During a period of volatile commodity prices, it's not too much of a reach to imagine a large integrated oil company outperforming the S&P 500 Index. After all, high downstream margins can more than offset poor upstream results during an oil-price trough. And conversely, in a $30 oil-price world, strong E&P results can more than compensate for squeezed refining and marketing margins. So it came as no surprise when Bob Gillon, vice president and oil and gas analyst for Stamford, Connecticut-based John S. Herold Inc., recently reported that in a study of 150 oil and gas companies over the 1995-99 period, BP Amoco outperformed the S&P 500. What was startling, however, was his finding that the only other surveyed oil companies to duplicate this feat over that period were two small-cap Denver producers-Evergreen Resources Inc. and Prima Energy Corp. Between year-end 1994 and year-end 1999, the shares of Nasdaq-listed Evergreen rose from $5.25 to $19.75, for a cumulative market return of 276%; the S&P 500, meanwhile, was up just under 200%. When this time line is extended through the end of May 2000, EVER's performance looks even more impressive. The company's stock, moving up to $28.13 per share by then, sported a cumulative 1995-2000 return of 436%; the corresponding-period gain for the S&P 500 still held at under 200%. No less remarkable has been the market performance of Prima Energy. In the 1995-99 period, Nasdaq-traded PENG shares rose from $5.11 to $16.04, for a cumulative return of 214%; looked at through the end of May, when the stock hit $42.75 per share, Prima's cumulative 1995-2000 return was an even more robust 737%. Taking a longer view of the stock, The Denver Business Journal last fall ranked Prima the top-performing Colorado company of the 1990s, citing a cumulative 1990-99 market return of 1,857%. (Adjusted for a February 2000 three-for-two stock split, that 10-year cumulative return is actually 1,765%.) How did this duo of Davids manage to outpace so many other oil-patch Goliaths? Niche focus is part of the story. But the bigger part is value creation-by paying attention to finding and development costs and rates of return on every well, funding growth internally, maintaining financial flexibility, controlling oilfield service and gathering needs, and exporting established expertise to other basins. "At the start of the 1990s, a lot of people in the industry felt that coalbed methane drilling-which involves the extraction of methane gas from shallow coals-was a very interesting concept, but one that probably didn't work too well outside the San Juan Basin," says Mark S. Sexton, president and chief executive officer of Evergreen Resources. "The consensus then seemed to be that once the tax credits for such drilling ran out, there wouldn't be much economic incentive to go after this very low-volume, marginal-type production. We, on the other hand, believed that there were technological applications associated with coalbed drilling that weren't being fully exploited by the industry." In line with this vision, Evergreen in 1991 pounced on the opportunity to acquire from Amoco 70,000 net acres of mostly contiguous coalbed methane acreage in the Raton Basin in southern Colorado. After that $350,000 buy, the company during the next three years built its coalbed methane lease position in the Raton Basin up to 130,000 net acres. Concurrently, it created two large federal units within its lease area. This had the beneficial effect of keeping the whole of Evergreen's acreage from expiring-whether federal, state or fee-so that orderly development of the leases could commence. In 1993, the company put its belief in the Raton play to the test by spudding its first four coalbed methane wells-right where it expected a pipeline to be built. The result? "Two of the four wells-drilled to the Vermejo zone below the Raton coal formation-came in the way we thought, the third was slow to produce, and the fourth was a barn-burner-with an initial flow rate of more than a million cubic feet of gas per day," says Sexton. After testing different well-completion techniques, the company drilled six wells the following year. By the start of 1995, nine of the 10 wells came online-collectively producing a meager 1.5 MMcf of gas per day. However, their output was right where Colorado Interstate Gas (CIG) had built a new pipeline. Today, Evergreen has 207,000 gross acres under lease in the Raton. It has drilled more than 250 coalbed methane wells that are collectively producing about 55 MMcf of gas per day. Along with this leapfrog in output, the company's financials have also exploded. Revenues have gone from $3.5 million in 1994 to $23 million last year, and they're projected to rise to $35 million this year. Cash flow from operations, meanwhile, has soared from breakeven to $13 million, with an outlook for $20 million-plus in 2000. And pretax income, negative in 1994, hit $8 million in 1999, and is expected to climb to $15 million this year. How good are the economics of the Raton wells? "The cost of drilling a Vermejo well is about $200,000, then you add another $150,000 for gathering to get the gas into the CIG system," says Sexton. "That gives us an all-in cost of $350,000 per well, each of which is recovering on average about 1.8 billion cubic feet gross of gas, or 1.6 Bcf net of royalty. In turn, that gives us an incredible finding and development cost of 20 to 25 cents per thousand cubic feet." With proved reserves of 559 Bcf at year-end 1999, Evergreen believes it has tapped only about one-third of the coalbed methane gas potential of its Raton Basin acreage. "That means, with another 800 high-graded drilling locations left, we're likely to develop close to 1.5 trillion cubic feet of gas-net to us," says Sexton. "Taking the long view, we expect to add about $5 per share of net asset value every year for the next five to