Why US energy policy and Wall Street should focus on US independents

July 30, 2001
During the recent American Association of Petroleum Geologists convention a management session of AAPG's Division of Professional Affairs focused on "The Executive Perspective on the Energy Odyssey of the 21st Century."

During the recent American Association of Petroleum Geologists convention a management session of AAPG's Division of Professional Affairs focused on "The Executive Perspective on the Energy Odyssey of the 21st Century." Petro-Hunt LLC participated in these presentations and a panel discussion representing small and midsize independent oil and gas companies.

Perhaps the central conclusion of the executives representing oil and gas companies including small, medium, and large independents, integrated, and multinational companies was that there is a right size and fit for all firms in the energy industries of today and the future.

The multinationals and fully integrated oil and gas firms have enough capital and other resources to explore and develop reserves internationally, in the deepwater Gulf of Mexico, and on the Alaska North Slope. Independent oil and gas companies are, however, much more successful in their production replacement through exploration and development (E&D), are more effective and efficient in their E&D programs worldwide, especially in the US, and most importantly are adding more reserves domestically than US-based integrated and multinational oil and gas firms combined.

A study of 37 publicly traded, US based companies and one private company was conducted by Petro-Hunt LLC to evaluate what type of companies have most successful E&D programs and determine why. The studied companies included four multinationals with assets of $25-150 billion each, five integrateds with $10-24 billion each, nine large independents with $1.5-17 billion each, and 20 small to midsize independents with assets under $1.5 billion each.

The most recent 10-K reports filed as a part of each of these public companies' Securities & Exchange Commission requirements were used as the source for the data unless noted. For most firms this is the 2000 fiscal year. These 10-K reports are a more thorough and comprehensive overview of the company and provide a basis for comparative analysis of more uniform data than provided in the annual report.

The companies were not randomly selected. They were selected to include the largest US based multinationals, integrateds, and large independents. They also include some of Petro-Hunt's partners, competitors, excellent fast growing companies, and some that are struggling.

Oil and gas companies "growth" strategies are generally divided into several categories including acquisitions, reserve revisions, enhanced oil and gas recovery, extensions, and exploration. The term growth is placed in parentheses here because some of these "growth" strategies may be increasing firm size as measured by total assets. In most cases this is neither generating new wealth for individual investors nor adding to the reserve base domestically or internationally. The issue of "growth" through value additivity is addressed to review what mergers are doing and what they are not.

Value additivity

The concept of value additivity or conservation of value is that the net present value (NPV) of projects and corporations can be added, but this does not increase the total value of the new organization to a value greater than the sum of the individual parts.

Therefore, the recent and likely-to-continue mergers of large oil and gas firms have not made the individual investor better off (except for changes in G&A expenses) nor have new resources of oil and gas been added to constantly growing US natural gas and oil resource requirements. In fact the individual investor and the US may be worse off than before. Why?

There are two reasons. First, individual investors may be worse off because their opportunities to tailor their portfolios are reduced. Pre-merger, investors have the ability to select from more firms to balance their desired risk and return in individual, fund, or corporate portfolios. Post-merger, investors' choices are reduced. The post-merger stock prices of recently merged companies support this conclusion.

Managers of these firms have stated that they need three to five years to show that these mergers will generate greater return to the individual investor. One problem with this view is that the net present value of assets in five years is approximately half the value today.

So, in fact these mergers will need to prove twice as valuable five years from now to break even on a NPV basis. The required rate of return will need to be even higher than this doubling of value to increase the NPV to the individual investor more than the pre-merger value of these firms' assets.

It is Petro-Hunt's general position that the majority of value of an acquired property should be realized in two to three years. If not, then it was a bad acquisition.

Secondly, larger firms are likely only to concentrate and develop those projects of the combined firm with the biggest impact. This may leave many smaller and intermediate size projects undeveloped because the individual impact on these megafirms is too small. These multiple small and intermediate projects may have received the attention and development if divided between two competing firms. As a result, not only is competition reduced, these newly combined companies add fewer reserves and resources to meet US energy demand.

E&D success

The ideas of production replacement and reserve replacement, often used interchangeably in the industry, are not the same.

