E&P Operator Vertical Integration Drives Strategic Changes

E&P Operator Trends to Vertical Integration
Strategic Threat to Service Companies?

Houston, Texas
November 14, 2011

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E&P VERTICAL INTEGRATION

Contents

1. PacWest Snapshot

2. Operator Vertical Integration

3. PacWest Market Intelligence Offerings

Client Confidential © PacWest 2011 | All rights reserved | 2


PacWest is a boutique strategy consultancy and market intelligence
firm that specializes in unconventional oil & gas
Firm Overview & Capabilities

Consulting & Advisory Market Intelligence Products
 Provide strategy consulting and  Offer industry-leading analysis of
advisory services to Oil & Gas unconventional market

 Strength in Oil & Gas supply market  Deep knowledge and strength in the
- Often work with operator supply pressure pumping / frac market
chain groups analyzing
supply/demand, developing  Employ combination of primary
sourcing strategies, building intelligence + secondary research
capabilities, etc.

 Unique in market: apply strategy
 With oilfield suppliers, often work at consulting capabilities to turn
C-Level or business lead research into actionable intelligence

All key staff come from top-tier strategy firms; consulting and market
intelligence capabilities reinforce/inform each other


A sampling of some of PacWest’s recent projects demonstrate our
depth of experience in North American and international shale
Sample of Recent PacWest Consulting Projects

PacWest Project Client Outcome
Analyzed Bakken & Eagle Ford supply/demand; conducted Operator avoided completion
demand planning exercise to develop new pressure pumping delays, avoided significant
sourcing/contract strategy additional costs
Developed Poland unconventional market entry, PE firm focused on high-growth
product/service, and JV strategy for a potential shale service segments only, with the right
company for a private equity client strategic partners
Developed an innovative economic and strategic analysis of Operator understood cost
operator all-in water management costs over 20-year implications, made optimal
timeframe, for Bakken & Eagle Ford assets economic decisions
Conducted a study of frac pump market focused on supplier Equipment manufacturer
strategic plans, manufacturing capabilities, and supply chain developed optimal strategic
capabilities investment plans
Conducted study of evolving service company landscape in Operator made better informed
Poland, including equipment, resources, and expansion plans contract award decision

We have resources in nearly every major unconventional
country/region to support international shale needs


Contents

1. PacWest Snapshot





Contents

1. PacWest Snapshot

 Drivers
 Integrated Operators
 Integrated Services
 Pioneer Case Study
 Southwestern Case Study
 Strategic Implications




As oil/liquids-driven activity has increased, vertical integration has
become the hot new sourcing strategy amongst some operators
New Sourcing Strategy or Near-term Solution?

Some operators have been increasing pursuing vertical integration for key
goods/services

- Is this a sourcing fad or new operator best practice?

- What is driving this trend?

- What type/size of operators are pursuing this strategy?

- What does this mean to service companies?



Vertical integration is driven by two primary factors: pricing and
challenges obtaining equipment/services when needed
Drivers of Vertical Integration

Pricing pressures continue
- Supply/Demand fundamentals have driven major pricing increases across nearly
every product/service
- Significant price escalation is projected to continue through 2012
- Some operators boast significant well cost savings from vertical integration

Security of supply is challenged
- US onshore operators continue to announce record breaking drilling programs
- Large backlogs of uncompleted wells exists for nearly every major onshore player
- Infrastructure challenges in key operating regions cause additional supply chain
constraints (e.g., Bakken)
- Service companies are forced to prioritize supply of key products/services to their
key customers

In addition to securing supply, some operators boast significant average well cost
savings from vertical integration


Contents

1. PacWest Snapshot

 Drivers



E&P VERTICAL INTEGRATION : Project Scope

A significant number of small- to medium-sized operators are currently
pursuing vertical integration strategies
Vertically Integrated Operators

The following peers have pursued vertical integration in one or more services:

Note: List of firms does not include all firms that are vertically integrated
Source: PacWest analysis, company presentations, company 10-Ks


The production base (i.e. cash flows) of operators pursuing vertical
integration varies significantly
2010 Production (MMboe)
300
273

250

200
173

150 141

Average = 92
100
70

50 42
21 15 2

-
OXY CHK EOG SWN PXD SD Lewis OAS



The scale of activity that vertically integrated operators are undertaking
also varies significantly
2010 Capital Spend and Wells Drilled
US Land Capex ($billion) US Wells Drilled
CHK 8.7 CHK 1,149

