Williston Basin, North Dakota (Bakken and Three Forks Formations)

Brigham Exploration Company / Statoil.

On August 24, 2009, we entered into a Drilling Participation Agreement (the “DPA”) with a wholly-owned subsidiary of Brigham  Exploration Company (“Brigham”) to jointly explore for oil and gas in up to 19,200 gross acres in a portion of Brigham’s Rough Rider prospect in Williams and McKenzie Counties, North Dakota.  Under the DPA, we earned working interests, out of Brigham’s interests, in fifteen 1,280-acre spacing units in Brigham’s Rough Rider project area by participating in the drilling of one initial well on each unit of acreage.  Accordingly, we have earned the rights to drill up to 30 gross wells in the Bakken formation and an additional 30 gross wells in the Three Forks formation, for a total of 60 gross wells, based on current spacing rules in North Dakota.  If the spacing is ultimately increased to four wells per 1,280 acre spacing unit, the potential number of drilling locations could increase to 120 gross wells.

The leases in the units are a combination of fee and state leases.  In some areas, the rights may be depth limited to the Bakken and the upper part of the Three Fork formations under the terms of the leases obtained by Brigham from third parties, while other leases may have rights to all depths.  Working interests earned vary according to Brigham’s initial working interest, after-payout provisions and the provisions governing each stage of the program.

Our earn-in rights were staged in three groups of units and were earned upon paying our share of all drilling and completion costs, or plugging and abandonment costs (if applicable), for all the initial wells (one for each unit) in each group. The numbers of initial wells (and units in the groups) consist of: six in the First Group; four in the Second Group; and five in the Third Group.  For information on the wells drilled through the date this Annual Report was filed, see “Item 2 – Properties – Oil and Natural Gas” below.  At the date this Annual Report was filed, we have drilled and completed all 15 wells in the initial phase of the DPA and have completed 5 additional gross infill wells.

Brigham is the operator for all the units covered by the DPA, and is compensated for services pursuant to an industry standard operating agreement, except that the customary non-consent provisions have been revised as to the drilling of subsequent wells (see below).

First Group:  We earned  65% of Brigham’s initial working interest in six initial wells drilled in the 1,280 acre units; our working interest ranges from 61.46% to 29.58% (48.55% to 23.80% net revenue interest (“NRI”)), for an average 49.54% working interest.

When we have received production revenues (less property and production taxes) from all six of the initial wells in this First Group equal to our costs on a pooled basis (“Pooled Payout”), our working interest will be reduced to 42.25% of Brigham’s initial working interest in the initial wells, and the NRI will decrease to a range of 31.56% to 15.47%, for an average 25.45% NRI.  At December 31, 2011, we estimate that the Pooled Payout for the First Group of wells will occur in the first quarter of 2013. 

We earned 36% of Brigham’s initial working interest in all of the acreage in the applicable unit. Brigham will have no back in rights on any subsequent drilling locations in these units (or in any of the units we earned in the Second and Third Groups). All working interest ownership in each initial well, and all of the subsequent wells, will be subject to proportionate reduction for third party leasehold rights. At December 31, 2011, three subsequent wells had been drilled in the First Group.

Second Group:  In 2010, we participated in the drilling and completion of the four wells in the Second Group.  Brigham provided us notice that it would be taking 50% of the working interest available to it, and we elected to take the remaining 50% of the working interest available to Brigham.  The four wells were all producing in 2011; our working interests range from 48.03% to 21.02% (NRIs range from 37.80% to 16.29%).

We have earned working interest rights in all the acreage in these four units.  For future wells drilled in these units, we will hold 36% of Brigham’s initial working interest (without back in rights), subject to proportionate reduction for third party leasehold rights.  After Pooled Payout on the Second Group’s four wells, we will assign to Brigham 35% of our working interest in the initial wells in each spacing unit, and the NRI will decrease to a range of 24.26% to 10.61%.  We anticipate that Pooled Payout for the Second Group will be reached in third quarter of 2012.

Third Group:  On January 11, 2010, Brigham provided us notice that it would be taking 50% of the working interest available to it.  In accordance with the DPA, we elected to take the remaining 50% of the working interest available to Brigham.  All five wells in this group were drilled and producing at December 31, 2010, one was producing, one was being drilled, one was being completed, and two were awaiting completion work.  Working (and net revenue) interests range from 41.76% (32.96% NRI) to 20.01% (15.81% NRI).