Production replacement as used here is the percent replacement of the previous year's annual production. Reserve replacement is a replacement of the firm's total reserves, and no firm studied over multiple years is totally replacing reserves in any single year through E&D activities alone.

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Fig. 1 displays finding and development cost (FDC) per thousand cubic feet of gas equivalent by production replacement percentage from E&D activities for individual firms. Exploration capital and expense and development capital are included in these FDC. Development or production expenses, most typically lease operating expenses (LOEs), are not included in the dollars spent for E&D programs.

The small and midsize independents (black diamonds) are scattered randomly throughout this plot, indicating these firms represent a large spectrum of success in their E&D programs. These data points are reduced to focus on the large independents (green triangles), integrated (blue squares), and multinational (red diamonds) E&D programs.

Fig. 1 is divided into quadrants at the $1.33 FDC/Mcfe weighted average during 2000 for these firms and 100% production replacement through E&D to evaluate these firms.

The stars, lower right quadrant, are replacing production at low FDC. They are increasing value, creating wealth for the individual investor, and finding and developing more reserves than they are producing. This group, comprised of 78% of the large independents, includes no integrated or multinational oil and gas firms.

The cash cows also have low FDC but have low production replacement percentages through exploration and development. This group is making good E&D investment choices but is consuming wealth and devaluing the firms' assets through consumption without 100% or higher production replacement. This group includes 22% of the large independents, 25% of the integrateds, and 50% of the multinationals.

The hot dogs are, perhaps, too aggressive and not controlling their FDC. They are replacing production but consuming too much investment to create wealth. This group includes only a small number of small to midsize independents.

Companies in the fourth quadrant are rapidly depleting (destroying) wealth and investment (DWIs). They have high FDC and low production replacement percentages. This group includes no large independents, 75% of the integrateds, and 50% of the multinational oil and gas firms.

These firms might benefit their investors most by selling their assets now rather than slowly depleting investor wealth and consuming individual and corporate investment through high FDC. Most of the larger firms in this category have been in the DWI category continuously for years and show little promise of changing.

They either need to become cash cows or stars or they will eventually destroy investor wealth. A review of the real stock prices (corrected for inflation) of these firms shows that this effect is occurring (half have stock prices that have grown at or below the rate of inflation for the 11 years ended Dec. 31, 2000; the average has grown at less than half the rate of the Dow Jones Industrial Average during this period).

Using this measure (Fig. 1), the large independents and a select group of small to midsize independents are best in replacing reserves and building individual investor wealth through exploration and development at low FDC. These firms have been able to utilize their organizational advantages.

These advantages are that they have the resources, expertise, applied technology, and flexibility to rapidly exploit trends in regions where they formally had to compete with the integrateds and multinationals. Since larger firms have left these niches, these new pioneering organizations are reaping the greatest benefit through continued exploration and development.

Rather than pursuing an exploration and development program to fully replace annual production, the average multinational could use the amount of investment needed to reach that level by purchasing half the successful large independents in this survey, and-or one integrated firm each year or one of the other multinationals every other year. This is obviously one of the methods used by these firms to "grow" their asset base, but as previously mentioned it has not added to individual investor wealth nor added to the domestic reserve base.

E&D effectiveness

Firms' replacement of annual production is evaluated in Figs. 2, 3, and 4.

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Fig. 2 is a comparison of US production replacement percent by company assets; Fig. 3 is a comparison of production replacement percent by dollars spent on exploration and extensions (worldwide); and Fig. 4 is a comparison of US production replacement percent by US production. Each shows similar trends of higher Production Replacement and effective use of E&D dollars by the independents.

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It is fair to point out that Fig. 2 does not accurately reflect a firm's effectiveness in replacing production through E&D. The integrateds and multinationals by definition have assets in refining, transportation, and marketing that the independents do not. It makes sense, then, that the larger companies production replacement percentages through E&D are lower based on total assets.

The same point cannot be made for Fig. 3. Here the markedly significant difference in production replacement percent between the independents of all sizes (131%) and integrateds and multinationals (44%) based on dollars spent on E&D are noteworthy. It is expected that production replacement by dollars spent on E&D should be a similar ratio among firms regardless of size.

