Magnolia Oil & Gas CEO and former Occidental Petroleum chief Steve Chazen is pursuing a business model of slow growth and big cash flow. “A lot of money has been eaten up chasing growth but hasn’t shown up in the bottom line.”

Usually, when CEOs of large, public companies step down, they don’t want to be public again—dealing with earnings calls nor investors. But when the brain trusts of private-equity giant TPG Capital called on Occidental Petroleum Co. CEO Steve Chazen following his announced retirement in 2016, they got the opposite response.

“Steve, would you like to be on a board?” Michael MacDougall, TPG director and managing partner, recalled asking Chazen.

“No.”

“Would you like to be an adviser?”

“No.”

“Would you like to look for deals?”

“No.”

“Well, what would you like to do?”

“I want to build a large company with a clean balance sheet with public investors, ideally the ones that have supported me at Oxy, which are some of the largest institutional investors in the country,” Chazen replied.

“And we said, ‘Well, we have a proposition for you,’” MacDougall told Investor.

And so was born TPG Pace Energy Holdings, a special purpose acquisition company (SPAC) led by Chazen, which IPOed in May 2017 raising $650 million. Including additional equity raised following the IPO, TPG Pace Energy Holdings raised just over $1 billion from public market investors. Primary backers include Fidelity Management & Research, Davis Selected Advisors and Capital Research and Management Co.

In March, the SPAC found its prize, partnering with privately held EnerVest Ltd. in its South Texas Eagle Ford Shale business. Set to close in the third quarter of 2018, TPG is paying EnerVest $2.6 billion for all of its South Texas assets, half in cash and half in stock. The resulting combination, Magnolia Oil & Gas Corp., is led by Chazen and Chris Stavros, the former CFO of Oxy. The Houston-based company’s name was chosen in honor of an early mentor of Chazen, Harold Scott, a geologist for the once Galveston, Texas-based Magnolia Oil Co.

The Magnolia portfolio includes 14,000 net acres in Karnes County, Texas, in the sweet spot of the Eagle Ford. About 35% of that total is nonoperated, but EOG Resources Inc.—the undisputed leader nationally in unconventional results—is operator for half of that. Giddings Field accounts for another 345,000 net acres, with potential in the Austin Chalk Formation. The acquisition comes with 40,000 existing barrels of oil equivalent per day (boe/d), 62% oil, with almost 31,000 boe/d in Karnes County.

While Karnes County represents the bulk of the valuation, prior to the acquisition EnerVest drilled four wells in the Giddings acreage into the Austin Chalk with average 60-day IP rates of nearly 1,800 boe/d, a teaser of what might be to come.

Chazen, who holds a bachelor’s degree and doctorate in geology and also a master’s degree in finance, worked more than 20 years at Oxy. Prior to that he was an investment banker with Merrill Lynch & Co. and a reservoir engineer at Columbia Gas Development Corp. He spoke with Investor following the deal announcement.

Investor We’re in an environment now where public-equity investors have largely abandoned the E&P space. How did you sell your investor group on the idea of Magnolia?

Chazen I sold the business model. There are a lot of companies you can invest in that are going to spend 200% of their cash flow, drill a lot of wells and pay $40,000 an acre in the Delaware Basin. This is not that model.

Because of my history, I can talk to people who have the money. I could appeal directly to the portfolio manager, and not necessarily the energy analyst, who is like the gatekeeper. You’ve got to get by the gatekeeper to talk to the guy who actually has the money.

The people I’m talking to are not actually even energy investors. They are investors in Johnson & Johnson or Google or somebody that runs large funds. The problem with energy is the dedicated funds are small and getting smaller, but the diversified funds are large and getting larger.

In order to have a good market for energy stocks, you need to focus on the diversified funds and make a story that they can understand. All this talk on “multiple benches” is not a story that somebody who can buy Johnson & Johnson or Google is excited about spending time on. So what you talk about is earnings, free cash flow and growth. That’s what sells. If you want to talk about benches and frack techniques and sand and PUDs (proved undeveloped reserves) that you haven’t paid for, that’s theoretical stuff. Talk to the energy guys about that. Don’t talk to (the investors) about it.

So our pitch was free cash flow. I’m only going to spend 50% to 60% of my cash flow drilling to create growth. The other 40% won’t be necessary.

Investor So, there is no investor fear of product glut or soft prices?

Chazen Yeah, but let’s say your fund is $20 billion or $30 billion, so you spend $100 million in this. We made only a handful of calls to raise the $355 million of additional equity before we announced the EnerVest deal. We raised most of the money in three calls.

Investor A lot of companies abandoned the Eagle Ford during the downturn for economic reasons. How price sensitive is your new acreage in the Eagle Ford?

Chazen We’re good to $28 or so. You’ve got to remember that the companies you are talking about were gassy. This stuff is oily, very oily—75%. The Karnes stuff. We’re in between EOG (Resources) and Marathon (Oil).

