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Interview

with Richard L. McAdoo, President & CEO, Continental Energy Corporation

06.09.2007 / Energyboardroom

You have worked for over 30 years in O&G for other companies, in positions ranging from technical to management. What is the most challenging thing about your current position at the head of an ‘elephant hunter’ in Indonesia?

Since Continental is primarily an exploration-focused company looking to find a major oil field, the places in the world where we can look are rather limited. The most challenging thing for us is therefore acquiring new blocks to work in and obtaining the financing for exploration. In North America, the small amount of acreage available plus the fact that the main areas have already been heavily explored, make a substantial discovery very unlikely. There are only a few places in the world that we consider correspond to our ambitions, of which Indonesia is particularly favoured because it has a vast territory with favourable geology and a long positive history in O&G. In addition, the Production Sharing Contract (PSC) system allows us to put together larger tracts of acreage.

Indonesia has gone through the typical international oil and gas cycle. In its early years, the country’s O&G was dominated by small players, basically plantation groups who got together and decided to drill a well on their surface oil seep. Later, the sector became the almost exclusive domain of the big international majors who have such a level of money and resources to invest that little room is left for anybody else. In the post boom 80s we started to see the decline of the majors, who started moving elsewhere as the big and easy discoveries had already been made. In the 90’s the majors focussed on M&A resulting in a consolidation of Indonesian operators from 15 to 5. This opened a door and now is the phase where the smaller and independent companies start to move in and fill the vacuum. In the latter stages of a country’s productivity cycle the smaller companies eventually take over since the major’s have moved on to greener pastures. Considering that this is the point where Indonesia finds itself today, and that there are still vast unexplored areas, I believe that the opportunities are huge for a company like Continental.

Does this mean that once you have been successful in making a big discovery you will try to monetize it and continue exploration elsewhere, or would you be interested in developing the fields yourselves?

Our business model is very simple: we want to have the luxury of being able to make that decision when the time comes. The life cycle of exploration companies over history has always been the same: they make some discoveries, accumulate a portfolio of producing assets, and either decide to become a significant independent or to sell out for an offer you or your shareholders cannot refuse. We would like to get to that point where one of those scenarios happens. Continental is quite prepared to produce and operate in Indonesia, as long as we have the proper financial resources at the time of the discovery. But if someone makes an offer for our assets that we can’t refuse, we will most likely sell and revert to exploration elsewhere.

Do you think that, as a whole, the Indonesian O&G sector is at a turning point after years of falling reserves, exploration and production? What are the key factors that will determine the possibilities of boosting exploration and production in Indonesia over the long term?

My view is that the trend is not very encouraging. Indonesia has to realize, whether it wants to or not, that it is in competition with other countries for the O&G investment dollar. Over the last several years we have seen a flight of exploration dollars from Indonesia towards Africa. It is generally thought that this is due mostly to regulatory and economic aspects, which is true to an extent, but I believe that one of the main issues is this very vague investment perception of Indonesian risk. This aspect has been greatly complicated by 9-11, the Bali bombings and the fact that Indonesia is a Muslim country. I have been actively promoting, pleading, and begging for finance in North America and Europe for exploration drilling funds for Indonesia since 1984, and it may be harder now than it has ever been.

In my experience there is a misconception in the USA, to a lesser degree in Europe, and suprisingly to me, in the Middle East, that Indonesia is not a safe place to invest. Having been here for a very long time, many other foreigners and I know that it is not the case. There are huge positives which I try to accentuate, like for example the fact that the Indonesian government has never defaulted on a PSC. Basically in Indonesia what you have is what you get. There has never been an instance of nationalization like in Venezuela or Mexico, or a case of changing the terms after the contract has been signed. Taking all this into account, coupled with the a well trained oil and gas work force, good oilfield infrastructure, large unexplored areas, and attractive geology, these are compelling arguments in Indonesia’s favour. I think the Indonesian government needs to promote its oil sector more to better portray these intrinsic qualities.

A lot of people point to the terms of the PSC as a problem in Indonesia. Indonesia invented the PSC, but now I think its time for Indonesia to rethink the PSC. The PSC’s detractors usually focus on the production sharing split, unfair to one side or the other. However, in my opinion, the signature PSC concept of ‘cost recovery’ has become the real problem and fixing it properly would increase O&G investment in Indonesia.

Under a PSC the oil company is entitled to recover all of its past exploration, development and production costs on a dollar for dollar basis out of an ‘off the top’ reimbursement from production. Great, this principal front end loads the investor’s rate of return but it has several drawbacks, three of which are big ones.

First, there is no incentive to be a low cost operator under a PSC after production commences because every dollar you spend you get back as cost recovery.

Second, the government subsidizes low crude oil price under a PSC. Each dollar the oil company spends it gets back. It does not matter how many barrels it takes to provide that dollar. The government alone bears the price downside risk. At low market oil prices the government gets a greatly diminished proportion of the total oil produced. This is of course reversed at premium world prices but regardless it puts governments in the oil price risk taking business.

Third, not every oil E&P investment dollar is the same yet cost recovery treats them as if they are. The principle of cost recovery does not recognize any difference in a high-risk dollar invested in frontier exploration versus a no-risk dollar spent on marketing oil at the delivery point.

The arguments over the production sharing split aside, I think the best thing the Indonesian government could do to provide incentives for new investment in Indonesian O&G to modify the PSC cost recovery terms in a significant way that amply rewards exploration and development initiatives; obviates the need for bureaucratic overregulation, and discourages production and operating overexpenditures.

As someone with a long-term and international experience in the O&G industry, how do you see the current oil boom? Is it likely to last?

