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Gold/Mining/Energy : Oil & Gas Exploration & Production Co.'s

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To: Ed Ajootian who started this subject10/6/2003 12:26:39 PM
From: Ed Ajootian   of 112
KCS has done well during the first half and grew proved reserves by 20% over 2002’s year-end number of 196 bcfe. The
company’s reserve life is now at nine years. The focus of the first half has been on cash-generating development projects.
For the second half, KCS is drilling a number of high-impact exploration wells like the Ray George, 5-Mile Creek and SKA.
If successful, we could see significant reserves addition at year-end 2003.
• In addition to the exploration projects, the company’s low-risk “bread and butter” assets at Elm Grove, Louisiana, and
Sawyer Canyon, Texas, continue to yield additional low-risk, high-return drilling locations. These two assets equate to 44%
of KCS Energy’s proved reserves. We like the fact that KCS could have multiple years of drilling inventory in these
“manufacturing” plays.
• We think the company is firing on all cylinders. We are confident of our 2003E production estimate of 34 bcfe. If the
drilling program continues to be successful during the second half, we would expect our 2004E volume estimate of 36 bcfe
to increase. We reiterate our Buy recommendation on this gassy story with organic growth. Our 12-month price target is

Company Profile
KCS’s primary focus areas are the Mid-Continent region and onshore Gulf Coast. The company has key operations in the
Anadarko and Arkoma basins, North Louisiana, West Texas and Michigan. Along the Gulf Coast, the focus properties are in
South Texas, Coastal Louisiana and the Mississippi Salt Basin. With the financing of the $61 million Senior Notes completed
in January 2003, KCS has been totally focused on the drill-bit, an effort that resulted in 50 bcfe of proved reserves for the midyear.
The reserves are booked based on $27.00/bbl (WTI) and $5.17/mmbtu (Henry Hub). At a lower gas price assumption of
$4.25/mmbtu, the reserves could swing by 5 bcfe to 6 bcfe. Of the 234 bcfe of proved reserves, 75% are proved developed and
80% are natural gas; KCS operates 80% of the assets. The reserve life is nine years. The geographic mix is 27% Elm Grove;
17% Sawyer Canyon; 25% Gulf Coast and 31% in other Mid-Continent Assets, the Rocky Mountains, Michigan and
By mid-year, the company had drilled 40 wells with a 95% success rate, and each successful well opens up more prospective
locations. We think the company has plenty of running room with this growing prospect inventory. The company increased its
2003 capital budget to $65 million from $55 million during the second quarter. We expect KCS to generate cash flow in
excess of $88 million for 2003, which is sufficient to fund its new spending program and reduce debt. With a robust drilling
inventory and strong commodity prices, we would not be surprised if KCS increased its 2003 spending plan again.

Be on the Lookout for High-Impact Drilling during the Second Half
The company has begun its high-impact exploration program in South Texas. If successful, any of these prospects can make a
meaningful impact on the company’s 2003 year-end reserves:
Ray George: WI 50%, pre-drill target size of 40 bcfe (in progress). The prospect is located 200 to 260 feet updip of an old gas
well, a fault-bounded structure.
5 Mile Creek: WI 30%, pre-drill target size of 20 bcfe (in progress). The prospect is located in the prolific Mission Valley
area. It is a structural trap defined by 3-D seismic data, with amplitudes on the crest.
SKA: WI 30%, pre-drill target size is 30 bcfe (in progress).
Coquat Deep: WI 50%, pre-drill target size is 25 bcfe. This prospect is defined by 3-D seismic. The area is faulted with
multiple pay zones. The main target is the Wilcox, and there are shallower zones supporting additional drilling locations.
Austin Deep: WI 50%, pre-drill target size is 50 bcfe. This prospect is defined by 3-D seismic; the area is faulted with
multiple pay zones. The well will likely be drilled in 2004. There are existing discoveries in shallower zones nearby, which
lowers the risk for the Austin Deep prospect.

