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An Oil Company That Rigs The Odds

Reef Petroleum of Michigan shows that in the risky, high-stakes game of oil, success is more than just a roll of the dice. It is gambling made science.
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We're coming to oil country now," declares Ron Kline, chief oil scout for Reef Petroleum Corp., an oil and gas exploration company in remote, picturesque Traverse City, Mich. Kline maneuvers a Jeep over the narrow road, dodging; potholes while scanning the empty sky for a Reef drilling site. Finally, a rig juts above the pines. As the skeletal derrick looms closer, he explains how Reef has sustained profits and a healthy drilling program while the oil and gas industry has been hitting the skids.

"This baby can get up to as much as 700 barrels of oil a day, and it's been one of the best producing wells in the state," he says, "although environmental laws hold us down to about 300 barrels a day. We drilled more wells in '82 than ever before, and we've always been shrewd at picking the good prospects."

A knack for tapping into high-productivity oil fields and steadily increasing drilling programs that have shown exceptional success rates boosted Reef's sales from $3.3 million in 1977 to $26.5 million in 1981 a 694% increase that made the company #188 among the INC. 500 fastest-growing private companies (see INC., December 1982, page 48). Reef was one of only 11 oil industry companies on the list.

In the face of a worldwide oil glut and slackening consumption, oil prices have plummeted, particularly hurting small independents of Reef's size, which must raise mostly outside capital in order to explore, drill, and produce. Spending is often a gauge of the industry's overall health, because exploration and drilling budgets reflect a company's confidence and largely determine production; in 1982, oil companies trimmed spending budgets slightly from 1981 levels.

By comparison, in 1982, Reef's spend ing rose 29%, to about $17.6 million, from 1981, and the company drilled 56 wells -- 2 more than in 1981 and 35 more than in 1980. It has enjoyed price stability in a fast-changing market because much of its Michigan crude is a desirable "sweet" oil, compared with others, such as those from Mexico, that have a high sulphur content. Reef is the largest, and recently most active, independent in Michigan, the 11th largest oil-producing state in the country.

The oil game is in many ways a crapshoot, in which a company locates a site likely to hold oil deposits, such as a basin or the underground remnant of an ancient sea, and buys land leases covering a broad area for later exploration and selection of drilling sites. If the leases don't pan out, the company is stuck with large exploratory costs and leases it cannot sell. Reef has been both lucky and aggressive in its search for and acquisition of rich oil discoveries. When it began in 1972, the company made an early and massive investment in a newly discovered trend, or line of reservoirs, in the northern part of Michigan's southern peninsula that became one of the state's most prolific oil fields and the company's namesake, the Niagaran reef trend.

In an industry that succeeds an average of 15% of the time in discovering usable oil and gas from new wells, Reef has hit oil 27% in the past decade. Says Kline, "We hit oil more often because our policy is to select highly trained people with proven track records." One company geologist has a post-graduate degree, an impressive credential for a small independent, and two have left to start their own companies.

Salaries at Reef are among the highest of the Michigan independents, and it offers attractive conditions, such as its pioneering workweek of four 12-hour days and four days off. It also tried a profit-sharing scheme allowing employees to share I% to 5% of the profits from a well but then boosted salaries instead.

Well-paid technicians have helped Reef post a consistently good return on investment. Michael Barratt, a division manager for Patrick Petroleum Co., one of Reef's Michigan competitors, has determined that, for the owner of a 40% working interest, 9.6 to 1 is the most likely return on an average well drilled in the Niagaran reef trend. On a similar well, Kline says Reef's return is 15 to 1 and often nearly 20 to 1.

Companies with staffs the size of Reef's drill an average of 15 holes per year; Reef drills 50 to 60. Five years ago it began a transition to company-owned rigs when a temporary rig shortage made leasing from rig contractors unreliable. Having its own fleet of rigs permits Reef to move quickly from disappointing finds to promising ones. Reef has a diesel-electric powered rig, which saves further drilling costs.

Reef's impressive performance reflects the tenacity of founder, chairman, and president David J. Hall. Hall, 42, a roughneck and a wildcatter in his teens, is today a self-made millionaire who gained enough savvy from his rough-and-tumble rise to enable him to take very well-educated risks in outmaneuvering opponents.

At 19, Hall drilled his first well -- a dry hole. Undeterred, he speculated by leasing prospects and drilling for oil. By 21, he had rising overhead, worthless leases, and about $100,000 of debt. Hall says "fear of failure" drove him on, and in 1963 he drilled his first successful well. He formed Reef Petroleum in 1972, capitalized with $135,000 of his own money and $5,000 from each of nine investors. Eight are still with the company. Hall now presides over an expanding empire of mostly oil-related affiliates and subsidiaries.

"We've been damn lucky," says Hall. "An oil company is made by a specific trend. But when the lucky break comes, you need experience to know how to handle it. You have to have the foresight and the guts to just move in when other companies would be hesitant." Hall's lucky break came in the early 1970s, when he invested heavily in the Niagaran reef trend, a shallow 10-to-15-mile-wide belt of oil and gas deposits running diagonally from Lake Huron in the northeast to Lake Michigan in the southwest. The trend, discovered in 1969, was to be Michigan's most extensive in decades.

