hen the management of Energy Cor-poration of America (ECA) needed a

capital source to accelerate develop-ment of its large resource base in Appalachia,the team knew it wanted to hang on to opportu-nities to participate in the upside. After review-ing several financing options, including debt,equity, royalty-trust equity and mezzanine, roy-alty-trust equity quickly stood out as a win-winfor the company and its unitholders.

When ECA was doing its road show for thetrust, the way the company kept its own moneyinvolved helped sell the story, says John Mork,ECA president and chief executive. ECA keptapproximately 50% of the trust units and has a70% economic interest in the assets because itretained 50% of the wells to be drilled.

The timing of the road show was interesting.“During the first week, the whole market

dropped 6%; the HBO television special‘Gasland’ premiered; the BP oil-spill saga wasin full throttle; and, any hiccup in drilling inAppalachia was being presented by the mediaas a Marcellus problem,” says Mork.

“Nevertheless, the demand was twice the of-fering size. The range of the offering was $19to $21 and we priced at $20. In looking at theproduct, the wells have performed 40% betterthan what the reserve report indicated.”

The management team was confident theproduct would sell even in difficult markets.“The royalty trust is relatively low-cost, nonre-course capital and it gives unitholders a long-term, stable return. Once the basic structure ofthe trust was developed, the company and un-derwriters put a lot of energy into designing aproduct that would be secure for investors andeasy for the market to understand. Plus, ECAMarcellus Trust I was actually designed to besuccessful in a low-gas-price environment.”

In July, ECA Marcellus Trust I (NYSE:ECT), sponsored by privately held, Denver-based ECA, completed its initial public offeringof 8.8 million common units for gross proceedsof $176 million. The trust consists of 14 pro-ducing horizontal Marcellus shale wells and 52horizontals to be drilled over four years, all inGreene County, Pennsylvania, where ECA

MARCELLUSROYALTY TRUSTA publicly traded royalty trust will help privately heldEnergy Corporation of America develop its Marcellusassets without giving up operational control.

ARTICLE BYBERTIE TAYLOR

FINANCING STRATEGY

1 Includes partial exercise of the over-allotment option.2 After the partial exercise of the over-allotment option, ECA and its affiliates retained an approximate 65% average economic interest in the underlying properties.

ECA MarcellusTrust I

Underlying PUDProperties

Producing Wells

Energy Corporationof America2 andPrivate Investors

PublicUnitholders Trustee

100%

100%

Hedging Contracts

PUD Royalty Interest(50% of net proceeds from

the PUD Wells)

PDP Royalty Interest(90% of net proceeds from

the Producing Wells)

4,106,300 Common Units(23%)

4,401,250 Subordinated Units(25%) 9,907,450 Common Units

(52%)

ECA’s Obligation todrill the PUD wells

ECA Marcellus Trust I Ownership Structure

Source: Raymond James & Associates Inc.

“ECA MarcellusTrust I wasactually designedto be successfulin a low-gas-priceenvironment,”says John Mork,president andchief executive,EnergyCorporation ofAmerica.

W

The trust isstructured todeliver astrongreturn—abouta 10% IRR—and is thefirst publicinvestmentvehicledesignedfor retailinvestors toown royaltyinterests inthe Marcellusshale.

Excerpted from

October 2010Copyright©Hart EnergyPublishing1616 S. Voss Rd.Suite 1000Houston, TX 77057(713) 993-9320

holds 9,300 acres.ECA has a commitment to drill 66 wells over

a four-year period at no cost to the trust. As thesponsor, ECA bears not just the drilling cost butalso the operating costs of the wells oncethey’re on production. It will own half the unitsthat comprise the trust, and it owns 50% of theeconomic interest in the proved undevelopedreserves.

Raymond James & Associates Inc. and Citiwere lead book-running managers, and Oppen-heimer & Co. Inc., RBC Capital Markets Corp.and Robert W. Baird & Co. Inc. were co-man-agers of the offering.