EOG 5.1 EOG 895

SWN 2.1 SWN 704

OXY 1.6 OXY 536

PXD 0.9 PXD 473

Lewis 0.6 SD 424

SD 0.5 Lewis 47

OAS 0.3 OAS 29 Average = 532
Average = 2.5

0.0 2.0 4.0 6.0 8.0 10.0 - 500 1,000 1,500
Note: Data is estimated for some operators as not all peers provide sufficient granularity in capital spending guidance; SWN wells drilled figure
includes 9 gross wells drilled in Arkoma Conventional asset; Lewis Energy wells estimated based on Oasis wells/spend ratio
Source: PacWest analysis, company presentations, company 10-Ks, Oil and Gas Investor


Contents

1. PacWest Snapshot

 Drivers




Some operators have chosen to vertically integrate across just a handful
of service categories
Vertical Integration by Operator & Category
Pressure
Operator Proppant Coiled Tubing Rigs Logistics
Pumping

Source: PacWest analysis, company presentations


Four operators own a total of 15 pressure pumping fleets (by mid-2012)
with an estimated total of 530,000 HHP
Pressure Pumping Vertical Integration

Chesapeake owns pressure Lewis Energy owns 2
pumping subsidiary Performance fleets/60,000 HHP of pressure
Technologies pumping capacity that it
Performance operates 2 operates in the Eagle Ford
fleets/60,000 HHP in MidCon and
adding another 2 fleets/80,000
HHP by EOY 2011
Also has 15% stake in Frac Tech
Services (more of a
financial/hedging strategy)

Pioneer currently owns 8 Spending $24 million to launch
fleets/225,000 HHP that it Oasis Well Services subsidiary
operates in Spraberry (5 fleets), Committed to buying 1 single
Eagle Ford (2 fleets), and Barnett frac fleet to operate in the
(1 fleet) Bakken; likely plans to add
Expects delivery of 3 additional additional fleet once it has
fleets by mid-2012; plans to ramped up operations
deploy them to Spraberry
Also owns/operates 4 CT units in
Eagle Ford and Raton Basin


EOG and Southwestern have each brought a frac sand quarry online in
the last few months
Proppant Vertical Integration

EOG Southwestern
 Spent $65 million to set up a frac sand  Spent $30 million in 2008 to acquire
quarry and plant in Chippewa, reserves in Arkansas and set up a plant
Wisconsin, with a capacity of 1.7  Quarry currently yielding 0.65 million
million tpa tpa
 Sand planned for use in Eagle Ford  Quarry went live in 2009 Q2 and
where C&J is doing the majority of supplies an estimated 70% of company
pumping under a dedicated contract sand demand
 Rail contract in place with Progressive  Estimates savings of $150,000 per well
Rail and Union Pacific and trucking
handled by a local company, Chippewa
Sand Transport
 Estimates savings of $0.5 million/well
 Also operates a 2nd frac sand quarry
near Ft. Spunky in Texas that it bought
in 2007 H1 for Barnett pumping
Source: PacWest analysis


Five operators own/operate a total of nearly 200 drilling rigs across
their US operations
Rigs Vertical Integration

Owns a total of ~115 drilling rigs Recently added 3 drilling rigs to
across 2 drilling rig subsidiaries bring total company-owned rig
Nomac owns ~95 rigs; launched count to 13
in 2001 with $26 million All rigs are operating in South
investment Texas
Acquired Bronco Drilling (22 rigs)
in Apr 2011 for $315 million Set up a drilling subsidiary in
Plans to add another ~30 2005, DeSoto Drilling Inc. (DDI),
newbuild by 2013; goal is to own which owns 11 rigs
2/3rds of total rigs DDI owns/operates 11 rigs, all
but one of the horizontal rigs in
Currently owns/operates 15 rigs play; remaining rig is on month-
in the Spraberry, 40% of its total to-month contract
rig count
Also owns/operates 2 additional Owns 20 drilling rigs total: 14 in
rigs in its Raton Basin asset Permian, 5 in MidCon, and 1 in
WTO
Owns a small fleet of workover
rigs