We have earned 36% of Brigham’s initial working interest in all the acreage in the units in this Third Group (which will not be subject to back in rights), proportionately reduced for third party leasehold rights.  After payout on a per initial well basis (“Unpooled Payout”), we will assign 27.7% of our working interest in each initial well to Brigham, resulting in NRIs of 23.83% to 11.49%).  We expect Unpooled Payout to be reached on these initial wells between mid-2014 and late 2019.

Effective December 15, 2011, the Company sold an undivided 75% of its undeveloped acres in the Rough Rider prospect to Brigham for $13.7 million.  Under the terms of the agreement, the Company retained the remaining 25% of its interest in the undeveloped acreage and its original working interest in its 20 developed wells in the Rough Rider prospect.  After the sale, our working interest in the undeveloped acreage in the Rough Rider Prospect ranges from 3.41% to 9.90%.  In addition, Brigham also agreed to commence drilling operations for at least three gross wells in the Rough Rider acreage in each of 2012 and 2013.  Drilling plans beyond 2013 are not known at this time.

Non-Participation in Subsequent Wells.  Under the form of operating agreement which governs operations for each of the 15 units, after the applicable initial well was drilled, we have the right to elect not to participate in the drilling or completion in subsequent wells proposed to be drilled in a unit.  If the Company or Brigham should make an election not to participate, the non-participating party will assign all its rights in the proposed well to the participating entity for no consideration.  However, our working interest rights in all acreage remaining in the unit would not be affected by the assignment.

Zavanna, LLC. 

In December 2010, we signed two agreements with Zavanna (a private oil and gas company based in Denver, Colorado), and other parties.  The Company paid $10,987,000 in cash to acquire 35% of Zavanna’s working interests in oil and gas leases covering approximately 6,050 net acres in McKenzie County, North Dakota.  The total net acres subject to the agreement has increased to 6,500 as a result of subsequent acquisitions from third parties.

The acquired acreage is in two prospects – the Yellowstone Prospect and the SE HR Prospect.  We expect this program will result in 27 gross 1,280 acre spacing units with the potential for 108 gross Bakken and 108 gross Three Forks wells, based on an assumed four wells per formation in each spacing unit.

Our interests in all the acreage in both prospects is subject to reduction by a 30% reversionary working interest under each prospect upon expiration of the “Project Payout Period” or “Project Payout,” as those terms are defined in the agreements, whichever occurs first.  Project Payout will occur when we have received proceeds from the sale of production (or from the sale of all or part of the acreage to third parties) equal to 130% of: the $10,987,000 paid on execution of the agreements, plus all drilling and completion costs (including dry hole costs) and surface gathering facilities for all wells drilled on the acreage (and on any additional acreage acquired in the two Areas of Mutual Interest contemplated by the agreements).  This acreage is referred to collectively as the “Project Payout Properties.”

However, if Project Payout does not occur within the Project Payout Period, the reduction due to operation of the reversionary working interest will take effect on all acreage other than the Project Payout Properties (i.e., that acreage on which wells not have commenced drilling, including all infill locations in drilling units where the Project Payout Properties are located).  The Project Payout Period for the Yellowstone Project is from the spud date of the initial well drilled in the prospect to July 15, 2014 and the Project Payout Period for the SE HR Prospect is from the spud date of the initial well drilled in the prospect to March 31, 2014.  After expiration of the Project Payout Period, all costs and expenses related to the Project Payout Properties will continue to be included in the Project Payout calculation until Project Payout occurs. 

On January 24, 2012 (but effective as of December 1, 2011), the Company sold an undivided 75% of its undeveloped acreage in the SE HR Prospect and the Yellowstone Prospect to GeoResources, Inc. (56.25%) and Yuma Exploration and Production Company, Inc. (18.75%) for a total of $16.7 million.  Under the terms of the agreement, the Company retained the remaining 25% of its interest in the undeveloped acreage and its original working interest in its 10 developed wells in the SE HR and Yellowstone prospects (including the two wells drilled with Murex Petroleum Corporation discussed below).  Our working interest in the remaining locations will be approximately 8.75% and net revenue interests in new wells after the sale are expected to be in the range of 6.7375% to 7.0%, proportionately reduced depending on Zavanna’s actual working interest percentages.


Murex Petroleum Corporation

 The Company also participated in drilling two wells operated by Murex Petroleum Corporation (‘Murex”) in the Yellowstone acreage block.  During 2011, two gross wells were drilled and completed and put into production.  The Amy Michelle 16-23 #1H well was drilled and completed with 15 fracture stimulation stages using a sliding sleeve.  We have an approximate 8.9% WI and 6.9% NRI in this well.  Additionally, the David Roger 18-19H well has been drilled and completed with 38 fracture stimulation stages.  We have any approximate 3.21% WI and 2.47% NRI in this well. 


