Analysts see 'major shift' in investor evaluations of oil firms

For the first time in history, the stock performance of exploration and production companies hasn�t improved with a rise in oil prices, perhaps signaling a major change in investors� evaluations of those firms, said officials of Simmons & Co. International, a boutique industry investment firm in Houston.

For the first time in history, the stock performance of exploration and production companies hasn�t improved with a rise in oil prices, perhaps signaling a major change in investors� evaluations of those firms, said officials of Simmons & Co. International, a boutique industry investment firm in Houston.

Investors apparently are starting to judge oil and gas companies like other industries�by their rates of return on capital invested�rather than by producers� cash flows, as in the past, said W. Mark Meyer, the new vice-president of E&P research at Simmons & Co.

�Capital efficiency is the buzzword now,� he said. �More than ever, the E&P business is about effective management of operations and spending. Those companies that best execute [that management role] will win in this environment.�

Simmons & Co.�s recently released study of the market forces affecting primarily independent exploration and production companies marks an expansion of its previously exclusive concentration on the oilfield service sector. But it�s a natural outgrowth, because, after decades of studying the primary influences on the oil field service industry, �We know more about the independents than anyone else,� said Matthew R. Simmons, president and founder of the firm.

Previously, an independent�s cash flow was equated with market value, and volume growth in production and reserves was enough for most investors, who rarely bothered to look at a producer�s return on investment capital employed, Meyer said. Rising wellhead prices historically lifted the equity value of all publicly traded upstream companies�the poor performers along with the good.

But as prices for West Texas Intermediate crude soared 41% from the third quarter of 1999, stock values for E&P companies inched up a mere 4%, said Meyer. He sees that as investors� emerging emphasis on capital efficiency in the face of recent lackluster returns by upstream energy companies.

�By buying back their stock during the downturn, the majors taught the market to focus on the return on capital employed [ROCE],� Meyer said. �The ROCE track record among many independents hasn�t been a pretty picture.�

During 1993-98, he said, total E&P capital spending increased at an annual rate of 22%. Yet annual production volumes grew only 8% in that same period.

Judged by that standard, oil company stocks may not be undervalued as most management�s claim, said Meyer. �Investors don�t want to buy stocks whose value is being destroyed,� he said.

New value measures
Meyer claims many of the financial yardsticks previously used to determine the value of upstream companies have outlived their usefulness and must be replaced by new measures of corporate capital costs. Simmons & Co. is trying to find a new yardstick that will give both investors and corporate management a more transparent indication of a producer�s real worth.

Exploration and production require significant capital expenditures, with producers usually putting more money back into the ground through drilling and other programs than the profits they produce. Yet, Meyer said, �None of the producers, including majors, have synchronized their spending with fluctuations in cash flow.�

The resulting fluctuation in drilling activity also triggers wide swings in service and supply costs. But most producers can�t afford to take a contrarian approach of concentrating spending programs during downturns when field expenses and cash flow are low��especially independents,� said David A. Pursell, veteran vice-president of upstream research at Simmons & Co.

�It�s not just about taking costs out of the business. It�s about improving overall performance for the best financial returns,� Meyer said. That also means investors must sort through a deeper set of company-specific performance issues to pick the most promising companies, he said.

Simmons & Co. officials are focusing on full-cycle economics as the best means of providing fundamental valuation for independent E&P companies, through their Economic Value-Added (EVA) concept that incorporates important financial drivers and eliminates accounting distortions. They acknowledge that the approach is limited, because all necessary data are not available publicly and reserve values are difficult to forecast for short-term investments. Yet those companies that outperform their peers on earnings should generate the best returns on capital in the long run, says Meyer.

Pursell says maybe a third of the publicly traded independents now evidence concern about their capital effectiveness. Development of such corporate awareness must come from the top down, he said.

Simmons officials figure it will take 6 months to 2 years for other company managers to �get� the new message that investors are sending. Some of the first signs of changes should appear in their 2000 annual reports, said Pursell. �The majors were talking about it before it showed up in their returns and stock performance,� he explained.

Meanwhile, Pursell said, �Some companies will fade away, some will be bought up, and some will decide strategically to get smaller, not bigger.� He cited Texaco Inc. as one producer that �is trying to get better, not bigger.�

But even companies that were the first to �get it� have taken their lumps in the market. When Burlington Resources correctly scaled back its operations, its stock �took a big hit� in the changing market, Pursell said.

Through its international operations, Triton Energy Ltd. in Dallas has positioned itself for a potential discovery of �company-maker� proportions, say Simmons officials, referring to Triton's Ceiba discovery of Equatorial Guinea. Yet in the past, that company has seen its stock suffer when an otherwise good discovery didn�t live up to Wall Street�s unrealistic expectations.

Vastar Resources Inc. is another independent that Simmons officials say has wisely concentrated its operations to be a top performer in the new market. But BP Amoco PLC plans to buy out Vastar�s public investors now that it has taken over ARCO, which controlled 81.9% of Vastar�s stock. �So one of the best-in-class independents gets taken out,� Meyer acknowledged.

�This is a transition period for investors as well as companies,� Pursell said. Nonetheless, he said, �External factors convince me that the market is not going to give up on returns.�

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