1

Responses to Small Entity

- Related Questions, 7/22/2011

The summary statistics about the small entities hint at an interesting market structure, one with a large number of very small operators and a small number of large small entities. This raises a question about why the market is structured in this manner and whether the average statistics hide significant economic impacts.

1. I would like to know more about the very small entities participating in this industry (say those operating zero to 5 or 10 wel ls). Is there a particular industry niche in which these small entities operate or a particular kind of well they operate?

EPA RESPONSE: Based upon the discussion that follows

— in response to this and subsequent questions

— there is no single industry nich e for small operators since small operators can have different business strategies and that small operators can own different types of wells. The organization of firms in oil and natural gas industry also varies greatly from firm to firm. Additionally, oil and natural gas resources vary w idely geographically, as well can vary within a single field.

The first important broad distinction among firms is whether they are independent or integrated. Independent firms concentrate on exploration and production (E&P) activities, while integrated firms are vertically integrated and often have operations in E&P, processing, refining, transportation, and retail. To our awareness, there are no small integrated firms.

Independent firms may own and operate wells or p rovide E&P

- related services to the oil and gas industry. Since we are focused on evaluating potential impacts to small firms owning and operating new and existing hydraulically fractured wells, we should narrow down on this sector.

Among many important roles, independent small operators historically pioneered exploration in new areas, as well as developed new technologies. By taking on these relatively large risks, these small entrepreneurs (wildcatters) have been critical sources of industrial innovati on and opened up critical n ew energy supplies for the U.S. 1 In recent decades, as the oil and gas industry has concentrated via mergers, many of these smaller firms have been absorbed into large firms. In fact, news reports indicate this trend is continu ing in new shale plays, such as the
Marcellus Shale in PA and NY

.
Another critical role, which provides an interesting contrast to small firms pioneering new territory, is that smaller independents maintain and operate a large proportion of the Nation’s lo w

1 IHS Global Insight. “The Economic Contribution of the Onshore Indepe nd ent oil and Natural Gas Producers to the U.S. Economy.” Prepared for the Independent Petroleum Association of America. April 2011. < http:// www.ipaa.org/news/docs/IHSFinalReport.pdf>2

producing wells (also known as marginal or stripper wells). 2 While marginal wells represent about 80 percent of the population of producing wells, they produce about 15 percent of domestic production (see Table 1 ).

Table 1 . Number of wells and production from marginal and non

- marginal production wells,
2009

Type of Wells Wells (no.) Wells

(%) Production (MMbbl for oil and Bcf gas) Production

(%)
Crude Oil Stripper Wells (<15 boe per year) 310,552 85% 311 19% Other Wells (>=15 boe per year) 52,907 15% 1,331 81% Total Wells 363,459 100% 1,642 100% Natural Gas Natural Gas Stripper Wells (<15 boe per year) 338,056 73% 2,912 12% Other Natural Gas Wells (>=15 boe per year) 123,332 27% 21,048 88%
Total Natural Gas Wells 461,388 100% 23,959 100% Source: U.S. Energy Information Administration, Distribution of Wells by Production Rate
Bracket. <http://www.eia.gov/pub/oil_gas/petrosystem/us_table.html> Accessed 7/10/11. Note: Natural gas production converted to barrels oil equivalent (boe) uses the conversion of 0.178 barrels of crude oil to 1000 cubic feet natural gas.

W e understand from industry sources that many of these wells were drilled and initially operated by major firms ( although the data are not available to quantify the percentage of wells initially drilled by small versus large producers )

. Well productivity levels typically follow a steep decline curve; high production in earlier years but sustained low production for decades

. Because of relatively low overhead of maintaining and operating few relatively co

- located wells,

some small operators with a particular business strategy purchase low producing wells from the majors, who concentrate on new opportunities. As small operators have pro vide d important technical innovation in exploration, small operators have also been sources of innovation in extending the productivity and lifespan of existing wells. 3 Plugging and abandoning wells is complex and costly, so sustaining the productivity of wells is important for maximizing the exploitation of proven domestic resources. However, t hese marginal gas wells are likely to be older and in conventional formations, and as such a re unlikely to be good candidates for re

fracturing/completion , which means they are unaffected by the proposed rule.

