CATCH A RISING STOCK

After a spectacular first-half 2000 rally in upstream oil and gas stocks, which saw the shares of many publicly traded independent producers jump as much as 100% in value, could there be room for more market movement in the exploration and production sector? The consensus is that another E&P stock rally is in the offing this fall. But make no mistake. Wall Street won't be taking a fire-sale, buy-the-whole-basket approach to the sector. As one Houston oil and gas analyst puts it, "...We're focusing not only on [E&P] stocks we think are cheap, but also on those that have good growth potential." Which upstream stocks match that profile? To find out, Oil and Gas Investor visited with four top, Texas-based E&P analysts: John Myers, managing director, Dain Rauscher Wessels in Austin; Shannon L. Nome, managing director, Banc of America Securities LLC in Houston; C. Van Levy, managing director, CIBC World Markets in Houston; and John M. Selser, director, RBC Dominion Securities in Houston. We asked each for their commodity-price outlooks and their top upstream stock picks. Four E&P stocks were cited twice: Ocean Energy, Nuevo Energy, Vintage Petroleum and Chieftain International. Collectively, the analysts indicated that the most impressive stock-value percent gains over the next 12 months will be achieved by Forest Oil, Denbury Resources, Chieftain International, Pogo Producing, Nuevo Energy, Burlington Resources, and Vintage Petroleum. (See chart.) The common threads linking all 21 producers selected: strong managements, undervalued assets and the ability to cheaply grow reserves, production, earnings and cash flow. Investor John, which stocks under your coverage look attractive this fall? Myers The first is Pioneer Natural Resources. This large-cap producer has dramatically changed and cleaned up its balance sheet during the past 18 months. Last year, it sold a lot of nonstrategic properties and paid down $400 million-plus of debt. More importantly, Pioneer refocused itself, such that 90% of its properties and reserve value is now in just 10 fields it knows very well-in the West Texas Permian Basin, the Hugoton/Pandhandle area of Kansas and Texas, Argentina and Canada. In these areas, where PXD is a key operator and low-cost producer, it has an inventory of 1,500 low-risk, development drilling locations. Pioneer has also made some recent discoveries in the deepwater Gulf of Mexico and offshore South Africa which, when they come on stream in 2002-03, will provide the company annual production growth of 25% to 35%. Further exploration upside in these offshore areas, as well as offshore Gabon, could accelerate this production growth. The stock is cheap relative to Pioneer's year-end 1999 asset value and its future earnings and cash flow. The only negative: the hedges it put in place during the downturn have hurt Pioneer's earnings. Those hedges, however, will roll off this year and we should see significant earnings improvement going forward. Investor Shannon, your top E&P pick this fall? Nome One is Ocean Energy. This is a large-cap growth story. Operating in the onshore U.S., the Gulf of Mexico and offshore West Africa, the company has a very returns-focused management team that has added a lot of discipline to the capital budgeting process. OEI is now less dependent on the winds of commodity prices. During the past year, that team has executed several noncore asset sales, reduced debt and made sure that the company lives within its cash flow. Ocean is now positioned for significant exploration upside relative to its existing asset base. In offshore West Africa alone, the company has more than a billion barrels of oil equivalent in net, unrisked reserve potential. In the deepwater Gulf of Mexico, its most recent discoveries-Nansen and Boomvang-have 75- to 100-million-barrels of reserve potential, net to Ocean. Production from Zia, Magnolia and Hickory is expected later this year or early 2001. Selser We, too, have Ocean as a top pick. It has cut more than $600 million from its $2-billion debt load, and its finding costs last year were half what they were in 1998. Also, it has been able to hold on to some high-growth areas, such as the deepwater Gulf of Mexico and offshore West Africa. For an independent, Ocean has world-class international assets, and although the stock is up quite a bit for the year, we think the potential for further upside is there. In 2002, we could see production rise by 20% as deepwater discoveries come online. Investor Van, your top picks? Levy Among large-cap stocks, Burlington Resources is a great value play and offers the best risk-reward ratio. The company is the largest North American natural gas producer, yet it's trading well below its breakup value of $61.13 per share. We like BR's high-quality asset base, focused largely in five North American areas: the San Juan Basin, the Midcontinent, western Canada, the Gulf of Mexico and the Gulf Coast. These areas possess low-risk exploitation opportunities, as well as higher-potential prospects that could significantly add to the company's North American gas reserve base-now 7.2 trillion cubic feet. In Canada, where it recently bought Poco Petroleums, it has been successful on 13 out of 16 gas wells. The company also has significant oil and gas reserves to book in Algeria, Egypt and the East Irish Sea. Investor John, besides Ocean Energy, which large-caps do you favor this fall? Selser One is Apache. The company has a fantastic