A version of this story appears in the October 2017 edition of Oil and Gas Investor. Subscribe to the magazine here.

Rosehill Resources Inc. CEO Alan Townsend said one of his lifelong ambitions is to lead a public E&P, and, after 40 years in the business, his wish has now come true. In April, privately held Tema Oil & Gas Inc., the West Texas and Barnett Shale operator he’s led since 2001, merged with KLR Energy Acquisition Co., a publicly held blank-check company. The reverse capitalization valued Tema at $445 million. The public face took the Rosehill moniker.

Rosehill’s near future is rooted in 4,800 Delaware Basin net acres the company cored up around legacy leases with 250 drilling locations before downspacing.

“Historically, you would say 4,800 acres is not much of a footprint, but, when you stack up the benches, it becomes 4,800 times eight or 10. All of a sudden this is quite a new realm” for Rosehill, Townsend said.

Rosehill Resources Inc. (NASDAQ: ROSE) is looking to aggregate smaller deals in the Delaware Basin "because they have such an impact on us," said CEO Alan Townsend.

The Houston-based company formerly known as Tema sports a storied past. Its earliest roots reach back to the formation of Amoco predecessor American Oil Co. in 1910. Tema was formed in 1999 as a subsidiary of Rosemore Inc., a holding company for certain ancestors of the Amoco founders, with assets carved out of the family-owned Atapco Oil & Gas.

Having depleted its Barnett Shale drilling inventory, Tema made a strategic decision in 2012 to go on a growth path in Loving County, Texas, where it held legacy acreage. Anadarko Petroleum Corp. (NYSE: APC) flanked them on one side where it “was building a city;” EOG Resources Inc. (NYSE: EOG), on the other. Tema drilled 21 wells there before releasing its rig ahead of the downturn in 2015, facing capital and operational challenges. Following the recapitalization of KLRE, it expects to drill an additional 22 to 24 wells by year-end.

One of those, Kyle 26 ST-1, targeted Second Bone Spring Sand with a peak rate of 2,130 barrels of oil equivalent per day (boe/d), 84% oil.

In addition to the Loving County blocks, Rosehill holds units in Reeves County, Texas, and Lea County, N.M., as well as some 4,500 net acres in the Barnett Shale, all proved developed producing. Overall, Rosehill’s daily production is more than 5,000 boe/d and it held more than 24.8 million boe of total proved reserves at the end of the second quarter.

RELATED: Rosehill: In Thick Of The Permian And Delaware Basin A&D

Before Tema, Townsend was president of Equitable Resources Energy Co., a subsidiary of Equitable Resources Inc., and CEO of Camelot Oil & Gas Co. He holds a bachelor’s and a master’s of petroleum engineering from the Colorado School of Mines. He discussed Rosehill’s prospects for the future with Investor.

Investor: What was Tema’s situation prior to the merger?

Townsend: We had this great asset, but we were capital-constrained. We had Anadarko and EOG surrounding us, knowing that they would offset us and drain us and lower the value of our property.

In the first quarter of 2016, we began the capital search because the parent company wasn’t going to put any more capital in us. We were too small to IPO. We were looking to see what we could do.

Simultaneously, Gary Hanna (formerly CEO of EPL Oil & Gas Inc.) put together the KLRE SPAC (special purpose acquisition company) in March of 2016, and they went on a search to find the appropriate company that they thought they could bring the public markets into and raise the value of that company.

Investor: Why did you choose to merge with KLRE and go public?

Townsend: The best answer to that is the team wanted to be able to participate in the growth. As a private company, they couldn’t participate as much in the growth of the company as they could as a public. There was no equity in it for the management team and no growth in the equity opportunities, as such. So the team saw that going on the public market would be an opportunity for them to participate in their efforts to grow the company.

Also, KLRE brings a deal flow. They had a lot of contacts with small independents like Tema throughout the Permian Basin. The combination looked much stronger as a whole.

Investor: What made Tema an attractive company for KLRE?

Townsend: We were an established management team, we had a position in the core of the best basin in the country, we had production and an inventory to drill up, and we had a parent company that was willing to participate in the process as opposed to sell out entirely. Rosemore wanted to participate in the expansion. They saw the value of the combination giving us access to public markets and what we could do with a two-fold strategy of organic growth and acquisitions.

Investor: How much common stock is available on the public market?

Townsend: About 7%. It’s very thinly traded, which is our major capital problem right now. One of the problems we had on our road show was that certain investor groups wanted to put more dollars to work than were available to put into Rosehill initially.

Rosehill's acquisition strategy could target individual units overlooked by larger acquiries, or federal leases in New Mexico.

