One Wild Ride in the Ultradeep

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McMoRan Exploration (NYSE: MMR) played its cards on Wednesday and shorts got shredded. Shares had been struggling as McMoRan fought a troublesome well and speculation grew that it would fail to produce. But because of its bloodlines, McMoRan had an ace in the hole: CEO Jim Bob Moffett.

In the end, it was not only his reputation, but also his position as Chairman of the Board of Freeport-McMoRan (NYSE: FCX) that likely made a difference. Freeport-McMoRan opened its war chest to buy both McMoRan and minority shareholder Plains Exploration (NYSE: PXP) at sizeable premiums. How well this goes over with Freeport-McMoRan shareholders remains to be seen, given the potential for conflict of interest among directors of the companies involved.

McMoRan shares dropped with a thud on November 26th and stubborn well Davy Jones sits front and center. McMoRan and its partners, Energy XXI (NASDAQ: EXXI) and Tex Moncrief, have poured hundreds of millions of dollars down this problematic well. Problems disclosed with Davy’s latest flowtest led to speculation that this is the event that kills the well. One JP Morgan analyst even set a $0 price target for shares. Moffett made his case for Davy’s survival in a follow up conference call.

Underlying all the action is the reality that McMoRan spends a lot on its "Ultradeep" drilling program, needs cash, and proof-of-concept Davy is a year behind schedule. These wells are uncommonly deep. McMoRan’s piercing the depths of hell with these wells. Pressure and temperature are extremely high, stretching equipment to its limit and beyond. That’s led to continuous problems and overruns amidst speculation that the reservoir will never produce.

Moffett himself is legendary in the oil and mining community. A geologist by trade, he’s been uncommonly successful, building the original McMoRan into mining power Freeport-McMoRan through a series of mergers. While still involved with Freeport-McMoRan, Moffett launched McMoRan version 2.0 as McMoRan Exploration, turning his attention back to his roots by wildcatting for oil and gas.

The new McMoRan wildcats with a capital "W." The Ultradeep is an extremely high risk project, probing deeper than any other through salt blankets that make imaging difficult. Staying above the salt restricts operators to younger source rock, and some of the prolific hydrocarbon producing rock onshore is much older. In the past few years, the majors made large Wilcox finds in the middle of the Gulf, where nothing covers these older formations. Major deepwater finds like Cascade, Jack, and Great White came from these formations.

Moffett’s idea is simple at its root. If you can reach the Wilcox onshore and you can reach it in the middle of the Gulf, it stands to reason that it’s accessible in between. To prove it, McMoRan reentered and deepened its abandoned Davy Jones well. This reduced costs, but provided challenges. Because Davy was originally intended to be shallow, at bottom depth the well was too small, slowing the entire process. Exploration’s gone well. Estimates of the gas in Davy alone hit multiple TCF (Trillion cubic feet). For context, not-so-small Linn Energy’s entire proven reserve is 5 TCF. Production’s the problem.

The latest problem evolved from initial problems perforating the formation. When completing a well, operators run a perforation gun into the wellbore to form cracks in the surrounding rock and enhance flow. Just as McMoRan finally got perforation and the well began flowing, drilling regulations and repairs conspired to force McMoRan to pull the rig off the well and kill it.

Killing the well involves pumping drilling mud down the well to stop its flow. "Mud" is a liquid that’s normally pumped down into the wellbore to cool and lubricate, carry out debris and offset pressure. For deep drilling, it’s fortified with Barite to add weight to the mud. The weight of the mud and the pressure of the rig’s pumps stop gas flow, making operations safe. Unfortunately, Barite from the drilling mud plugged the fractures in the perforated segment. After trying a workaround by flushing the well with solvent, they’ll now have to turn to more complicated methods to stimulate the well.

The implication for the rest of the Ultradeep play is the real question. This is really an exploratory well that’s being brought to production to pry as much data from it as possible, and DJ1 is an outlier in two respects. The small wellbore is the first. A larger wellbore should alleviate many problems. Moffett believes that, and John Schiller, CEO of Energy XXI concurs. Completion of Davy Jones 2, a well drilled with a wider bore on the same field should test that conclusion.

Other Ultradeep wells also made discoveries much shallower than Davy, some above 25,000 feet, where conventional equipment can be used for completion. Between the inordinate constraint of the tiny wellbore and the fact that all Davy’s production zones fall in Ultradeep sections, success or failure at DJ1 seems unlikely to impact the entire Ultradeep program. Every well is unique, and it’s worth remembering that DJ1 represents an extreme even among the Ultradeep wells.

How the buyouts play on the Street is also an issue. The two boards are significantly intertwined. Moffett’s simultaneous position as Chair and co-Chair of Freeport-McMoRan and McMoRan Exploration provides reason for concern. Richard Adkerson is co-Chair of McMoRan Exploration, as well as President, CEO and Director at Freeport-McMoRan. Plains CEO Jim Flores sits on McMoRan’s board and gains a comp package that would make a Kardashian blush.

McMoRan looked stuck, but shorts neglected to consider management’s other options. Shorting deep pockets is rarely a good idea and Moffett had much deeper pockets in Freeport than some acknowledged. With Moffett’s Ultradeep project on the line and so much overlap in the boardroom, it seems implausible that Freeport would let McMoRan go down. But did they go too far? MMR holders receive a 74% premium on MMR’s Wednesday close and Plains shareholders get a 39% premium on PXP. With such large premiums, it’s not surprising that lawyers are circling.

Freeport-McMoRan shareholders voted with their feet, shaving 20% off its market cap in a couple of days. Whether this is a buying opportunity or the start of a longterm headache for FCX shareholders is unclear, but Freeport-McMoRan is a very different company than it was a couple of days ago. That could justify the selling in some eyes. On the other hand, the Ultradeep prize is staggeringly large. One thing’s certain. McMoRan’s found a way to make the already intriguing Ultradeep even more interesting to watch.

JustMee01 owns shares of Energy XXI Ltd. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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