THE BOSTON BUYSIDE

When Apache Corp. issued 15 million common and half as many convertible preferred shares last spring to help pay for its Gulf of Mexico property acquisition from Shell E&P Co., about 40% of the $655 million the Houston independent raised came from Boston portfolio managers and institutional investors. Since the 18th century, when Boston was an important seaport and hub of colonial commerce, the city has played a major role in investment and finance. The first mutual fund was born here, spawning a multi-billion-dollar industry that today funds numerous industries. Boston's investment professionals have a reputation of being careful and smart. But they obviously weren't consulted in a 1918 decision that still rankles much of New England. Harry Frazee, who owned the city's American League baseball team, the Red Sox, wanted to invest in a Broadway musical. So he sold one of his pitchers to the New York Yankees for $125,000 at the end of the season. The pitcher was Babe Ruth. And the Red Sox, who had won the World Series several times before, haven't won a world championship since. Oil and gas executives focus on wiser financing sources. "Typically, if you are trying to raise money or if you have a transaction or any large corporate event, and you wanted to visit a couple of cities and get buy-in from the investment community, you'd want to do New York and Boston-New York because it has such broad participation, and Boston because it is such a big money center," says Robert J. Dye, Apache vice president for investor relations. "Boston is a broad-based money management center where companies manage funds in the trillions of dollars. There are a lot of serious players located there who are knowledgeable investors." Vince White, vice president for investor relations and corporate communications at Devon Energy Corp., adds, "Boston clearly is one of the top two pockets of institutional money for the oil and gas industry. We have significant shareholders there, both before and after the latest offering." Institutions and funds in the New England financial center own about 8% of Devon's outstanding common stock. They bought a similar percentage of the approximately $400 million of equity that the Oklahoma City independent issued recently, when reloading its balance sheet and reducing high-cost debt it incurred when acquiring PennzEnergy Co. Boston institutions and funds invest heavily in upstream oil and gas. Oil and Gas Investor used Investment Data Corp.'s online service, Bigdough.com, and searched Securities and Exchange Commission archives to examine Boston area firms' equity holdings in the sector. The research found that 35 firms held upstream oil and gas equities, with a total market value of more than $84 billion, on June 30, 1999. Securities of major oil companies represented nearly $47 billion of the total. Independent producers-including integrated natural gas companies with significant E&P operations-follow, at more than $21 billion, and oilfield service firms, at nearly $16 billion. The 35 firms generally lived up to the conservative reputation of New England money managers. Larger companies attracted the most investment, in the three main upstream categories. Exxon Corp., Mobil Corp. and BP Amoco Plc led the majors. Halliburton Co. and Schlumberger Ltd. led the service companies. And the Houston large-cap trio of Burlington Resources Inc., Apache and Anadarko Petroleum Corp. led the independents. That much investment creates a need for specialists. "At one time, it was possible to catch six oil and gas analysts riding the Framingham train [into downtown Boston] during my morning commute," recalls William D. Burt, a vice president at Eaton Vance Management. "We didn't actually talk to each other. But there was a lot more oil and gas expertise on board than many people would have guessed." There also seems to be as many approaches to oil and gas investment in Boston as there are investors. Some concentrate on exploration and production stocks. Others include service and supply companies and downstream oil operations in their portfolios. A few make long-term commitments, while the rest hold positions for briefer periods. All believe that serious money can be made from investing in oil and gas. "You have to look at the investment merit of this industry on the basis of returns," maintains Donald J. Kilbride, vice president and director of research at The Boston Co. "There's nothing that says you have to own energy securities. So the industry's challenge is to recognize that the competitors for investor interest are other businesses such as health and technology." The Boston Co., which is part of Mellon Bank, owns more than $1 billion in oil and gas-related equities. "Exploration and production involves a depleting asset that has to be replaced. It's easy to conclude that it will never be a great business by traditional investment measurements. But producers' cash flows benefit when oil prices move from $12 per barrel to $24. So money can be made," observes Jack McPherson, a vice president and analyst at Evergreen Investment Management Co., one of several investment groups within First Union Corp. He has about $5 million of his small-cap fund, which totals approximately $1.5 billion, committed to upstream oil and gas. "We're always looking for new investments. Our weighting is not necessarily set in stone," McPherson says. Other Boston institutional investors and fund managers prefer approaches that are entirely their own rather than traditional benchmarks. "I don't even know what return on capital employed [ROCE] means, as a measurement of the E&P industry. Measurements like that don't apply to this industry," says Dan Rice, a