There has been a sea change in the approach of oil and gas presenters at energy conferences this year, and investor audiences like the mantra they're hearing: financial discipline and not just growth, but profitable growth. Buysiders believe strong North American natural gas fundamentals and pricing over the long term are going to translate into highly visible reserves, production, cash flow and shareholder returns for those operators whose every move is tied to bottom-line improvement. Investors also appear pleased that oil and gas companies have finally decided to eschew their mind-numbing geological maps, seismic surveys and logs, in favor of charts that illustrate not only their reserve and production profiles going forward, but also how they're going to get the capital they plan to spend, how prudently they're going to invest it, their balance-sheet strength, and their attention to increasing shareholder value. To find out more about what investors are thinking-and looking for-as they listen to energy presentations, Oil and Gas Investor chatted with two leading buysiders: Nikolaos (Nikos) Monoyios, vice president and portfolio manager for OppenheimerFunds Inc. in New York, and G. Bryan Dutt, managing partner of Ironman Energy Capital LP in Bellaire, Texas. OppenheimerFunds Inc. manages more than $130 billion of assets-with the energy weighting of the firm's overall $60-billion equity portfolio just north of 5%. The three Main Street mutual funds that Monoyios comanages have an aggregate $17 billion worth of equity investments. The largest of those funds, the $14-billion Main Street Growth and Income Fund, carries an above-average 8% market weighting in energy versus 6.9% for the S&P 500. Ironman Energy Capital is an energy-only, $50-million hedge fund whose aim is "to trade nimbly in and out of equity positions, predominantly in the oil and gas sector," according to Dutt. "We also invest in alternative energy companies, independent power producers, coal companies-anything that's energy, since it's all inter-related." Dutt was formerly an E&P analyst with the New Orleans investment banking firm, Howard Weil, and a partner at Centennial Energy Partners, a New York buyside firm. Investor Nikos, what sentiments have you heard expressed at oil and gas presentations this year? Monoyios Everybody is surprised by how strong commodity prices are, in particular natural gas prices. The industry and investors alike have been so focused on storage numbers that they all expected significant weakness in gas prices this year. Well, that hasn't happened. What may have been overlooked is that gas supply has started to decline and industrial demand might pick up as the economy improves. Dutt On the service side, the consensus is the worst is over; companies are anticipating recovery in the third and fourth quarters, followed by a very strong 2003 and 2004. As for the E&P companies, they're cautious-even skeptical-about the sustainability of strong commodity prices. Most are anticipating modest price declines in the short term. Longer term, however, virtually everyone is bullish on natural gas, and they all have the same mantra: production declines are greater than they've ever been and they'll continue to accelerate, and we don't have the gas rig count to replenish reserves. Investor Your own outlook? Dutt We're looking for an average $3.50 gas price for the year. As for crude, there's too much of a war premium built into prices right now. We see an easing back to an average $22 to $23 for the year. Investor Nikos? Monoyios There seems to be a new, higher $3-to-$5 price plateau for gas-despite the recent negatives of a record warm winter, a mild recession, and a lot of drilling during the past couple of years. We expect that trend to continue. Hopefully, gas prices won't rise higher than $5, because that would only tend to kill demand. In short, look for future gas prices to be much better than they've been in the past. Investor The rationale? Monoyios One, gas is getting a lot harder to find, and two, new gas wells generally have much steeper decline curves than wells in the past. So you have to run faster just to stay in place. Meanwhile, on the demand side, there's a 2% to 3% annual growth in U.S. gas consumption. Investor Bryan, what sectors of the oil and gas industry do you currently like? Dutt We're mainly in U.S. oilfield-service companies, excluding drillers for the most part. Our holdings include Tetra Technologies and Tidewater. We're also very positive on natural gas producers. Investor Elaborate on your service holdings. Dutt Tetra Technologies is engaged in well abandonment, a rapidly growing business; production chemicals; and the testing of wells. The company is a market leader in all three areas. In the case of Tidewater, it's the market leader in the supply-boat business, and it's poised to outperform consensus estimates. Also, the company has a tremendous balance sheet-it's essentially debt-free-and is going to have huge free cash flow during the next several years. Investor Why the aversion to drillers? Dutt Their stocks are expensive on a P/E and cash flow basis, and on virtually any other valuation measure you use, except for replacement costs. There's one U.S. driller we currently own-Patterson-UTI. It has been on a buying frenzy lately, acquiring competitors at attractive prices. I think Wall Street's going to be shocked at the earnings leverage this company now has to improving dayrates, particularly as the gas rig count escalates significantly. It wouldn't be hard to imagine a $100 share price for this stock, which has been trading around $28. Investor Which E&P companies do you find most attractive? Dutt Ultra Petroleum, which has a large acreage position in the Pinedale Anticline in Wyoming. With a greater than 95% drilling success rate there, the company has had exponential growth in gas reserves during the past three years, and should continue to grow reserves dramatically. We also like St. Mary Land & Exploration because the stock is trading cheaply, on the basis of discount to net asset value and cash flow multiples. The company just raised some money, and we believe it's going to make an acquisition, which might give it more focus and better multiples. Investor What about Canadian oil and gas stocks? Dutt Right now, these stocks have a huge buyout premium built into them. So, for once, the difference in trading multiples between