In March, Diversified Gas & Oil Plc (DGO) covertly closed in on its target, code name “007.”

Everyone loves a good cryptogram, and like other oil and gas acquirers, DGO created a way to discuss its pursuit and acquisition of Alliance Petroleum Corp., a subsidiary of Lake Fork Resources Acquisition Corp., for $95 million.

Why 007? Searching for a synonym for Alliance, a thesaurus offered “bond.” As homage to the fictional spy, James Bond, and a nod to DGO’s investors across the Atlantic in London, Project 007 was born.

Investors asked the same question, but DGO couldn’t answer until it was ready to make the seller’s name public, until “which we were unable to explain fully,” said Eric Williams, CFO. “Now that we can [tell it], it gets a good laugh.”

DGO’s covert A&D program may be the most adventurous part of the company. The Birmingham, Ala., company and a few others companies like it in the region are E&Ps minus the exploration. They buy legacy Appalachian gas production. And even in these has-been, outdated wells there’s a lot of life and money left. The companies don’t spend much, if anything, on drilling, and they keep capex to a minimum.

Rusty Hutson Jr., DGO’s CEO and founder, has taken to explaining the company’s business to investors this way: “We’re boring, and we like it that way.”

DGO sees legacy assets as a safe bet for consistent cash flow, relying on natural gas wells that are producing steady, predictably declining production.

“Our model is a contrarian model,” he said. “We’re looking at assets no one else is looking at.”

Lately, more companies have been tempted by the allure of shale returns, which only opens more opportunities for companies such as DGO or Carbon Natural Gas Co. Carbon, based in Denver, has drilled some horizontal wells, but it also invests in legacy assets where economies of scale are key to profitability.

“It takes the same amount of people to operate a thousand of these wells as it does 5,000,” Patrick R. McDonald, Carbon’s CEO, said last June at Hart Energy’s DUG East conference. “Obviously your per unit cost is better and your per unit G&A [general and administrative] is better if you have 5,000 or 10,000 or 15,000 of these shallow gas wells.”

Carbon and DGO have both angled for increased scale. In August and September of last year, Carbon closed deals with Cabot Oil & Gas Corp. and EnerVest Ltd. to buy assets in West Virginia for $62.8 million. The Cabot transaction increased third-quarter 2017 production by 124% compared with third-quarter 2016.

In March, DGO also got bigger, closing its Alliance acquisition and a second deal with CNX Resources Corp. for a combined $180 million. Between the two deals, the company added 107 million cubic feet of gas equivalent per day (MMcfe/d) and 2.4 million undeveloped HBP acres.

The acquisitions advance DGO’s strategy of gaining scale within the Appalachian Basin by acquiring assets that allow the company to “realize operating efficiencies, enhancing our operating margins,” Hutson said.

The castoffs

A bright yellow, 5-quart Pennzoil oilcan depicting a winking owl (an image patented in 1939), was recently listed on eBay for $110. At that asking price, it would far outstrip the value of a barrel of West Texas Intermediate, with crude included.

For all of its successes in streamlining fracking and completions, the oil and gas industry is still trying to make out the line between what is vintage and what’s obsolete.

In the Appalachia, the rapid ascendancy of the Marcellus Shale as a natural gas king reversed the previous polarity of the region. But the old vertical wells remain.

In Pennsylvania, about 7,100 unconventional wells produced 5.1 Tcf of gas in 2016, according to the state’s Department of Environmental Protection. Conventional wells lazily sighed 107 Bcf from about 56,700 wells.

Across the Lower 48, conventional wells accounted for about 34% of U.S. natural gas production in 2016, according to U.S. Energy Information Administration data.

Despite attention and money bestowed on the Marcellus and other gas plays, the sheer number of vertical wells make for formidable legacy production.

Hutson witnessed the Marcellus Shale starting to take root.

“The larger companies began losing interest in operating conventional production wells in Appalachia,” he said.

Hutson saw opportunity.

Conventional contrarian

Hutson’s great-grandfather, grandfather and father spent decades bent over the oil patch. During the summers, particularly in college, Hutson’s father insisted he work digging up fields for future pipelines.

Hutson was the first in his family to graduate from college, partly through a desire to avoid digging those ditches.

His studies led him to a career in banking and finance.

Despite the importance he places on his oil and gas lineage, perhaps DGO’s key to its success is that the founder views the company through a financial lens.

“We’re looking to get the highest return on capital that we can get,” he said. “It could be anything, really. It just so happens that these are oil and gas assets.”

The current turn of the market against growth for growth’s sake, he says, was partly dictated by the market itself.