Contents

1. PacWest Snapshot

 Drivers




Pioneer’s 2011 capital spend is forecast to be $2.1 billion, with 62%
allocated to Permian and 13% to vertical integration
Pioneer 2011 Capital Spend ($billion)
US Land Capex Pioneer Capex
EOG 6.4
CHK 5.2 $0.10
$0.10
APC 2.9
$0.12
OXY 2.8
DVN 2.3 $0.21
PXD 2.1
HES 1.7 $1.30 $0.30
APA 1.7
MRO 1.6
NBL 0.9
MUR 0.3 Average = 2.6 Alaska Other Eagle Ford
Barnett Combo Vertical Int./Facil. Spraberry
0.0 2.0 4.0 6.0 8.0
Note: Data is estimated for some peers are not all peers provide sufficient granularity in capital spending guidance


Pioneer’s vertical integration strategy extends to rigs, pressure pumping
equipment, and various other surface equipment
Pioneer’s Vertical Integration Approach

Pioneer has chosen to vertically integrate (i.e. own and operate) many of its critical services that
are typically delivered by service companies and are generally the largest spend categories
It has vertically integrated in the following service areas:
- Drilling rigs: currently owns 15 rigs
- Frac fleets: by year-end 2011, it will own 8 frac fleets and it expects delivery of 3 fleets in mid-
2012 for a total of roughly 300,000 HHP that is company-owned
- Coiled tubing units: by year-end, it will own 4 CT units
- Pulling units: currently owns 31 pulling units
- Various other equipment including water hauling trucks, BOPs, frac tanks, etc.
- Also includes yards, buildings, and storage facilities to support vertical integration
While the company does not own frac sand quarries itself (as does EOG), it does source its frac
sand directly, through Carmeuse and potentially suppliers, rather than relying on 3rd parties
- It has sand supply in place through 2015
It has also contracted for cementing services through 2016
Pioneer received 12 rigs and 3 frac fleets near year-end 2010; given equipment order lead times,
it likely began implementing its vertical integration strategy during the middle of 2010


Pioneer has pursued vertical integration in all of its core unconventional
assets that it is currently developing
Pioneer Assets
Vertical
PXD Asset Details
Integration
Largest operator in the Spraberry trend and is one of the most active
Permian
developers in the Permian
Raton Largest operator in the Raton CBM basin where it is focused on shale
Basin resource development
Eagle Ford Owns 310,000 gross acres which it is aggressively developing
Barnett Owns significant assets in the wet gas zone of the play in the NW;
Combo currently developing
Entered the North Slope in 2002 and discovered the Oooguruk gas field
Alaska
in 2003, which it brought online in 2008
South 45% interest owner with PetroSA in offshore asset that now produces
Africa small amount of gas
Operates 600+ gas wells and has working interest in 1200+; owns
Hugoton majority of gathering/processing infrastructure; new development
activity minimal until gas prices recover
Edwards Long history in the trend; development minimal until gas prices recover


Spraberry is Pioneer’s core asset accounting for nearly two-thirds of
capex and it has pursued vertical integration most aggressively here
Pioneer Spraberry Development

2011 Wells Put on Production Supply Discussion
250 Quarter-by-quarter supply chain activity:
- Q1: 4 frac fleets (3 company-owned, 1
230 235
dedicated 3rd party)
200
- Q2: in May increased to 6 frac fleets (4
company-owned, 2 dedicated 3rd party)
150
- Q4: Adding 5th company-owned frac fleet
146
The company owns 14 drilling rigs (40%)
100 110 As of Q4, the company will own 5 frac fleets,
representing 71% of capacity, in addition 2
50 dedicated fleets with Baker Hughes
- Ordered an additional 3 fleets which it
expects to receive in mid-2012
-
Q1 Q2 Q3E Q4E The company also owns 23 pulling units and
various other equipment, including water
Rigs 30 35 45 by YE
hauling trucks, frac tanks, BOPs, construction
equipment, and fishing tools
Source: PacWest analysis, company presentations (in some cases, exact well counts are estimates)


Pioneer is running 12 rigs in the Eagle Ford and has deployed company-
owned frac fleets and coiled tubing units in the play
Pioneer Eagle Ford Development

2011 Wells Put on Production Supply Discussion
40 Quarter-by-quarter supply chain activity:
- Q2: deployed 1st company-owned frac
35 35
fleet in addition to dedicated fleet
30 - Q3: brought 6th and 7th CGPs online
- Q4: Adding 2rd company-owned frac fleet;
bringing 8th CGP online
20
As of Q4, the company will own 2 frac fleets,
18 representing 67% of capacity, in addition to a
dedicated frac fleet with Weatherford
10
- Second company-owned fleet is expected
to be delivered during Q4
4 The company also owns a single coiled tubing
-
unit and expects delivery of a second CT unit
Q1 Q2 Q3E Q4E
during Q4
Rigs 8 10 12 12
Testing white frac sand (10 wells) in shallower
areas; generating $700 million savings/well


