GROWTH AND RETURNS

Oilmen used to watch the majors operating in North America with a great deal of interest, thinking that as the majors go, so goes the industry. That's no longer true. After leaving the continent in favor of big plays elsewhere, the majors have been supplanted by the new industry bellwethers-the super-independents. Super they are. Most of these companies produce as much-or more-in North America as the majors once did. Every day, EnCana and Devon Energy each produce more gas in North America than ChevronTexaco, ConocoPhillips or Royal Dutch/Shell do. The super-independents sport multibillion-dollar drilling budgets. They have grown dramatically in the past five years through increasingly larger mergers and acquisitions. Most are significant players in the deepwater Gulf of Mexico. But with greater size and range come new challenges. Volume or returns? Acquisitions or more divestitures? "Size offers both virtue and vice in the E&P business," noted Merrill Lynch analyst John Herrlin in his report last year on Burlington Resources. So with fanfare, and somewhat emulating what the majors did a decade ago, the super-independents have announced new strategies to meet growth and return targets. These include repositioning asset portfolios to ensure longer reserve lives. Companies such as EnCana and XTO Energy spotlight their low-risk, repeatable gas plays, also known as resource plays, while Burlington Resources talks of basin excellence. Last summer Anadarko Petroleum went through an intensive, MBA-like exercise, in the words of new chief executive Jim Hackett, and then announced its intent to divest assets worth a minimum $2.5 billion after-tax. Then in September, Devon Energy said it planned to sell noncore proved assets that could fetch as much as $2 billion. In both cases, the companies plan to use most of the proceeds to reduce debt and buy back their own stock, hoping to boost returns on paper, in addition to what they might achieve in the field with the drillbit. "The E&P companies that reinvest to optimize their growth-and-returns balance should command the highest valuations in the long run," says Prudential Securities analyst Michael Mayer. This explains why the U.S. rig count seems stalled at about 1,250 despite higher commodity prices. Then too, some experts believe there are no more viable rigs available to work beyond that number. No doubt maturity and resource depletion are fighting with executives' need to show their investors continued growth-and returns. "Our analysis of drilling results since 1997 tells us that the broad North American E&P industry has seen significant deterioration in portfolio quality," says Gil Yang, E&P analyst with Citigroup's Smith Barney in a January report. His analysis of drilling results, oil and gas portfolio quality and depth for 12 large-cap U.S. and four Canadian producers implies that companies are spending more and getting less value to show for it than they did before 2000, after adjusting for oil and gas price changes. "We see that the projects executed in the late 1990s usually had inherently stronger returns than more recent projects...Almost universally, we find that sequentially rising commodity prices since 2001 have led to diminishing incremental value added each year." If ever-rising commodity prices-and the larger capital expenditures that accompany them-are not adding enough incremental value, then what more can a company do? Will the new asset mixes held by these super-independents add value, or will more deals be needed to bolster the proved undeveloped (PUD) reserves inventory every year? Growth in reserves and production is only one side of the coin. Wall Street also wants returns. For his E&P coverage group, Yang estimates an average rate of return in 2005 of 13%-if gas prices are $5 per thousand cubic feet equivalent. But he notes that drilling results appear to have fallen off in recent years. Acquisitions have likewise generally added less incremental value-despite rising oil and gas prices. He thinks sellers have captured the upside of their properties but the aggressive prices paid by buyers have contributed to the deterioration in value creation. "In my view, the biggest change in the market in the last 12 months is the value people are willing to put on proved undeveloped locations," says Gregg Jacobson, a managing director with M&A firm Randall & Dewey. That manifests itself in transaction values when one sees the dollar value paid per daily barrel of production. One can look at a transaction based on several other metrics, such as reserve value or acreage value, but if taking total dollar value divided by current production, deals used to be $20,000 to $30,000 per daily flowing barrel. In the past six months, the median value in the U.S. has been $45,000 to $55,000 with premiums up to the $75,000 range." Most of the premium deals are being closed by public companies that have to point to where they will get next year's production growth, Jacobson adds. Next year's PUD conversions come from this year's acquisitions. "If you look at the success of Chesapeake, Newfield, XTO, Apache, they were aggressively