Investor One of the assumptions you make for your EBIDTA is a WTI price of $58. How do you support that?

Chazen We picked $58 because that’s what the analysts are using to compare companies. Breakeven for the company is in the $30s. And don’t forget I’ve got all this (projected) free cash flow. Every dollar up or down in oil price is $10 million in incremental cash flow.

Investor In reality though, what do you expect?

Chazen I expect $55 plus or minus $5. But the point of all of this is you’ve got to be able to survive the bad times. You build an asset base that survives the bad times. I can execute this physical program at—call it—$40 oil.

Investor You’ve talked about emphasizing full-cycle returns and have used the phrase “extracting oil for money.” What do you mean by that and how do you plan to do that?

Chazen It’s about margin. Other people don’t focus on margins. They are buy-and-grow people. I’m not going to push this. I could put more rigs to work, burn up all the cash and grow 35% or 40% a year. That’s wasteful.

I’m focused on steady returns, easy-to-plan costs, making sure costs are aligned. Most of these guys are talking about volume growth, and I’m talking about free cash-flow growth. We estimate 2018 EBITDAX of $513 million, with a capital spend of $262 million or 50% of EBITDA.

Investor How much of that strategy is a reaction to markets?

Chazen (There is) no reaction. So we went out a year ago and said this is what we wanted to do and I was thrown out of some places—not physically. A lot of money has been eaten up chasing growth but hasn’t shown up in the bottom line.

Investor Is this a true paradigm shift in how E&P companies are valued?

Chazen We don’t know. It’s a temporary one, for sure.

If you go back 10 or 15 years, the business was about cash flow and earnings. The shale revolution brought with it a lack-of-earnings-driven revolution because it was all about the future and growth.

You’ve got a new group of investors who thought this was like a high-tech company, where you have a lot of growth and negative cash flow and then the good things happen, like a pharmaceutical company that is going to invent a cure for cancer. Then all of a sudden Pfizer is going to buy you at 40x. But there was no Pfizer.

Investor How important was the PDP (proved developed producing) component of the asset base toward your business model?

Chazen It’s important. I won’t go somewhere where I have doubt about whether the oil is there or not. I’ll put up with lots of other risks, but if I can’t say with 100% certainty that the oil is in place, I’m really not interested. So that leads you to PDP, ultimately.

So the Austin Chalk in the Giddings area, I know the oil is in place there. They’ve started to figure out how to get it out. Whether it turns into a big deal or a medium-sized deal or a small deal, I don’t know. But I didn’t pay much for that option.

Investor So why these assets? Why the Eagle Ford now?

Chazen Because I could get good oil assets; I have a good reservoir at a reasonable price that is pretty easy to understand and is something I’m capable of managing.

Investor So where is the true value to Magnolia? Is it going to be in developing the Karnes County asset or is it in the Giddings unconventional opportunity?

Chazen The true value is in the cake, not the icing. Maybe we’ll get thick icing (from Giddings) but the true value is in Karnes. That’s where most of the value will be.

The Karnes County properties are as good as any acreage in the U.S. They have five- to six-month paybacks, which are about one-third of a typical Delaware Basin Wolfcamp well. We also have a 10-year inventory of locations, which have economic characteristics similar to the wells we are currently drilling.

In the Karnes area you really need a measured approach because the goal is to extract every barrel. Not to extract them as quickly as possible but to extract every barrel. It is expensive acreage and I don’t want to leave any oil behind.

Investor Yet you highlight recent Austin Chalk results in Giddings Field that are far superior in some cases to different benches in the Permian Basin. It seems this would be the place where you’d want to step up the capital at some point.

Chazen My expectations are modest on this. My hope is higher but my expectations are modest. I’m in no hurry. I don’t want to waste money by hurrying and getting disappointing results. If you work at it and figure out where exactly you want to drill, your probability of success is much higher.

I’m going to limit the guys to the cash flow that they produce inside of Giddings, so we’re not taking any money out of the Karnes area and dumping it in here. They can spend their cash flow, but no more.

Investor So you’re really working two separate divisions?

Chazen Separate. It is not that I wouldn’t intellectually want to put more money in it. It’s simply a way of ensuring that they are drilling what they think are their best ideas.

Investor Historically, the Austin Chalk has had mixed success, but these four EnerVest wells have done exceptionally well. Why now?

Chazen Historically, you drilled near the existing natural fractures because you wanted God to frack the wells, not you. That’s been disappointing. So (EnerVest) ran seismic to figure out where the fractures were not, and drilled with the same technique they have used in Karnes. That’s where these new Giddings wells came from, but they didn’t have any money to pursue this.

Magnolia Oil & Gas anticipates the Austin Chalk will bloom like the Texas Indian paint brushes from its newly acquired Giddings Field assets in Fayette County, Texas.

