When the management of Energy Corporation of America (ECA) needed a capital source to accelerate development of its large resource base in Appalachia, the team knew it wanted to hang on to opportunities to participate in the upside. After reviewing several financing options, including debt, equity, royalty-trust equity and mezzanine, royalty-trust equity quickly stood out as a win-win for the company and its unitholders.

When ECA was doing its road show for the trust, the way the company kept its own money involved helped sell the story, says John Mork, ECA president and chief executive. ECA kept approximately 50% of the trust units and has a 70% economic interest in the assets because it retained 50% of the wells to be drilled.

The timing of the road show was interesting.

“During the first week, the whole market dropped 6%; the HBO television special ‘Gasland’ premiered; the BP oil-spill saga was in full throttle; and, any hiccup in drilling in Appalachia was being presented by the media as a Marcellus problem,” says Mork.
“Nevertheless, the demand was twice the offering size. The range of the offering was $19 to $21 and we priced at $20. In looking at the product, the wells have performed 40% better than what the reserve report indicated.”

The management team was confident the product would sell even in difficult markets. “The royalty trust is relatively low-cost, nonrecourse capital and it gives unitholders a long-term, stable return. Once the basic structure of the trust was developed, the company and underwriters put a lot of energy into designing a product that would be secure for investors and easy for the market to understand. Plus, ECA Marcellus Trust I was actually designed to be successful in a low-gas-price environment.”

In July, ECA Marcellus Trust I (NYSE: ECT), sponsored by privately held, Denver-based ECA, completed its initial public offering of 8.8 million common units for gross proceeds of $176 million. The trust consists of 14 producing horizontal Marcellus shale wells and 52 horizontals to be drilled over four years, all in Greene County, Pennsylvania, where ECA holds 9,300 acres.

ECA has a commitment to drill 66 wells over a four-year period at no cost to the trust. As the sponsor, ECA bears not just the drilling cost but also the operating costs of the wells once they’re on production. It will own half the units that comprise the trust, and it owns 50% of the economic interest in the proved undeveloped reserves.

Raymond James & Associates Inc. and Citi were lead book-running managers, and Oppenheimer & Co. Inc., RBC Capital Markets Corp. and Robert W. Baird & Co. Inc. were co-managers of the offering.

“ECT is a yield-oriented product with downside protection and plenty of upside potential for the unitholders, which is something the market craves during difficult times,” Mork says. “There’s nothing else out there that a retail investor can buy that will act like ECT. The product is structured to deliver a strong return—about a 10% IRR—and it’s also the first public investment vehicle designed for retail investors to own royalty interests in the Marcellus shale, which can do well with $5 gas.”

Royalty-Ttrust Appeal

The royalty-trust security structure is a good fit for ECA’s long-term development plans and culture of controlling drilling costs, Mork says. The structure functions like a “preloaded master limited partnership (MLP)” as it already has the properties in it, and these will be developed during the next three years at no cost to the unitholders. This allows distributions to grow for the unitholders, which is unprecedented in royalty trusts, he says.

This approach also allows ECA to remain private and is in line with its planning cycle, which is in decades, not quarters.

Since its inception in 1963, ECA has focused on finding and developing oil and gas primarily in the Appalachian Basin, Gulf Coast and Rocky Mountain regions of the U.S. and in New Zealand. The company owns and operates 5,100 wells, 5,000 miles of pipeline and has 1 million acres in North America.

“The company was formed by my father with virtually no capital,” Mork says. “The original plan was to get geological prospects, raise money from individuals and drill gas wells in Appalachia while making a profit. When I joined the company from Unocal Corp., we changed the business model and bought existing production in addition to drilling wells. The breakthrough came on a prospect in West Virginia in 1976 when we were very undercapitalized.”

During that year ECA drilled two discovery wells, then drilled 200 development wells between them without a dry hole. Since 1976 the company has grown at a compound annual rate of about 23% per year.

During the next year, the company plans to drill about 40 Marcellus wells, several in the Eagle Ford, a couple in Montana and at least one in New Zealand.

“Our capital budget for fiscal 2011 is about $175 million. We’re very excited about the Marcellus, and we recently completed a significant oil well in Montana and finished the seismic on a 1.5-million-acre onshore license in New Zealand, where we’ve had one discovery so far. We also recently entered a joint venture with a private company to develop Eagle Ford shale assets in Texas.”

In reflecting on his firm’s choice for capital, Mork says it’s a mistake for companies to target the cheapest capital available or to not secure enough to meet development plans.

“E&P companies are asset intensive, and therefore capital intensive. I believe that access to capital is more important than cost of capital. If you think about a royalty trust, it’s like an E&P company without management—a plus to some—and the trusts tend to trade at higher multiples than E&P companies. Investors were clearly drawn to that combination with ECT.”

Attractive Upside

Because there was such a high drilling component targeting the Marcellus shale (approximately 30% of the proved reserves were proved developed producing with 52 wells to be drilled by ECA at no cost to the trust), Raymond James & Associates wanted to structure the trust to provide downside protection to public investors, but still provide the opportunity for investors to participate in any production or pricing upside.

“So we took a page out of the MLP playbook, which was the concept of target distributions, subordination and incentive distributions (commonly known as IDRs),” says Howard House, managing director and co-head of energy investment banking at the firm.

“We used the Ryder Scott reserve report and Nymex strip to forecast quarterly distributions for the 20-year term of the trust. ECA agreed to subordinate half of its units and we set the subordination threshold at 80% of the target distribution. So, if the actual distributions are less than 80% of the target distributions, cash flow will be diverted from ECA’s subordinated units to common unitholders.

“To compensate ECA for subordinating a portion of its units, we came up with an incentive threshold where if distributions exceed 120% of the target distributions then ECA and the unitholders split the upside 50/50. Unlike an MLP, where the IDRs stay in place forever, once the subordination period terminates, the IDRs go away and everyone is on equal footing. The subordination period ends four quarters after the drilling is completed.”

House says the trust provided a compelling investment opportunity in that investors who bought the units in the IPO will realize a 10% internal rate of return on investment if target distributions are received over the 20-year term. House adds that ECA’s retained economic interest of 65% aligns its interests with investors, another attractive feature.

“ECA received a very attractive valuation for the assets sold. In terms of dollar values for proved reserves in the ground, ECA was paid about $3.25 per Mcf and 1.7 times the SEC PV-10 value. Equally significant, the valuation of ECA’s undeveloped acreage exceeded $45,000 an acre. These valuation metrics are not an ‘apples to apples’ comparison with a conventional divestiture because, once the drilling is complete, the undeveloped acreage reverts back to ECA and the trust is left with the wellbores.

“From a strategic standpoint, this approach is preferable to doing a joint venture because you’re not letting competition into your acreage area,” adds House. “The sponsor gets to stay private and has 8.5 million units that it can ultimately monetize down the road. At the end of the term, a portion of the wellbores reverts back to ECA and the company has a right of first refusal on the remaining wellbores.”

House says that the royalty-trust structure may be appropriate for other E&Ps that have exposure to resource plays, though they’d need to be experienced operators with history in the play. Raymond James would also look for some component of proved developed producing reserves, though it doesn’t have to be substantial, he adds.

“The company also has to demonstrate that it has a good understanding of what to expect from its drilling program, and it has to be in a play that is sufficiently developed for a reputable reserve engineer to create a report to project future production.

“The Marcellus is far enough along where Ryder Scott was able to develop a type curve from ECA and various other operators. In addition to the Marcellus, the ECA trust structure has potential application for qualified players in the Eagle Ford, Haynesville, Barnett and Bakken plays.”

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