2 Duda, J.R., G. Covatch, D. Remson, S. Wang. 2005. Projections of marginal wells and their contributions to oil and natural gas supplies. Society of Petroleum Engineering Journal, SPE98014. <http://www.netl.doe.gov/technologies/oil

- gas/publications/AP/Ma rginalWells_AP

- DOE.pdf>

3 Duda, J.R., G. Covatch, D. Remson, S. Wang. 2005. Projections of marginal wells and their contributions to oil and natural gas supplies. Society of Petroleum Engineering Journal, SPE98014. <http://www.netl.doe.gov/technologies/oil

- gas/publications/AP/MarginalWells_AP

- DOE.pdf>3

Although, small operators maintain a large proportion of the marginal and stripper well population, this does not indicate that some small operators are not also drilling and hydraulically fracturing wells al ongside larger operators in unconventional formations.
C ompanies of any size can drill and complete any type of well

. For example, Savoy Energy Corporation’s mission is to economically extract oil from abandoned wells through recompletion

and work

- over activities. 4 Savoy Energy had $174 thousand in assets in 2009; ranked 137 in the Oil and Gas Journal’s top 150 producers by assets. 5 Although, Savoy Energy may own abandoned oil and gas wells, the firm is re

- completing wells

, potentially , with hydraulic
f racturing technology.

2. Do these small or niche operations correspond to higher cost/revenue ratios or higher cost/capital ratios? For example, do these small entities use these REC solutions currently?

EPA RESPONSE: The ana lysis in the RIA, based on limited data, indicate s that small er firms (defined by SBA criteria as having fewer than 500 employees) have higher engineering compliance cost/revenue and engineering compliance cost/capital ratios than larger firms. This is partly explained by the fact that smaller firms tend to be independents focused on E&P, while
the relatively few large firms tend to be vertically and in many cases horizontally integrated, with processing, transportation, refining, and even retail operations.

Also, s mall er independ ents may have more vo latile financial indicators because much depend s on the projects they are engaging in at the time the ratio is determined , as well as economic conditions during the years summarized by the financial indicators. Also, there may be some unusual data points driving some of the high impact ratios

. Please see additional analysis provided at the end of this document for more discussion of these data.

We assume small firms are performing RECs in CO and WY, as in many instances RECs are required under state regulation. However, we have had insufficient time to work with oil and gas commissions in these States to understand whether appropriate data is available to examine this assumption.

In addition to State regulations, some companies are implementing RECs voluntarily such as through participation in the Natural Gas STAR Program and the focus of recent press reports

. In
our review of Gas STAR and other information, we o nly found examples of large operators voluntarily performing RECs o n hydraulically fractured wells. That said

, there could be examples of s maller companie s implementing existing RECs that are not sharing those experiences with Gas STAR.

4 Savoy Energy Corporation. (2011). Savoy Energy Corporation: About Us. Available online at: http://www.savoyenergycorp.com/index.html

5 OGJ. (2010). OG

J 150. pg. 5. Available online at: http://www.ogj.com/index/ogj

- survey

downloads.html#ogj2001004

As describ e d in more detail below, m any smal l independent E&P companies often do not
conduc t any of the actual field work. The se firms will typically contract the drilling, completion, testing, well design, environmental assessment, and maintenance. Therefore, we believe it is likely that small independent E&P firms will contract for RECs from service providers if required to perform RECs. An important reminder is that performing a REC is a straightforward and inexpensive extension of drilling, completion, and testing activities

.

3. Is the average REC cost valid for these very small fi rms or the wells they operate?

EPA RESPONSE: To the extent that very small firms may specialize in operating relatively few
low

- producing stripper wells, an other way to ask this question is whether these low

- producing wells are likely candidates for re

- fracturing/re

- completion and, if so, whether the expected costs
and revenues would be valid. T hese marginal g as wells are likely to be older and in conve ntional formations, and as such a re unlikely to be good candidates for re

- fracturing/completion.

To the extent the marginal wells may be good candidates for re

- fracturing/completion , the REC
costs would be valid. The average REC cost is valid for RECs performed on any well, regardless

of the operator size. The reason for this is that the REC service is contracted out to specialty service providers who charge daily rates for the REC equipment and workers. The cost is not related to any well characteristic.