record of being able to purchase reserves cheaply and exploit them fully. The four major acquisitions it made in 1999, totaling about $1.4 billion, are still paying dividends. This year, APA is generating tremendous cash flow-well in excess of its budgeted capital expenditures. This gives Apache quite a bit of firepower. In fact, it has already made about $500 million of acquisitions this year-at costs well less than $1 per thousand cubic feet. In addition, the company is expanding its exploration budget for prospects in Australia, Egypt, Poland and Canada. As a result of these moves, we're looking for production to grow 20% this year, and about 5% next year-without giving effect to any additional acquisitions. The stock is not particularly cheap, but given the quality of management, the company's strong cash flow and its ability to make things happen, the stock is going to do very well and we would consider it a core holding. Investor What other large-cap names do you like? Selser Cross Timbers. We think XTO still has more upside in front of it. The company has amassed more than 2 trillion cubic feet of gas equivalent reserves, primarily in the Midcontinent. These are long-lived reserves that don't have steep production declines. This opens the door for Cross Timbers to generate cash flow three times the capex budget that's necessary to replace production-creating the ability for the company to pay down debt or make further acquisitions. We see Cross Timbers' debt-to-total-capitalization ratio going from 80% to 60% by the end of 2001-just from free cash generation and noncore asset sales. Meanwhile, production should rise 13% this year and next. Another pick is Forest Oil. Its proposed merger with Forcenergy roughly doubles the size of FST, in market cap and reserves. Forcenergy had been one of our top picks prior to the merger announcement, trading at a steep discount to its peer group. Now the undervalued assets of Forcenergy will be repackaged into a company that is itself strong. The result will be a bigger and better Forest Oil, which has been doing a more improved job lately of exploiting its own Gulf of Mexico, Canadian and international assets. So we think the time is now right for investors to take another look at Forest Oil, which uncovered a real gem in Forcenergy-before a lot of other companies could get to it. It's a combination that's going to bear a lot of fruit. Forcenergy's approximately 175 Gulf of Mexico leases match well with Forest Oil's Gulf position. In addition, Forcenergy has critical mass in Alaska's Cook Inlet with significant reserve exposure. One oil prospect it's drilling could be as large as 125 million equivalent barrels. Investor John, besides Pioneer, what large-cap producers do you like? Myers Stone Energy. This is an extremely well managed acquire-and-exploit company that has a great cost structure and a great inventory of more than 100 Gulf of Mexico shelf drilling prospects. These prospects should allow SGY to continue its historic annual production growth rate of 15% to 20% per year. This year, we expect production volumes to average 190 million cubic feet per day, up from 169 million last year. Added production growth could come from its Gulf of Mexico properties at South Timbalier 8, Eugene Island 243, South Pelto 23, West Cameron 176 and East Cameron 64. With a balance sheet that has only $100 million of debt, Stone should continue its history of very attractive acquisitions. Investor Shannon, you've named Ocean Energy. What are some other large-cap favorites? Nome Louis Dreyfus. This is a very gas-focused producer that has had a lot of recent drilling success in South Texas, where it has ramped up production from zero to 180 million (gross) cubic feet equivalent per day. It also has plenty of development projects ahead of it in the Permian Basin and the Midcontinent. In addition, LD has high-potential, 50- to 150-billion-cubic-foot targets offshore Texas at High Island and Mustang Island. So this is a drillbit story, not one of a fully hedged company with no upside. In fact, only 40% of the company's current production is hedged. We also like Newfield Exploration. In addition to its well-documented success in the Gulf of Mexico shelf, the company has made its first discovery in China's Bohai Bay on a 120-million-barrel prospect. NFX has a 35% working interest in the prospect, which borders 100- to 800-million-barrel discoveries by other operators. In addition, Newfield has expanded in South Texas, which should be another growth driver. We see overall production rising 23% this year, to 140 billion cubic feet equivalent, and another 20% next year, to just under 170 Bcfe. With a debt-to-cash-flow multiple of less than one-half the average for its peer group-the company has a healthy balance sheet. The last large-cap we like is Vintage Petroleum, which historically has been a successful acquire-and-exploit U.S. producer. A few years ago, it successfully transferred that strategy abroad, to oil prospects in Argentina. Since then, it has added gas exploration in Bolivia and, this year, oil prospects in Ecuador and Yemen. We see VPI as a growth and value stock, with an overlooked exploration component. For 2001, production should rise 11%, to 198 billion cubic feet equivalent. Recently, Vintage has been trading at 1.1 times enterprise value-to-historical, price-normalized liquidation value-one of the lowest multiples in its peer group. Levy Vintage is one of our top picks as