin play concept. One of the largest gas fields in North America, Elmworth was found in a 5,000-square-mile area which had been written off by the majors after 40 dry holes. Masters described the company's exploration philosophy and how Elmworth, with a potential 440 trillion cubic feet of recoverable reserves, at least 1 Tcf net to Canadian Hunter, was discovered. He is a strong proponent of the team approach, using the best and brightest supplemented by expert consultants. Detailed log analysis, innovative computer mapping of regional log characteristics, regional paleogeological studies, aggressive leasing, persistence, good salesmanship, committed funding and guts led to the discovery. Recipes for failure To better appreciate that which leads to success, it is instructive to analyze that which leads to failure-in this case, mediocre or inconsistent exploratory results. (See box.) Some examples of companies which failed by following losing exploration strategies, are described in the following case studies. The independents The former Weeks Petroleum enjoyed immense income from royalties in its original play in the Bass Straits off Australia. But, the company subsequently wasted its assets by not focusing in strategic plays or balancing risk. Weeks chose to pursue only high-risk, frontier plays all over the world, with only modest success. Controlling shareholders, principally the Weeks family, finally sold the assets to an Australian company, which then liquidated the worldwide exploration staff in the U.S. A recent example of "betting the farm" on a single exploration play is typified by Chesapeake Energy in the Louisiana Chalk play from 1994 to 1997. Chesapeake had significant success with deep, highly productive horizontal wells in the Giddings Field, in the Austin Chalk Trend in Texas. Based on that, and some early encouraging results in the Deep Chalk in South Louisiana, Chesapeake assumed that the potentially productive fairway extended hundreds of miles across the Gulf Coast into South Louisiana. The company boldly acquired more than 1 million acres in the play. It initiated a very aggressive and expensive deep horizontal drilling program on the premise that it had a fantastic opportunity with hundreds of potential well locations. It repeatedly raised capital on Wall Street and went heavily into debt to pursue its hopes. Some of the early Louisiana Chalk wells indeed had spectacular flow rates of oil and gas-a few in excess of 3,000 barrels of oil and 15 million cubic feet of gas a day. Unfortunately, the wells declined rapidly and produced significant amounts of water. Chesapeake eventually abandoned the play as noncommercial. It was forced to take major financial write-offs that nearly broke the company in 1997. The majors Integrated oil companies go through phases of exploration success followed by periods of exploration drought, but because of their size and diversification, they can usually weather a string of dry holes without financial ruin. Amoco's tremendous success in the 1970s in the Rockies Overthrust Belt and the Gulf Coast Deep Tuscaloosa play are examples of management hiring and motivating the best and brightest explorationists, using technological innovation, taking risks and being persistent. The experience of Texaco Inc.'s North Sea division in London in the mid-1970s is a case study in how management discouraged exploration initiative. Texaco was a great company for entry-level geologists in the 1970s. Rookie employees went to in-house and nonexclusive training programs, and received lots of hands-on experience in wellsite work, formation evaluation and mapping. However, after the first five years, the rigid Texaco corporate culture of the period was unresponsive or downright negative about new ideas and procedures. It seemed that people advanced by maintaining the status quo. The company appeared to be more concerned with reducing costs than finding oil. Bright young geoscientists soon left Texaco for more fertile fields, where, with the proper support and motivation, they found their new employers significant reserves. As a result of not nurturing new exploration concepts, Texaco's track record in the North Sea in the 1970s was mediocre compared with its major competitors. The utilities During the late 1970s and early 1980s, many large gas utilities entered the exploration game either as nonoperating joint venture partners, or by forming their own exploration subsidiaries. For example, the Brooklyn Union Gas Co. (now KeySpan Energy) formed Fuel Resources Inc. (FRI) as its exploration subsidiary. FRI participated in about a dozen joint ventures with operators in the Appalachian Basin, Gulf Coast and Midcontinent regions during the 1980s. Like many utility-owned exploration companies, FRI's results were not impressive, and the interests were eventually all sold. Similar results have occurred more recently with Detroit's MCN Energy, which has divested nearly all its E&P assets in the last year. Utility companies are by nature risk adverse, driven by a regulated rate of return on their capital. Exploration risk is not in the corporate culture. The vice president of exploration of a large Appalachian gas utility was once told during the budget process, in all seriousness by his chairman, that there were to be no dry holes! Utility exploration that failed generally had little in-house expertise, no strategic focus, no competitive technical edge, and was often managed by financial or regulatory people who had limited experience in the petroleum industry. In the late 1980s and early 1990s many