When it comes to doing deals in South Texas, what you know is important, but who you know is absolutely crucial.

“There’s definitely a clique down there,” says Charlie Chambers, president and chief executive of Houston-based Rosetta Resources Inc. “You have to be established with service providers, landowners, lease brokers and the legal part of the business. It’s a pretty tight community and we’re fortunate to have experienced people who have been down there awhile. That’s a big part of what it takes to be a successful operator in South Texas.”

Glenn Hart, chief executive of Houston-based Laredo Energy IV, echoes Chambers. “It’s all about the relationships in South Texas,” he says. “We’ve been down there for so long, we know almost every single one of the landowners in the region we work, and more importantly we know all of their attorneys who represent them.”

Widely considered to be the Barnett shale of its day, South Texas came of age 25 years ago when new frac technology and horizontal drilling made it possible to crack the code of the gasrich Lobo trend, which is focused primarily in Webb and Zapata counties. M&A activity in the area consists primarily of large independents whose appetite for properties with running room is constantly fed by small independents, and small independents that amass a suite of properties through leasing that will be attractive to the majors and large independents.

Hart has successfully built and sold four companies focused in South Texas, all with private-equity backing of EnCap Investments LP. His first, Michael Petroleum, was sold to Calpine Natural Gas (now Rosetta Resources). This led to the formation of Laredo I and Laredo II, which were both sold to Chesapeake Energy Corp., and Laredo III, which was sold in January to El Paso Corp.

“Laredo Energy (I) didn’t have any numbers behind it when we started it, since we had no idea how it was going to go,” he says. “When we started, we had absolutely no assets. It was the funniest feeling I had ever had in my career. We didn’t own one acre or one well, and I remember thinking this must be what an artist feels like to stare at a blank canvas. It was a little bit of a frightening experience.”

Hart’s string of success with Michael Petroleum and three versions of Laredo is representative of what many private-equitybacked independents come to South Texas to do: build to sell.

“We always build to sell, but there is an art to selling properties,” he says. “You have to work it backwards. Initially, you have to think of what the buyers will want and what kind of buyers will pay the best prices. Generally speaking, the large public companies have an appetite for a lot of drillable, ready-made locations. If it’s too small they won’t fool with it; if it’s too big, you narrow the list of candidates that might bid on it.”

As Hart and his team build each company, they work to amass approximately 25,000 to 40,000 gross acres with proved reserves of 75- to 150 billion cubic feet (Bcf) worth $200- to $500 million. This is the size Hart calls “the sweet spot.”

“Once we get in that size bracket, we start looking at the industry and determining if buyers still have an appetite, and then we start being concerned with getting our properties to the right point in their maturity cycle to sell them,” he says. “If you sell them too soon, there are not enough proved reserves or production to get the best price, and if you drill up most of the upside, buyers lose some interest as well.

“There is kind of a sweet spot in our opinion that is the confluence of the conditions of the industry at the time and the point of the maturity cycle of your particular set of properties.”

One of the large independents Hart and his team have built Laredo to sell to more than once is Chesapeake. The Oklahoma City company has a major presence in South Texas with more than 150,000 net acres and current net production of 200 million cubic feet of gas per day. The company started its position with the purchase of Laredo I in 2003, and followed that by the acquisitions of Legend, Laredo II, Axio and, most recently, Sierra Resources, which closed in July 2006.

Mark Lester, Chesapeake executive vice president, exploration, says the company isn’t focused on just proved developed, producing (PDP) reserves when buying in South Texas. PDPs have been between 20% and 80% of proved reserves.

“We also always look deeper when we do acquisitions. That’s pretty common company-wide as we target acquisitions we believe bring with them a lot of additional drilling opportunities,”

Lester says. “Often, when we’ve done acquisitions, they come with a certain portion of PDP properties, and not only do we look at using our geological and geophysical expertise to search out additional drilling opportunities for the equivalent producing zones, but very commonly we will see opportunities deeper than what had already been producing.”

Chesapeake is focused on continued growth in South Texas. It has five rigs in the area: three drilling in the Lobo/Wilcox trend in Zapata and Webb counties, and two in the Vicksburg trend in Hidalgo County. It plans to keep up that pace in South Texas through acquisitions and the drillbit.