valuing PUDs and it has worked terrifically well for them. The success of the acquire-and-exploit players has raised the bar, if you will." The size of asset purchases has increased dramatically in the past two years and now rivals the size of buying an entire corporation outright. XTO spent $1.1 billion last year buying fields from ChevronTexaco. Chesapeake spent more than $2 billion. "The scale at which those companies are now pursuing acquire-and-exploit is larger than anyone's tried before," he notes. So, the super-independents are charging forward with a mix of low-risk, repeatable developments, high-risk exploration and acquisitions. "If you can't do all three and shift among them during the cycles, you're not going to survive long-term, even though you may be a shooting star in the short term," says Larry Nichols, chairman and chief executive of Devon Energy Corp. Burlington's volley Burlington Resources is credited with being one of the first among large-cap producers to seek growth and returns. In 1998, chairman and CEO Bobby Shackouls declared, "Growth really matters, but it doesn't matter if it comes at the expense of returns." At the time Burlington suffered from derision and doubt on the Street. Today, however, its returns, which used to trend lower than its peers, are among the best and Shackouls' plan has been emulated by others. In his 1997 letter to shareholders, he said he wanted to double Burlington's value in five years and generate returns in the low- to mid-teens while doing so. But first, the company was quitting the volume-growth race to focus on returns, noting how poor returns had been in the E&P business historically. The industry was known for destroying capital. And at the time, the dot-com technology craze was exploding, so investors were ignoring the E&P industry regardless of its performance. "Across the board, our sector was underperforming the large integrateds in terms of share price multiples, and we wondered why," Shackouls says. "Consistently their return on capital employed was higher than the independents. We analyzed their business plans and found a clear correlation between share prices and financial returns, in spite of modest or sometimes no volume growth. "Through time this debate evolved into an either/or proposition, but this created a dilemma for our sector: the equity market historically rewarded independents for growth. But as companies get bigger, growth is harder to achieve, and chasing it at all costs destroys capital, especially when commodity prices are high, E&P companies are flush with cash, and service costs and acquisition prices are rising." With that, Burlington changed course. It left the shallow-water Gulf of Mexico, bought a substantial position in Canada through two large corporate acquisitions for $3 billion, augmented core areas such as the San Juan Basin, and in the end, sold 10% of its production and reserves for more than $1.3 billion. Speaking to analysts at a meeting in 2001, he admitted the steps being taken were bold, "some of which may have seemed untimely since many of our peers were still emphasizing growth. However, those actions underpin the very essence of what drives Burlington today...." Burlington, he vowed, would generate a return on capital in excess of its cost of capital, and post at least 10% growth in cash flow per share. It would do this by balancing drilling, mergers and bolt-on acquisitions, and financial engineering (such as stock buybacks and hedging) as warranted by the commodity cycles. By 2003, he was telling analysts, "we stepped out of the pack [four years ago] and made what we considered to be a fairly straightforward assertion: 'returns do matter.'" There have been bumps along the way as the company transformed itself. In 1999 and 2000 it underperformed on production growth. Shackouls says it was tempting to abandon the return goals in order to deliver growth at all costs. But he didn't. What's more, he struck a blow for shareholder returns by initiating a share-repurchase program that since late 2000 has resulted in the buyback of nearly 15% of the shares for $1.4 billion. Just recently the board authorized a further $1-billion buyback. Chief financial officer Steve Shapiro joined Burlington in 2000 to help engineer the transformation that was under way, along with chief operating officer Randy Limbacher. He told analysts the balance sheet was a "fly wheel" to be managed through the price cycles and that everyone would focus on per-share metrics. He implemented a global purchasing program to cut costs. The company does rigorous post-mortems on projects and shares learning across divisions, making internal experts available to all other teams. The company set a production-growth target of 3% to 8% annually and aimed for sector-leading returns as well. Capital expenditures were to remain fairly even every year, growing modestly as the company grew, but not chasing commodity prices up and down. "It was a matter of three things: getting the assets right, financing right, and the workforce right," Shapiro says. "And we had to find new investors who were balanced between growth and returns, who