senior vice president at State Street Research & Management Co. "We prefer EBITDA [earnings before interest, taxes, depreciation and amortization] to EV [enterprise value], and knowing that multiples to these expand when oil prices go up and contract when prices go down. The byword is volatility. These stocks are more volatile than a small-cap growth fund. But if you measure them correctly, they can provide returns that are at least equal to the S&P 500." He also tries to determine producers' recycle ratios by dividing their production netbacks after all expenses, on a barrel-of-oil-equivalent basis, by their all-in finding costs. "We try to be forward-thinking, so we focus very heavily on expected recycle ratios. When we see them go to about 1.5 to-preferably-two times, the stock is looked at closely," Rice explains. "Our job is to find the highest recycling companies trading at the lowest multiples. They will offer the highest upside growth opportunities." State Street is one of only a few New England companies that makes energy-specific equity investments. Outside of $175 million in its mutual funds, it has about $500 million in small-cap energy stocks and $20 million in a hedged fund. E&P issues represent about 85% of its oil and gas portfolio, with the balance invested in oilfield service companies. "We're aggressive in the sense that our portfolios are pretty concentrated," Rice says. "Typically, 40% of the assets will be in 10 top holdings. We file 13-D reports with the Securities and Exchange Commission for as many as 30 to 35 companies. About half of the portfolio turns over yearly. We're the quintessential buy-and-hold company." Not every major Boston oil and gas financial source deals in equities. "We principally make loans to oil and gas companies, from E&P to refining and marketing to gas gathering to the newer unregulated entities," says William A. Kinsley, senior investment officer in John Hancock Mutual Life Insurance Co.'s bond and corporate finance group. "We are interested in how the market values an equity. It's just not the only factor in our decisions." The bond group manages about $35 billion of the $130 billion that is under management at John Hancock. The group invests close to $11 billion per year, or about $200 million per week, in corporate bonds. Oil and gas bonds represents less than 10% of the bond portfolio. Of that amount-about $2.8 billion-90% are bonds of investment-grade companies. The balance is "any investment that makes sense," Kinsley says. In addition to bonds, it uses preferred stock, convertible notes and, in some cases, partnerships as investment vehicles. It makes deals of up to $100 million, but comes into them with no specific size in mind. Kinsley and his colleagues, Eugene X. Hodge Jr. and Eileen M. Forde, don't put as much weight on ROCE and similar benchmarks because they are very broad indicators geared to the equity side of financing. "From a bond side, we look at different criteria to assess risk. To be able to differentiate one company from another is an area where we have established some expertise," Kinsley says. Hancock's recent oil and gas financings include helping a service company in Louisiana fund a $135 million purchase of two supply boats and a Canadian producer finance a US$250-million offshore oil project. Roughly 70% of the debt that the group provides is private, with the remaining 30% public. It considers more than numbers in making its choices. Geographic focus is important. "So is management credibility, specifically how it reacts and when it buys assets," says Forde. "The goals have to be credible," Hodge adds. But the group emphasizes that oil and gas investments do not receive a specific allocation. All investment areas compete for funds. "Not having a firm allocation keeps you from filling the coffers with deals in a bad environment," Forde observes. Hancock's recent oil and gas financings include helping a service company in Louisiana fund a $135-million purchase of two supply boats and a Canadian producer finance a US$250-million offshore oil project. Roughly 70% of the debt that the group provides is private, with the remaining 30% public. Equity investors use similar standards in their E&P commitments. When it comes to crude oil, Eaton Vance's Burt says the immediate bias is toward foreign crude that can be found for $1 to $3 and produced for between $3 and $5 per barrel. The world's deepwater areas also hold special appeal because they are relatively new exploration theaters where producers can generate bonanza profits from high volumes. He considers natural gas different because North America is a more isolated market where the fuel has produced lower relative income until recently. "Now, after many years of waiting, gas seems to be coming into its own, at a price around $2 per thousand cubic feet," says Burt. "The challenge is to find a well-managed independent gas producer." Eaton Vance's largest oil and gas equity positions in mid-1999 were with Anadarko, Halliburton, Exxon, Mobil, Baker Hughes, BP Amoco and Schlumberger. Burt appreciates the improved outlook that has resulted from rebounding oil, and gas, prices. But Burt also believes good times can be dangerous for producers. "The industry's problem is how to invest ever larger amounts of money and keep its returns up. It's easy to grow complacent and believe you have a corporate magic that allows you to repeat your successes year after year. The resources business doesn't work that way." Nevertheless, the oil and gas business still appeals to investors. "The industry loses control at times and stocks turn into bargains. Money can be made as financial performance returns to normal levels." The Boston Co.'s