“ECT is a yield-oriented product with down-side protection and plenty of upside potentialfor the unitholders, which is something themarket craves during difficult times,” Morksays. “There’s nothing else out there that a re-tail investor can buy that will act like ECT. Theproduct is structured to deliver a strong re-turn—about a 10% IRR—and it’s also the firstpublic investment vehicle designed for retail in-vestors to own royalty interests in the Marcellusshale, which can do well with $5 gas.”

Royalty-trust appealThe royalty-trust security structure is a good

fit for ECA’s long-term development plans andculture of controlling drilling costs, Mork says.The structure functions like a “preloaded mas-ter limited partnership (MLP)” as it already hasthe properties in it, and these will be developedduring the next three years at no cost to the

unitholders. This allows distributions to growfor the unitholders, which is unprecedented inroyalty trusts, he says.

This approach also allows ECA to remainprivate and is in line with its planning cycle,which is in decades, not quarters.

Since its inception in 1963, ECA has focusedon finding and developing oil and gas primarilyin the Appalachian Basin, Gulf Coast andRocky Mountain regions of the U.S. and inNew Zealand. The company owns and operates5,100 wells, 5,000 miles of pipeline and has 1million acres in North America.

“The company was formed by my fa-ther with virtually no capital,” Morksays. “The original plan was to get

geological prospects, raise money from individ-uals and drill gas wells in Appalachia whilemaking a profit. When I joined the companyfrom Unocal Corp., we changed the businessmodel and bought existing production in addi-tion to drilling wells. The breakthrough cameon a prospect in West Virginia in 1976 whenwe were very undercapitalized.”

During that year ECA drilled two discoverywells, then drilled 200 development wells be-tween them without a dry hole. Since 1976 thecompany has grown at a compound annual rateof about 23% per year.

During the next year, the company plans todrill about 40 Marcellus wells, several in theEagle Ford, a couple in Montana and at leastone in New Zealand.

“Our capital budget for fiscal 2011 is about$175 million. We’re very excited about theMarcellus, and we recently completed a signifi-

Raymond James,which was leadmanager and solestructuringadvisor on thesethree royaltytrusts, took apage out of theMLP playbook indesigning theECA trust.

Royalty Trust ComparisonsCCoommppaannyy DDeettaaiillss EECCAA MMaarrcceelllluuss TTrruusstt II WWhhiittiinngg UUSSAA TTrruusstt II MMVV OOiill TTrruusstt

IPO/Sale Date 1-Jul-10 24-Apr-08 19-Jan-07Type Royalty Interest Net Profits Interest Net Profits InterestTerm 20 Years 9.1 Gross (8.2 Net) Later of 20 Years

MMBOE Produced or 14.4 Gross (11.5 Net) (~10 years at IPO) MMBOE Produced

Reserves by Category 32% PD / 68% PUD 100% PDP 86% PDP / 14% PUDReserve Mix 100% Natural Gas 55% Oil / 45% Natural Gas 99% Oil / 1% Natural GasSubordination 25% of Common Units None NoneSubordination Threshold 80% of Target Distributions None NoneIncentive Threshold 120% of Target Distributions None NoneOffer Price $20.00 $20.00 $20.00 Current Price1 $19.93 $19.90 $27.93 Paid Distributions1 $0.27 $8.89 $8.37 Total Return1 1.02% 71.40% 104.91%IPO Market Capitalization $352 Million $277 Million $230 MillionOffering Size $182 Million $234 Million $173 MillionPercent Sold at IPO 52% 84% 75%Retained Economic Interest2 65% 24% 40%$ per BOE of Proved Reserves $19.44 ($3.24 per Mcfe) $33.78 ($5.63 per Mcfe) $19.97 ($3.33 per Mcfe)Structuring Advisor Raymond James Raymond James Raymond James(1) As of 9/7/2010.(2) Includes retained working interest and units in the trust.Source: Raymond James & Associates Inc.

cant oil well in Montana and finished the seis-mic on a 1.5-million-acre onshore license inNew Zealand, where we’ve had one discoveryso far. We also recently entered a joint venturewith a private company to develop Eagle Fordshale assets in Texas.”