didn't want just growth. A challenge was to not end up with a weak share price during the transition, and to communicate the strategy internally." What has been the result of all this? Return on capital employed (ROCE) has steadily risen. (Burlington defines it as net income and interest expense divided by net debt and equity.) In 1999 ROCE was 2%; by 2001 it was 9.9%, including the effects of asset impairments. By 2003, ROCE was 17.7%, outranking Burlington's peer average of 12%. Return on equity was about 40% better than that of its peer group. In 2004, it generated ROCE of 20% annualized, along with 9% growth in production. Net debt-to-capitalization was about 54% at year-end 2001; today it is below 25%. "Now, when many E&P companies speak about their investment strategies, it's like hearing Burlington's business model replayed by others," Herrlin wrote last fall. Burlington ended 2004 with a little more than $2 billion in cash. Shackouls-and investors-are eagerly looking for the company's best way to redeploy that firepower. If the right acquisition comes along, he says he's ready. "But I won't chase a deal just to do a deal. It's got to be the right fit with our basin-excellence model-or maybe get us into a new core area as a leading producer." Anadarko goes to school In December 2003, Jim Hackett became the new CEO at Anadarko Petroleum when the company's founder and chairman, Robert Allison, wanted to retire. For a couple of years, Anadarko had been going through some tough times. Growth had stalled, the stock no longer traded at a premium, and it seemed to have lost its luster. Hackett acted quickly. Six months later, in June 2004, Anadarko unveiled major initiatives to retool its asset base, announcing it would sell 317 million barrels equivalent of reserves deemed noncore-representing nearly 25% of its production. By year-end 2004, it had closed or entered seven transactions totaling $3.3 billion, pre-tax, including the largest upstream asset divestiture in the industry since 2000 and the second-largest Gulf of Mexico divestiture, at $1.3 billion. Its only offshore production now is Marco Polo in deep water, but it has plenty of deepwater blocks under various stages of exploration and development. Why would a company divest so much if The Street has been criticizing it for its slow growth rates? Repositioning for new growth. Returns. "The challenge is this industry has always been achieving return on capital and growth per share," Hackett says. "If you define ROCE as 20%, you probably can't do both, but if 10% on a sustainable basis is the measure, then yes, you can achieve growth and good returns. Independents have to show some growth to distinguish themselves from the majors. For example at APC, we plan to produce 5% to 10% growth in production per share and 6% to 10% growth in cash flow per share. This combination of growth and over 10% returns is part of the important balance." A key part of boosting per-share metrics is using about 44% of the proceeds from the asset sales to repurchase shares. Last year it bought back 20.3 million shares and retired $1.2 billion of debt. At press time, Hackett reinforced his strategy by announcing Anadarko will reallocate $150- to $200 million from drilling in 2005 to additional share buybacks instead. The company's 2005 capital budget is still at least $2.7 billion. It also plans to use additional free cash flow for share repurchases. In 2004 the company bought back $1.3 billion of its shares. "Sometimes [managing to achieve higher per-share returns] means investing more in the reserves we know best-our own." Hackett knows where he wants to go. "We'll focus on games we can win. That means continuing our exploration focus. We've driven our debt-to-cap south, so we'll have a supercharged balance sheet. We've improved profitability-and growability for the future." In 2005, Anadarko's exploration budget will be 25% of the total, versus about 19% last year, in keeping with the company's desire to renew its exploration focus, which Hackett calls "R&D." But he says a company can never get overbalanced on any one measure as it then risks getting ahead of its science or failing to get the return it expects from a project. Change is going on in the halls of Anadarko, but some 80% of the production is still in North America. More attention is being paid abroad, though, with newly announced activities or concessions in the Middle East and Indonesia to augment its existing plays in Algeria, Venezuela and Qatar. And, late last year, the company broke ground on a project to build a liquefied natural gas (LNG) plant on Canada's East Coast. It will be fed by gas from Algeria, where the company has long had major production in partnership with Sonatrach, the state oil company. To engineer Anadarko's transformation, Hackett assembled a management team of 80 people to dissect the industry, the competition and the company. The team reviewed each asset to see what it could do not only in 2004 and 2005, but longer term. Information flowed into models that indicated that 20% of the company's production would be better off in other hands. Additionally, a management