Rosemore currently owns about 83% of us. We thought they would be at about 60% to 62%, but we had significantly higher KLRE SPAC redemptions than anticipated. But we don’t want to do an equity raise at $6.40 (per share). The oil market is depressed right now.

We do expect to get traction. The thought is that when we have an acquisition—and we are hot on the trail of acquisitions—then we’ll have an event in which we could either go to the market for equity or use some other financial tool until such time as the equity window opens.

Investor: Now that you’re public, are you a mouse among elephants?

Townsend: We look at our size a bit differently. If we do a 5,000-acre acquisition, we double our size. If we do a 10,000-acre acquisition, we’re triple. The big guys aren’t looking for those size acquisitions, but, to us, it’s meaningful. We see ourselves as an aggregator of opportunities that are similar to what Tema was and are trying to pull those together.

Investor: But the perception is that the Delaware is picked clean for acquisitions.

Townsend: The larger deals are harder to come by. The fact is we’re looking for smaller pieces because they have such an impact on us. We’re seeing assets from private equity companies that were sponsored primarily for land deals—not drilling and production. Then there’s the private company angle as well. So I’d say, from our point of view, it’s the private equity teams that put together land positions and it’s the private companies that are going to be our main focus.

But the larger acquirers have also been told by Wall Street that, ‘you’ve made your acquisitions; now stick to your knitting and execute on what you’ve bought,’ so the demand for those properties has softened a bit as well.

Investor: How do you plan to identify these opportunities?

Townsend: We have the entire basin mapped. In our database, we have virtually every well that’s been drilled in the Delaware Basin. We’ve got a highly skilled technical team that can build a development plan within 10 days for a reasonable piece of property, so we can take a hard and quick look, which gives us an advantage. We’re actively seeking acquisitions and talking to a lot of people.

We’re not restricted to the Texas side, though; we will look in New Mexico as well. We do have current ownership of about 1,500 acres in the New Mexico side. I spent a lot of my career in the Rockies, so I’m not particularly worried about (working with) federal leases. We could make that into a core area.

Investor: Currently, your position is not contiguous. Do you plan to core up around your current acreage? Or look elsewhere?

Townsend: Contiguous to our current position is problematic. I think it will be difficult to do. As you might suspect, we’ve already pored over all those leases and done what we thought we could do on a bolt-on aspect, but we’re looking outside of that immediate core area. We think Loving County is pretty leased up; we don’t see that as being a prime target.

We like the blocky stuff, but we think it might be an advantage to say, “We’ll take that 640 (acres) right there.” If you think of it as 40 wells, that in itself could be 40 million barrels or more of reserves.

We think an individual section has enough capacity to fund its own infrastructure. That’s what we’ve done up here (in Loving County) to a large degree because (the blocks) are so separated. Obviously, there are better economics if you can block it up, but we’re not going to shy away from something like that.

Investor: How much powder do you have for acquisitions?

Townsend: We don’t have any dry powder to do that; we’re going to have to go to the markets to get that. Because we’re in the core of the core and we do have an aggressive growth pattern, we can use our stock as currency as a portion of the acquisition price and give some upside associated to the stock. We think a lot of the sellers don’t necessarily want to give up all the upside.

Investor: So you’re willing to dilute to grow?

Townsend: Yes, the plan is to dilute to grow. We call it “accretive dilution.”

Investor: How far would you take that?

Townsend: There’s no limit that’s been put on it. When we started out anticipating that Rosemore would have about 60% interest, we envisioned that they’d be down to 30% in fairly short order or lower. There is no magic number. They don’t need to hold over 50%. With the growth trajectory we want, they expect to be diluted—significantly.

Investor: What size deals are you targeting?

Townsend: Initially, $100- to $200 million. Biting off bigger than that might be difficult from a capital market standpoint—maybe not impossible, but initially our focus is a little smaller. Once we get one of those under our belts, then our market value gets significantly higher, and we will be capable of handling larger acquisitions.

Investor: What does your drilling program look like post-closing?

Townsend: We picked up a rig in March and a second rig in April in anticipation of the close, and we are now on track to drill 22 to 24 wells in 2017. Our drilling times have improved dramatically.

Investor: What are you targeting first?

Townsend: We’re going to target the combination of the Third Bone Spring, Wolfcamp X-Y and the Lower Wolfcamp A. We see those as our most profitable. They’re over-pressured reservoirs that give you better EURs in the long term. We’re going to develop them on cluster drilling.

Investor: Describe that.

Townsend: We started with five-well clusters where we drill two wells to the Third Bone, one on the X-Y and two on Lower Wolfcamp A. Then we frack them all before bringing any on production, the thought being that, if you do it in that kind of sequence, you don’t have the issues of depletion with one well on production. We think you can get a more effective frack job on it.