Large operators may receive a discount for offering larger contracts which help a service provider guarantee that REC equipment will be utilized. However, we should note that the existence of a potential discount for larger contracts is based on a strong assumption; we do not
have evi dence to support this assumption. Since co ntracting REC equipment is analogous to contracting for drilling equipment, completion equipment, etc., the premium would likely be in the same range as other equipmen t contracted by small operators . Since the RE C cost is a small portion of the overall well drilling and completion cost, the effect of any bulk discount disparity between large an d small operators will be small, if in fact it does exist.

4. Are the REC solutions as effective on these niche wells as they are on the average well?

EPA RESPONSE: Although small operators may own the majority of marginal and stripper wells, they will make decisions based on economics just as any sized company would. For developing a new well, any sized company will expect a return on their investment meaning the

po tential for sufficient gas, condensate, and/or oil production to pay back their investment and generate a return that exceeds alternative investment opportunities . Therefore, small or large operators that are performing hydraulic fracture completions will experience the same distribution of REC performance. For refracturing an existing well, the well must be a good candidate to respond to the re

- fract ure/completion with a production increase that meri ts the
investment in the re

- fracture/completion

. For b oth a new well and a re

- completed well , the cost5

of the REC will be a small percentage of the overall cost of the event , from 0.3

- 0.7 percent according to our analysis

.

Smaller operators have specific business plans and field development strategies that may be niche and more closely associated with smaller operators, such as purchasing more mature fields or such as operating stripper wells ; however, not all small ope rators have the same objectives or the same type of wells

.

Additional Analysis in Response to Small Entity Discussion

Our sample of E&P firms (which includes independents and integrated firms) includes 122 small entities according to SBA criteria. The engineering compliance costs

- revenues ratios indicate that 9 small entities exper ience an impact between 1 and 3 percent (7.4 percent of small firms)
and 6 small entities experience an impact greater than 3 percent (4. 9 percent of small firms).
Table 2 below details the analysis for these 15 firms. Please refer to the discussion in Section
3.5 of the RIA to better understand how the Oil and Gas Journal and American Business Directory Information were used to develop the analysis.

Before examining the quantitative analysis, however, we would like to discuss the results of rapid resear ch into the objectives and recent history of the 15 small entities, based upon review of corporate websites. The following set of findings indicate s the po ssibility that the impact
ratio s for 6 of the 15 small entities may be over

- e stimated:

Cano Petroleum , according to its corporate website primarily focuses of enhancing recovery from proven, mature oil fields. This means the company may do little hydraulic fracturing of natural gas wells. < http://www.canopetro.com/ > CNX Gas Corporation was acqu ired in 2010 by CONSOL Energy, a large firm.

< http://www.consolenergy.com/ > Daybreak Oil, according to its corporate website, targets shallow oil reserves in Kern County California. This means the company may do little hydraulic fracturing of natural

gas wells . We are also unaware of unconventional gas plays in CA in which fracturing
would likely be occur ring

. <http ://www.daybreakoilandgas.com/ >
EnerJex Resources , according to its corporate website, primarily performs E&P on onshore oil properties in the U.S. This means the company may do little hydraulic fracturing of natural gas wells. < http://www.enerjexresources.com/ > NGAS Resources Incorporated is in the process of being acquired by Magnum Hunter

Resources . We however, were unable to determine t he impact indicators for Magnum Resources, as it seems to have been recently formed from Petro Resources.

< http://magnumhunterresources.com/ >6

Tri

- Valley Corporation , according to its corporate website, is an oil and gas production company with California properties . We are unaware of unconventional gas plays in CA in which fracturing would likely be occur ring

. < http://tri

- valleycorp.com/ >

A few observations are worth noting on Table 2. First, not surprisingly, the firms’ employ relatively few people. However, the amount of industrial activity, indicated by revenues, expenditures, and wells drilled indicates the likelihood that many of these firms contract for support services. Second, capital and exploration expenditures are high relative to revenue, which appears to hold true more generally for independent E&P firms compared to integrated major firms. This would seem to indicate the capital

- intensive nature of E&P activities. As expected, this would drive up ratios comparing estimated engineering co sts to revenues and capital and exploration expenditures. Third the high capital and exploration expenses compared to revenues may indicate that firms are following aggressive production strategies. As mention in the first response in this document, smal ler producers have historically taken risks to open up new resources or employ new technologies; some of this behavior may be indicated by the analysis presented in Table 2.7

Table 2 . Additional Analysis of Oil and Gas Journal and American Business Directory Information, 15 Small Entities with Engineering Compliance Cost to Revenue Ratios Greater than One Percent.