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These data suggest that unlike Independents the larger firms are unlikely or unwilling to spend similar ratios on E&D relative to their total annual production. Both of these (production replacement and dollars spent in E&D) are uniform, upstream measurements and ratios for firms regardless of other assets owned. Fig. 4 shows an even wider disparity between independents (138%) and integrateds and multinationals (36%) US reserve replacement by US production.

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Fig. 5 has been used to more poignantly express this idea to geoscientists and provides a consistent measure for E&D among independents', integrateds', and multinationals' upstream segments. That is that geoscientists at independent oil and gas firms are two and a half to three times more effective and-or efficient than geoscientists at integrated and multinational firms as measured by E&D production replacement.

Based on membership data provided by AAPG, the small and midsize independents average more than 9 bcfe/AAPG member/year, the large independents average 11, the integrateds average three, and the multinationals average four. This presentation is intended to make a point to geoscientists and managers of project and corporate E&D portfolios and investors on productivity, effectiveness, and efficiency by firm type.

Although no additional data defining reasons for these disparities are part of this evaluation, differences in the exploration and development methods and organizational behaviors observed at these firms may be made that account for some of these differences.

Replacement, energy policy

The 20 small to midsize independents and nine large independents in this study replaced 5.4 tcfe domestically in 2000 and 8.7 tcfe worldwide. The five integrated and four multinational US-based firms replaced only 4.0 tcfe in the US and 12.3 tcfe worldwide.

In the US, the independents added more new reserves than the integrateds and multinationals combined. The majority of the US-based integrated and multinationals were included in this evaluation; the majority of the independents were not. The volumes added and differences in volumes added by various size firms is likely even greater than represented, especially domestically.

The role of the independent oil and gas producer should not be overlooked in the US. The independent has been the premier US oil and gas explorationist historically, and this study shows that these efficiencies continue today. With the integrateds and multinationals de-emphasizing and in most cases abandoning onshore Lower 48 US efforts, the importance of the independents to our domestic production replacement will become even more important. The significant role of the independents needs to be considered by the US government in its development of a national energy policy to assure reserves for future years.

There are important steps that could assist independents in their reserve replacement goals and materially assist the US with its domestic natural gas and crude oil production. First, the availability of domestic oil and natural gas depends on drilling a much larger number of wells than is currently being accomplished and-or considered by the industry. An energy policy should include changes that would encourage and facilitate independents and other oil and gas companies in developing needed domestic reserves.

Large capital commitments are a major factor in developing prospects and getting them drilled. These capital requirements are often larger than available within the industry. Independents' capability to respond and drill the number of wells needed and the ability to internally generate the additional capital required would be enhanced if all geological, geophysical, leasehold, and tangible (in addition to intangible as presently permitted) drilling costs could be expensed in the year incurred. These changes do not affect the amount of cost recovery that presently exists under the current system but only the timing and would assist independents in replacing reserves lost annually to production.

Secondly, increased supply would be facilitated by increased access to lands under which oil and gas resources are trapped. Large prospective areas of the Lower 48 states were available for energy development under multiple-use policies in the past.

Recent presidential and other executive directives prior to this year have hampered utilization of such areas and are limiting energy resource availability to consumers. Because many of these utilization limitations were done by executive order, some can be quickly reversed by the same processes and without Congressional delay.

The independent oil and gas producers have proven to be the premier firms in finding domestic oil and gas reserves most efficiently. Simple but effective steps in developing a US energy policy that aid this group in finding these resources such as cost recovery and access to large areas of land, presently off limits, are essential to meet our nation's energy resource requirements.

The author

Bill Fairhurst is exploration manager-chief geologist for Petro-Hunt LLC, a midsized independent exploration and production company based in Dallas. He joined Petro-Hunt in 1996 after 15 years with Marathon Oil Co., where he served as a geologist and manager in exploration, development, and acquisition and disposition groups. He received a BA degree in geology and management from Ohio Wesleyan University, an MS degree in geology from the University of Missouri-Columbia, and MBA degree concentrating in finance from the University of Houston.