utility companies, faced with poorly performing E&P subsidiaries, made the strategic decision to sell their exploration assets, or to spin them off as independent companies. To its great credit, Brooklyn Union Gas learned from its mistakes as a promoted nonoperator. It established a strategic focus in the Gulf of Mexico by forming Brooklyn Union Exploration Co. An experienced management and technical team was hired; the company prospered; was spun off in an IPO; and now operates successfully as The Houston Exploration Co. Meanwhile, Transco Energy, a company which had expertise primarily in interstate gas transmission pipelines, made a strategic decision to enter the coalbed methane play in the Black Warrior Basin of Alabama. Transco formed Transco Coal Methane Co. in 1989, and committed to a 500-well development program and the construction of a new 250-million-cubic-foot-a-day pipeline. The company invested more than $300 million in the play; and the results were an unmitigated financial disaster. Wells were drilled in advance of the pipeline to qualify for the Section 29 tax credit, and on the expectation from limited early results, that each well was essentially a "cookie cutter" in a broad homogeneous regional development play. Unfortunately, Transco's completion procedures were ineffective, gas production was below forecasts, dewatering took longer than anticipated, water production was higher than forecast, and operating costs were significantly higher than budgeted. When the new pipeline was commissioned in 1990, a grand total of just 11 million cubic feet a day flowed. Where did Transco err? It did not do its technical homework adequately and it rushed headlong into the play. The company sold off all its conventional oil and gas reserves and its coalbed methane assets in 1992. Eventually it was acquired by The Williams Cos. The fund companies The vast majority of the companies of the late 1970s and early 1980s that financed their exploration efforts through the sale of public limited partnerships were not long-term winners for their investors. Several billions of dollars of Wall Street limited partnership drilling fund money flowed into the coffers of oil and gas companies during the oil boom of the 1979-1984 period. The companies ranged from small independents that were reasonably successful in their limited areas of operations to large "fund" companies that drilled throughout the U.S. Seemingly unlimited amounts of money poured in from individual investors. Exploration staffs were huge. Companies had division offices in nearly every basin. Tens of thousands of wells were drilled. In the final analysis, none of the "fund" companies were truly successful at finding economic reserves on a consistent basis. The former securities firm of E.F. Hutton & Co., for example, raised $1.2 billion in 135 public and private limited partnerships between 1976 and 1984 for 20 of these operating companies. As of the mid-1980s, none of the programs had paid out, or was likely ever to pay out on a pretax basis. Why were the track records so poor? The answer is simple. Technical staffs were for the most part young and inexperienced; exploration focus or development of a competitive edge was rare; and prospects originated in-house or bought off the street were all too often drilled without a thorough analysis of all the risk elements. When established companies expanded rapidly beyond their areas of expertise and began to drill significantly more wells than they had previously, they faltered. Building on success A factor that many successful companies, large or small, have in common is a major discovery early in the company's life. The early success was generally the result of a focused exploration effort and special knowledge. Luck sometimes happens, but one must make "luck" happen by being in the game in the right way. Occidental Petroleum, for example, started life as a drilling fund promoter, but was rapidly propelled into the big leagues by the Grimes gas field discovery in the Sacramento Valley. Then it hit a home run in Libya. Marathon Oil Co. was anchored for many years primarily by its Yates Field in West Texas. A major discovery for a young company generates an upbeat attitude for management and staff and creates an aggressive exploration mindset. Cash flow from early major discoveries can be reinvested in subsequent exploration without dry hole fear, but caution is the better part of valor at this point-one must diversify risk to avoid wasting assets in the expectation that one can consistently find such company-making discoveries. Whether building a new enterprise from scratch, or participating with an established E&P company, a capital provider must perform in-depth due diligence to determine whether the investment candidate is truly a long-term winner. Reviewing the annual quantitative benchmarks of a company's performance and evaluating a current portfolio of 3-D-seismic-defined prospects, is not sufficient to predict long-term results. One must also evaluate the quality of the technical staff and management, their exploration strategies and tools, and the thoroughness of their approach to, and execution of, the exploration process. If the E&P company possesses-and retains -the positive characteristics that are described in this article, then oil and gas investors can look forward to a profitable experience. M Skip Hobbs is an AAPG-certified petroleum geologist and managing partner of Ammonite Resources Co., a firm of domestic and international petroleum consultants that is headquartered in New Canaan, Connecticut.