Estimated Engineering Compliance Costs Engineering Compliance Cost:Revenues Ratio Engineering Compliance Cost:Capital Ratio Estimated Wells Drilled*

Company Emp

loyees Revenues

(2008

- 09 average in 2008 dollars) Capital and

Exploration Expenditures (2008

- 09 average in 2008 dollars) Cap.

And Expl. Exp: Revenues Ratio W/

Product Recovery W/O

Product Recovery W/

Product Recovery W/O

Product Recovery W/

Product Recovery W/O

Product Recovery Gas Oil

Approach Resources Inc. 45 60,020,211 63,952,753 107% 990,193

- 61,656 1.65%

- 0.10% 1.55%

- 0.10% 26 15

Cano Petroleum Inc. 63 34,887,046 71,462,081 205% 1,057,773

- 65,941 3.03%

- 0.19% 1.48%

- 0.09% 27 16
CNX Gas Corp. 174 732,425,975 427,479,290 58% 10,054,401

- 620,880 1.37%

- 0.08% 2.35%

- 0.15% 259 149
Credo Petroleum Corp. 13 13,646,985 11,575,551 85% 230,131

- 13,832 1.69%

- 0.10% 1.99%

- 0.12% 6 3
Cubic Energy Inc. 17 2,541,405 10,581,561 416% 82,373

- 5,172 3.24%

- 0.20% 0.78%

- 0.05% 2 1
Daybreak Oil & Gas Inc. 2 531,741 685,797 129% 86,307

- 5,158 16.23%

- 0.97% 12.58%

- 0.75% 2 1
Double Eagle Petroleum Co. 24 46,921,924 36,199,845 77% 498,371

- 31,343 1.06%

- 0.07% 1.38%

- 0.09% 13 7

EnerJex Resources Inc. 13 4,982,265 6,270,633 126% 2,168,953

- 130,738 43.53%

- 2.62% 34.59%

- 2.08% 56 32
Glen Rose Petroleum Corp. 17 145,732 826,201 567% 74,079

- 4,320 50.83%

- 2.96% 8.97%

- 0.52% 4 2

Index Oil and Gas Inc. 2 2,365,275 NA NA 32,005

- 2,007 1.35%

- 0.08% NA NA 1 0

John D. Oil and Gas 7 4,440,787 1,767,977 40% 221,467

- 13,729 4.99%

- 0.31% 12.53%

- 0.78% 6 3

NGAS Resources Inc. 111 70,999,440 35,232,168 50% 1,108,051

- 69,837 1.56%

- 0.10% 3.14%

- 0.20% 29 16
Rex Energy Corp. 163 58,208,561 56,862,983 98% 1,096,455

- 67,765 1.88%

- 0.12% 1.93%

- 0.12% 28 16
Tengasco Inc. 29 12,608,954 603,392 5% 159,794

- 10,070 1.27%

- 0.08% 26.48%

- 1.67% 4 2

Tri

- Valley Corp. 32 4,778,011 3,843,164 80% 73,724

- 4,675 1.54%

- 0.10% 1.92%

- 0.12% 4 2

TOTAL 712 1,049,504,312 727,343,395 69% 17,934,077

- 1,107,122 1.71%

- 0.11% 2.47%

- 0.15% 466 268
Note: Oil and Gas Journal reports total wells drilled. As described in RIA, we divided apportioned 63% to gas wells and 37% to oil wells, based on distribution of drilling activity reported by EIA. S haded firms may have overstated engineering compliance cost e stimates. Sources: Oil and Gas Journal. “OGJ150.” September 21, 2009; Oil and Gas Journal. “OGJ150 Financial Results Down in '09; Produ ction, Reserves Up.” September 6, 2010; American Business Directory for employee numbers.