well. The company has demonstrated consistent growth, doubling its reserve base every 2.5 years in the past 10 years through acquisition and exploitation. Yet, Vintage is very undervalued, despite this growth, a 10-year inventory of 3,800 exploitation prospects, low finding costs ($1.18 per equivalent barrel), and an improving balance sheet. It has traded recently at well below our estimated liquidation value ($39.45 per share) and at 8.3 times 2000 earnings versus an average peer-group multiple of 12.9. Investor John, you've named Ocean Energy, Forest Oil, Cross Timbers and Apache. Any other favorite large-cap picks? Selser Kerr-McGee. Operationally, the company has improved considerably in the last couple of years. We expect KMG to drill about 20 exploration wells worldwide this year-as many as eight to 10 of those in the deepwater Gulf of Mexico. Next year, we look for production growth of more than 20% as its deepwater discoveries come on stream. Overall, this undervalued company, which has steady earnings and cash flow from its chemicals business, trades at four times 2001 enterprise value-to-EBITDA versus a group average multiple of 5.6. We also think Pogo Producing is a real sleeper. PPP's assets in Thailand are extraordinary. The company has a 46% interest in a 734,000-acre offshore area, where it increased production last year by 20%. Moreover, Pogo continues to drill there with a very high success rate. In fact, it has more discoveries now than the three platforms it is constructing can cover. We see the company's overall production rising 32% this year-40% of that increase coming from Thailand; the remainder from the Gulf of Mexico. Given this, the stock should be trading at premium multiples. Investor Moving to mid-cap stocks, what are your top choices, John? Myers Houston Exploration. This producer-which operates principally in South Texas and South Louisiana, the Gulf of Mexico, the Arkoma Basin and Appalachia-is 97% leveraged to gas. Every 10-cent increase in gas prices raises THX's cash flow about 25 cents per share and earnings about 16 cents. The company also has a growing production profile. Last year, in the Gulf of Mexico, it drilled 18 wells; 14 were successful. Half of these will come online later this year, which should boost daily output 15% to 20%. In addition, Houston Exploration has a large inventory of low-risk, development drilling locations in South Texas and the Arkoma Basin, which should also contribute to volume growth. Cheaply priced, the stock is trading at about 4.8 times this year's EBITDA versus an average group multiple of 6.0. We also like Chieftain International, an onshore and offshore Gulf of Mexico operator with 70% to 80% of its production levered to gas. CID will have dramatic gains in largely unhedged gas output this year and next, mainly as the result of several recent discoveries. In second-half 2000, we believe the company will add another 35 million cubic feet to recent net daily production of 80 million cubic feet. Going forward, the company has a very aggressive exploratory drilling program that has significant upside. In addition, Chieftain has virtually no debt, so it's well positioned to make acquisitions. Levy We also have Chieftain as a top pick. The company has undergone a major strategy shift that's producing tangible results. Historically, it had been a prospect purchaser, which resulted in high finding costs. A couple of years ago, however, it made a management change and began shooting seismic in the Gulf of Mexico, participating in lease sales and developing prospects on a promoted basis. The result: finding costs last year were 85 cents per thousand cubic feet, down from $2 in 1998. In addition to drilling 13 development wells this year, Chieftain has an inventory of 25 to 30 exploration prospects it will be drilling over the next two years. So the stock has plenty of upside. However, the market's not recognizing this. CID is trading well below its asset value of $22.42 per share; meanwhile, some peers are trading at two times their asset value. We believe the stock should trade at close to 150% of asset value. Investor Shannon, who do you like among the midcaps? Nome Nuevo Energy. This is more of a value play, in that the stock has been a laggard versus its peers recently. Why? Nuevo has fully hedged its oil production for 2000, so there's no near-term exposure to improving prices. Also, it hasn't had much notable exploratory success in the past few years. However, its hedges wind down to about 60% of production for 2001, and then as its exploration efforts gain traction, NEV should have a much better growth story to tell. The company has an interest in the East Lost Hills gas play and the offshore, 100-million-barrel net Tranquillon Ridge oil play, both in southern California. In addition, Nuevo has exploratory wells planned in Ghana and Tunisia for later this year. Recently, the stock has been trading at 0.8 times liquidation value versus a five-year, price-normalized multiple of 1.1 and an average multiple of 1.5 for its peer group. Levy We also see Nuevo as a deeply discounted value play. At today's high oil prices, we come up with a net asset value for NEV of $63.78 per share; yet its shares have been trading below $20. This means that an investor could buy this company's reserves on Wall Street for only $2.70 per equivalent barrel of oil. The knock on Nuevo, of course, is that it has hedged its 2000 production at well below recent market