Imagine taking the field in the Super Bowl with a 21-point lead, even before the first tick of the game clock. In many respects, that's what a small, private E&P company-Spinnaker Exploration Co.-did at its birth in late 1996, long before its initial public offering last fall. "Like any startup, we needed a large pool of capital at the start to set sail," says Roger L. Jarvis, chairman, president and chief executive officer of Houston-based Spinnaker. "But more importantly, we needed a competitive advantage before even thinking about spudding a single well in the Gulf of Mexico." The bulk of its capital formation needs were satisfied in 1996 by a $60-million private equity infusion from E.M. Warburg, Pincus & Co. LLC in New York. To boot, Spinnaker's management and Petroleum Geo-Services (PGS) ponied up another $15 million of capital. But NYSE-listed PGS did more than pour equity into Spinnaker. The highly respected marine seismic company granted the fledgling operator a perpetual license to use PGS' existing multiclient, 3-D seismic marine data and all its new seismic data products through March 2002. For any producer trying to make a splash in the shallow and deepwater Gulf of Mexico, this allowed for a highly advantaged technological leap into that upstream pond. "As a result of our arrangement with PGS, we started in early 1997 with 3-D seismic data on 1,400 Gulf of Mexico blocks-one of the largest such databases then held by any operator in that area," says Jarvis. "Today, we have 3-D seismic data on more than 6,200 Gulf of Mexico blocks-about two-thirds of that from PGS. Looked at another way, we now have seismic coverage on more than 31 million acres offshore Louisiana and Texas." Needless to say, with such hydrocarbon-hunting muscle behind it, Spinnaker has participated in every federal offshore lease sale since March 1997. As a result of this activity-and partnering or farm-in arrangements with some of the biggest upstream names in the industry-Nasdaq-listed SPNX now holds interests in 138 Gulf of Mexico blocks, 102 of them on the shelf and 36 in the deep water. More impressive, however, is the company's track record since it began putting its toes in the Gulf waters, particularly in the shelf region. "To date, we've drilled 21 discoveries out of 30 wildcats-a 70% success rate," says Jarvis. Between year-end 1997 and late 1999, these strikes have translated into a better-than-sixfold gain in net proved reserves, from 13.4 billion cubic feet equivalent to 84 Bcfe. Meanwhile, daily production, which is 90% gas, increased more than ninefold, from 600,000 cubic feet equivalent to 55 million cubic feet equivalent. "Central to our strategy is the belief that an exploration company must have a very large pool of prospect opportunities on its plate relative to its projected activity-because the high-grading process defines the efficiency of capital deployment," says Jarvis. Translation? If an operator like Spinnaker drills 15 to 20 wildcats a year in the Gulf of Mexico, it's likely to have a higher rate of success if it can choose from a couple hundred good prospect ideas, rather than from 25 or 30. "Put more bluntly, it's been shown time and time again that when too much money chases too few good ideas, the outcome isn't favorable," says Jarvis. "Spinnaker was set up to reverse that relationship. Through our arrangement with PGS-and the seismic data intensity that flows from it-we've been able to assemble large pools of prospect opportunities and rigorously high-grade those to the best possible drilling candidates. As we see it, that's a good formula for getting the most bang for your buck." So is Spinnaker's attention to maintaining a low cost structure which, including operating expenses and G&A, runs about 60 cents per thousand cubic feet equivalent. "In line with this, and assuming a Henry Hub natural gas price of $2.66 for 2000, we're looking at cash margins north of $2 per Mcfe," says Jarvis. To enhance cash flow stability, the company has hedged an estimated 40% of its natural gas production through September 2000, using a series of costless collars with various floors and ceilings. Through this mechanism, Spinnaker will receive for the entire hedging period an average spot market price between $2.54 and $2.74 per MMBtu. How does this hedging mechanism work? If average spot gas prices fall between the floor and the ceiling of a particular gas-pricing collar for a given month, Spinnaker gets whatever the average spot market price is. To the extent that average spot gas prices fall below the in-place floor of a particular pricing collar for a given month, the financial counterparty to the hedge pays SPNX the price difference up to that floor. Conversely, to the extent that average gas prices rise above the in-place ceiling of a particular pricing collar for a given month, Spinnaker pays the counterparty the difference between that ceiling and the higher average spot market price. With such stable, high cash-flow-generation capability-and no debt on its balance sheet pro forma its September 1999 IPO-Jarvis expects the company to be able to internally fund more than half its 2000 capex budget, which will be $115 million, versus $85 million for 1999. "The remainder of our spending for 2000 will come from available cash and bank credit facilities as needed," says Jarvis. As of late 1999, SPNX had aggregate credit facilities of $25 million from Bank of Montreal and the New York lending office of Credit Suisse First Boston. How will the $115 million be spent? "We've identified through 3-D seismic data 49 good exploratory prospects and 23 encouraging leads on Gulf of Mexico blocks where we own an interest, and at least another 100 promising leads on acreage we don't own," says Jarvis. "Drawing from this opportunity pool, we expect to drill upwards of 20 exploratory wells in 2000, mainly in the shelf area. That's what will drive our near-term reserve, production and cash flow growth. However, we also have some high-quality prospect exposure to the deepwater Gulf with some very good partners-and that should have a significant positive impact on our long-term growth." Indeed, one analyst points out that in the deepwater