What the typical lay person doesn't realize, and the trigger-happy high-tech investor forgets, is that money can still be made in the independent sector of the oil and gas industry. Fast-growing exploration and production startups rise from the launching pad every year. They were doing so even in the depths of the industry depression of 1998-99, when capital was tough to come by and market sentiment was as cold as a polar bear napping on an iceberg. Take the case of Prize Energy Corp., based in the Dallas suburb of Grapevine, Texas. In less than 18 months, this new company has sprinted from a starting line with no assets and three co-founders, to become a publicly traded independent producer (Amex: PRZ) with 120 employees, $580 million in SEC-10 proved reserves and a total enterprise value of roughly $460 million. The company did it through two significant transactions: buying a $239-million group of properties from Pioneer Natural Resources USA in July 1999, and consolidating the assets of Vista Energy Resources Inc. of Midland, Texas, through a reverse merger in February 2000 for $83 million. The latter deal effectively took it public during a time when E&P IPOs were virtually impossible. Since then, the stock has risen from $12.50 to around $20 at press time. Natural Gas Partners V, LP and Philip B. Smith of Tulsa formed Prize in January 1999 to implement the tried-and-true acquire-and-exploit strategy, one with which Smith was intimately familiar, having been president of acquiror Tide West Oil Co. (The latter was itself acquired by Denver's HS Resources in 1996 for $200 million.) Between these two deals, Prize now owns interests in 250 fields and about 2,000 wells. The 50 largest fields account for 75% of the value. The company's top property is the Warwink (Cherry Canyon) Field in Winkler County in the Delaware Basin of West Texas, which holds about 7% of the total reserves. In addition to development drilling and recompletions, this early-stage firm will continue to pursue acquisitions. "But, we're in no hurry," says president and chief operating officer Lon C. Kile. "We want to be very disciplined. We have two or three years of inventory on our existing properties for recompletions and field extensions. Like Apache or Devon Energy or the old Parker & Parsley Petroleum Co., we want to acquire-and-exploit. It's not flashy stuff; we're just grinding it out-three yards and a cloud of dust." This year's capital budget is about $55 million (excluding possible acquisitions). Some $30 million is allocated to drilling in the onshore Gulf Coast region, $12.5 million to the Permian Basin, and $10.6 million to the Midcontinent, mostly in northwest Oklahoma. Kile says he prefers to buy properties with a production history of at least three to five years, and focus on engineering to maximize their production and reduce operating costs. "We've noticed that people tend to drill wells, watch them for about a year and then sort of forget about them. We want to focus on them, reduce expenses by 1% or 2%, improve price realizations by the same amount, and raise the decline curve. If we do those things over a 15-year life cycle, we'll add a lot of value." Prize will be actively looking for more properties upon which to execute this concept. With a bank line of $400 million, a borrowing base of $250 million and $200 million of outstanding debt against that line, Kile estimates that Prize could probably handle an acquisition of up to $100 million. Over the next two or three years, he reasons, the majors and super-independents such as Anadarko Petroleum-Union Pacific Resources will be divesting more assets, some in areas in which Prize operates. What's more, many smaller-cap companies will have to consolidate in order to achieve a market cap that will attract institutional investors' attention. "We are of a size now that we can facilitate that consolidation, as we did with Vista," Kile says. "Right now, we are doing small deals, say, for $4 million, to consolidate working interests in projects we already have. I don't plan to get into the Gulf of Mexico, but we might get into the Rockies in two or three years. We don't want to dabble up there, though, so we would have to make a sizable deal." Kile thinks it is important to manage the risks of capital allocation on whatever asset portfolio Prize manages. For example, he recently sold down an 88% interest to 60% in an expensive $4-million well that spudded in Acadia Parish, Louisiana, in June. Prize came into being in January 1999, but it really took off when it acquired a large package of properties from Pioneer that July. This happened soon after beleaguered Costilla Energy of Midland, Texas, failed to close on a $400-million deal that had been pending for several months and was supposed to close in March or April. Prize acquired 72 million barrels of oil equivalent reserves from Pioneer for 4.1 times 1998 cash flow, or $3.32 per BOE. The financing consisted of $30 million worth of PRZ preferred stock issued to Pioneer, and $168 million of bank debt. FleetBoston led the financing with First Union, CIBC World Markets and BankOne participating. At the same time, Prize turned around and sold mineral interests associated with these properties for $32 million. A key backer that contributed $45 million in common equity was Natural Gas Partners, the private equity investor originally from Fort Worth (recently relocated to Dallas, thanks to the recent tornado in the downtown Fort Worth area). NGP has backed 36 E&P startups since its inception in 1988. Kile, who since 1985 had been an executive of Pioneer and its predecessor, Parker & Parsley Petroleum co., was executive vice president at Pioneer and knew the properties well. "When Pioneer first started the process of selling these properties back in 1998, it considered either selling them outright or spinning them out in some kind of entity that might someday go public," he recalls. "Then Costilla came along and offered $400 million, so that pretty much killed the spinout idea. They were going to close on December 8, 1998. But then the commodity price environment changed drastically." Unfortunately, debt-laden Costilla was swimming against a powerful riptide in 1998. It was attempting to acquire properties worth much more than its size warranted, and cash flow was plummeting in the middle of the worst industry conditions seen in decades. Pioneer renegotiated the sales price and other terms, extending the closing date twice, eventually to April 1, 1999, but Costilla could not find financing. Key shareholder Enron Capital & Trade Resources was not willing to inject additional capital in order for it to complete the transaction. Ultimately the deal collapsed in mid-April and Costilla filed for Chapter 11 bankruptcy. The sense of urgency on Pioneer's board was growing by the day, because it had been counting on