Kenny Rogers' Gambler may have known with certainty when to hold 'em or when to fold 'em, but the Gambler was a card shark and not an oil and gas operator.

Unfortunately for oil and gas operators, exit strategy advice from professional advisors often mimics the Gambler's bromides--but it costs far more than a sip of whiskey and a fresh cigarette. Furthermore, industry rule of thumb exit strategies haven't provided much help to operators in resource plays where selling outcomes reflect art and luck rather than science.

Today's new tight formation plays add further contradictions to deal making rules of thumb. For example, resource plays start in an atmosphere where the best thing an operator possesses from a promotional standpoint is the number of acres under lease. Sometimes, the absolute worst thing an operator can do early in the play is to drill the acreage.

Without sufficient technical data and analysis, all acres start conceptually equal from an economic standpoint. However, the reality is that some acres on the animal farm of resource plays end up more equal than others, particularly once drilling starts and operators encounter technical challenges.

Traditional oil and gas exit advice has been arbitrary: sell when you get to a specified production level; or, leave some meat on the bone; or, sell when a property hits a certain percentage of PDPs; or, sell when you reach "critical mass."

The question is whether it is possible to nudge a resource play exit strategy from the realm of art into the kingdom of science, allowing an operator to make the decision to exit on a rational basis.

That question has perplexed David Marcell, managing director, A&D Group for BNP Paribas. How does an operator quantify, for example, a term such as "leave some meat on the bone?"

Marcell has done a deep dive into the minutiae of resource plays to search for ways to quantify risks and develop a model for successful exit strategies. In a provocative session before 400 attendees at Hart Energy's 10th Annual A&D Strategies and Opportunities conference in Dallas at the end of August, Marcell discussed exit strategy guidelines that allow a company to make informed decisions on how to exit resource plays.

"If you're going to be selling something, you need to understand that from the very beginning," Marcell explained. "These resource plays all have a cycle they go through and you need to understand where you are in that cycle."

To Everything There Is A Season

Resource play cycles typically begin with a land grab and are followed by early technical challenges. Marcell examined metrics in resource plays involving property transactions as potential signposts for operators who intend to sell. Once the industry solves technical issues, deal count quickly rises in new resource plays as operators enter a period of land acquisition and consolidation. Afterwards deal volume simmers down. Marcell noted that transaction peaks occurred in the Barnett shale (2006), the Haynesville (2010), and the Marcellus (2010) shales. The Mississippi Lime, Wolfcamp, and Eagle Ford, Utica, and Bakken shales have not yet peaked on a deal volume basis, or in value per acre.

Marcell outlined for conference attendees how asset fundamentals and market drivers influence exit value. For asset fundamentals, it is a matter of defining the resource base through proved, probable, or possible reserves, coupled with the economics of the play and market risks comprised of variables associated with technical and execution capabilities. In other words, some companies are better at acreage acquisition; other companies may be better suited at delineating a parcel and exiting. Finally, some firms have the technical acumen and capital resources to optimize production before an exit.

As far as exiting, external market drivers such as commodity price, the prevailing regulatory climate and internal business objectives, such as a property’s strategic fit in a portfolio, all impact the potential exit value for an E&P company.

Timing is Not Quite Everything

For most operators, the decision path on when to sell revolves around timing. Selling out early in a rapidly developing play creates an outcome range of values that is fairly narrow for the seller. The valuation process entails itemizing the property and offering it within a framework bounded by market demand and commodity price, Marcell explained.

"But if you want to increase that value, then you have to move it up the value chain somehow," he said. At that point, operators face decisions based on where the property lies in the arc of development. An early-phase property requires investment in acreage de-risking to establish stabilized IP rates. Taking on drilling risk in developing a property allows the operator to define geologic and reservoir assumptions, which in turn expand the potential upward range in the valuation estimate before the operator decides to put the property on the market.

Marcell posited that the investment phase in drilling has a side benefit over and above value enhancement. It enables operators to focus on what needs to be done specifically to prepare for an eventual sale. If course corrections become necessary, the operator can adapt the exit strategy accordingly, whether it involves adding additional rigs, establishing a more accurate PUD multiplier, or adjusting to changes in the commodity price cycle, all of which can influence the timing on when to sell.

Ultimately the decision path on when to exit rotates through several recurring steps beginning with a sell early option, followed by an option to sell after the initial drilling phase, and finally selling after a second drilling phase.

Valuation in a "sell now" strategy is confined within the variables of market demand and commodity price.

The range of property valuation increases after an initial drilling phase and the range of outcomes start to respond to the initial results of the program as well as constraints to the framework of market demand and commodity price.

Selling after a second drilling phase significantly increases the potential value through actionable data on well production, the establishment of a type curve, and the ability to produce consistent well results.

While ultimate outcome still resides within the framework of market demand and commodity prices, the potential valuation on a dollar-per-acre basis can increase exponentially after the second drilling phase.

In order to realize higher valuations, the seller will need to successfully navigate compounding risks in the form of subsurface issues, execution issues, or potential negative developments in the larger market.

A Model For Success?

Marcell presented a conceptual model to illustrate exit strategies. Potential exit value increases significantly once operators overcome initial technical challenges. The property then enters a return on investment phase (ROI) as an operator begins converting probables to PDPs/PUDs. At that point the exit window for maximizing value is defined in association with ROI economics. Adding incremental capital at various rates will increase the PDP/PUDs conversion rate and offer a predictive mechanism for estimating how incremental capital expenditures can impact potential exit value over the course of the development.

In other words, an operator can develop clarity on what his return will be for every dollar he invests in developing the parcel under a near infinite number of subsurface, execution, and market outcomes.

"As we drill these probables we create a ton of value and the incremental ROI goes way up because we are capturing value from a PUD multiplier," Marcell explained. "It will hit the end of where you have probables left and you reach your project ROI. The exit window closes, mathematically, when you've drilled up all probables, and your incremental ROI dips below your rolling project ROI. Ultimately, the exit window exists during the phase of development where your incremental investments are accretive to project ROI. Beyond that, incremental investments resemble single-well economics only."

When to exit within the high potential valuation window depends on an operator's goals.

"If an operator is driven by exit value, there is one set of decisions," Marcell noted. "If an operator is driven by ROI, it will indicate a second place to exit. And if an operator is driven by minimizing capital expenditure, it will also give you an indication. You're going to know where you sit on the curve at all times, how the near-term investments impact your outcome, and you're going to be able to pick when—and if—you pull that parachute. That's what having clarity to take action in the exit window is all about."

Contact the author, Richard Mason, at rmason@hartenergy.com.

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