Gulf of Mexico, Spinnaker plans to continue partnering with such experienced major operators as Shell, Elf Aquitaine, Spirit Energy, CNG Producing, British Borneo and Murphy Oil. Observes Jarvis, "This is a company that's not going to live or die based on any one prospect. That's why we don't try to hype any one well. Too many small operators do that and wind up being perceived by the market as a one-trick-pony. We instead take a portfolio approach in talking about our prospects. And with good reason. That's the idea upon which this company was built-growth through a huge inventory of balanced shelf and deepwater opportunities." Based on their stakes in SPNX after its IPO, it would seem that the company's management and its original backers share this view. E.M. Warburg, Pincus & Co. owns 28% of the company; PGS, 23%; and management, 15%. The remaining 34% of Spinnaker is now owned by the public. But has John Q. Public booked passage on the right upstream vessel? Two prominent Wall Street analysts and at least one major buysider think so. "This is a relatively high-risk exploration story, but it's being pursued with the benefit of leading-edge 3-D seismic technology in an effort to mitigate that risk," says Phillip Z. Pace, Houston-based managing director and E&P research analyst for Credit Suisse First Boston, the lead manager of the Spinnaker IPO. "Through its competitively advantaged 3-D database, the company has assembled and high-graded a large and growing Gulf of Mexico prospect inventory; as a result, drilling activity will remain high for the foreseeable future," says Pace. "In addition, Spinnaker has no long-term debt, has high producing margins and the lowest cost structure among all the E&P companies I follow." The company's cost structure, including operating expenses, production taxes, interest and overhead, comes in at 61 cents per Mcfe, versus a peer group average of 91 cents. "In addition, its estimated cash operating margins for 2000 are $2.14 per Mcfe-second best in our 20-company E&P coverage universe and well above that group's average of $1.80." Says Pace, "I have a long-standing rule of thumb that if you find a small company that has a niche focus, a good balance sheet and high inside ownership, you likely have a winner. Combine that with a competitive advantage-in this case an intensive level of 3-D data-and you're looking at a real dynamic growth story." Based on SPNX's existing discoveries, the analyst looks for production growth of 123% and 40%-plus in 2000 and 2001, respectively. Cash flow, meanwhile, should rise from $2.94 per share to $3.70 as earnings edge up from 47 cents per share to 50 cents. His 12-month stock price target: $22 per share. Given these forecasts, one wonders why the 8-million-share IPO turned in such an inauspicious market debut, raising only $116 million last fall versus a targeted $130- to $140 million. "From mid-September 1999 until we priced the deal later that month, the stocks of comparable E&P companies were off 15% from their earlier peaks," says Pace. "What's more, on the day of the IPO, the overall market was down 200 points before a closing rally. Thus, the IPO wound up getting priced at $14.50 per share instead of $16 to $18. Considering all this negative momentum in the market, the buyside reception to Spinnaker was relatively quite good." The analyst adds that during the months that followed the IPO, the shares of Spinnaker were one of the better performers in his coverage group-trading above $15 per share. In contrast, those of other E&P stocks he covers, including Stone Energy, Newfield Exploration, Basin Exploration and Chieftain International, struggled during that time. One of the buysiders who reacted positively to the IPO was Doug Hohertz, vice president and portfolio manager for The Mitchell Group, a Houston-based institutional fund manager with $350 million focused exclusively on publicly traded energy equities. Hohertz shares Pace's view regarding the market timing. "Had the offering gotten off early in September, when E&P stocks were trading much higher, the market reception would probably have been more favorable, in terms of pricing." What did The Mitchell Group like about the Spinnaker story? Several things. "First, given our expectation of a better natural gas market going forward, we liked the company's high concentration on gas production," says Hohertz. "Second, we felt that the access SPNX had to 3-D seismic data all across the Gulf of Mexico would be a powerful asset for future growth. And in fact, looking at the drilling success it has achieved so far, that data has already proven a major benefit. "Third, through conversations with several of Spinnaker's partners, we were already familiar with many of the prospects it plans to drill through 2000, and thus felt comfortable with the reserve and production growth profile the company laid out," he says. "Finally, we felt that by coming out of the IPO debt-free, Spinnaker would be able to fund its near-term exploration and development plans." Says Shannon L. Nome, managing director and senior E&P research analyst for Banc of America Securities in Houston, "Spinnaker believes that high-quality 3-D seismic data should drive a company's prospect-generation process, as opposed to the prospects themselves driving the need for data acquisition." Although the company's track record is short, this strategy has paid off, she points out. "Since inception, about 70% of the company's exploratory wells have been completed as discoveries-almost double the industry average success rate." Looking ahead, the analyst observes that Spinnaker's opportunity set is brimming. "The prospects the company plans to drill through 2000 offer an estimated net unrisked reserve potential exceeding 650 Bcfe-about 7.7 times the company's 84 Bcfe of proved reserves this past fall." Nome expects Spinnaker's average production volumes to double in 2000, as cash flow rises to $2.65 per share and earnings move up to 44 cents per share. Her mid-2000 stock price target for SPNX is $20 per share. All these analyst forecasts assume, of course, that Spinnaker is taking the right tack and will have plenty of wind in its sales.