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Shell to Investors: "We're Not in Kansas Anymore"

Photo credit: SandRidge Energy

Shell (NYSE: RDS-A  ) is joining a growing list of oil and gas companies that are abandoning the Kansas portion of the Mississippi Lime. The company has decided to put its entire position up for sale. That includes the 45 producing wells it has drilled, as well as 600,000 acres. The reason is pretty simple: The economic returns are not there and so its only option is to exit.

Shell isn't the first company to give up on Kansas. Major North American drillers Chesapeake Energy (NYSE: CHK  ) , Encana (NYSE: ECA  ) and Apache (NYSE: APA  ) have all been out of the state for more than a year. None could earn a high enough economic return to justify the investment to continue drilling there.

The problem is that energy companies have encountered too much water and not enough oil. This has forced them to drill saltwater disposal wells in order to avoid the expense of trucking out the produced water. The other issue is that some wells come online and produce a few hundred barrels of oil per day, while some produce just a few dozen barrels of oil daily. That makes it tough for producers to earn a quick enough payback on the initial investment.

The only company that really has seemed to find the right formula to unlock the play's oil is SandRidge Energy (UNKNOWN: SD.DL  ) . The company has chosen to make the expensive up-front infrastructure investments to drill disposal wells and to build out electric infrastructure to power its wells without requiring expensive generators to extract the oil. Having paid up to put the infrastructure, the company can focus its drilling around that core position to earn a more-than-adequate 50% internal rate of return. 

Its core position actually includes three counties in the state, which shows that it's not so much Kansas that is the problem, but instead having a focused position built around infrastructure. This will actually enable SandRidge to selectively add to its position around its core because its infrastructure is such a competitive advantage.

That said, don't expect SandRidge to go on an acquisition spree and lock up all the acreage in Kansas that its competitors don't want. The company is backing away from exploring much further north into Kansas as it already has the potential to drill 3,000 wells within its core acreage. That's not to mention the emerging opportunities to drill additional wells within its core to take advantage of the stacked pay potential of other zones.

That puts companies such as Shell and Chesapeake at a disadvantage because there just aren't a lot of willing buyers with the capital and the patience to develop the acres that both companies would like to unload. Apache and Encana don't make likely buyers, either. Encana is refocusing its business to run at optimal levels to improve returns. Meanwhile, Apache thought that the 880,000 net acres it scooped up from Kansas to Montana held 3 billion barrels of oil, but it's actually working to trim back its portfolio in order to drive returns from only its most promising prospects such as the Permian Basin. Bottom line, neither company will be going all out to drill in Kansas anytime soon.

There is clearly oil and gas in Kansas, but it will take the right companies to develop those resources. It could turn out that the best operators will be either a foreign or a private buyer as it's pretty clear that most other investors are leery of the Mississippian as it runs north into Kansas. However, for the right company with the right focus, the Mississippian has the potential to be a solid play. It's just not the right play for a major oil company like Shell nor is it well suited for companies such as Chesapeake, Apache or Encana that are looking for higher returns to appease investors.

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