Castleton Resources Executive Q&A: Haynesville & Flush

[Editor's note: A version of this story appears in the October 2020 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

Haynesville- and Cotton Valley-focused Castleton Resources LLC, one of U.S. shale’s headline-makers this past year, hasn’t had a rig drilling for it in two years. “[Acquisitions have] been a better use of capital by a factor of two,” said Craig Jarchow, presi­dent and CEO of the Houston-based producer.

In December, it bought Shell Oil Co.’s Haynes­ville position for an undisclosed sum. In August, it picked up the legendary Terryville Field in north-central Louisiana for $245 million from Range Resources Corp.

Also in August, minority owner Tokyo Gas America Ltd., a subsidiary of Japan’s largest gas utility, Tokyo Gas Co. Ltd., upped its stake from 46% to 70% from Castleton Commodities International LLC (CCI), the international ener­gy trader that formed the E&P in May of 2017.

Castleton Resources, which will be renamed TG Natural Resources LLC, now owns more than 315,000 net acres in East Texas and North Louisiana, producing nearly 500 MMcfe/d net.

Using TG Natural Resources as its base, To­kyo Gas “will continue to aim for further busi­ness expansion in East Texas and Louisiana,” Kazuya Kurimoto, president and CEO of Tokyo Gas America, said in a press release.

Oil and Gas Investor visited with Jarchow shortly after closing the Tokyo Gas deal and after a hurricane ripped through western Lou­isiana.

“The hurricane literally passed right above the Terryville assets,” he said. “We had some trees down, but the power outages were tempo­rary. Only a small amount of production was of­fline temporarily, so we really dodged a bullet.”

Jarchow began his career as a geologist and geophysicist, including for Amoco Corp. and Apache Corp., and joined energy private-eq­uity firms First Reserve Corp. and Pine Brook Road Partners.

The plans for TG Natural Resources are to keep consolidating as long as the numbers work. It may lead to an IPO.

Investor: What’s the walking rig in the room that no one is talking enough about?

Jarchow: I’m sure you’re hearing about it too: Capital is fleeing the upstream sector. I think this is why Range and Shell went with us: They viewed the financial risk of Castleton clos­ing as being lower. In both cases, financing was a nonissue.

With some of these recent bankruptcies, the commercial banks are being impaired sub­stantially. It used to be that the first-lien, re­serve-based loans were almost never impaired in a bankruptcy. They are now. This is causing a number of banks to get out of this business.

We in the upstream business need to rethink how we’re financing our operations. The cost of capital is going up. There won’t be access to nearly as much first-lien, revolving credit facilities—very cheap debt—from commercial banks because they’re leaving.

The anchor-tenant banks will still be around, but these facilities are going to be smaller, and we’re going to have to be more creative with the other parts of our balance sheet. In my mind, that’s one of the biggest—if not the big­gest—challenges that we face as an industry in the next six to 12 months.

Investor: In past cycles, such as after the 1980s, the commercial banks eventually reappeared. Will that happen here too?

Jarchow: In time, some of them will be back. Some of them may never be back. Some have said, “We want to get out of fossil fuels alto­gether.”

I don’t think that that’s going to be a fleeting policy on their part. No matter what you think about that decision, I don’t think it’s something you reverse easily. So getting out for those rea­sons—no fossil fuels, no fracking—they may never come back.

Investor: Reading oil and gas-operators’ 8-Ks, there seems sometimes to be 861 nanocap E&Ps out there. Will they go away?

Jarchow: It’s more difficult to be a very small public company now. Capital is fleeing this business. But the other thing that’s going on is all of this algorithmic trading—a huge percent­age on any one day is algorithmic, essentially driven by computer programs or index funds or ETFs.

The active investors are playing a small­er role, and these are the people who roll up their sleeves and meet with management teams and study plays, and they’re the ones through which other companies are differentiated in the market’s mind.

The challenge you have as a small company is in being heard by the people who discrimi­nate among operators—so you’re not just an­other Haynesville or Bakken or Permian play­er and no different than anyone else.

You need to be a certain size to get the atten­tion of active investors. And that size is much bigger than it used to be because of all the au­tomatic trading.

Investor: What do you think the minimum size is now?

Jarchow: It’s hard to say. I’m certain it’s not a $50 million market cap, that’s for sure. It’s a lot bigger than that.

Investor There are fewer Haynesville oper­ators—less than a dozen now. Where is this going?

Jarchow It’s getting to be a shorter list. Nat­ural gas is a bit better than it was, but it’s still pretty low. And if you play your cards right, it’s still a very good living, but it’s not easy. And you name a basin in the U.S. and there are too many companies and there is too much G&A and not enough economy of scale. This is just a fact.

When we acquired the Shell assets, we liter­ally added zero additional ongoing G&A. And, with the Range property, it will increase our production 60% and only increase our G&A 7%. That’s the way consolidation should hap­pen: We need to get our costs down.

Here in the Haynesville, there are just too many companies, and they are largely private companies. And they’re all pretty good com­panies. And we’re all pursuing different strate­gies, succeeding to one extent or another.

Since a lot of these companies are owned by private equity, you would expect that at some point they would be consolidated or they would be consolidators. It’s just a question of time.

So we will have fewer companies. The num­ber keeps going down with each new deal, and that needs to happen—not only in our basin, but throughout North America; there’s just too much cost in the system.

Investor: Plans for going public?

Jarchow: Well, we’re trying to continue to grow. And one of the things about successful companies is they eventually outgrow their investors. That’s one of the definitions of suc­cess. At some point, if you’re a successful company, you have to continue to access capi­tal in the form of equity capital.

We have a long way to go before we outgrow Tokyo Gas and CCI. But, if at some point we do, it’s not a bad thing. It’s a measure of success.

