PORTFOLIO MANAGEMENT STRATEGY OFFERED FOR PRODUCING PROPERTIES

Oct. 7, 1991
David A.B. Brown The Windsor Group Inc. Boston Domestic independents are too often the forgotten participants of the U.S. exploration and production industry. As a group, they are diverse in character and culture and differ greatly from the more visible integrated domestic and international producers. Independents are frequently companies of scale, with the 30 largest accounting for $7.5 billion in annual revenues. They often lack the more formalized financial, planning, and control systems
David A.B. Brown
The Windsor Group Inc.
Boston

Domestic independents are too often the forgotten participants of the U.S. exploration and production industry. As a group, they are diverse in character and culture and differ greatly from the more visible integrated domestic and international producers. Independents are frequently companies of scale, with the 30 largest accounting for $7.5 billion in annual revenues. They often lack the more formalized financial, planning, and control systems common to large integrated operators or other industrial companies of comparable size.

Not surprisingly, all oil and gas companies, particularly independent operators, have a strong sense of industry. They frequently behave in ways that suggest they consider themselves as coproviders as opposed to competitors. The desire to gain share by outperforming their in-kind brethren generally is not a driving force of management in independent operators. In fact, what truly distinguishes many independents is that their strategy is a reflection of the owner's desire for scale, earnings, or lifestyle.

This article proposes a framework to analyze the independent's performance in a competitive environment. We believe that different strategic positions in an industry offer different profit potentials.

We will examine some traditional industry methods of evaluating an operator's performance, including revenue, growth, market share, and reserve additions. Oil and gas production, however, is a different business-these performance measures do not correlate with financial returns. This is a commodity business, and the low cost producer in a field or region has a competitive advantage.

We believe that the nature of competition in the E&P business is in asset management. Independents should approach the management of producing reserves as that of a portfolio of separate businesses. Existing assets should be scrutinized on their cash generation ability as well as their returns. New investments should be screened for their incremental return together with their cash needs.

Competition among independents is ultimately defined by their relative financial performance against each other within a given field or reservoir. Different fields require different production techniques, investments, and technologies and different approaches to combine activities of scale. The most efficient producer will generate the best returns.

REVENUE GROWTH

Fig. 1 illustrates the revenue growth rates and relative market share positions of select, public U.S. independent operators.

The independents shown may not be true in-kind competitors due to different geographic orientation, oil/gas reserve mix, historic production strategies, size of company, etc. However, this chart does serve as a calibration of competitive momentum.

We have segmented the independents into three categories:

  • Large independents have minimum revenues of $200 million/year.

  • "Corporate" independents were originally divisions or subsidiaries of larger companies.

  • Medium independents are operators with revenues ranging from $20 million/year to $200 million/year.

Left off this chart are small E&P companies as well as master limited partnerships. Company statistics were revised to reflect current operating companies. The revenues shown are adjusted for acquisitions and divestitures.

The large independents' combined revenues have held constant since 1986. More interesting is the segmentation of growth into two categories. Some large, mature market leaders are losing share while others, such as Oryx, have made aggressive expansions.

Four companies in this group have experienced revenue decreases of approximately 5%/year, while three firms have breakaway growth rates.

The corporate independents have the largest revenues and drive the overall growth rate. Unlike the large independents, they have more stability in their performance. However, individually none has demonstrated the aggressive growth present in the large or medium independents.

The medium independents have recorded 5%/year revenue growth since 1986, twice the industry norm. Also note the extreme distribution of growth rates. Several of these producers exceeded the best performers within either of the other two groups. Medium independents also turned in some of the worst performances.

It is not unusual that the smallest participants within an industry frequently outperform the pack in absolute growth. This is why market leaders sometimes adopt strategies which try to arrest the dilution of their share position.

The real task before this smallest group of producers is to sustain their revenue growth rate as they become larger. The chart suggests that producers may face a different set of competitive dynamics as they approach $500 million in size.

RESERVE ADDITIONS

The traditional measures of success within the energy industry have been based upon reserve additions. We believe this historic fixation on reserve additions as a yardstick of future success may present an incomplete story without a comparison to the total capital required and the net effect the additions have on operating costs.

However, companies continue to claim bragging rights by:

  • Replacing more reserves than their annual production,

  • Replacing reserves at a lower cost than their historical rates, or

  • Replacing reserves at a lower cost than industry averages.