these sale proceeds to help pay down its own enormous debt load in the bleak first half of 1999. Pioneer re-started the sales process, going back to those companies that had been interested before or whose bids had come in below that of Costilla. The board set up a special committee to review all bids and other options after the Costilla deal failed. It was May 1999. Board members Smith and Ken Hersh (of Natural Gas Partners) were recused; Kile was put on administrative leave. Soon, however, all three resigned from the board and/or the company and set out to buy "the Costilla properties." Prize won the properties for less than the original $400 million asking price. All parties say it was fair and not an insider, pre-planned deal. It was, however, an opportunity of a lifetime beckoning Smith and Kile. Although Natural Gas Partners contributed $45 million of equity, the trio needed much, much more to buy the package. Recalls NGP's Hersh, "This was not pre-ordained. Pioneer knew people would look at us like we were insiders, so they were very careful to treat us like any other bidders. We had to come up with a bid that would beat the others and had from May 16 to June 30 to get $235 million. We had no financing, nothing. We worked like crazy getting this deal done." That's when FleetBoston and the other banks joined the financing. Pioneer went back to all previous bidders, but for one reason or another, none could pay as much as Prize, or close by the required June 30. Hersh, Smith and Kile upped the bid to $245 million. Counting the Prize preferred stock that Pioneer took at the time, which has since increased in value, plus cash flow from the properties assigned back to Pioneer, the total compensation now approaches about $380 million-close to the $400 million it originally hoped to receive from Costilla in 1999. Says Kile: "This has worked out well for Pioneer-the $30 million they took in our preferred stock is now worth about $70 million by virtue of our stock price rise, the commodity price environment we have now and working the acquired properties. Pioneer was able to finally sell the properties, it knew we could close, and it could pay down debt, yet keep some of the upside by owning our preferred stock." In March 2000, Prize bought out about a third of Pioneer's position in the company, repurchasing stock for $18.6 million. Pioneer still holds nearly 20% of the common stock in Prize, but two of its representatives have left the Prize board of directors. NGP owns 62% of the company still. A search is under way to add some independent directors to this closely held company and increase the public float. Meanwhile, after two acquisitions and the share buyback, it is now up to Smith, Kile and vice president Richard Massengill to create value from the assets under their management. As of April, total proved reserves were 96 million BOE with a reserve-to-production ratio of 13 years. They've established five asset teams based on core regions, each including landmen, geologists and engineers, to focus on exploiting the properties. These team also evaluate potential acquisitions before they are made, because management wants them to know the properties' potential and buy into the idea of the deal-after all, they are the ones who will have to make it work after it closes, Kile says. "We feel we're able to give these properties the attention they deserve. At Pioneer, for example, they were 'low man on the totem pole' compared to some other things Pioneer wanted to do. Here, they make up our core areas: the Permian Basin of West Texas and southeast New Mexico, the Midcontinent area in western Oklahoma and the Panhandle, and onshore South Texas and Louisiana. The team at Prize has really rolled up it sleeves, looking at old well files, doing additional development drilling and recompletions." Even as the company began working the properties acquired from Pioneer last summer, Prize's Smith was negotiating the $83-million Vista deal, which was announced last October and closed in February 2000. During the downturn, Vista had been unable to make any property acquisitions of a meaningful size, so it then turned to discussions with potential merger candidates, but again, no deal was forthcoming. Meanwhile, in April 1999, Costilla finally gave up and announced it would not close on the $400-million Pioneer package. At that time, Smith decided to look at these for Prize. While he was in Midland looking at the properties, he also met with Vista. He noted that many of the Pioneer and Vista properties in the Permian Basin were in the same general vicinity of each other and a good fit might make sense. (True to oilpatch tradition, the Vista principals, Randy Hill and Cory Richards, have since formed a new acquire-and-exploit firm, Cortez Oil & Gas Inc., in Plano, another Dallas suburb.) In addition to the operational synergies, the transactions between Prize, Pioneer and Vista reflect the relationship nature of the oil business-and the need for private equity investors to implement their exit strategy. Three of Vista's directors were partners in Natural Gas Partners, which had funded Vista, and two Prize directors were also members of Pioneer's board. In this case, Dain Rauscher Wessels rendered the fairness opinion for Vista shareholders. The Vista deal gave Prize another 20 million BOE, including 38 billion cubic feet of gas reserves in the Permian Basin and Gulf Coast areas at a cost of about $4.15 per BOE. The assets, mostly in West Texas, have significant multi-zone recompletion potential. So far Prize has recompleted eight wells in the Warwink Field area, increasing total production from about 100 barrels of oil per day to 350 a day. Total cost for the eight wells was between $350,00 and $400,000, Kile says. Some 38 recompletion opportunities have been identified on Block 18 alone, with 108 in the broader Warwink area. These recompletions and workovers to the Cherry Canyon and Upper Brushy Canyon sands cost just $30,000 to $40,000 per well. "Warwink is not like shooting fish in a barrel, but it's close," says Kile. "That's why we liked the Vista opportunity. It's more a question of having the capital to do this properly. You have to watch over your production to see if it's what you expected. You must watch your water production and reinject water into non-producing formations." The discounted rate of return at Warwink may be as high as five to one, with minimal capital outlay and low risk-very much the type of property to be used as a platform for Prize's growth. "It's best to stay home and do what you do best," Kile says. "If you're going to be an acquire-and-exploit company, you've got to protect your balance sheet or you'll lose the growth aspect and find yourself in the penalty box. I think doubling the size of this company in the next five years is achievable, but it has to be done right." M