Kilbride suggests, "Production growth tends to be what investors value in an E&P stock. Now, they want to see increasingly profitable production. The focus should be on producing the right kind of barrels." Individual producers can't control oil and gas prices, so keeping costs down has grown more important. "I see a lot more discipline on the cost side now. These companies still are treasure hunters. Their resources are hidden. But that doesn't give them a license to be irresponsible." He thinks producers create value in exploration. "And we're getting better at taking the risk out of that part of the business. As an investor, I want an E&P company to explain the level of capital needed to accomplish this, realizing that it's still not a perfect business." Evergreen focuses its E&P investments on small- to midcap companies. McPherson concedes that the majors offer some protection with their dividends, but adds that the small-caps, especially, can work overlooked properties and grow. "They also can move into a no-man's land as midcaps when the law of large numbers kicks in and they try to expand production," McPherson says. "They seem to be more focused now on return on investment. Lowering finding and development costs is key in this volatile price environment. It's nice to see they're a little more focused. It can be hard because commodity prices are out of their control. But they still have to be able to execute their end of the business and capitalize on price cycles." State Street's Rice distrusts commodity price comparisons unless they're from peak to peak or trough to trough. He also expects oil prices to become increasingly volatile because OPEC finally has recognized that keeping prices unstable is the best way to maximize its members' revenues. "It potentially paralyzes majors' planning departments and keeps non-OPEC production from coming on stream," Rice says. Boston-area investors have generally accepted the notion that OPEC members are finally complying with their assigned export quotas. They were not giddy when oil prices reached more than $25 per barrel in the fall. "Investors realize that OPEC doesn't want prices that high in the long term," Burt says. "At that level, billions of dollars would go back into the ground and the overcapacity problem would return. We certainly won't see $30 oil for more than a short period at the most. It's to everyone's advantage to get the price of oil back to $20." Rice also doubts that higher crude prices could be sustained. He uses an $18 to $19 range for planning purposes, but allows for wide swings to reflect the increasingly unstable environment. Two years ago, he would have used a $17 to $18 range. "I'm in the lunatic camp that thinks oil prices will get closer to $30 per barrel than $20, then drop to $12 or $13 because someone in OPEC is cheating. It will be contrived, of course, and an excuse to turn on the spigot until the culprit learns its lesson," he says. He also expects OPEC to move to reduce prices when the international rig count returns to a specific point. "When it hits a level near 750, I'll become concerned and start being more defensive in my portfolio." Several Boston investors took oilfield service equity positions in early 1999 as they anticipated a rebound from severely depressed share prices. The group's stock prices jumped as much as 70% by midyear, before settling 30% higher year-to-date by the time the Red Sox faced their arch-rival, the Yankees, for the American League championship. Oil service stock prices retreated because producers used their extra cash flow, from higher oil and gas prices, to clean up balance sheets instead of increasing exploration budgets. "But the service companies are reasonably healthy, largely because of all the consolidation that has occurred during the last few years," says John Hancock's Hodge. "It was much worse in 1986. Not that many companies in the group have gone out of business this time. Several even made acquisitions to expand their service lines at attractive prices." Kilbride suggests that service companies particularly learned a hard lesson during the 1986 crude oil price plunge. "There had been massive overinvestment in the early 1980s to the point that the industry was overbuilt when prices broke. We're seeing more partnerships now between producers and service companies. Both sides realize that they need each other." He considers service companies unique, within the bigger oil and gas picture. "While they are affected by commodity prices, their near-term financial results are less directly influenced than producers' near-term results. The oil service stocks seem to anticipate the impact of changing commodity prices. They can move quickly, sometimes in anticipation of spending by producers that can take place in two or three years. But it can be difficult to explain the merit of an investment in this sector on that basis." Burt notes that service company stock prices rocketed early in 1999 in the face of horrible conditions. "While gas prices still looked pretty good, we were staring at $11 oil and the oilfield activity outlook was particularly bad. With strong gas prices and the hint of a turn in oil, the market could see better times ahead and the stocks went up. "Then the market realized that the pace of recovery would be much slower than expected, particularly for high-margin international activity. The turn was out there, but the market concluded the service stocks had galloped too far ahead. They were again overpriced, now that everyone was starting to believe that a substantial recovery would take place well into 2000." He still considers oil service stocks attractive as a class. "We've flushed out what I call camp