Any management team should be prepared to go public. Otherwise you’re doing your in­vestors a disservice. If you are unwilling to go public, you are cutting off an avenue for your investors to achieve liquidity, a lower cost of capital or multiple expansion.

If you’re a successful company, you’ll out­grow your investors. So, yes, we are prepared to go public. We have no plans to do that any­time soon—just because, well, we haven’t out­grown our investors yet.

“When we acquired the Shell assets, we literally added zero additional ongoing G&A. And, with the Range property, it will increase our production 60% and only increase our G&A 7%. That’s the way consolidation should happen.”

Investor: How did you come to pick natgas as your weighting and in the East Texas Basin?

Jarchow: It all began with CCI, our parent com­pany. They’re big traders in a lot of commodities but particularly in natural gas. There was a view that this would be an advantaged location.

Tokyo Gas is our other big owner. They’re the majority owner now. And they’re very in­terested in natural gas. That’s their focus.

So we have two owners that are very familiar with the natural gas market and felt that being long in this location was a good match with the rest of their portfolio because they have offset­ting positions elsewhere.

Investor: Tokyo Gas and Osaka [Gas USA Corp., now a majority owner in neighbor Sa­bine Oil & Gas Corp.] both took several years to choose and raise their stakes in the Haynesville.

Jarchow: They’re very sophisticated investors. These are world-class companies. Whatever they invest, they are pretty careful about it. They think it through. They dip their toe in the water initially. They look for good partners, and when something is working, they grow that.

That’s Tokyo Gas’ approach to us. They originally invested in our company in May of 2017. They have been a part of our board. The familiarity, the trust, the business relationship, the partnership—not only with management, but also between CCI and Tokyo Gas—that’s all been built over time.

Investor: Natgas was unloved at the time you picked the Haynesville. Did that help? You were getting things a lot cheaper.

Jarchow: That’s been part of our thinking. This is a cyclical business—oil and gas. Things go in and out of favor. Natural gas has been out of favor for a long time. So we have been able to seize the opportunity from that. Part of what it takes to succeed in this business is contrarian investment that ultimately works out and being able to stay in the game when commodity pric­es are very low.

It’s not so easy to buy low and sell high. The problem is that, when commodity prices are low, nobody has any money. The capital re­treats. So buying low is hard.

But we’ve been able to do the Terryville deal with Range. And we’re very pleased with what we got.

Investor: Is it the Cotton Valley over there?

Jarchow: There are other payzones, but it’s really a Cotton Valley story. Terryville’s reason for being is a very big fault in the subsurface. It looks like a crescent pointing north. And these Cotton Valley sands are trun­cated against the fault.

Some of the Cotton Valley zones are over­pressured, and there are some very favorable reservoir conditions in and around that fault that made Terryville Field what it is today. It’s a Cotton Valley story.

Investor: When will you pick up a rig again?

Jarchow: Our thinking two years ago, when looking at acquisitions and at the numbers, was that acquisitions were a better use of cap­ital than drilling and completions. It’s not that we don’t have economic Haynesville loca­tions; we have lots of them. It’s not that we don’t have lots of other projects we can do. We just feel it is a better use of our capital.

Sometimes we forget in this industry that our business is about allocating capital. Sometimes that means drilling and completing wells. We’ve been focused on business development and acquisitions.

And at the end of last year, we acquired the Shell Haynesville assets. And then we just fol­lowed with Terryville. In both cases, if you look at how much we paid per proved Mcfe, we paid less than what it would cost us to find it with the drillbit. So this use of capital indeed proved to be the most effective.

Investor: Does having Tokyo Gas’ and CCI’s credit standing help win deals?

Jarchow: I think that’s why both Shell and Range decided to engage with us on these acquisitions. They, first of all, view us as clos­ers—that we would close the deal that we started. And they viewed the financing risk as much lower, just because we have such sub­stantial partners in Tokyo Gas and CCI.

“One of the things about successful companies is they eventually outgrow their investors. That’s one of the definitions of success. At some point, if you’re a successful company, you have to continue to access capital in the form of equity capital.”

Investor: Associated-gas production is down in oil basins, and LNG exports are picking back up. What might natgas prices look like this winter?

Jarchow: It’s going to be very interesting in the next 12 months. Some respected analysts are saying prices will be at or above $3 toward maybe the second half of next year and that we might even be challenging $4.

I wish this proves to be true. But we never count on it. Gas is about $2.50 now [in early September,] and that’s fine with us. If it goes up, we’ll be very happy, but we by no means require it. Our business is very strong finan­cially. We can make a very good living at cur­rent low gas prices.

And that’s how we in the Haynesville and other gas producers think about our business­es: “The analysts think it’s going to go up a bit, and that’s nice, but let’s not count on it.” And we certainly aren’t.

But you’re right about the LNG facilities and the associated gas. In the near term, hopefully it will be a nice opportunity for us to make a little bit more money.

Investor: Castleton’s owners are gas traders, so you’re likely hedged.

Jarchow: Yes, yes. We are.

Investor: You’re not drilling or completing right now, so lower OFS costs aren’t coming your way?

Jarchow: Right. Costs are down. But these prices won’t go on forever because these ser­vice firms are just trying to keep the lights on right now and equipment wears out, so it won’t last forever.

We’ll start to see capital charges for upgrad­ing and maintaining equipment that we’re real­ly not paying right now.

We still are drilling and completing wells in our nonoperated positions with other operators, and we get the AFEs. So we pretty well know what’s going on from a price perspective.

But, right: We currently have no rigs run­ning, and it’s not because we don’t have good locations. We do. It’s just that acquisitions are a better use of capital right now.