The Abraxas MLP creates a vehicle to get back into the acquisition business, says Abraxas chief executive Bob Watson.

For 10 years, publicly held San Antonio-based Abraxas Petroleum Corp.’s business strategy included struggling under debt at times totaling up to $315 million. The company kept drilling, but it always seemed to be in a sort of holding pattern.

That has come to an end. A new era began in May 2007 when the $175-million-market-cap producer formed a master limited partnership (MLP) of some of its assets, raising $147 million and wiping out its debt. Its balance sheet is cleaner and it has cash now for drilling.

“In January 2007, after we completed our year-end reserves report, we started to look at different alternatives to refinance our debt,” says Barbara Stuckey, Abraxas director of corporate development and vice president of the general partner of the MLP, Abraxas Energy Partners LP. “We had $125 million of high-yield notes that were call-able in April.”

Abraxas’ proved oil and gas reserves totaled 99 billion cubic feet equivalent (Bcfe) at year-end 2006, 83% gas, 48% proved developed, more than 95% operated. The reserve life exceeded 15 years.

The company’s discounted present value was about $161 million at $56.42 oil and $5.82 gas. 2006 production was 7.7 Bcfe, a 26% increase from output of 6.1 Bcfe in 2005.

Meanwhile, Abraxas could not restructure its debt without unanimous consent of bondholders, says Stuckey, and the first call was approaching. In early 2007, a number of banks suggested alternative debt financing.

“But we thought those ideas were a bit ordinary,” Stuckey says. “We wanted something that was really going to change the face of the company, not something that was just going to refinance the debt and save 3% on the interest.”

Stuckey and Abraxas Petroleum chief executive Bob Watson were familiar with the Canadian royalty-trust structure by way of the former Abraxas Canadian subsidiary, Grey Wolf Exploration, which went public in 2005.

“We were familiar with the trust market in Canada, and then we saw the evolution of the new E&P MLPs in the U.S. come about. We recognized the valuation arbitrage between C-Corps and MLPs, and we started to get to work,” says Stuckey.

Watson, who founded Abraxas Petroleum in 1977 and took it public in 1991, saw an opportunity to become completely debt-free by forming an MLP with some of Abraxas’ long-lived, predictable, gas-producing assets, most of which are in Texas.

“The MLP market was hot,” he says, “and it was extremely low-cost capital for us to do that. The MLP would create a vehicle we could use to get back into the acquisition business. We had basically been out of that business for the past 10 years, and we were very much looking forward to getting back in.”

Watson and Stuckey brought the idea to investment banker A.G. Edwards & Sons (which has since merged with Wachovia Securities) and together they came up with an MLP structure they felt would work.

A.G. Edwards was exclusive financial advisor in the formation of the MLP and sole agent for the private placement of MLP common units in May, raising some $100 million for Abraxas.

Buyers of the 6 million MLP common units at $16.66 each included Lehman Brothers MLP Opportunity Fund LP and Citigroup Global Markets Inc., Third Point LLC and funds managed by Fiduciary Asset Management LLC, Merrill Lynch Commodity Partners LP and Tortoise Capital Resources Corp.

Abraxas retained a 47% interest in the new MLP, and the unit-buyers hold 53%. The MLP then entered a $150-million credit facility, of which $35 million was drawn at closing.

Concurrently, Abraxas privately sold 5.9 million common shares at $3.83 each to several buyers of the MLP units, raising $22.5 million.

Much of the net raise from the transactions, some $147.3 million, was used to repay all of Abraxas’ and its subsidiaries’ outstanding debt. The remainder, Watson says, will be used to fund future drilling and for general corporate purposes.

The deal was well received in the market. The placement was 100% subscribed by eight institutional investors, and seven also participated in the concurrent common-share offering.

“While we were on the road show, it was evident to the MLP investors that this was a watershed event for Abraxas, so they also wanted to own a piece of the parent company,” says Watson. “We retired the debt with the proceeds and, after fees and expenses, we put about $8 million of cash in the bank.”