I believe that this is a sustainable boom for several reasons. First of all, the major oil companies have not gotten over-excited like they did during the last one. There is less of a chance of a sharp downturn once excitement starts to fade. Secondly, one of the main differences this time is the whole demand-side situation with China, India, and Indonesia. These are the three most populated countries in the world and have the fastest-growing economies in the world. Their enormous demand for energy is an element that was missing in previous boom/bust cycles. Continued growth in these countries is going to sustain demand for the foreseeable future.

Within the current context of Asian growth and uncertainty in the Middle East, Indonesia has the potential to turn its geographic position into a real asset. Indonesia is perfectly located close to China and India. It offers easy access to North America across the Pacific Ocean. There are no Straits of Hormuz type choke points controlling flow of Indonesian oil that are beyond Indonesia’s control. This leaves Indonesia is in a wonderful position to be a major player in global O&G, the challenge is to get production back up and become net exporter once again. The solution is to create incentives for the international oil companies. The time is now and I don’t think Indonesia can do it alone.

Under what circumstances did you join Continental and how did this American company end up getting so involved in Indonesia?

I was involved in the signing of two new PSCs with Indonesia in 1997. In retrospect it was at the worst possible moment because it was right at the onset of the Asian financial crisis and just before the political turmoil that came with the 1998 regime change in Indonesia. During that time, I was dealing with a different group of financial backers and owned a large percentage of the company myself. Outside funding dried up but I was able to do a reverse merger with Continental Energy Corporation, and my investor group exchanged ownership of the PSCs in Indonesia for a large position in Continental’s shares.

All your bets are placed on discovering a “company maker” oil field in Bengara-II Block in East Kalimantan. What makes this area so special and prospective for Continental?

Continental concluded the acquisition of the Bengara-II Block through a direct negotiation with Pertamina at the time. The Bengara-II Block contains the last great unexplored delta, the Bulungan Delta, of serious size, in East Kalimantan. The block is only 20 to 30 kilometres away from Tarakan Island which has been producing oil since 1906. The Bulungan Delta is about a third the size of the Mahakam Delta in the adjacent Kutai Basin which has provided company-maker discoveries for several oil companies.

We have an aggressive drilling campaign underway at the moment. We have 4 rigs operating in the Bengara-II Block, 3 drilling rigs and a workover. We expect to finish 4 wells this year and are encouraged enough by results to date that we are preparing a plan of development for a large structure that will require 3D seismic to fully appraise.

How does the famous quote ‘oil is first found in the mind’ referred to on your website apply to Continental Energy Corporation’s business philosophy? How does this reflect on its human resources?

It was a famous American geologist named Wallace Pratt who said that. Pratt was one of the founders of the American Association of Petroleum Geologists (AAPG). It’s true because a geologist somewhere has to dream of the discovery before you can actually find it. It is as simple as that. I find his quote has extra significance in that when he said it in a speech in 1952 he was replying to the doomsayers and pessimists of his own time who then contended that all the world’s oil had been found and by the 1960’s we would see the end of oil.

At a price you can always buy or lease the latest, greatest exploration technology to obtain state of the art data. You cannot always readily employ the innovative minds to interpret that data. You should also always be mindful of the counterpoint corollary to Pratt’s law, ‘wishful thinking won’t find oil either’.

Pratt reportedly ended that speech with the words: ‘When no man any longer believes more oil is left to be found, no more oil will be discovered’. The human resources implications of his speech are crystal clear. At Continental there will always be a place for the explorationist who believes and can ground that confidence with a pragmatic approach.

What are you doing to minimize and spread the risks that can be associated to your business strategy? How successful have you been in obtaining financing?

The company takes on partners at an early stage in order to reduce risk. For example, Continental has a 50-50 joint venture with an American company called Geopetro Resources, in which we are actively working and sharing costs on identifying and acquiring promising new Indonesian exploration blocks.

We recently concluded our first major institutional placement with Australia-based Macquarie Bank, a financial institution that is very knowledgeable about oil & gas and extracting industries. Besides the private placement that turned Macquarie into Continental shareholders, there was also an agreement on a mandate for Macquarie to provide up to $100 million USD to finance selected acquisitions of new properties or other oil companies.

Continental has maintained that their focus is on Indonesia, yet a subsidiary called TTX was formed last year to pursue E&P opportunities in the USA. What is behind this change of strategy?

It is a change of strategy only in sense that we are expanding our geographical base. We formed a company in Texas simply because we are continuously presented with lots of opportunities in Texas, Oklahoma and Louisiana. Our subsidiary there is monitoring those possible investment opportunities, but so far we have not found anything we are interested in.

We recently appointed a new director who is based in Dubai. Realistic opportunities are now open to us to make a geographical expansion given the Macquarie financial backing. We attended a conference on Iraqi petroleum last week. Oil opportunities in Iraq are just to big to ignore, if and when the problems there ever get resolved. The Kurdistan region in the northern part of the country is attractive to us and we are actively looking into it at the moment.

The Middle East region is not too far a step out for us from Jakarta, it is only a 6 hour plane ride. Its also now a major financial centre, therefore we get more bang for our buck because the Mid East offers both new projects and oil savvy finance. Many parts of the Middle East are reaching a similar stage in oil development as Indonesia. There are a lot of smaller projects which the major companies are not so interested in doing, some of which would fit us fine.

What are your ambitions for Continental Energy Corporation, how do you see yourselves 5 or 10 years down the road?

Continental Energy Corporation aspires to have a solid production base, but not lose sight of our entrepreneurial, exploration focussed roots. In the future, the greatest challenge will be finding visionary explorationists and acquiring large unexplored areas to set them loose in. We see favourable financing opportunities to support these ambitions thanks to high sustained oil prices and strong demand from countries like China and India.

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