From David Cost - Son Of Margaret Pierson Cost (a member of the Piper family)

I  wanted to highlight some general Exploration and Production ("E&P) topics and definitions which are pertinent with regard to your STS investment.

Horizontal Drilling

Oil and gas production in the continental US has been undergoing a renaissance over the past decade due to advancements in drilling technology known as horizontal drilling.  Oil and gas reserves are trapped in various strata deep in the ground throughout the continental US which have previously been uneconomic to drill using conventional, vertical wells.  The strata are too narrow and the oil and gas reserves are trapped in rock formations known as shale, which make the reserves unable to flow to the surface once a well is drilled.  Seismic readings have long indicated sizable reserves existed in several shale plays throughout the US but there was no way to pull the reserves out of the ground economically.   In recent years energy companies have devised a method for drilling wells where the drill bores down vertically until it reaches a certain depth and then veers sideways, or horizontally.  Once a well operator reaches a shale strata where reserves exist, the horizontal portion of the well can stretch over a mile in length.

After a well operator has drilled the horizontal well the next step is to release the oil and gas reserves which are still trapped in the rock, or shale, formations.  Producers follow up the drilling of a horizontal well with a series of steps where water and other chemicals and materials are shot under heavy pressure down the well to fracture the shale rock and release the oil and gas.  This method is known as hydraulic fracturing, or "fracking".  Horizontal drilling and fracking are enormously complicated endeavors and are in many ways a wonder of human ingenuity.

Shale drilling in the US has exploded in the past decade.  Places as diverse as North Dakota, Pittsburgh and Fort Worth, TX are undergoing economic revivals as a direct result of advancements in horizontal drilling and hydraulic fracturing.  While increased energy production from shale plays in the continental US will not completely replace our foreign oil dependency it has already begun making a small dent in the "borrow from the Chinese to pay the Middle East" trade flows which have contributed to our country's difficult financial situation.  There are some additional implications of shale drilling, some of which are pertinent to the STS:

• Natural gas v oil.  The first shale drilling in the US was in natural gas plays.  Oil shale drilling has only begun in the last few years as operators figured out how to extract oil from shale reserves.  Oil is a global commodity; natural gas predominantly a regional commodity.  As we know, oil prices rise and fall as global demand rises and falls.  In the short term oil prices are driven by global economic activity (demand) and news from large oil regions such as the Middle East, Russia and Nigeria (supply).  But the long term trend for oil prices is up, as demand from developing nations is expected to eventually surpass global supply, which is believed to be close to maxed out.  US oil shale drilling will not alter this global supply/demand equation, which means if an operator strikes oil in a US shale play, it will probably benefit over the long term from the global trend of rising oil prices
  
• US natural gas prices have been depressed for the past few years, predominantly due to a supply/demand inbalance in the US.  With ample shale reserves in the US as far as the eye can see as a direct result of natural gas shale discoveries, most experts believe until the US implements a comprehensive energy policy promoting natural gas as a "bridge" between oil & coal use today and future alternative energy sources in the decades to come (thus increasing demand), natural gas prices will have a hard time breaking out to significantly higher prices for an extended period of time.  [Side note:  as sad and horrible as the news out of Japan has been, one by-product has been increased speculation that the US will have to rethink its strategy for meeting future US electricity needs by adding to its nuclear energy fleet, with natural gas-fed electricity plants the logical alternative.  Natural gas E&P company stocks rose following the Japan tsunami as a result of this speculation.]
  
• Decline curves.  Shale wells drilled utilizing horizontal drilling tend to exhibit steep production declines almost immediately, with production in Month 13 often 50% lower than Month 1 and production in Month 25 often 75% lower than Month 1.  In the out years the production declines tend to slow, leading to a long “tail” of steady production at lower levels.  Shale drilling is enormously complicated and complex; it is also simple math.  How much does it cost to lease the land, how much does it cost to drill and maintain the well, what is the Initial Production in oil and gas from the well, what does the decline curve look like, what does the tail look like (how long will the well produce) and what are the estimated oil and gas prices over the lifetime of the well?  These are the calculations E&P companies are making every day, determining where to drill next
  