Watson and Stuckey decided not to IPO the MLP at that point. “We wanted to do a two-step process when we were ready. So we did the private placement first, then formed the MLP, and paid off the debt at the parent company,” Stuckey says.

The IPO was still in the registration process at press time, and expected to begin trading on the American Stock Exchange in the first half of 2008.

Abraxas brought in a key investor, Lehman Brothers, for the private placement, then took on $35 million of debt capital from Societe Generale to “bridge the gap,” says Stuckey. Societe Generale was administrative agent for the MLP’s credit facility and SG Americas Securities LLC was book-runner and lead arranger.

Proceeds from the IPO of the MLP will be used to pay off this debt. Abraxas Petroleum will own a 2% general-partner interest in the MLP upon closing the IPO of an additional 2 million units, raising some $50 million, and a 38.3% limited-partner interest. The MLP plans to pay $0.375 per unit quarterly.

Going forward

Abraxas dropped 65.4 Bcfe of proved reserves (58% proved developed, 91% gas) in South and West Texas into the MLP. The contributed assets involve some 16,400 gross acres with net production of 16.1 million cubic feet equivalent per day, representing about 85% of Abraxas’ daily output.

It retained about 33.4 Bcfe of proved reserves (29% proved developed, 67% gas) and some high-impact proved undeveloped and probable locations. The company also retained resource plays in the Woodford shale in West Texas and in the Mowry shale in Wyoming, in addition to several exploration projects in South Texas targeting the Wilcox formation. Altogether, Abraxas has 88,200 gross acres with 3.3 million cubic feet equivalent per day of net production.

“We will still be drillbit-focused,” Watson says. “There’s no doubt about that. We still have a lot of drilling to do on our existing properties. Prior to the MLP, we didn’t have the balance sheet to support a very active drilling program, but now we do. So we will be busy drilling wells, while looking for accretive acquisitions, not only for Abraxas but for our limited partnership as well.”

Abraxas has assets in Wyoming and West and South Texas, representing about 10 years of inventory (90% operated) on existing leaseholds. It will look at acquisitions in any area in which it has previously operated, which is essentially all of the producing states west of the Mississippi River and east of California.

More specifically, the company is looking at Texas exploration plays in the Janssen prospect in Karnes County, the Goebel prospect in Live Oak County and the Plummer and Tuleta prospects in Bee County, all targeting the Wilcox formation.

“We have a long track record of being very innovative and adding value, and now, with a clean balance sheet, we should be able to accelerate that ability to add value,” he says.

The MLP will keep production rates essentially flat by drilling development wells within its current asset base.

Watson says Abraxas’ 2008 capex budget of $35 million is going to be heavily weighted toward oil development, specifically in its West Texas assets. At some point in the future, when the production stabilizes and becomes predictable, those assets may be dropped down into the MLP.

“We have shallow Permian plays on the eastern shelf of the Permian Basin, centered around Scurry, Mitchell and Coke counties. We also have some Spraberry, Wolfcamp and Devonian oil plays in Midland County. So we will be drilling development wells there,” says Watson.

“We’re not looking for any barn-burners, but at today’s oil prices, the collective program exhibits some pretty exciting economics and will add a considerable amount of oil production to our mix, and that’s essential in a time of high oil prices and low gas prices.”

While most of Abraxas’ existing wells are vertical, it plans to drill more horizontal wells going forward. A strategy of drilling horizontals in the Mowry shale in Wyoming, when added to the low-risk vertical wells elsewhere, will optimize the company’s risk-reward ratio, he says.

“Additionally, we have leases in Scurry and Mitchell counties that have never been waterflooded, so we’ll be in-fill and pattern drilling to set up waterfloods in those areas in 2008.” Abraxas is also in the Wilcox play in South Texas, where its drilling is 3-D seismic-driven.

The company’s total value, including its interests in the MLP, has gone up considerably. “We’re pretty proud of the way we look,” Watson says. “It would take a very exciting offer for us to consider bailing out after putting in all the hard work and anxiety that we did over the last 10 years, struggling with an overleveraged balance sheet. We wouldn’t give it up quickly or cheaply.”

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