committee of 11 people met for half a day every week for several months. They had reading materials and assignments. "This was an internal exercise, like an MBA for our staff (with no external consultants), based on what I see. It was led by our director of planning...I changed my ideas some during the process," he says. "It was a great exercise, and I credit Anadarko's board members with being open-minded about it. It was important to me to have them bless it. We really did something meaningful here and didn't just sell something for $200 million. The additional benefit was that I got to see how people thought and interacted, and what kind of courage they had-whether they were for the corporation or for the division, and what could they sacrifice." The exercise helped employees to focus and not get carried away with the ever-rising oil and prices experienced last year. Hackett's goal was to get back to good cash flow-per-share growth. The only thing that keeps him awake at night now, he says, is worrying about how to attract enough good people to Anadarko and how to keep them happy working there. The 2005 target is per-share growth in production of 7% to 11%. "It's all about net growth per share going forward," Hackett says. "But you have to be flexible and not let your strategy overcome your good sense. You don't want to spend money unwisely just to pursue a strategy." Devon's balance At press time the data rooms were open as Devon Energy began its process of divesting certain noncore assets, which were to be sold during the first quarter. Analysts predicted it could net up to $2 billion-yet this represents only a small portion of the total company. In addition, since October, Devon has bought back 3 million shares for $111 million. As a result of asset sales and using some capital for the share buyback, near-term production growth estimates are basically flat for this year and 2006. Beyond that, however, growth will start to ramp up smartly when high-impact fields now being developed come onstream, so CEO Nichols is not worried. Selling assets to clean up the portfolio is not a new idea, he says. "We did that two years ago, for example, by getting out of Indonesia. One characteristic of today's crown jewels is that ultimately, they become noncore, something you want to sell to keep your people and capital focused on the right things. When the commodity price comes back up, that's when you sell those things and then do more drilling." Nichols believes Devon is at a turning point where all the acquisitions it's made in recent years-PennzEnergy, Mitchell Energy, NorthStar Energy, SantaFe/Snyder, Anderson Exploration and Ocean Energy-begin to bear fruit. Selling the noncore portions is just the next act of the play, as he says, in his plan to amass as much natural gas inventory as possible. "In 2002 we thought that North American gas production would start to go down and that values would therefore be permanently higher. We bought Anderson, for example, because we wanted a lot of low-risk gas-drilling locations in the deep basin and foothills play of Canada." He says he hears investors put companies into categories, with Devon as the big buy-and-exploit one. "Oh, you're an acquire-and exploit company; you're an exploration company. But I think any company has to do all three things. We certainly have. "Some companies in our peer group are pursuing nothing but low-risk, short-term resource plays that give them immediate reserve growth and low finding and development costs," he says. "That's really the new buzzword for exploitation. It's fine and we've got some plays like that too, but on the other hand, any exploitation play ultimately comes to an end." Devon's 2005 budget calls for spending $2.7 billion. The company has a lot of exploration to do in the deepwater Gulf of Mexico and offshore West Africa, on the assets it gained with its acquisitions, joint ventures and lease sales. "I don't see a need for Devon to make further acquisitions-or the availability. Those companies that haven't already built up their portfolio are having to do so now and it's getting harder and more expensive as less quality assets are available at the right size and right price. "I don't want to sound smug, but I am delighted we ground away at the acquisitions we did. Now we have a large and very diversified portfolio we can drill, whether it's in a low-risk play like the Barnett Shale we acquired with Mitchell Energy, or the higher-risk Mackenzie Delta that we picked up when we acquired Anderson. We assembled our portfolio when it was less expensive and the world wasn't as focused on those assets." Analyst Lloyd Byrne of Morgan Stanley thinks that while Devon may underperform in the near term due to asset sales, it has an attractive opportunity set now, plenty of free cash flow, accelerating deepwater exploration momentum, and a projected 5% compounded annual growth rate in production for 2004 through 2009. It takes time to position a company favorably, and time for that position to start turning into growth and returns. Now Devon is ready, Nichols believes. At year-end it had a net debt-to-cap of 30% and $1.8 