The company has also pursued vertical integration in the Barnett and
Raton, its other two core unconventional resource plays
Pioneer Barnett & Raton Development

Barnett Supply Discussion Raton Supply Discussion
The company has 2 rigs currently under The company currently owns 2 drilling rigs
contract with 3rd parties The company currently owns 1 frac fleets
- Plans to increase to 4 rigs by year-end - Does not appear to be using any 3rd party
Deployed 1 company-owned frac fleet in pumpers for additional fracs
2011 Q2 The company owns 2 coiled tubing units
- Has also used Weatherford and Baker The company owns 8 pulling units
Hughes to frac wells
The company also owns and operates a frac
The company also owns a single coiled tubing fluids laboratory in the Raton basin, which
unit and expects delivery of a 2nd CT unit presumably serves all of Pioneer’s frac fleets
during Q4 across its assets



Pioneer claims that its vertical integration model will generate a 45%
IRR on a third-party savings basis, excluding managerial burdens
Pioneer Vertical Integration Savings
Pioneer has spent $440 million on vertical integration over 2011:
- $300 million for equipment delivered in 2011
- $140 million for equipment to be delivered in the middle of 2012 (3 frac fleets and other)
- Likely spent additional capital in 2009 to reserve orders
Pioneer claims that the $440 million investment will generate a 45% IRR before taxes, though
that is strictly on a cash savings basis and does not include incremental managerial burdens of
these “businesses”; does not consider cost of capital

Service Area/Savings Spraberry Eagle Ford Barnett Total
Frac Fleets
YE Fleets 5 2 1 8
Fracs/Fleet/Year ~115 ~55 ~60 ~93
Savings/Frac $0.35MM $1.70MM $0.75MM $0.58MM
Annual Savings $200MM $185MM $45MM $430MM
Rigs & Other Services
Annual Savings $30MM - - $30MM
Annualized Cash Savings $230MM $185MM $45MM $460MM


Contents

1. PacWest Snapshot

 Drivers




Southwestern forecasts that it will spend $2 billion in capital over 2011,
with nearly 2/3rd of that spend in the Fayetteville
2011 Capital Spend ($billion)
US Land Capex Southwestern Capex
Fayetteville Appalachia New Ventures
EOG 6.4
CHK 5.2 Midstream Corp Other Areas

MRO 3.0
3%2%
APC 2.9 10%
OXY 2.8
DVN 2.3
9%
PXD 2.1
SWN 2.0
HES 1.7
15% 61%
APA 1.7
MRO 1.6
NBL 0.9
MUR 0.3 Average = 2.6

0.0 2.0 4.0 6.0 8.0
Note: Data is estimated for some peers are not all peers provide sufficient granularity in capital spending guidance


Since 2007 Q1, Southwestern’s new producing wells per quarter has
increased 25% YoY, while its rig count has decreased 11% YoY
Fayetteville Development, wells put on production (2007 Q1 – 2011 Q2)

2010: 553 286
170 159
160 2009: 446 149
150 143 145
137
140
130
2008: 329 122
120
120 2007: 255 111
110 106
97 93
100
90 83
74 77 75 74
80
70
58
60
50 46
40
30
20
10
-
2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

Rigs 19 18 16 14 12


Southwestern has succeeded in reducing drilling days per well by 17%
YoY for an average 53% reduction since 2007
Fayetteville Development

Days to Drill Well Cost
20 $4.00
17

$2.90 $3.00 $2.90
14 $3.00 $2.80 $2.80
12
11
10 $2.00
8

$1.00

- $-
2007 2008 2009 2010 2011 H1 2007 2008 2009 2010 2011 H1



Southwestern has chosen to pursue a vertical integration strategy only
in its core Fayetteville asset
Southwestern Assets

Proved
Vertical
SWN Asset Reserves Details
Integration
(Bcf)
Focus of the company’s E&P operations; the company
owns nearly 1 million net acres in the play; as of EOY
Fayetteville 4,345
2010, company had spud 2,445 wells in play since
commencement in 2004
Traditional area of operations located in western
Conventional Arkansas; have recently expanded activity to the
226
Arkoma south and east of the traditional fairway area, but has
significantly reduced capital spend
Owns nearly 175,000 net acres in play in NE
Appalachia 38 Pennsylvania and have participated in a total of 25
wells since drilling commenced in 2009
Active in region since 2000 in Cotton Valley and has
East Texas 321
expanded activities to target Haynesville/Bossier



