Brian Kerrigan, CIT director.

?When privately held Spyglass Cedar Creek LP needed capital to fund construction of gathering lines and a development drilling program for its Cedar Creek gas field, the small-cap E&P turned to Houston-based CIT Energy. The latter is a unit of CIT, headquartered in New York City.


The under-drilled Cedar Creek gas field in Harding County, South Dakota, produces from the Cretaceous Eagle and Judith River sandstones in the Cedar Creek anticline. The main evidences of structural deformation in the basin are folding and faulting, and some of these structures, like the Nesson, Cedar Creek, Little Knife and Billings anticlines in nearby North Dakota, also produce oil. But it’s no sure thing.


Spyglass started its drilling operations on the first well of a $4.1-million, four-well program on the South Cedar Creek project in 2006. The Spyglass Price #13-24R well in Section 24, T19S-R4E of Harding County, was the first of five exploratory wells. It is a 5,950-foot re-entry, previously drilled by Summit Resources in 1997, and targeted bypassed gas potential in the Cretaceous and bypassed oil potential in the Paleozoic. It was designated a “tight hole” by Spyglass and is still being evaluated.


Another well, Spyglass State #4-16 in Section 16, T19S-R4E, was drilled to about 6,250 feet to evaluate oil potential in a Paleozoic structure.


Spyglass’ further development program, led by founder and general partner Kevin Sellers, fell behind schedule due to weather. The prospect area had received an unusual amount of rainfall, making it difficult to truck in equipment to build a much-needed gas-gathering system.


“They received more rainfall in three weeks in June than they did all of last year,” says Brian Kerrigan, CIT director and lead arranger for the deal. “The fields were either under water or soaked with mud. We understood that the company’s timeframe was delayed, but not through any fault of its own.”


Sellers met Kerrigan and CIT Energy president Peter Gaw at NAPE Expo in 2007. “Sellers chose us because one of the things that differentiate us is that CIT is able to do senior, second-lien and mezzanine debt. There are other players out there who offer second lien and mezzanine, but most of them don’t offer first-lien loans.”

CIT has a solid relationship with Spyglass, talking frequently with the company about Cedar creek and other working opportunities, say Brian Kerrigan, CIT director. The under-drilled Cedar Creek gas field produces from the Cretaceous eagle and Judith river sandstones in the Cedar Creek anticline in South Dakota.

The New Braunfels, Texas-based E&P has about 63,500 acres of leasehold in South Dakota. The play requires a shallow, vertical drilling campaign. Each gas well only takes about a day to complete. Spyglass eventually drilled and tested seven producing wells, but had to shut in the wells due to the lack of gas gathering. In addition, Sellers wanted to buy out his existing partner, GP Energy Inc., with $2.75 million to gain a 100% working interest.


“Spyglass is one of a series of limited partnerships that we manage,” says Sellers. “In this particular situation, because we had an acquisition, the cost of the capital will be less, in the long run, with the continued utilization of a debt facility rather than giving up asset equity.


“So, although we had one-time expense fees and so forth with the mezzanine financing, if we had used only an equity structure, we would have had to go back to the money source again later to fund the full development. With our relationship with CIT, we now have that facility in place.”


CIT loaned Spyglass enough to build a 13-mile gathering system to connect to the seven existing wells and expected future wells to an interstate pipeline to take the gas to market. The pipeline was up and running as of June 19. CIT also gave the company additional capital to drill another 13 wells, for a total program of 20 wells.


“Our risk appetite, as a lender, is a little lower than that of Spyglass. We know what level of risk we like, and Sellers knows what he likes, so we play very well in this sandbox together,” Kerrigan says.


Gaw agrees. “We are here for the long haul with them. We are not just a transactional shop.”


The deal with Spyglass is mostly debt, but there are equity kickers associated with it, in the form of a net-profits-interest (NPI) schedule, as a percentage of Spyglass’ net operating income.


Kerrigan says, “Our competitors might have structured that as royalty income. The reason we didn’t do that is because royalty is a percentage of the revenues as opposed to the operating income. This is really better for Spyglass at the end of the day, even though it is more difficult for CIT to go out and monetize an NPI, but we can do that where our competitors wouldn’t.”


Of the total $22-million deal, $10 million is a commitment amount. CIT structured a first-lien loan (senior debt revolver) and a second-lien term loan. The other $12 million is a term loan. Once it has production online, Spyglass can quickly start borrowing from CIT, on a senior-debt basis, lowering the cost of capital.


“Spyglass is a perfect example of the types of clients that we like in the E&P space,” says Gaw. “We look at small- to midcap clients that are in the development stage of production. Those companies’ first $25- to $30 million of capital is one of the biggest challenges they have. They are ramping up production and need to look across the capital structure for first lien, second lien, mezzanine and equity.”


Also, CIT did not require personal guarantees on the loan by Spyglass principals. “That’s a testament to how much due diligence we undertake on the technical side,” says Gaw. “We are relying on the quality of the property and the level of reserves.”


To that end, CIT employed Jerry Jeram, an on-staff senior petroleum engineer with 30 years of experience, to look at the reserves. He worked with Spyglass’ own data to close the deal.


Gaw says, “Many capital providers rely on third-party engineering. We frequently work with small-cap or newly emerging companies, so having that technical expertise in-house does several things for us. One, it gives us a higher comfort level as we look at transactions. Two, it gives us speed to market. And three, it gives us a broader understanding of the properties.”


CIT has about 40 people dedicated to its Houston-based energy group. “We cover the industry from the drillbit to the light switch,” says Gaw. It has about $2 billion committed to the energy business in the U.S. and abroad, with an average deal size of $30- to $50 million, going higher when it is a lead arranger for syndicated deals.


“I don’t think there is a more robust industry than energy right now. I’ve been doing this for 25 years and I think the interesting thing is that all segments of energy are ramping up at the same time,” says Kerrigan.


Normally there are different stages of activity, he says, but now all segments are expanding due to high commodity prices and a prior lack of investment. All aspects of energy, from manpower and equipment to supplies, are stressed.


“The energy market is frothy right now. From structural and leverage standpoints, the deals are getting more aggressive,” says Gaw.

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