billion of cash on hand for debt payment and stock buybacks. "I look out there and see quite a portfolio now," Nichols says. "We have projects like the heavy oil Jackfish play in Canada, where we plan to begin development this winter. We have a whole list of projects in the deepwater Gulf. We have the Mackenzie Delta, which clearly is a long-term project. The market put no value on it when we bought it, so we essentially got it for free. We're looking for other ideas in China, where our Panyu Field offshore has far exceeded our expectations. "One thing that distinguishes us is we really are spending money on exploration for the long-term. People criticized us for our acquisitions and having all those PUDs, but now we are set to enjoy the last act of the play. "We are in the middle of the pack right now on returns because we have been spending our capital priming the pump in the last two or three years. We now have that balance that was not possible for us a few years ago when we were a smaller company." Kerr-McGee's strategy Through its recent history, Kerr-McGee has made some bold corporate moves in addition to drilling in its core positions in the U.S., U.K. and China. It sold a scattered mix of its North American production to Devon in the 1990s, kicking off the latter's impressive growth decade. In 1999 it acquired Oryx, which gained it more international exposure and enhanced its Gulf of Mexico position. Then in 2001, it acquired HS Resources, a Denver-based company with assets mostly in the Denver-Julesburg Basin of Colorado. Kerr-McGee was then focused on its many deepwater Gulf plays, where it has been highly successful. And, it too cleaned up the portfolio, having sold about $1 billion of assets in 2002. But it returned last summer to the acquisition mode by buying Westport Resources for $2.7 billion, to further its natural gas position in the U.S. "We shrunk two years ago, by selling non-core and high-cost assets, but now we are back on the growth track. Long-term we are aiming for an internal production growth rate of 3% to 6% annually," says Dave Hager, Kerr-McGee senior vice president. "Frankly, in the next few years it looks like we may hit the upper end of that range. We funded a strong program for 2005 because of Westport. We're fully funded to the capabilities of our organization." The onshore assets will provide a stable foundation for the company's higher-profit opportunities in the Gulf of Mexico and internationally. "Onshore has a repeatable, low-risk production profile and strong cash flows," Hager says. Meanwhile, discoveries made in 2004 in Alaska, in offshore Brazil's Campos Basin, and in China in a deeper structure southwest of its existing production in Bohai Bay, will generate growth in the future. The Constitution-Ticonderoga fields in the Gulf will be the next to see a new spar for production, with initial production capacity of 70,000 barrels and 200 million cubic feet of gas per day when it comes onstream in 2006. Kerr-McGee had been focused on tactical acquisitions in and around its core areas and was not necessarily looking for a big deal like the Westport transaction, Hager says. In the past three years, it had moved 300 million barrels of oil equivalent (BOE) from the proved undeveloped category to the proved producing. "But the more we came across Westport-we started seeing their name in the Gulf Coast, the Midcontinent, and particularly in the Rocky Mountains-it planted the concept in our minds that there was a rationale for talking to them. At the same time, they were thinking it was getting more difficult to grow through their main avenue, acquisitions." Today, Kerr-McGee's upstream capex budget for 2005 is $1.7 billion for development and another $380 million for exploration, with about $200 million of that targeted for the Gulf of Mexico. The company doesn't release its return-on-capital targets publicly, Hager says. It's a little more complicated, since the company also has a chemical segment as well. But oil and gas production growth appears steady. In 2004, Kerr-McGee produced about 310,000 BOE per day. That number is estimated to grow to more than 352,000 in 2005. By 2006, production could be from 363,000 to 382,000 BOE per day, Hager says. "We are very happy with our mix of assets now. It offers a balanced approach that makes sense for our shareholders," he says. "We have low-risk, repeatable plays and exploration opportunities of a meaningful size. We're focused on areas we like a great deal." In the end, large independent producers such as these contribute a significant percentage to the U.S. rig count, and they report having a lot of potential to follow up on with the drillbit. But they will not be more active than what they deem necessary for moderate and sustainable production growth-growth that at the same time creates high enough returns to please investors. If that means sitting on a lot of excess cash flow and biding time, or buying back stock and hiking dividends, that's what they plan to do. High commodity prices will not lead the companies to drill like crazy, to get all that high cash flow in the door. The crazy days are long gone.