Joint ventures Another company that got its start in South Texas with Hart’s assets is Rosetta Resources. In June 2001, Calpine purchased Michael Petroleum, which was Hart’s first South Texas effort. When Rosetta broke away from Calpine, it found itself with legacy assets in South Texas, and decided to make it one of its core areas, not through producing-property acquisitions, but through amassing acreage.

“We’ve competed for assets, but have not been successful,” says Mike Rosinski, Rosetta executive vice president and chief financial officer. “In lieu of that, we have purchased sizeable acreage contiguous to our existing fields.”

Rosetta currently holds approximately 90,000 acres in Webb and Zapata counties, where its holdings represent approximately 45% of the company total. Buying acreage isn’t easy.

“There is a lot of competition because it’s highly prospective and there are plenty of drilling opportunities,” says Rosinski. “The big ranchers tend to be sophisticated, knowledgeable guys who will drive hard bargains before they’ll lease out their mineral rights.”

Many leases in the region are held by production, but landowners are savvy. It is a challenge for those already holding highly sought South Texas leases, and an opportunity for those wanting in. “Leaseholders in some cases are pressuring operators to either drill or release undeveloped acreage that is currently held by production,” says Chambers.

Many companies opt for joint ventures to get a foot in the play. Rosetta contributes capital and technical expertise in exchange for rights to explore on other operators’ lands.

A huge acquisition There is room in South Texas to grow a company from the ground up, which is what president and chief executive Allan Keel is doing with Houston-based Crimson Exploration Inc.

The company, which is currently listed on the OTC Bulletin Board, recently made headlines with the purchase of $290 million worth of South Texas assets from Exco Resources Inc.—assets Exco had just purchased from Anadarko Petroleum Corp. as part of a larger package. The acquisition added 96 billion cubic feet of gas equivalent (Bcfe) to Crimson’s proved reserves, and puts the company on the fast track to the growth Keel and team had been working toward.

Crimson was formed in 2005 when Keel and Oaktree Capital Management LP joined to acquire a controlling interest in GulfWest Energy, a small company with limited reserves and production Keel planned to use as a platform for a Gulf Coast focus. Even with strong financial support from Oaktree, Crimson continued to walk away from the M&A table empty-handed.

Exco planned to acquire the Anadarko package that included South Texas properties, and Keel knew South Texas isn’t a core area for Exco. With the support of Oaktree, which had invested with Exco in the past, the Crimson team proposed the deal to Exco.

Also attractive about the assets: they are not new to Keel. He and Crimson’s key engineer were with Westport Resources, which had owned them. Westport was acquired by Kerr-McGee, which was acquired by Anadarko. “We knew that, while Kerr- McGee and Anadarko held these properties, not a lot of capital was invested in them, so we believed additional opportunity remained.”

Crimson’s proved reserves tripled through the one deal, and its daily production jumped from 7 million to more than 50 million cubic feet of gas.

Reserve life, MLPs Though South Texas assets have shorter reserve lives than some other areas and landowners have sophisticated lawyers, operators there want more.

“We explore for two primary objectives in the area: the Lobo and the Perdido,” Chambers says. “Other intervals exist both shallower and deeper. The attractive part of the Lobo and the Perdido is technology has advanced enough that it’s more predictable and our success rate has improved. Economics are good for us here and, with our large acreage positions and talented people, we’ll be here for awhile.”

Chesapeake continues to get high rates of return in South Texas. Lester says, “Since January 2004, we’ve drilled 214 wells (there) and our average finding costs are less than $2 per thousand cubic feet equivalent,” he says. “We’re basically spending $3 million to find 2 Bcfe.”

At Crimson, the fact that much of the team had worked in South Texas before made it easy to decide to focus there. Keel says, “Our in-house expertise and the people we have onboard have knowledge and relationships with other operators in that region. We feel like we have more to gain by working in that area where we’re more familiar, as opposed to going after the Midcontinent or East Texas.”

While reserve life tends to be shorter than that of the longlife properties the MLPs are designed to monetize, Rosetta’s Chambers says South Texas properties could fit an MLP model. “Lobo production comes on at high rates, but levels out and goes on for a long time. There is predictability toward the end of the production curve. This profile could be attractive for an MLP structure. We will continue to expand our production base in the area and, at the proper time, may consider the merits of an MLP.”

Much focus has been on the Barnett shale in North Texas, but Hart notes that Webb and Zapata have been the No. 1 and No. 2 gas-producing counties in Texas for 25 years.