eight years." To support that aim, the company has embarked on an aggressive $80-million capital spending program for 2000, $60 million of which is earmarked for drilling 100 Raton wells and adding more infrastructure there, including enhanced compression and larger and more extensive gathering lines. What about the rest of Evergreen's 2000 capex budget? "We're taking what we've learned in the Raton Basin and applying that expertise to several coalbed methane recovery concepts in the U.K., where we have more than 500,000 acres of onshore leases, not far from Liverpool," says Sexton. "What's going to help in this regard is that we have our own well service company. That allows us to experiment with a lot of different drilling and completion techniques, which is a big part of our competitive advantage." What will also help Evergreen is its clean balance sheet and increasing borrowing capacity. The company finished last year with only $15 million of debt on its balance sheet. Meanwhile, the Denver operator's lending group now includes not only its historical lead banker, Hibernia Bank in New Orleans, but also Bank Paribas, Wells Fargo, Bank One and Fleet Boston Bank. "Our credit capacity is growing at about 1.3 times what we're spending in the Raton Basin, and I think we'll wind up this year with $150 million as an available line of credit " says the Evergreen president. "However, I don't believe that represents our full credit capacity. That's just the amount we're asking." Concludes Sexton, "As the result of niche focus and attention to getting the most proven reserves and production for our dollar, we're halfway toward building a $1-billion company in net asset value-and I don't think it's a question of if we'll get there, but only when." John S. Herold's Gillon says that Evergreen and Prima Energy have some of the lowest operating costs among U.S. gas producers, as well as some of the lowest finding and development costs in the industry. "What this leads to for both companies are very high operating margins. So they consistently make money. "Too often, we measure this industry by cash flow-which is an important factor in terms of a producer's ability to replace reserves-but lose track of the fact that operators must be profitable," he says. "Evergreen has been profitable every year since it began concentrating on coalbed methane production in the Raton Basin, while Prima has made money every year from diverse operations around the Rockies. So both companies are constantly adding value, which has a great deal to do with why their shares have been better-than-average performers in the market." Karl E. Bandtel, senior vice president and portfolio manager for Wellington Management Co. in Boston, explains why Evergreen has such strong buyside appeal. "The key distinguishing characteristic of this producer versus the average E&P company is value creation. For every dollar it has spent, the company has created roughly $2 worth of value. The other thing we like about Evergreen is its focus on natural gas. Given the outlook for a strong gas market for at least the next several years, that focus adds even further to its value-creation capabilities." Echoing Gillon, Greg L. McMichael, vice president and senior energy analyst for A.G. Edwards & Sons in Denver, believes the main reason that Evergreen's stock has outperformed the S&P 500 in the past five years is because it is-or is very close to being-the lowest-cost producer in the U.S. upstream sector. The analyst estimates that the operator's 1995-99 finding and development costs were about 25 to 30 cents per Mcf, versus an industry average of more than $1 per Mcf. Also, he notes that in the same period, Evergreen's operating costs were 30- to 35 cents per Mcf compared with an industry average of about 60 to 70 cents. Recently, McMichael upgraded the stock to Buy. Why? "The company's production in the Raton Basin has resumed growing, after being flat during fourth-quarter 1999 and first-quarter 2000. In fact, we see production rising about 24% this year, to 17 Bcf, and another 27% in 2001, to 21.5 Bcf." The analyst also upgraded the stock because of recent encouraging results in the U.K., where Evergreen has drilled the first of 12 onshore coalbed methane gas wells planned for 2000. "The first well encountered about 75 feet of gas-saturated coal. That pay is more than twice as thick as the coalbed formations in the Raton Basin." His 12-month price target for EVER is $32 per share. Listen to Richard H. Lewis, chairman and chief executive officer of Prima Energy, and hear a grass-roots growth story with plenty of attention to three things: costs, margins and value creation. "I started this company in 1980 in the basement of my Denver home and funded it with $25,000 and $350,000 of private equity, raised primarily from friends and family," he says. "Later that same year, we took Prima public in the Denver penny-stock market, where we were one of probably 200 startup oil and gas companies trying to raise anywhere from $1- to $5 million. For our part, we raised $3 million." From that startup, Lewis, a certified public accountant, pursued a simple strategy. "We focused heavily on areas of the Patch that weren't capital intensive-where we thought we could attain a competitive niche by watching our costs and securing leases that could be developed on an economically attractive basis." With an emphasis on development and exploitation drilling-which seemed to have the best risk-reward ratios-Prima and three other independents partnered 50-50 with Amoco in 1981 to develop the shallow gas assets in the Bonny Field in Colorado's Denver-Julesburg Basin. The company put about one-third of its IPO proceeds into drilling up that field and borrowed another $5 million to develop the gas gathering system for it. Some 18 years later, after Bonny had produced about 20 Bcf, Prima sold its interest