“Some of the shale companies, especially recently, have been talking more about return on capital,” he said.

“From my perspective, most of the companies that you see out there today on the E&P side are run by CEOs who are geologists or engineers. Guess what they like to do? They like to drill,” he said. “I am more of a financially minded person. I have an accounting and financing background.”

It wasn’t until 2001, that Hutson’s father presented him with a package of wells in West Virginia. Still working in corporate banking positions, he secured rights to the wells through owner financing, funding the rest with a home equity loan.

“My wife was ready to kill me at the time,” he recalled.

By 2014, with the Marcellus siphoning off interest in conventional production, Hutson’s business model expanded. It was an equation with just one missing variable: money.

Amidst a downturn, DGO was too small to entice private-equity investment, and banks had battened down on lending. A friend suggested Hutson try the London Stock Exchange. In 2015, the company finally listed a $13-million corporate bond in London on the ISDX Growth Market.

“We used that money to acquire Eclipse Resources’ assets in Ohio and Seneca Resources’ assets in Pennsylvania,” he said. The company acquired about 3,500 wells in two transactions totaling $8.4 million.

In February 2017, DGO successfully launched a $50-million IPO on the London Stock Exchange. The IPO was the largest for an oil and gas company in the U.K. since 2012 and perhaps the first conventional company to go public since Pacific Coast Oil Trust in May 2012.

Golden idle

Investors have apparently seen the good in being boring.

The company started off 2017 deals with the purchase of 1,300 producing wells from EnerVest for $1.75 million. It followed with an acquisition of Titan Energy LLC’s 7,300 producing gas and oil wells for $35 million.

DGO’s stock in London is up by roughly one-third from its debut about a year ago.

As tight oil and gas plays have come to dominate, potential sellers are starting to recognize DGO as a bulk buyer of the legacy assets they no longer want.

Some E&Ps have begun to regard their legacy wells as potential liabilities, Williams said.

Before joining DGO, Williams worked for a Permian Basin pure-play company. Whenever a legacy well was knocked off production—by an offsetting frack, for instance—engineers’ time could be swallowed restoring production to keep the lease HBP.

“Your risk from a financial perspective is that your drilling costs get out of line, and your engineers aren’t paying attention to that, because they’ve got these other assets to manage,” he said.

In the East, many larger Marcellus and Utica shale players have moved on. They’re no longer geared to operate mature flatline production, Hutson said.

“They have an extensive amount of overhead that’s necessary to drill unconventional production,” he said.

While conventional assets can prop up baseline production, in the aggregate they’re not contributing meaningfully to a portfolio of horizontally producing wells, Williams said.

“It becomes a much better use to monetize mature, conventional assets, pull that value forward and reinvest the proceeds into the drillbit.”

By contrast, DGO’s overhead decreases with each new acquisition. At the end of 2017, the company’s unit cost per Mcfe was roughly $1.24. With its deals with Alliance and CNX, unit costs will drop by about 13% to $1.08 while increasing production.

“We have been very successful in not only increasing production but definitely decreasing the operating cost per unit,” he said.

DGO essentially pumps out cash flow while looking to acquire other businesses and returns that fit. Hutson acknowledges that may sound like an MLP.

He said the difference is DGO is buying at the “bottom of the spectrum” with acquisitions at about 4x cash flow. The company also isn’t adding high levels of debt.

“The MLPs weren’t able to do that,” he said. “MLPs were just unfortunately buying assets at a much higher commodity price, leaving them exposed to downside pressure.”

DGO also tucks new acquisitions into a geographically concentrated area. It then squeezes efficiencies and costs out of what it buys.

“A lot of time the wells have been neglected. They haven’t been taking care of. We’ll go in, clean them up, clean out the rigs to get the production levels up,” he said.

DGO’s well tenders also optimize visits to meters depending on production levels. High producers are visited often, while others may only require inspection once a month.

In January, DGO went to the London stock exchange seeking to raise $100 million of equity for its Alliance and CNX acquisitions. The company instead netted nearly $290 million.

“We’re able to fund these transactions purely with equity, which really gives us a lot of running room on the debt side to find further acquisitions,” Hutson said.

And while many E&Ps showcase the rates of return their shale plays offer, “investors never really see that” outside of integrated companies, Williams said. DGO’s philosophy is to use cash flow to pay interest expenses, taxes and a 2017 dividend with a 4.3% yield.

The company plans to operate nearly 30,000 producing wells with less capex than most E&Ps spend drilling and completing a single well. DGO’s capex is largely limited to vehicle purchase to replace well tenders’ trucks.

“It’s not,” Williams said, “the typical E&P story.”

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