followers. That type of aggressive momentum investor has stepped aside," he says. "But there still is a classic recovery under way where upstream spending will increase. So these stocks should do well from this point onward." McPherson is not so certain that this will happen soon. The service sector rebound clearly is being delayed as producers rebuild balance sheets with their spare cash flow. "Given the consolidation that's taking place among the majors, we have wondered how long this dislocation would last. There has been an uptick in activity, but we haven't seen it in the service companies' numbers yet. The reality is that the majors have to start spending for service companies to benefit. Still, if a couple of billion dollars is saved when two majors or large independents get together, it eventually will be spent. The question is when." Independent producers are showing more savvy in dealing with Wall Street, "but the industry still suffers from a reputation of being a good-old-boy network," he quickly adds. "It always has had good people. They just seem smarter now about Wall Street's ways." At John Hancock, Kinsley observes that producers have not necessarily become more hard-nosed about managing their finances, simply more professional. But Kilbride sees certain producers using a lot more cost discipline. "Not only did they survive this last downturn, they also have reaped the benefits. Over a cycle, oil and gas companies are generally net spenders of capital, so a producer has to manage his balance sheet carefully at all times," Kilbride says. Many upstream companies emerged from the most recent downturn in reasonably good shape. "Others did not do as well because they had too many geographic stakes," Burt says. "They discovered it was too easy to spend money diversely and not have much to show for it after five years." Boston's oil and gas investment community is watching consolidation trends. Members generally agree that the stage has been set for financially stronger upstream independents to make substantial acquisitions. Part of this has been driven by the majors and large independents steadily moving their E&P emphasis overseas. "Twenty-dollar oil is fine for a company that is well-positioned overseas, but not for one that primarily has domestic reserves, particularly onshore," Burt says. "The majors have to keep a long-term perspective," McPherson adds. "They can't set their budgets based on $25 oil. But projects meaningful to their results become more difficult to find if a budget is based on oil prices in the midteens." "There's no country more drilled than the United States," says Kinsley. "We can understand sizable companies wanting to develop substantial reserves by drilling internationally. We have financed several of them, but with criteria that are no different than what we use in the U.S." He suggests that the wave of megamergers that began in August 1998 with British Petroleum's acquisition of Amoco has been driven largely by multinational oil companies wanting to develop core positions around the world. Other assets are being divested in the process, and independents find these properties appealing because the majors have not fully developed the assets. "It's not that they're not good or profitable," says Hodge, also of John Hancock. "They simply don't make a big enough dent in what the bigger companies need in production." Meanwhile, Kinsley expects many upstream transactions in the coming months to be relatively minor. "We see churning of properties, not sizable divestitures, but smaller-field-type sales, often involving mature properties." Rice thinks megamergers could create growth opportunities even for smaller independents. But he warns that a volatile price environment will make it difficult for them to buy the majors' properties and expect to make money on them. "Part of what we're seeing with companies cleaning up their balance sheets and husbanding their money is in anticipation of majors putting a lot of their properties on the market." Despite their growing financial discipline and increasing knowledge of how Wall Street works, independent producers still make mistakes when they seek outside financing. Several Boston portfolio managers, analysts and institutional investors remain skeptical and would rather not hear about geologic expertise or a great prospect with significant reserve potential, for example. "There's a propensity to promise to increase production by 5% per year," says Kinsley. "But there's absolutely no way that can be achieved, except in a few cases." "This has nothing to do with the area's merits, but everyone seems to be interested in developing deepwater Gulf of Mexico prospects," observes Kilbride. "Certainly, the early results seem mixed. Everybody can't be out there. But a lot of producers seem to be trying." He prefers niche players who can produce oil and gas efficiently. "If they can invest capital well in a region where others can't, we like to hear about it," he says. A high-quality management with a good track record will also help an independent in winning financing in Boston. "The goals should be credible and ratcheted," says John Hancock's Forde. "Given a $20-per-barrel oil price, it should be ready to produce a specific result." Rice puts less emphasis on a producer's management. "We're more interested in a company's prospects," he maintains. "Some of our biggest hits have been with companies where the perception was poor, but the assets turned out to be good." It's not surprising, then, that Boston's oil and gas investment community brings a discipline to its business that's indisputably Yankee-even if it is a dirty word around much of New England from April through October.