This Gulf Driller is Shifting Gear

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Energy XXI (NASDAQ: EXXI) is an independent Gulf of Mexico oil producer heavily weighted toward oil. Historically, it’s been an "acquire-and- exploit" operation dedicated to wringing every last drop from legacy GOM oil fields. That discipline has served them well. Yet, CEO John Schiller seems ready to break with the past and embark in a new direction. How investors will react to that change will be interesting.

Not long ago, XXI shifted their drilling program to emphasize horizontal drilling. None of that will change. A real surprise came, though, with the announcement of 2013 drilling plans and capex. Energy XXI will defer on a large number of planned drilling targets on their properties. All involve natural gas reservoirs.

Weakness in natural gas prices has hit all producers. However, the recent slip in natural gas liquid (NGL) pricing exacerbated the problem. Nat gas producers, particularly onshore, shifted their focus to wet gas opportunities to offset revenue weakness from plunging nat gas prices. The resulting glut in NGL supply crashed NGL pricing, eliminating that important source of added revenue. Energy XXI isn’t immune from its effects.

Although XXI will temporarily cancel a total of seven wells, it won’t be cutting its capex budget. The more interesting aspect is the new drilling that will replace that gas-heavy segment of its drilling inventory. Just last month, Energy XXI agreed to a joint venture with Exxon Mobil (NYSE: XOM) to explore a set of Vermilion blocks in the Gulf of Mexico.

The area has significant resource potential, and Exxon already has a large amount of seismic acquired. In total, the JV area contains seven large prospects, all of which are expected to be oil-rich. Energy XXI will serve as operator, drilling two wells at 100% cost. That commitment earns them a 50% JV from there on. Interestingly, Energy XXI remains the operator for the duration, meaning that after these first two wells, Energy XXI will be drilling on Exxon’s property and Exxon will be picking up half the tab.

Exxon apparently has a great deal of interest in the properties, but doesn’t have room in their capex budget to get to it right now. Since some of the properties are getting closer to lease expiration, Exxon turned to a partner to fund the initial phase of the project and Energy XXI happily obliged.

Pendragon, the first well planned was chosen in part because its block is approaching leasehold expiration. The target underlies a salt overhang just south of Energy XXI’s producing Vermilion 164 block. Drilling should have already begun, with results anticipated in 3-4 months. More significantly, Pendragon was also chosen because of its geological similarity to the largest prize in the JV. Drilling for that target, Merlin, will commence immediately after Pendragon if results are promising.

Schiller wouldn’t share any detailed estimates of reserve potential, but did sketch it out in rough terms. Pendragon has the potential for as many as a dozen separate oil-bearing zones or ‘pay sands’ between 7 and 16 thousand feet deep. The big prize, Merlin may have twice as many pay sands and the reserve potential is triple-digit.

Adding 100 MMBOE (million barrels of oil equivalent) would be a very significant event for XXI, which reported only 120 MMBOE in proved reserves year-end. Needless to say, Vermilion exploratory success could be a redefining event for the company. That’s really one of the most interesting aspects to all of this. The entire project marks a change in trajectory for Energy XXI.

Together with their Ultradeep partnership with McMoRan (NYSE: MMR), XXI’s drilling program is slowly becoming more exploratory in nature. The Ultradeep program, operated by McMoRan, is probing Miocene, Wilcox and Cretaceous rocks deep underground on the Gulf of Mexico shelf. These older rocks, which account for some of the more prolific hydrocarbon producing reservoirs in the deepwater Gulf of Mexico, were thought to be buried too deep on the shelf to be reached by the drill bit.

McMoRan and their partners proved otherwise. The pay-off will be substantial in the long run, but questions remain surrounding production. High temperatures and pressures impede production this deep underground, and going from discovery to production meant designing and fabricating equipment to specifications that had never before been attempted. The proof of concept for the entire program is now really production at Davy Jones 1, a huge Wilcox-aged natural gas reservoir and McMoRan’s first Ultradeep discovery.

A flow test on DJ 1 is long overdue and investors have been anxious. McMoRan recently said that a flow test was imminent, and Schiller confirmed that the test should begin the week of Nov. 12. Testing could be complete 10 days later, but no one can be sure how things will progress until the test is actually underway. Any way you slice it, it looks like this month investors will finally get the test we’ve been nervously awaiting.

Between the two projects, Energy XXI’s success is now undeniably tied to two large exploratory programs. That’s a large change for the development focused company. The interesting question is really why was this latest decision made? Did gas prices force Schiller’s hand? Did the Exxon JV just present a temporarily better return on investment? Or has Schiller grown Energy XXI to the point where he needs bigger projects to move the needle?

This last point is the most interesting. Energy XXI’s made hay by living off others’ table scraps. Has the dog now outgrown its business model? If so, it will be interesting to see how Schiller adapts. Only time will tell if this is just a case of responsible capital allocation, or the start of something new for Energy XXI. Either way, investors will be watching both DJ 1 and Pendragon with a great deal of interest.

JustMee01 owns shares of Energy XXI, but holds no financial position in any other companies mentioned above. 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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