Investor What other areas did you look at in which you saw potential?

Chazen I looked at several areas in the Permian outside of the core Midland and Delaware. There are a lot of smaller operators there and there is a lot of oil in place there. It should work but it’s not (working). Sometimes it’s technique. Who knows why? There are probably good consolidation opportunities there.

We looked in the Scoop/Stack/Merge, but it’s too gassy for me. There is some good, oilier acreage that people have who were in earlier. It’s also more variable than I liked. I like sure things. I like things where I can see how I’m actually going to do it. Some variability is OK, but there is a lot more variability up there than I felt comfortable with.

Then, I looked over at the Delaware Basin: It’s priced for perfection. It might be perfect, but there is no optionality for free there, that’s for sure. Every time the pricing starts to weaken, some idiot—a new entrant—comes in. They’ll pay $40,000, $50,000 an acre for it and inflate everybody’s expectations again.

We also looked at the Haynesville—lots of gas. Decent margins, good reservoirs, completely known. I don’t think there is any mystery at all. But there are lots of lousy (takeaway) contracts that were done at a different time.

In oil, you want to protect the downside but you also understand there’s a reasonable upside in oil over time. I can’t say that about gas. I’m really hard pressed to say anything more than $3.50 for gas. It doesn’t have the same kind of price optionality that oil does.

Investor So do you have any interest in gas?

Chazen It needs to be really cheap. I’ve got to make the 50% margin rule. So if gas is $3 per thousand cubic feet (Mcf) my total cost at the overhead and everything can’t be any more than $1.50/Mcf.

When I looked at it there was one company that was in that area. The rest of them had much higher (finding and development) costs than made sense to me. And that company had transportation issues, so it’s a tough place.

Investor Predictions are that natural gas will become a dominant energy source and that the Eagle Ford is close to future demand via LNG buildout on the Gulf Coast. Are you thinking more about the here and now?

Chazen I’m thinking about the next 10 years, not the next 100. My experience in looking around at properties is, there is one hell of a lot of gas in this country. And it’s in the hands of people who want to grow their barrels of oil equivalent 25% a year into a market that’s growing 5% to 8% a year. It doesn’t strike me as a way to get rich.

If you could consolidate a big piece of it, if you could buy everybody in the Haynesville or everybody in the Northeast, then that makes it rational. But you have a bunch of people in a classic prisoner’s dilemma: Nobody wants to cut the production back because the other guys could take their market share and they’ll be disadvantaged in the market.

Investor Is it a moot point to ask if you’re interested in Eagle Ford gas?

Chazen I think it’s pretty clear that I’m not.

Investor Will Magnolia look to be a consolidator in the Eagle Ford?

Chazen We’ll do small acquisitions but I’m not a consolidator of the basin. I’m not interested in somebody’s acreage 200 miles away.

We look for a business model. This is about a business model of high quality reservoirs, lots of oil, and only spending 50% to 60% of your capital. The business will grow 10% to 15% a year with that spend level because you have the short payback periods. You’re not trapped like somebody in the Delaware Basin. I could have gone to the Delaware Basin, but you’re stuck with at least a 100% spend for two years. It’s always two years away before payback.

Investor You worked with Oxy for 20 years, a large, multinational, integrated company. Magnolia is very different. How does that experience translate to Magnolia?

Chazen The financial model is the same or similar. I’ve bought assets all my life, so I understand the assets reasonably well. I can understand how it works. It’s a lot simpler. I don’t have to travel halfway across the world. I don’t have to worry about industry issues. I don’t have to make speeches at the American Petroleum Institute. I’ve talked to investors, so that’s really not an issue.

Investor Why are you jumping into a new venture at this point in your life, and how do you see it differently?

Chazen I like investors. I like investing. I’ve done OK for myself. Every place I’ve worked, I’ve made people around me rich. The secretary at Oxy—she came to Oxy broke—and when she left Oxy she was a millionaire.

I don’t need more money, and so what makes me happy is seeing a successful venture, people doing well and investors doing well. This model does well and it’s easier to manage than a big international company, something I can do.

When you’re 35 years old, you envision that if you had all this money, you’d fly around the world and play golf and drink wine. But I’ve already flown around the world. I’ve got a pension from somebody I used to work for that covers my bills. This is what I do. I was built for work. Usually the unsuccessful CEO is the guy who wants to play golf.

Investor Tell me about your experience with the space program.

Chazen When I came out of school there was a downturn in the oil business. I knew somebody and they got me a job (in 1974) at the Johnson Space Center running the lab that brought the rocks back from the moon. We put them inside of nitrogen containers and they would bring in scientists to study them.

I didn’t know anything about moon rocks; I basically managed the lab. I did that for four years while I went to business school at night at the University of Houston. But because your clients were these scientists, I learned how to handle difficult people, which did me well as I became an investment banker after that.

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