Core Areas: Generating More Drilling Locations
As of mid-2003, KCS drilled 40 wells, with 38 successful (95% success rate). During the first half, the company did most of
its drilling in the Elm Grove area of Louisiana and the Sawyer Canyon area in Texas. Combined, these two areas contribute
44% of the company’s proved reserves. We like these plays, as the programs are repeatable, relatively low-risk and have quick
payout periods.
The Elm Grove Field in North Louisiana: (100% WI in 8 sections, 33% in 1 section). KCS drilled 9 wells by mid-year and
expects to drill 9 more before year-end. The company is prospecting for the Hooston interval and the Cotton Valley group.
The average well cost is $1.2 million and the initial production rate is 3 mmcf/d. The reserve potential is 1 bcfe to 3 bcfe. The
company has 50 to 100 additional locations—at 20 wells per year, this could support a 2- to 5-year drilling program. This Elm
Grove area is competitive, but KCS Energy has made long-term agreements with drilling and service companies to keep a lid
on drilling and fracturing costs. These agreements and contracts enhance the economics of the Elm Grove Play.
At the Sawyer Canyon Field, in Sutton County, Texas (90%-100% WI), KCS drilled 14 wells by mid-year, with IP averaging
370 mcf/d per well. The average well cost is $400,000, with reserve per well at 0.4 bcfe/well. The acreage can support 35 to
100 more well locations, and KCS plans to drill 20 wells per year in the Sawyer Canyon field in 2004 and 2005. Spacing is
currently 80 acres; it could be down-spaced to 40-acres at selective locations if commodity prices continue to stay high.
In East Texas at the Joaquin Field: (74%-100% WI), the company drilled 2 wells by mid-year and expects to do three more
by year-end. Average well cost is $1.5 million, with an initial production rate of 1 mmcf/d to 3 mmcf/d. The reserve potential
is 2 bcf to 4 bcf per well; the company has 5 to 10 additional well locations.
At the Talihina Field in Oklahoma (30% to 100% WI), the Weyerhauser 2-22 discovery flowed 4.0 mmcf/d. The
Weyerhauser 3-22 and Blake 11-21 are being completed. The company expects to drill 5 wells by year-end in this Arkoma
Basin play. The well cost is $1.6 million, with an initial production rate of 2 mmcf/d to 4 mmcf/d. The reservoir is the
Jackfork Formation (up to 200 to 400 feet thick). The structures are complex, with steep dips, and reserves per well average 2
bcfe to 6 bcfe. The company has 5 to 15 additional locations. The partners in this play are Chesapeake Energy (CHK/NYSE-
$10.76; Not Rated) and Ward, which is private.

Valuation and Price Target
In valuing our E&P companies, we use a price-to-cash flow multiple. We establish a reasonable range based on historic
averages of a group of broad-based E&P companies, which includes twelve E&P companies with market capitalizations
ranging from $900 million to over $11 billion.
Our 12-month price target of $8.00 is based on approximately 4 times our 2004 cash flow per share estimate of $1.92. We
used a low cash flow multiple to reflect KCS’s high leverage, which is currently about 93%. We are very encouraged by
KCS’s drilling success and believe that, if commodity prices continue to be strong, the company could end 2004 with a debt-tocap
ratio in the low-60% range. We also revised our net asset value (NAV) analysis for KCS using the company’s mid-year
reserves of 234 bcfe. Using our 2004 price forecast of $26.00/bbl for oil and $4.75/mmbtu for gas, we arrived at $10 per share,
net of debt. We reiterate our Buy rating on KCS.
Investment Risks
• KCS has a small market capitalization, a relatively thin float and light trading volume, which, under certain circumstances,
could make the stock more volatile.
• The company’s production mix is roughly 80% natural gas: with each $0.10/mmbtu change in Henry Hub natural gas prices,
both 2004E EPS and CFPS could be impacted by $0.05 each. Also, with each $1.00/bbl change in WTI oil price, the 2004E
EPS and CFPS could both be impacted by $0.03.
• In addition, the high debt level makes KCS more sensitive to positive or negative moves in U.S. natural gas prices.


Above is from Sanders Morris Harris report 9-5-03
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