• Environmental issues.   Water contamination resulting from horizontal drilling techniques is an enormous concern in the US.  The state of New York has placed a moratorium on all shale drilling due to concerns about contamination of water sources.  The documentary Gasland, 60 Minutes and the New York Times have all discussed the risks of water contamination at great length.  The biggest risk of water contamination comes from the handling of  waste water which flows back up to the surface after the fracking process.  Waste water contains trace hazardous materials and naturally occurring radioactive elements, which when concentrated can be harmful to animal and human health.  Waste water handling is a big deal and there have been some notable wastewater releases which have contaminated local waterways
  

South Texas Syndicate

Using the above horizontal drilling summary as a primer, the following information can help the beneficiaries understand some of the information coming out of the STS:

• The Eagle Ford Shale covers over 15 TX counties and contains 3 subsections encompassing the type of reserves embedded within the shale:  the "Dry Gas Window (where wells produce only natural gas)," the "Wet Gas Window (where wells produce both gas and oil)" and the Oil Window.  The STS, in La Salle and McMullen Counties, straddles the Dry Gas and Wet Gas windows of the Eagle Ford play.  Given the fact operators and investors are more bullish in their outlook for oil prices than natural gas prices in the short term, the bulk of the initial drilling on the STS has been done in the northern half of the ranch, which encompasses the Wet Gas window and where production has consisted of both oil and natural gas.  The Cullen Lease, btw, the subject of the Pioneer lawsuit which was settled in March, 2011, is square in the Wet Gas window.  This explains why the STS was so keen to get Pioneer, or someone, to drill some Eagle Ford wells on the Cullen Lease
  
• Waste water.  Part of Patty Ormond’s job as landman was to oversee how operators were handling and disposing of waste water from the STS wells.  Having a competent landman overseeing wastewater disposal is an important, and potentially underappreciated, element of protecting the STS from environmental liability down the road
  
• The STS wells appear to be following normal decline curves (one can track the production decline well-by-well by reading the monthly beneficiary letters from JP Morgan).  What that means economically is each well will produce more income in Year 1 and if no additional wells are drilled one can expect the income to fall dramatically in subsequent years (although out years’ production tends to level off and have a long "tail").  However even Petrohawk STS #1, the first well drilled in 2008, is still generating solid gas and oil production, so as more and more producing Eagle Ford wells are layered on top of each other over time they may still produce steady income in the out years
  (it is still too early to know how much oil and gas production will come out of Eagle Ford wells in the “tail” years)
• The 3 latest wells drilled on the STS have produced more oil than the first wells drilled.  That is a very good sign and is the reason total monthly oil production has been rising recently after falling in the last few years
  
• There were 7 wells which began producing on the STS in 2009.  Adding Petrohawk STS #1 drilled in 2008, by year end 2009 there were a total of 8 wells producing on the STS.  In 2010 4 additional wells were put online, for a total of 12.  STS income spiked in 2008 due in large part to leasing revenue as the land rush on the STS hit full bore; in 2009 the combination of lower oil and gas prices due to the Great Recession and lower leasing revenue caused distributions to fall.  In 2010 income rebounded due to increased production from the 8 legacy wells and the 4 new wells drilled which began producing in 2010.  Again, exiting 2010 there were 12 producing wells on STS land
  
• There are 14 additional wells which have been drilled on the STS currently awaiting completion and fracking (per the March, 2011 beneficiary letter).  In addition, Patty Ormond reported in October, 2010 the rig count (number of operating drilling rigs) on the STS is expected to double in 2011.  Petrohawk already has published plans to drill 9 more wells in 2011.  Talisman plans to drill 14.  Pioneer/EOG will be required to drill 1 Eagle Ford well on the Cullen Lease in 2011 as a result of the recent settlement of the Pioneer lawsuit.  This is just a summary of publicly announced wells-- Hunt Oil,  Tidal Petroleum and others may also be planning to drill more wells in 2011
  

• Adding all producing, drilled and announced wells to be drilled (as of March, 2011), by the end of 2012—even if no additional wells are drilled on the STS after Dec 31, 2011—there may be over 50 wells producing oil and gas on the STS, up from 12 at YE10.  Presuming each new well has roughly the same economics as the existing STS wells and presuming similar prices for oil and gas, STS income flowing to the beneficiaries could rise substantially from the annualized run rate as of the end of 2010.  There are several roadblocks to increased production, including delays in well completion, difficulties encountered in drilling the wells and production results worse than expected.  However given the known plans for STS drilling already in the works, combined with the 14 wells awaiting completion, one can have great confidence the distribution checks emanating from the STS will rise in the months and years ahead
  

David Cost