Given the high finding and development (F&D) costs now being experienced by E&P companies, one researcher has come up with a new metric to better evaluate the upstream economic performance of the industry and spotlight individual producers positioned to outperform their peers on a return basis.

This metric, return on drilling dollars (RODD), calculates the internal rate of return associated with the cost to bring a new unit of production online and the cash flow that same unit generates over time.

"In 2006, we calculate that E&P companies as a group averaged a 4% RODD-a level clearly lower than the cost of capital for the group, around 10%," says Joseph Allman, E&P analyst for JPMorgan Securities in Houston.

Significantly contributing to this poor industry performance last year was a key component of the RODD metric-proved developed F&D costs. In 2006, those costs rose to $4.03 per thousand cubic feet equivalent from $2.39 the prior year.

In short, producers are generally getting inadequate rates of return because proved developed F&D costs are so high, the analyst says.

Although Allman recommends using net asset value (NAV) as the primary metric for evaluating stocks, he suggests using RODD as a supplementary screening tool. "We would focus on [producers] that are able to capture the highest returns [on drilling dollars] because their costs are low and their reserves are high value, but [their stocks] are still trading below NAV," he says.

"Other opportunities exist in companies that are experiencing a significant improvement in returns not reflected in their current valuation."

Among large-cap producers within his coverage universe, XTO Energy Inc. stands out as the only one that achieved a strong RODD in 2006-15%. "Based on a Nymex pricing assumption of $7.80 gas and $62 oil, we estimate the company's RODD will increase to 25% in 2007."

Allman notes the stock is trading at a 14% discount to NAV. However, "we're likely to hear news that could move the needle somewhat for XTO as it releases more data on its East Texas Cotton Valley horizontal wells, a handful of new Piceance Basin wells in Colorado, and its step-outs in the Barnett, Fayetteville and Woodford shales."

Within the analyst's midcap coverage group, Ultra Petroleum Corp. ranks first in the E&P group in terms of RODD for 2006 (36%) and for 2007 (41%).

"Increased density drilling and deeper drilling at Pinedale/Jonah fields in Wyoming offer Ultra the opportunity to maintain a strong RODD for the foreseeable future."

Allman also cites Gulf Coast producer Denbury Resources Inc. That operator had a 2006 RODD of 16%, which he estimates will rise to 20% this year. "Given oil's premium price relative to natural gas, Denbury's oil-heavy profile helps it achieve superior cash margins and, combined with below-average proved developed F&D costs, superior RODD."

Among small-cap independents, the analyst points out that Mariner Energy Inc. last year achieved an 11% RODD, which is expected to soar to 29% in 2007. He explains that the company's superior cash margins, combined with its high-present-value Gulf of Mexico production, give it above-average returns relative to its peer group.

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