Texas and Louisiana

Crimson Exploration Inc.  (Eagle Ford Shale)

On February 22, 2011 we entered into a participation agreement with Crimson Exploration Inc. (“Crimson”) to acquire a 30% working interest in an oil prospect and associated leases located in Zavala County, Texas (the “Leona River prospect”).  Under the terms of the agreement, the Company has earned a 30% working interest (22.5% net revenue interest) in approximately 4,675 gross contiguous acres (1,402.5 net mineral acres) through a combination of a cash payment and commitment well carry.  All future drilling and leasing will be on a heads up basis with no carry by the Company.  The prospect is an Eagle Ford shale oil window target in Zavala County, Texas.  Crimson is the operator of the prospect.  The KM Ranch #1H well was drilled to a total depth of approximately 12,500 feet (~6,000 ft. vertical, ~6,500 ft. horizontal) by Crimson at the Leona River prospect.  It was completed in the second quarter of 2011 and had an announced initial gross production rate of 418 BOE/D from 11 fracture stimulation stages.  The KM Ranch #2H well in the Leona River prospect was also recently drilled to depth and it is anticipated that completion operations will commence in March 2012. 

In June 2011, the Company entered into a second participation agreement with Crimson to acquire an interest in an Eagle Ford oil prospect and associated leases located in Zavala and Dimmit Counties, Texas (the “Booth Tortuga prospect”).  Under the terms of this second agreement with Crimson, we have acquired 30% of Crimson’s working interest (an approximate 22.5% net revenue interest) in approximately 7,186 gross acres (2,156 net).  All of the leases are currently held by production and produce approximately 115 gross BOE/D (20 net BOE/D) from the Austin Chalk formation.  We estimate that under current spacing there is a potential for up to 44 gross (13.5 net) Eagle Ford drilling locations on the acreage.  All drilling and leasing on this prospect will be on a heads up basis.  Crimson also operates this prospect.  The initial well at the Booth Tortuga prospect, the Beeler #1H well, has been completed with 20 fracture stimulation stages and initial well flow back operations have commenced. The operator plans to evaluate initial well results over the course of the coming weeks.

Currently, our total acreage in the Leona River prospect and the Booth Tortuga prospect is approximately 11,861 gross acres (3,558.5 net).  Based upon assumed 120 acre spacing units, there is the potential for up to 98 gross and 29.6 net Eagle Ford drilling locations.  Looking forward, the Company continues to seek additional leasing opportunities in the Eagle Ford oil window jointly with Crimson.

Houston Energy L.P. 

The Company has an interest in two producing wells with Houston Energy; we have a 7.65% WI (6.23% NRI) in one well and a 25% WI (17.63% NRI) in the other.  During December 2011 our average aggregate daily production from the two wells was 11 BOE/D.

PetroQuest Energy, Inc. 

The Company has an interest in three natural gas and oil producing wells with PetroQuest in coastal Louisiana, with working interests of 11.9% (8.32% NRI), 50.0% (36.0% NRI) and 17.0% (12.75% NRI).  During December 2011, our average aggregate daily production from these three wells was 116 BOE/D.  PetroQuest operates all of the wells.

Southern Resources Company 

Our agreement with Southern Resources covers a 13.5% working interest (9.86% NRI) in 1,282 gross (173 net) acres in Hardin County, Texas.  The Company earned a working interest in all the acreage by participating in the initial test well and paying $135,000 in seismic, land acquisition and legal costs.  The Company agreed to carry the seller in an 18.75% working interest to the casing point decision (“CPD”) in the initial test well, and a 12.5% carried working interest in the second test well to the CPD.  Subsequent wells will be paid for proportionally to all parties’ working interests.  Mueller Exploration, Inc. will operate all of the wells. 

During September 2011, we drilled our first well in the program, reaching a total depth of 11,265 feet on October 17, 2011 and encountering what we believe are two prospective pay zones,  the EY3 and EY4 channel sandstones.  Preliminary production testing on the EY4, the deepest prospective zone, indicates an estimated production rate of approximately 80 BOE/D and 624 MCF/D.  The well is scheduled to commence production in March 2012.  Once the EY4 zone is depleted, the operator plans to move up hole to test the EY3 zone, which was the primary objective.  The Company’s net cost in this well at December 31, 2011 is $755,000.  Based on the initial results of this well, we believe there may be the opportunity to drill up to three additional conventional wells on this acreage.