Though producers' year-end 2004 balance sheets were strong and surplus cash levels are building, drillbit reinvestment rates are still incredibly low, according to analyst W. Mark Meyer of Simmons & Co. International. With commodity prices still strong, why are some companies having such a hard time putting the money where the drillbit is? After taking a hard look at merger and acquisition activity and new drilling projects-two major reinvestment vehicles-Meyer suggests that recycling major amounts of capital into any growth activity these days is easier said than done. "More selective prospect screening, increasingly competitive M&A markets and real human-resource limitations have forced E&P companies to either adopt more aggressive behaviors in order to take on additional opportunities or 'sit on their hands' with respect to investing additional capital," Meyer says. Worldwide increases in oil and gas demand have put additional pressure on E&Ps to grow organically or through M&A. In partial response to that pressure, many companies have proudly announced significant capex increases going into 2005. But Meyer says within his coverage universe of 18 large-, mid- and small-cap companies, the plan is to reinvest only 68% of the discretionary cash flow they create in 2004. This was "despite upward budget adjustments of 22% year-to-date versus the initial 2004 drillbit spending plans laid out in late 2003 and early 2004." In light of these announcements, the assumption is there is indeed cash lining the company coffers, so why aren't they using it to increase growth? With regard to drilling, "[There is] an eroding cushion of safety between economic rates of return and the perilous combination of skyrocketing well-construction costs and collapsing natural gas prices," Meyer says. In all fairness, the M&A market is changing too. Meyer says, "The biggest change relates to the apparent buyer willingness to pay higher prices for producing assets of lesser quality or properties that are more speculative in nature. Few deals are able to meet the minimum return criteria strictly on the economic merits of the seller's proved reserves." His analysis of corporate transactions in 2004 reveals that buyers made more aggressive assumptions about commodity prices and exploitation potential. Another growth opportunity many producers don't seem to be excited about is share repurchases. Meyer says, "With some exceptions like Anadarko, Burlington Resources, Devon Energy and EnCana, E&P companies have treated the share-repurchase program in a manner that reminds us of the popular Ross Perot-ism about the proverbial crazy aunt in the basement-'everyone knows she's there but no one wants to talk about her.'" For executives, the decisions related to reinvestment are not going to get any easier. Meyer predicts that inflation pressures tied to the drillbit and M&A, alongside the need to tolerate more risk, will continue to make these decisions even more complex. Also, with companies stockpiling cash instead of deploying it more frequently, a likely end-result will be M&A competition getting a bit stiffer. And in the face of growing global demand, "sub-70% drillbit reinvestments will likely remain commonplace." -Bertie Taylor

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