We have charted each company's relative performance in reserve additions in Fig. 2. The additions shown here include those that have been purchased.

When gas is converted at dollar parity, the industry average growth rate of reserves expressed in barrels of oil equivalent (BOE) was 3.5%/year, or 40% higher than the growth in company revenues.

Since each company's circle represents an agglomeration of assets, the question arises as to why companies are net adding or shrinking proven reserves. And, why are some companies (e.g., Cabot) aggressively adding gas reserves in times of declining sales?

The large traditional independents are dominated by gas, with the exception of Mitchell Energy. There is an interesting phenomenon in this group. The three producers with breakaway sales growth-Anadarko, Apache, and Noble-have the only above average segment growth rates in oil reserves.

The corporate independents generally hold the largest relative reserve positions in both oil and gas. Several of these companies have very large reserve bases and have been adding to them at above average rates since 1986. Most notable was Oryx's North Sea acquisition in 1990.

Some companies may have built their reserve bases disproportionately on gas rather than oil for extenuating reasons. Enron, for example, pursued tight gas because of the available tax credits.

Medium-sized independents show a surprising aggressiveness in their reserve additions, particularly in oil. Unlike the other groups, gas and oil reserves are about equal. It is puzzling to see such dramatic success within such a nonhomogeneous group of companies. The risk and failure rate is clearly higher in this group.

Part of the extreme growth is due to new company formations, or due to additions to low base reserves. However, perhaps even improved seismic has not completely taken away all the elements of the wildcatter's luck.

FINANCIAL PERFORMANCE

Financial returns are the reflection of an operator's management judgment and execution skills. Fig. 3 compares three key ratios for each of the three groups of independents: net after tax (NAT), return on assets (ROA), and return on equity (ROE).

There are obvious differences in asset mix, asset quality, and business strategy. Some companies are capitalizing on market needs, while others are forced to play the hand they have been dealt.

However, there is a dramatic variance in the average returns produced by the three groups. The returns experienced by medium independents are much more volatile relative to the other two groups. The large independents' performance is virtually the same as the performance turned in by the corporate independents despite the latters' significantly greater average revenue.

Of more importance, there is little correlation between financial returns and the preceding performance measurements. This may be evident as the individual data points were not labeled for reasons of simplicity. For example, Union Texas has below average revenue growth and the best returns of its segment. In contrast, Maxus, which has about the same size reserves as Union Texas and which also has comparable below average revenue growth, has the lowest returns of its segment.

Superficially, neither revenue growth, market share, nor reserve additions is driving financial performance. This begs the "chicken-or-the-egg" paradox:

  • Do choice assets produce competitive advantage and excess financial returns, or

  • Do financial returns provide the vehicle for companies to grow and build perceived competitive advantage through increased revenues and reserves?

PORTFOLIO APPROACH

Superior financial performance without commensurate growth in reserves or increased spending efficiency may appear inconsistent. Over the long run it is an orderly liquidation of the business. However, for a short time (a year) it reflects the competitive position and management talent of an operator in assembling and producing an asset portfolio.

A rigorous approach to portfolio management compares property performance relative to both competitors and other properties held by the operator. The asset portfolio provides the key to improving financial performance through prudent management of the properties.

Internally, an operator needs to examine the returns provided by producing assets. Cash needs can then be balanced for optimum returns within the constraint of self-funded growth.

Externally, competitive advantage is ultimately based on an operator's ability to produce at lowest cost within a given field. Given commodity pricing constraints, a company needs to have a low cost position in a field in order to generate returns in excess of its cost of capital and to exploit the asset potential. Higher market valuations will follow as higher returns attract a higher market premium.

ASSET UTILIZATION

An effective method of arraying and managing these assets begins with the ROA-isobar graph for the fictitious Brazos Holdings shown in Fig. 4.

Simply put, there are two classic ways to drive a return-by increasing the margin or by utilizing the asset better. The ROA-isobar chart plots both parameters on logarithmic scale. Connecting appropriate points on each axis yields a diagonal line along which a constant return on assets occurs. Therefore, a firm could produce a 20% return on assets by selling product with a 1 0% net margin and having revenue of twice its asset level or by selling at a 4% net margin and turning its asset base five times during the year,

Clearly, these two examples would be in two different businesses. However, different producing fields may also look like two different businesses because of different profitabilities due to reservoir structure, lift cost, hydrocarbon mix, technologies employed, regulatory restraints, etc., while asset turns are often driven by production decisions, market pricing, and state limitations.