Southwestern’s vertical integration strategy extends to drilling rigs,
sand, water sourcing, water hauling, in-field logistics, and civil works
Fayetteville Vertical Integration Strategy
Drilling Rigs Frac Sand
 Set up a drilling subsidiary in 2005, DeSoto  Spent $30 million in 2008 to acquire
Drilling Inc. (DDI), which owns 11 rigs reserves in Arkansas and set up plant
 DDI owns/operates 11 rigs, all but one of  Quarry went live in 2009 Q2 and supplies
the horizontal rigs in play; remaining rig is roughly 70% of company sand demand,
on month-to-month contract saving estimated $150,000 per frac job

Water Sourcing Water Hauling
 Sources all water internally, though this is  Owns a network of water hauling trucks to
quite common among operators handle the majority of its water hauling
 Experimenting with fracs to reduce water needs internally
consumption 10% (~$60,000/job)
In-field Logistics Civil Works/Well Site Prep
 Owns a network of trucks to handle the  Company handles site work that
majority of in-field hauling needs contractors might otherwise do,
internally particularly pressure pumpers

The company claims to save an estimated $0.3 million per well as a result its vertical
integration efforts


Southwestern employs Schlumberger, Calfrac, and Cudd for its pressure
pumping services in the Fayetteville
Fayetteville Pressure Pumping Strategy

2011 Frac Jobs Discussion
Schlumberger 48%  Southwestern employs three different
Pumper Share: Calfrac 32% pressure pumpers in the Fayetteville
Cudd 20% - Schlumberger, Calfrac, and Cudd
60
 Each pumper is on a 1-year contract that
50 11 10 started in the February-March timeframe;
11 each operates under a slightly different
40 10 9 18 contract
16
16 9
7
- Contracts are bid year-to-year
30 4
14 13  The company’s pressure pumping demands
20 15 13 11 are some of the most basic in the industry
29 29 - Frac depths range from 2,000 to 5,000
25
10 20 21
17 feet with ~5,000 feet laterals
14 15
- Currently running 100% slickwater fracs
0
 Company has seen pressure pumping price
Jan Feb Mar Apr May Jun Jul Aug increases in the 4-5% range over 2011,
Legend: Schlumberger Calfrac Cudd significantly less than most other operators
in the area
Note: Data from Jun, Jul, and Aug does not yet include all fracs completed during those months
Source: PacWest analysis, PacWest FracDB, company presentations (in some cases, exact well counts are estimates)


Contents

1. PacWest Snapshot

 Drivers




If timed properly, vertical integration can yield significant near-term
benefits to operators, but the model also entails significant risks
Vertical Integration Strategic Considerations

Benefits Risks
Ensures equipment availability and avoids Bear risk of idle equipment/staff if price
delays during a tight supply market environment necessitates activity reduction
Potentially lowers per well costs if service Added enterprise complexity can potentially
business is operated efficiently serve as distraction for management/staff
Potentially increases per well costs if service
business is not operated efficiently

Implications
Model can yield significant benefits during times of tight supply but those benefits become
marginal as supply market loosens and turn negative as the market collapses
Operators need to be strategic about the “exit opportunity” – requires market foresight to know
when the market is going to loosen and when to you should get out of the business
North American supply market is just beginning to loosen from its peak in mid-2011 and things
appear to be likely to equalize by late-2012 or early-2013
– Market opportunity for vertical integration may be over for operators


Greater operator vertical integration represents a potential strategic
threat to service companies
Strategic Threat?

Larger independents increasing looking at peer’s well cost advantages with a keen eye

However, several factors reduce the vertical integration opportunity:
- Backlogs for frac fleets and other key equipment currently exceed 9-12 months in
many cases
- Market tightness in key equipment and services appears to be loosening and
moving towards a more stable balance – the ideal time to seize the opportunity
was likely 12-18 months ago, when a handful of prescient operators placed orders

Given this, PacWest does not believe vertical integration is a new, long-term operator
sourcing trend
- It is an interesting short- to medium-term trend to note and monitor, but it does
not represent a meaningful strategic threat to service companies



Contents

1. PacWest Snapshot





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E&P Operator Vertical Integration Drives Strategic Changes

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E&P Operator Vertical Integration Drives Strategic Changes