Is This Exxon’s New BFF?

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The market is trying to figure out a direction for shares of Energy XXI (NASDAQ: EXXI) after a downgrade from Buy to Neutral by Global Hunter Securities on Tuesday.  The downgrade comes just a day after news of a new transaction with ExxonMobil (NYSE: XOM).  Back in late 2010, CEO John Schiller bet the farm on a $1B acquisition of ExxonMobil’s offshore-Louisiana Gulf of Mexico production assets.  The acquisition changed XXI’s prospects tremendously, nearly doubling its size, providing seemingly endless drilling opportunities for the modestly sized independent, and creating a joint venture with one of the biggest oil corporations in the world. 

Obviously, this isn’t an impactful deal from Exxon’s perspective.  Yet, it does show trust in the junior partner, since XXI will serve as operator.  Most of these Exxon blocks are also on recently acquired 2009 and 2010 leases, not just leftovers on Exxon’s plate.  Apparently, Exxon has taken notice of Energy XXI’s performance with their legacy assets.  The joint venture seems like a vote of confidence in that regard. 

Exxon will transfer one block to Energy XXI, and the partners will then explore nine additional contiguous blocks, with 2 wells initially committed.  While the blocks contributed to the joint venture by Exxon weren’t disclosed in the press release, a little surfing at the federal BOEM (Board of Ocean Energy Management) website makes it pretty clear that the blocks in question are Vermillion 163, 165, 178, 179, 180, 181, 183, 184 and 185.  Only Vermillion 164, which transfers to EXXI outright, is held by production. 

The deal transfers Vermillion 164 and its production assets to Energy XXI for a total cost of $35 million.  Current production is a modest 1,100 BOEd (Barrels of oil equivalent per day).  While Vermillion 164 itself has significant potential for easy production gains, according to Schiller it’s not the primary driver according. 

The adjoining blocks, particularly Vermillion 179, are more significant.  Energy XXI acquires a 50% working interest and operates the nine adjoining blocks.  Recent sub-salt drilling of their own blocks led Energy XXI to reevaluate the interpretation of seismic data on these shelf fields.   They see a parallel here, with a salt canopy on block 164 extending southward onto Vermillion 179 that likely obscures a sizeable reservoir.  The first well will test this target. 

Probable reserves for the entire complex are estimated at 375 MMBOE (million barrels of oil equivalent).  Although Schiller was not explicit, I presume that’s all ten blocks, given the size of the number.  Energy XXI’s proved reserves are currently 120 MMBOE for comparison.  Total cost to XXI is estimated at an additional $40 million if both wells are successful and completed.  It’ll shift a rig from its current activity and defer on two planned gas targets at Golden Bear and Wombat to get the work started.  The first well, Pendragon, will spud in November.

While the deal represents a departure from Energy XXI’s development focus, it does have a precedent in the Ultradeep McMoRan (NYSE: MMR) partnership.  (Schiller’s Ultradeep update was very brief, giving little detail on Davy Jones progress; the company just mentioned that cleanout continues.)  In both cases, Energy XXI chose to partner when embarking on higher risk speculative exploration-oriented plans.  That keeps exploration capex minimal and moderates risk, while still giving XXI some speculative upside. 

The cost to XXI for this joint venture should be easily managed with XXI’s cash flow, weighing in at less than half the Ultradeep’s expenditures.  Exxon puts up all 10 blocks and pays 50% of costs for the two committed wells.  Other than the drilling cost itself, there is some opportunity cost with respect to postponement of Golden Bear and Wombat.  However, neither is a priority given the poor pricing of natural gas.  I see nothing here but positives.  The deal also opens up a toehold at the western edge of XXI’s holdings.  Given its preference to concentrate its holdings, it will be interesting to see if the company looks for other bolt-on opportunities in the general area. 

Some color on the potential for future acquisitions also popped up in Wednesday’s presentation.   Chief Financial Officer West Griffin acknowledged that acquisition opportunities are increasing in the Gulf of Mexico.  XXI is now looking at a couple of deals per month, as opposed to one per quarter, and expect more property to be changing hands in the future. 

Speculation regarding an acquisition overseas has been increasing with Energy XXI.  When pressed on where the company might be looking, Griffin did acknowledge that Southeast Asia was a possible fit.  Griffin was also very clear that the company will be looking for an opportunity geologically analogous to its current operations, with lower cost development opportunities when the time came. 

It will be an important step forward if XXI does complete an international acquisition.  Geographical risk is a serious concern for Energy XXI, and the share price drop on the downgrade demonstrates that as well as anything.  Hurricane Isaac threw a wrench into the works, even though it did little damage to production assets. 

Current production dipped to 45MBOEd (thousand barrels of oil equivalent per day) from 47.6 MBOEd at the end of June, and average production for the quarter is forecast at a disappointing 37 MBOEd.  This comes on the prior expectation of production north of 50 MBOEd on the back of a lot of nice recent drilling success.  That’s the outcome with no actual damage to Energy XXI’s property.  Shortfalls came from shut-ins and delays reestablishing production, due in large part to third-party damage.  Considering that Isaac was relatively tame, it’s easy to see the potential consequences of a serious hurricane to the company.  That’s why I’m encouraged by the recent chatter about international acquisitions. 

Coming off the downgrade, shares have stabilized at $33.50 after losing over 5% on Wednesday.  Always busy, the next few months should be interesting for EXXI holders.  There’s potential news from Davy Jones still looming, multiple rigs at work, and the Pendragon Joint venture well should spud soon.  Now, it sounds like additional acquisitions could also be in the cards for this restless independent, even after this latest Exxon deal.  Apparently, Schiller remains on the hunt.  Stay tuned.

JustMee01 owns shares of Energy XXI. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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