prices. However, the company has at least a 14-year reserve life, so it has the ability to participate in most of the upside we see for oil prices down the line. In addition, Nuevo is a very efficient operator, with a current full-cycle return on investment (cash flow divided by finding costs) of 73%. Investor Van, any other mid-cap stocks you like? Levy Swift Energy. This producer-with a very focused asset base in South Texas and recent exploration success in New Zealand-has a strong operating track record. During the past five years, SGY has grown reserves at a compound annual rate of about 37%; production, about 40%; and cash flow, around 33%. For this year, its full-cycle, cash-on-cash return on investment is expected to be about 132%. With 81% of its reserves and 64% of its production oriented toward gas, we think this is a great midcap vehicle for investors to participate in the strong gas market we're witnessing. In addition, Swift is trading at a discount to net asset value, plus the market isn't fully valuing its New Zealand discovery, which could add another $10 per share to NAV. Investor John, your favorite among small-caps? Myers Prima Energy. We love the management of this company. Dick Lewis has a tremendous track record of profitable growth for PENG. It has been the top-performing stock in my group during the past decade. (See "Above The Crowd," Oil and Gas Investor, July 2000.) The company has a great balance sheet, with no debt and $20 million in cash, and typically generates more cash than it spends on its capital program. Prima also has significant upside, not only from its existing property base in the Wattenberg Field in Colorado's Denver-Julesburg Basin, but from its coalbed methane play in Wyoming's Powder River Basin. The company holds more than 135,000 net acres in the play, where there's the potential for more than 1,000 wells to be drilled. The finding costs associated with this play are only 20 cents per thousand cubic feet, and that-together with strong gas prices-should allow for rapid production, earnings and cash flow growth in the coming years. I would argue that this company has more foreseeable growth than any company that we follow in the E&P group. Investor Shannon, your small-cap pick? Nome Spinnaker Exploration. For this Gulf of Mexico operator (which went public last September), we see hockey-stick-type growth from a very small asset base. At year-end 1999, its proved reserves were only 105 billion cubic feet of gas equivalent. However, we estimate that its prospect inventory is six to eight times that. (For a profile of Spinnaker, see "Setting Sail," Oil and Gas Investor, February 2000.) Underpinning this is a quality, disciplined management and technical team, a huge 3-D seismic database and a rock-solid balance sheet-something most of SPNX's peers can't boast. All this makes the company a preferred partner to the majors. We expect Spinnaker to exit 2000 with production of 110 million cubic feet equivalent per day-more than double its first-quarter 2000 average rate. Investor Van, your favorite small-cap? Levy We like Belco Oil & Gas. This operator represents excellent value, trading at a deep discount to its liquidation value of $19.20. BOG, which has a 50-50 oil-gas mix in its 11-year reserve life, has a balanced drilling program in its four core areas (the Permian Basin, Midcontinent, Rockies and Gulf Coast). The company has also done a good job of making selective acquisitions of cash-constrained operators in these areas. What's more, it has a very low cost structure. Its G&A, for example, is about eight cents per thousand cubic feet of gas equivalent-the lowest in the industry. Meanwhile, its current full-cycle, cash-on-cash return on investment is 48%. Besides this, Belco's growth has been excellent. Since 1993, production has grown at an annual compound rate of about 39%; reserves, at 38%; and cash flow, at 35%. Our other small-cap pick is Comstock Resources, which operates in the Gulf of Mexico, southeastern Texas and East Texas/North Louisiana. It plans to spend $60 million this year in these areas, drilling 33 development and 15 exploratory wells. Year to date, Comstock has had excellent drilling results, particularly in the Gulf of Mexico. As a result, its 71% gas-leveraged production for 2000 will be ramping up. This year, we're looking for a full-cycle, cash-on-cash return on investment of 81%. In addition, the company's balance sheet has improved and its borrowing base has been increased to $190 million, leaving about $80 million of unused capacity. An undervalued stock, CRK trades at a discount to its estimated net asset value of $13.53 per share. Investor Besides Prima Energy, what small-caps do you like, John? Myers Denbury Resources. This 75% oil-leveraged producer, focused on the Mississippi Salt Basin and South Louisiana, is slowly getting into the Gulf of Mexico shelf, where it has enjoyed some recent gas-related drilling successes. Denbury has considerable, steady production growth potential-15% to 20% annually-from its CO2 and waterflood projects in Mississippi, as well as from its onshore and offshore South Louisiana exploration projects. DNR also has a solid balance sheet, which gives it the flexibility to go out and make further accretive acquisitions in its core operating areas. Also, the company's stock is cheaply valued-selling at only 72% of Denbury's year-end 1999 asset value and 4.5 times 2000 EBITDA versus an average peer-group multiple of six. M