Reef was one of the first to begin seismic work and develop a drilling program in the area, and from 1972 to 1975 Hall bought up more than 26,000 acres in mineral rights, at $200 to $400 an acre. No other independent bought in to that degree, and Hall's acreage position held a treasure. In the Traverse City area alone, the number of oil and gas-related companies soared from 0 in 1969 to 105 in 1982. In the oil boom town, Reef's holdings make the company a dominant force.

But survival in the Byzantine world of oil also requires skill and strategy. "We tried to take advantage of the Niagaran reef trend," says Hall. "Our philosophy is to go the extra mile, because on the extra mile there's no traffic." In first assessing the trend's potential, Hall weighed the same publicly available seismic and geological evidence other companies did; he was privy to no special information. He says the trial-and-error lessons of his youth helped him glean insights from esoteric charts and graphs that others couldn't.

Drilling on the Niagaran reef by major oil companies gathered momentum, and Hall suspected the discovery of a huge trend was imminent when he noticed that new finds were sprouting up at an exponential rate in a swath between Lake Huron and Lake Michigan. The finds and the subsequent leasing of land stretched in a wide arc toward both coasts. He surmised correctly that the trend was an extinct sea and that it extended farther than other companies had projected.

First, Hall bought up mineral royalties from landowners who had already leased their land to the majors. He added to capital by selling part -- usually three-fourths -- of the rights to a property at a profit and keeping an interest that paid him some of the bounty when drilling succeeded. He soon acquired bank loans and leases that permitted him to act as operator, recovering his lease-and-development costs by selling some of the working interest to investors.

Reef has had very few problems in attracting capital, although tight capital is one reason the oil industry is hurting. Banks are especially jittery about lending to oil companies since early in 1982, when the speculative investing of Penn Square Bank in Oklahoma City brought its sudden collapse, costing other banks and oil-venture investors hundreds of millions of dollars. The major oil companies tend to draw from large pools of internal funds, but most independents are strapped.

Reef's success rate, on the other hand, has given the company a good reputation with investors and bankers, and it rarely goes begging for capital. Roger Thompson, vice-president of the Energy Division at Empire National Bank of Traverse City, says, "We've got a lot of money out to them, and we feel they're a good return on an investment. They've got a charisma that everybody wants to be part of."

Also easing Reef's path to capital is its affiliation with Reef Energy Corp., a public company incorporated in 1979 when Reef Petroleum's 12 limited partnerships wanted liquidity and rolled themselves into one entity. The investors bought shares for about $4 million and entered into an operating agreement with the private company whereby Reef Energy has the right to as much as a 10% participation in any project Reef Petroleum undertakes. The public company also has the right to invest in the projects of other oil companies. Reef Energy pays about 4% of its roughly $2.5 million a year in revenue to Reef Petroleum for management costs. A major advantage is that Reef Petroleum knows it has a participant waiting in the wings for whatever it does.

The relationship in which the private company manages the public, which has no employees, is rare but not unique. It is common for oil companies to drill, produce, or lease in a partnership, in order to raise capital more easily and to spread risks. David Hall heads both companies; two people sit on both boards; three other directors of the public company own stock in both companies and are original investors in the private one; and H. Terry Snowday Jr. is a director of Reef Energy and vice-president of Reef Petroleum.

Reef has posted a stunning performance over the last 10 years, but it will soon have to face market realities and tighten its belt. Domestic spending for the entire industry is forecast at about $40.1 billion in 1983, a 12% drop from the 1982 level. The majors, accounting for about 50% of total industry expenditures, will spend about 0.3% less on domestic exploration and production. But among independents, spending is expected to plummet an average 23%. Reef's spending this year may drop as much as 20%, and only 20 to 30 wells will be drilled, with 10 or 20 other prospective wells farmed out to contractors.

The worsening oil market caused the company's 1982 sales to drop about 23% from the 1981 level, largely because of a one-time sale of assets in 1981 of reserves of sour gas, a type of gas considered difficult and dangerous to extract. At the same time, Reef has accumulated more valuable oil and gas reserves and plans to expand its seismic test program dramatically. "Our acreage position is going to be the envy of a lot of independents," Hall says of Reef's 256,000 acres under lease in Michigan.

Still, growth plateaued last year, and the ordinarily cash-soaked company has cut some of its flashy indulgences -- fewer expensive cars and no repeat of Christmas 1981, when women employees got fur coats and men got cashmere jackets.

Hall is nevertheless confident, saying, "the drilling prospects for 1983 are selective and probably the best in our history. The future is going to be even brighter than the past has been." One reason for forming Reef Energy, Hall says, was to test the waters in case Reef Petroleum wanted to go public. He equivocates on that likelihood, to avoid running afoul of Securities and Exchange Commission rules. But he does say that "our intent is to develop a reputation and a rapport with the public, so if we decide to go public with the main company, we will have a good track record." Squinting as if at a distant horizon, Hall adds, "It's a bridge to the future that we hope to walk over someday."

Last updated: May 1, 1983




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