It is important to note that due to operating skills and efficiencies, what is a profitable field for one operator may be only marginal for another. And an ROA analysis alone is not indicative of a field's cash needs or its cash generation ability.

CASH BALANCING

The cash use/cash generation chart shown in Fig. 5 is a companion graph to the previous one. It arrays the portfolio of producing fields by plotting their cash ratio against expected revenue growth.

The concept of cash use/cash generation is a simple one: How much cash does an asset consume in order to return $1 of cash? For example, a cash ratio of 0.2 implies that, over a given time, a field uses 200 to generate $1 of cash. The ratio is calculated from standard components of cash flow:

  • Operating cash flow is usually a source.

  • Changes in net working capital can be sources or uses.

  • Capital expenditures are uses.

The cash uses for a property are summed and divided by the sum of the cash generated to calculate the cash ratio. Within the constraint of self-funded growth, sources of cash from financing activities would not be considered-the graph is an internal, managerial tool.

The cash use/cash generation concept can be both backward looking and forward looking. First, it can be used as a post audit of asset performance by comparing the recent history of growth and cash dynamics to identify which assets funded the firm and effectively isolate its underpinnings of value. It will also show where cash has been consumed either as an investment or as a leak of value.

When used as a forward looking tool, the chart displays revenue growth vs. forecast cash need. Usually above average growth, such as new fields coming on, will have above average cash needs. Since available cash is a limited resource, the graph forces consideration of investment priority.

Portfolio theory advocates focusing funds on one or two investments with high likelihood of success. Spreading funds evenly across all businesses tends to limit the potential of high fliers and over-fund marginal opportunities.

In this example, outliers such as the Overthrust can be evaluated for strategic purposes. Should investment continue where potential revenue growth is low and expected cash needs are high? Likewise, the Appalachia property offers excellent growth, but appears to be cash starved. Should investment be accelerated based on the strong cash throw-off from the Permian basin and other properties?

SUMMARY

Independent operators can use the graphs together, as shown in Fig. 6, to begin managing their producing properties as a portfolio. The net income axis of the ROA-isobar is an indicator of competitive position in a field. Crudely stated, there must be some advantage present if a commodity can be produced in one field with a higher margin by one producer than others. The asset turns axis will likewise show to what degree the potential is being exploited.

When combined with the cash use/cash generation chart, cash position can be weighed against the more conventional return measures. It is possible to have low return fields serve as stable cash generators. Within the constraint of self-funding,

operators can examine whether to keep stable fields or sell the assets to invest in higher risk, larger potential properties.

In short, the cash ratio chart can encompass the operator's risk profile. For example, in Fig. 6 could more investment in Appalachia produce higher growth-if revenue growth is the operator's objective?

The classic portfolio approach would suggest finding winning properties, investing in them, and likewise backing away from marginal producers. We would suggest that desired properties initially appear as high growth cash users. The object is to manage them into larger stable cash generators to fund future projects.

A close watch needs to be kept on timing and investments. New growth properties which always seem to use funds can turn into sink-holes. Likewise, without proper maintenance, stable generators can become marginal producers and command only a fraction of their prior value.

The key component that this approach does not consider is time. Once the concepts are understood, historical averages and discounted cash flows can be used in the analysis for accuracy. The cash use/cash generation chart can be prepared using best available estimates for present values of operating income; depletion, depreciation, and amortization; capital expenditures; etc. The value creation opportunities of the firm can be quickly identified, as well as cash traps.

By the same token, substituting cash flow for net income on the ROA-isobar yields a cash ROA analysis which may be even more revealing when examined for a period of several years.

Every business has a distribution of success rates due to varying competitive advantage. This brief overview of independent operators does not attempt to explain why certain groups, or even specific competitors, have over-or underperformed their peers.

It establishes a framework for analyzing key success factors and suggests an approach for establishing competitive advantage.

Competitive analysis is required to manage an asset portfolio and increase overall returns.

Success is driven by the prioritization of cash investment opportunities based on incremental returns and long-term focus. Size of play, reservoir structure, and production technologies employed all contribute to competitive positioning.

Participants in other industries have successfully used these portfolio techniques in their search for competitive advantages and above-industry returns. Current and future cost positions within an independent's collection of producing fields may go a long way in explaining why some producers do better than others.

The challenge is to identify and exploit each competitive advantage.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.