In reflecting on his firm’s choice for capital,Mork says it’s a mistake for companies to tar-get the cheapest capital available or to not se-cure enough to meet development plans.

“E&P companies are asset intensive, andtherefore capital intensive. I believe that accessto capital is more important than cost of capital.If you think about a royalty trust, it’s like anE&P company without management—a plus tosome—and the trusts tend to trade at highermultiples than E&P companies. Investors wereclearly drawn to that combination with ECT.”

Attractive upsideBecause there was such a high drilling com-

ponent targeting the Marcellus shale (approxi-mately 30% of the proved reserves were proveddeveloped producing with 52 wells to be drilledby ECA at no cost to the trust), RaymondJames & Associates wanted to structure thetrust to provide downside protection to publicinvestors, but still provide the opportunity forinvestors to participate in any production orpricing upside.

“So we took a page out of the MLP play-book, which was the concept of target distribu-tions, subordination and incentive distributions(commonly known as IDRs),” says HowardHouse, managing director and co-head of en-ergy investment banking at the firm.

“We used the Ryder Scott reserve report andNymex strip to forecast quarterly distributionsfor the 20-year term of the trust. ECA agreed tosubordinate half of its units and we set the sub-ordination threshold at 80% of the target distri-bution. So, if the actual distributions are lessthan 80% of the target distributions, cash flowwill be diverted from ECA’s subordinated unitsto common unitholders.

“To compensate ECA for subordinatinga portion of its units, we came upwith an incentive threshold where if

distributions exceed 120% of the target distri-butions then ECA and the unitholders split theupside 50/50. Unlike an MLP, where the IDRsstay in place forever, once the subordinationperiod terminates, the IDRs go away and every-one is on equal footing. The subordination pe-riod ends four quarters after the drilling iscompleted.”

House says the trust provided a compellinginvestment opportunity in that investors whobought the units in the IPO will realize a 10%internal rate of return on investment if targetdistributions are received over the 20-year term.House adds that ECA’s retained economic in-terest of 65% aligns its interests with investors,another attractive feature.

“ECA received a very attractive valuation forthe assets sold. In terms of dollar values for

proved reserves in the ground, ECA was paidabout $3.25 per Mcf and 1.7 times the SEC PV-10 value. Equally significant, the valuation ofECA’s undeveloped acreage exceeded $45,000an acre. These valuation metrics are not an ‘ap-ples to apples’ comparison with a conventionaldivestiture because, once the drilling is com-plete, the undeveloped acreage reverts back toECA and the trust is left with the wellbores.

“From a strategic standpoint, this approach ispreferable to doing a joint venture becauseyou’re not letting competition into your acreagearea,” adds House. “The sponsor gets to stayprivate and has 8.5 million units that it can ulti-mately monetize down the road. At the end ofthe term, a portion of the wellbores reverts backto ECA and the company has a right of first re-fusal on the remaining wellbores.”

House says that the royalty-trust structuremay be appropriate for other E&Ps that haveexposure to resource plays, though they’d needto be experienced operators with history in theplay. Raymond James would also look forsome component of proved developed produc-ing reserves, though it doesn’t have to be sub-stantial, he adds.

“The company also has to demonstrate that ithas a good understanding of what to expectfrom its drilling program, and it has to be in aplay that is sufficiently developed for a rep-utable reserve engineer to create a report to pro-ject future production.

“The Marcellus is far enough along whereRyder Scott was able to develop a type curvefrom ECA and various other operators. In addi-tion to the Marcellus, the ECA trust structurehas potential application for qualified players inthe Eagle Ford, Haynesville, Barnett andBakken plays.” �

ECA’s executiveteam celebratedECA MarcellusTrust I’s recentIPO at the NewYork StockExchange, whereJohn Mork(center),president andCEO of ECA, rangthe opening bell.