We’re actually frack-mapping our current five-well cluster. We’ve finished two of the fracks and we’ve got two going on now. We are using microseismic to frack-map all five frack jobs because we want to see the effectiveness of the frack designs and the ultimate drainage patterns required to optimally produce the reserves. We’ve drilled two five-well clusters so far, and we are going to experiment with three-well clusters to see if we can maintain our production rates and cash flows more aggressively.

Investor: Do you plan to stay at two rigs through 2017?

Townsend: Yes and through 2018. The size of our footprint is such that we optimize at two rigs, so we’re looking in the $130- to $135-million range for 2017 (capex) and nearer $150- to $200 million in 2018. If we make an acquisition, we can handle two or three more rigs in the acquisition area.

Investor: Is there anything that would cause you to slow down?

Townsend: Capital, but we don’t want to disappoint the Street. We want to show them that we can execute so we’re out there doing that, and I think the capital will be available to do it.

Investor: Are you okay with spending beyond cash flow? What’s your philosophy on that?

Townsend: I don’t think a growth company in this basin at this time can grow within cash flow, so we’re going to have to find some way to fund that until such time as the cash flow is sufficient to be self-funding. We anticipate—in our core property—that will be in early 2019.

Investor: What’s your plan for the Barnett Shale assets?

Townsend: Divestiture. Our objective is to be a pure-play Delaware Basin company. We’re actively marketing the Barnett right now.

Investor: As a growth company, are you concerned about flooding the global market with oil?

Townsend: I’m not. And I’m not quite sure we could flood the global oil market independently.

I’m a firm believer in the free market. The Permian, in particular, adds a throttling to the global oil price. The cure for low-priced oil is low-priced oil and the cure for high-priced oil is high-priced oil. The Permian is unique as we can be profitable in the $45 to $50 range. If we roll up to the $60 to $65 range, that would make a number of other basins profitable and it would drive up my capital cost in the Permian Basin.

Investor: Do you like the price being somewhat capped?

Townsend: I don’t dislike it. I’d rather have it steady in the $45 to $50 range than run up to $65 and drop to $30. Old guys like me say, “Just give us a steady price and we can figure out how to make money.” Don’t let it be so volatile.

I hate $100 oil. Hundred-dollar oil has no discipline. Operating costs mean nothing. You throw dollars at everything that moves and, then, when the price inevitably drops, you’re holding the bag because you spent too much money to drill the wells. I can live with a drop from $50 to $40, but $100 oil dropping to $50, that’s disaster, and I think it is for the entire industry.

It makes for a healthier industry if we have a steady oil price, and that’s what I see going forward. I don’t see $75 any time soon.

Investor: Are you hedged?

Townsend: We are going to hedge aggressively when the market conditions give us the opportunity. Our credit facility allows us to jump to 85% of our PDP for the first two years and 75% of our PDP after that, and we are going to try and get to that number.

One of the reasons I think that we couldn’t bust through $50 per barrel is that, every time oil hit $50, a bunch of guys like me were jumping in and saying, “Sell!” I’ll take fifty bucks in 2018 and smile. I like fifty bucks. Right now, I think the strip for 2018 is $48 and change. We’re probably going to put more in now because the difference in a dollar and a half isn’t that significant.

Used to be, investors didn’t want small oil companies to hedge, but that’s changed. Now, they want to make sure the company can fund its capital program and its debt. We want to make sure we get the kind of returns that we predict in our economic analysis and, hence, that gives the imperative to put hedge positions in place.

Investor: What do prospective investors not understand about Rosehill at this point?

Townsend: That we’re going to cure the small-float issue. There is a good bit of interest in the stock, but the lack of liquidity has discouraged investors and we need more liquidity to allow investors to trade in the stock. We have an aggressive plan to get that cured in the near term.

Investor: What does 2018 look like for Rosehill?

Townsend: We’ll continue to develop our core property, and I would anticipate by 2018 we will have additional acreage to develop on a new core operating area. We easily have the capacity to handle four rigs, possibly five, and, should we get over five, we’re going to add staff. Right now, we have sufficient staff to swallow another acquisition.

Investor: And your longer-term vision?

Townsend: I think we’re going to be a significant multiple higher than we are now, and I hope that the valuation of the stock follows that. I now have the best team I’ve ever assembled. We’re going to continue to be an operational team that effectively executes our development plans. When you boil it down, our job is to drill wells and get them on production. We’re going to execute and we’re excited at the opportunity to do that. We’ve got a great thing going here.

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