While the majority of independents are increasingly pinning their hopes and fortunes on natural gas, a few companies remain heavily weighted toward oil, including production of heavy oil. These commodity contrarians took the hardest hits during the last price downturn, as their heavier oils were trompled in the price market even more severely than that of the Nymex benchmark, West Texas Intermediate. Executives of three oil-weighted companies-Plains Resources Inc., Nuevo Energy Co. and Denbury Resources Inc.-recently shared their downturn management strategies with Oil and Gas Investor. Nuevo is the biggest independent oil producer in California; Plains is second. Meanwhile, Denbury is the largest producer of oil in Mississippi. "We got what we call the triple whammy," says Douglas L. Foshee, Nuevo chairman, president and chief executive officer. "First WTI went down, then what we receive for our oil as a percentage of WTI dropped. Plus, we use steam generated by natural gas to assist us in getting a lot of our crude out of the ground, and gas prices went up. So, production costs went up. It all made for a pretty tough year." Houston-based Nuevo reported financial losses in 1998 and through the third quarter of 1999, but Foshee expected to see positive earnings in the fourth quarter. The company has reserves of about 300 million barrels of oil equivalent, of which 90% is crude and 90% of that is in California. The rest of its reserves are onshore the Gulf Coast and offshore West Africa. John J. Myers, a Dain Rauscher Wessels exploration and production analyst, is optimistic about Nuevo's financial prospects. "Nuevo is well positioned to pick up more assets as the majors divest in California and West Africa. The stock looks cheap, if you believe in $20 oil. I think Nuevo's net asset value is about $25 a share, yet the stock is trading at $14 to $15." (In mid-November, it had improved to $17.) The stock of oily independents lags the recovery in oil prices, says Myers, who believes the companies profiled in this article are good investment opportunities with significant upside. "I think their stocks probably are lagging somewhat just because the market is much more skeptical longer term about oil, than it is about gas prices. These stocks haven't rallied as much as the rest of the group." Kenneth H. Beer, an analyst with New Orleans-based Johnson Rice & Co., agrees the market is reacting more favorably to the strong gas market, even though oil prices have shown a bigger upward bounce. "Oil has gone from $10 to $20-plus. Relative to gas, oil actually has had a much stronger and bigger recovery. With $12 oil, there were a lot of reserves that just were not worth putting money into, but with $18 to $22 oil, you see a pretty dramatic step up because a lot can be exploited at that price," Beer says. For instance, Nuevo has five to 10 years' worth of projects that are economical at $20 oil, Beer says, and "their balance sheet now is in very stable condition so they can take advantage of all the exploitation opportunities they have." Foshee says the company did not start out with a preference for oil rather than gas. "Strategically, we buy the out-of-favor commodity and sell the in-favor commodity. Nuevo was a natural gas company that made investments in West Africa and California in 1995 and 1996. Those were predominantly oil investments when the commodity was out of favor, and those two locations were out of favor." Nuevo sold most of its natural gas portfolio in early 1999 when gas was in favor, while it bought oil properties later in 1999 when oil was still below $15 a barrel. "This will be the strategy going forward, modified only by the fact that we think we have some core competencies distinctive to crude oil. One core competency is the ability to get crude oil out of the ground with secondary recovery techniques," Foshee says. "...We'll probably always try to play to that strength, but we will continue trying to be good portfolio managers and never forget that we are in a cyclical business." Likewise, Dallas-based Denbury Resources did not deliberately target oil. Its strategy calls for a balance of oil and gas reserves. "We did a large acquisition at the end of 1997, which was all oil, that gave us a big tilt toward oil at rather the wrong time," says Gareth Roberts, president and chief executive officer. The purchase was of producing properties in the Heidelberg Field in Jasper County, Mississippi, from Chevron U.S.A. for $202 million. The field was in the same area as Denbury's other core Mississippi properties and included about 122 producing wells. In addition, Denbury acquired minor interest in Heidelberg Field from three other entities for about $5.9 million. Currently, Roberts sees oil properties as a better bargain than gas properties. "We think there is tremendous opportunity in oil. I think oil for the time being is easier to find and develop than natural gas. It's definitely cheaper, if you are buying the asset," Roberts says. The Denbury executive and Greg L. Armstrong, Plains president and chief executive officer, both seek to capitalize on reducing the inefficiencies of oil reserves that they purchase. "For Plains, we have proven that we are not very good at discovery or exploration, but we are very good plumbers. Somebody else has taken the exploratory risk. What we really do is focus on initially improving the unit economics," Armstrong says. Plains cuts wellhead costs by reducing expenses and decreasing the basis differential through improved marketing. Then, it lowers the unit operating cost. Third, it increases production through improved production practices and recovery techniques, along with applying new technology, Armstrong says. With improved economics, inactive wells can be put into production, improved recovery operations can be initiated, and infill or step-out wells can be drilled, he says. Plains came to focus on oil rather than gas because oil is the most inefficient commodity both in the reservoir and in the marketplace, Armstrong says. "In most natural gas reservoirs, 65% to 85% of the volume will be