in the field and its gathering system for $26 million. Before that, however, Prima acquired in 1988 Denver's Golden Buckeye Petroleum Corp. for about $1 million, and took over operation of about 130 wells in the Wattenberg Field in the D-J Basin. During the next several years, the company made a number of other acquisitions in that field, the most significant being a farm-out from Union Pacific Resources. "Since then, we've drilled 300 more Wattenberg wells and refractured another 150 old wells," says Lewis. "This, together with our drilling in the Bonny Field, accounted for most of Prima's growth in production, reserves, cash flow and earnings during the 1990s-all funded from internally generated cash flows." Growth, indeed. Between 1989 and 1999, Prima's net income rose from $580,000 to more than $9 million while earnings per share climbed from seven cents to $1.03. In the same time, cash flow per share soared from 15 cents to $1.98; daily production, from 282 equivalent barrels of oil to more than 4,000 BOE; and the discounted present value of reserves, from $8 million to $108 million. Also, through stock buybacks, Prima reduced its common shares outstanding from 9.3 million to 8.6 million. "The vision that has driven this company during the past decade is value creation for the shareholder," says Lewis. "We've tried to achieve this by being the lowest-cost producer with the highest cash-flow margins per unit of production." He notes that during the 1989-99 period, Prima generated on average more than $10 of cash flow per equivalent barrel of production while finding costs averaged less than $3 per BOE. "This meant we were able to fund growth internally by reinvesting cash flow at a ratio greater than three-to-one over our finding and development costs. Put another way, for every $1 we spent to find and develop reserves during the past decade, we added another $2-plus of free cash flow to go out and drill for more reserves." The average return on equity for investors over this time was 21.3%. What does Prima do for an encore? The company has now accumulated a 138,000-net-acre leasehold in the hot, rapidly developing coalbed methane play in Wyoming's Powder River Basin. "We've identified more than 2,000 potential drill sites that look prospective, and we intend to drill 200 wells there this year," says Lewis. "These are wells that cost on average $60,000 to $70,000 each to drill, with average reserves per well of 300- to 350 MMcf of gas and finding and development costs of 20 to 25 cents per Mcf. So the economics are outstanding." To further improve the economics of its drilling in the Rockies-which may also include activity in Wyoming's Green River, Wind River and Big Horn basins-Prima has two oilfield service subsidiaries. Action Oilfield Services has been active in the D-J Basin for 13 years, and Action Energy Services in Gillette, Wyoming, provides drilling and oilfield services support in the Powder River Basin. "You're in a better position to control the cost, timing and quality of work performed on your wells when you own and operate the well-servicing equipment." Seeking to capture as much value as possible from the wellhead to the burner tip, Prima has yet another subsidiary-Prima Natural Gas Marketing-which is active in buying and selling gas not only for Prima, but for other operators. With the same value-chain strategy in mind, the company also plans to build its own gas gathering and compression facilities in the Powder River Basin. Between its existing working capital, $20 million of cash in the bank, no debt, and unused bank lines, Prima is in a position to pursue further opportunities, including an acquisition in the range of $50- to $80 million. "But it's got to make good economic sense," says the CPA. Clearly, the private equity investors that backed Lewis in 1980 have got to feel that their investment has made terrific economic sense. Observes Lewis, "If you had invested $25,000 in that private placement and held the stock through today, it would be worth a little over $2.5 million." Wellington's Bandtel says that Prima, like Evergreen, is a producer that has consistently created value. "That was demonstrated during this past decade by the increase in its PV-10 value, which was significantly greater than the amount of dollars Prima spent in that time," he says. "It's also reflected in Prima's 30% annual growth rate in earnings and cash flow during the 1990s. At the same time, proved reserves per share increased at an annual rate of 20%. All this is the result of attention to costs, as well as selling assets at the right time and getting into new plays at the right time." Bandtel notes that while Prima's proved reserves in the Powder River Basin may be only 54 Bcf currently, its probable and possible reserves exceed 450 Bcf. "So there's significant growth ahead for this company." John Myers, managing director and E&P analyst in Austin for Dain Rauscher Wessels, says Prima's success is largely attributable to management's conservative approach. It takes on low-risk, high-return investments, such as development drilling in the Wattenberg Field, and makes smart acquisitions, in terms of not overpaying or financing them with high-yield debt. "We're very positive on the stock for three reasons," says Myers. "First, it has a terrific management team; second, we're very optimistic about natural gas prices for the next 18 months; third, we like the growth potential of this stock. "At a time when most producers in the industry are having a tough time replacing their reserves and finding much growing room, Prima has a lot of potential growth coming not only from its existing assets in the Wattenberg Field, but also from its Powder River Basin properties-both conventional and coalbed methane. We think this company could see a tripling or quadrupling of its production within the next several years."