recovered through a normal production process. It's a lot like filling a balloon. Once the reservoir has been discovered, the same amount of gas comes out, whether I hold the balloon or you hold the balloon, so there is really not much value to be added to that." Most of the value from gas stems from the discovery process because there is very little enhancement that operators can add through the production process, he says. "An oil reservoir on the other hand is very inefficient." About 15% to 20% of oil in place will be produced through normal production techniques. Secondary practices will get an equal amount, but much of the oil is still untapped, he says. "So, if you can recover even 10% of the oil that is remaining, it's a challenge, but it's also got value. There is a tremendous number of old oil fields in the U.S. with a lot of oil remaining." The Houston-based producer takes the approach one step further; it has a midstream business that handles about 850,000 barrels of oil daily. Plains All American Pipeline LP is a publicly traded limited partnership of which a Plains subsidiary, Plains All American Inc., is the general partner. The pipeline company transports, gathers, stores and markets oil, primarily in California, Texas, Oklahoma, Louisiana and the Gulf of Mexico. At press time, Plains All American Pipeline revealed it had incurred a $160-million loss due to unauthorized trades by an employee, who was fired as a result. Plains Resources, which owns 54% of Plains All American Pipeline, will not see its own business-exploration and production-affected by the pipeline's losses, but it will not enjoy the quarterly dividend it usually receives from the pipeline, at least not in the fourth quarter. And, the value of its interest in the pipeline has declined. Stephen A. Smith, an E&P analyst with Dain Rauscher Wessels, said Plains Resources successfully acquires mature, underdeveloped crude-oil properties and then improves both the production and the operating margins. Stock of Plains Resources was severely punished by the market, upon news of the pipeline debacle. "The reaction seemed to me to be overdone with respect to the parent company, and I have no opinion on the subsidiary," Smith says. Armstrong says hedging and the ability to perform are key to Plains' survival strategy. "We were well hedged going into the downturn, at prices of roughly $19 a barrel for 50% to 60% of our production. Our midstream business is not commodity price dependent and actually makes money in a volatile environment." Plains took a full-cost ceiling writedown at the end of 1998, but with the exception of that, the company made money throughout 1998 and in the first half of 1999. "We used that opportunity-when we were hedged and the prices for assets were low-to acquire additional properties. Between our upstream and our midstream, we made about $200 million of what we consider very-attractive acquisitions in 1999." Of the total, $180 million was on midstream assets and $20 million, upstream. Nuevo managers have bitten the hedging bullet, reversing their historic resistance to the risk management practice, in the pursuit of stable cash flows and the ability to fund existing exploitation opportunities. "In February 1999, when we were looking at $12 WTI, we decided our primary goal was to make sure we survived. So, at the moment we saw a WTI number that allowed us to be cash flow positive, we hedged aggressively," Foshee says. The company also divested its East Texas reserves and paid off a large portion of its revolving bank debt, with the proceeds. In early 1999, its net debt was 36% of total capitalization. "We did several things to survive. One, we made sure our balance sheet was very clean. The second thing was to hedge at the first opportunity to guarantee positive cash flow, and the third thing was to control our cost structure, both in lease operating expenses as well as general and administrative costs. Fourth, we cut our capital spending," Foshee says. Indeed, a picture of a Swiss Army knife is on the cover of Nuevo's 1998 annual report, under the headline "It's all about survival." Nuevo also repurchased 1.5 million shares of its common stock for about $25 million during a three-month period in 1999 at an average purchase price of $16.67 a share, including commissions. "We believe in this company and think our prospects for the future are bright. We're just putting our money where our mouth is by acquiring shares at what we view as extremely attractive prices," Foshee says. Denbury was aided during the price crunch by a cash infusion from its largest shareholder, Texas Pacific Group, a Fort Worth-based investment firm. TPG bought 18 million additional shares for $100 million, bringing its ownership of the company to 60%. Denbury used the proceeds to reduce its debt to $10 million. It has since sought to buy assets at low prices. "Even though prices have recovered, it's interesting the prices of assets and the prices of oil-company stock have not gone back up to the level that you would expect. It's still very much a buyer's market for assets," says Roberts. Denbury's reserves are 80% oil and concentrated in Mississippi; its gas reserves are in Louisiana. The heavy oil it produces typically sells for about $5 less than the Nymex price of WTI. Unlike Nuevo and Plains, Denbury only hedges when it has significant debt. "Right now, our year-2000 hedging of oil is very minimal," Roberts says. Denbury's budget has not been changed substantially, since oil prices have improved. During 1998, Denbury's cash flow was $30 million, or half of what it would have been if oil had averaged $18.50 a barrel for WTI. "We basically are remaining very conservative. But as time goes on, our balance sheet gets healthier and healthier. We're just being patient," Roberts says. Although the last downturn was particularly difficult for Nuevo, Plains and Denbury, they still believe there is money to be made from heavy oil-with some financial savvy and secondary-recovery acumen-while their peers are chasing natural gas.

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