U.S. and Canadian oil and gas stocks is so insignificant that I prefer to stay with U.S. stocks. We do, however, own a lot of shares of Precision Drilling, the largest driller in Canada. Hank Swartout, its chairman and president, started out with two rigs and has built Precision into the dominant service company in that country. While it's currently suffering from low utilization rates, the drilling industry there will turn, and the company will continue to grow. In addition, it has been investing around US$50 million or more a year to develop a new downhole-tools division, to compete against the likes of Smith International, Halliburton and Baker Hughes. Investor Nikos, what sectors within energy do you like? Monoyios In our $14-billion, large-cap Main Street Growth and Income Fund, the firm's largest equity fund, about $1.25 billion, or 8% of that fund, is weighted to energy-half of that in ExxonMobil, Royal Dutch and ChevronTexaco. These integrateds are very high-quality companies, which is what we've been emphasizing during the past six months because of all of the concerns about quality of earnings and accounting that have surfaced in the market. These companies are beyond reproach, have strong balance sheets and good returns on capital employed-17% in the case of ExxonMobil. Investor What about the other half of the fund's $1.25 billion of energy investments? Monoyios It's primarily in E&P companies and refiners; we currently have very little exposure to the oil-service sector. Investor Which E&P stocks are particularly compelling? Monoyios We still like the Canadian upstream companies. The two largest remaining in our portfolios after last year's mergers are Talisman Energy and Canadian Natural Resources. We also hold several small-cap stocks with very good gas exposure, such as Paramount Resources, Compton Resources and Meota Resources, which is run by the team that managed Poco Petroleums. All three small caps have substantial gas exposure, are rapidly growing their reserves and production, and have high-impact exploration plays, especially Meota and Paramount. Another thing we like about Paramount is that management owns around 50% of the stock and is very conscious of shareholder dilution. Also, it's very forward thinking. It will make investments in frontier areas before pipelines are put in place, the land becomes expensive, and everybody wants to compete in the region. Investor What about your U.S. upstream holdings? Monoyios Our largest holding in the U.S. E&P area is Murphy Oil. It has a very high-quality asset base and a lot of growth potential from high-impact exploration plays in several areas: the deepwater Gulf of Mexico, Canada, Malaysia and Ecuador. In addition, the Murphy family owns about 45% of the stock and is very conscious of shareholder value and dilution. Investor What about smaller-cap U.S. producers? Monoyios We like some of the Rocky Mountain-area producers like Tom Brown and Western Gas Resources. They operate in fields where there's a lot of gas, and where advances in drilling and completion technology have released a lot of value. We also like Quicksilver Resources. It's closely held, has a good gas position in Michigan, and has coalseam-gas expertise. Its two pilot coalseam-gas projects in Canada could have a very substantial effect on production and reserves. Investor Bryan, as you listen to presentations, are you hearing anything different in approach this year versus prior years? Dutt E&P companies in general today are putting more of an emphasis on financial discipline, stressing returns, especially return on capital employed. Also, in the wake of Enron, we're hearing companies talk quite a bit about the quality of their earnings and their accounting-in terms of transparency. They want to get across to investors that their earnings aren't made up-that they're not the result of accounting slight-of-hand. Investor So they're not emphasizing geological maps as much this year. Dutt That's right. Historically, E&P companies have been run by wildcatters, mainly geologists. Typically, they fall in love with prospects, and want to bombard investors with maps and logs. The problem is, 99% of the investors don't have the technical ability to decipher whether or not they're being told the truth. So that was really a waste of time. Investor What's the best oil and gas presentation you've heard this year? Dutt Rowan Cos. made one of the best at the Howard Weil conference. It pointed out that drilling contractors aren't achieving adequate rates of return on the massive amount of equipment they're putting into the field, and that they're going to need higher dayrates to realize returns that justify their invested capital. Investor What's the worst presentation you've heard this year? Dutt It was at the same conference. The company is experiencing some turmoil, and investors are concerned with some major litigation against it. But rather than address those issues, the company's presentation at the conference focused on some new-age, pyscho-babble, business model that made little or no sense to many in the audience. Investor Nikos, any new approach you're hearing this year by presenters? Monoyios A few years ago, companies were just fixated on growth, without considering whether it was profitable growth. Now we're hearing a lot more about return on capital employed. The other thing companies are talking more about is per-share growth. Charts now show not only growth in reserves and production, but also growth in these areas on a per-share basis. Managements appear, on the whole, to be focused more on creating value for the shareholder. Investor Which presentation impressed you most this year? Monoyios Murphy Oil made an excellent one at Howard Weil. So did El Paso Energy, talking not only about their assets-which are very well positioned-but also their opportunities, which differentiated them from the rest of the high-flying energy traders. Among the E&P companies, Devon Energy, Apache Corp. and EOG Resources successfully showed how they're focused on building value per share. Investor The worst presentation you've heard? Monoyios Those of E&P companies that talked only about growth targets, but not about returns, profitability or how they're going to finance that growth. They alarmed me. Any company can grow if it doesn't care about how many shares it issues or how much debt it acquires. Investor Bryan, what's the mood of the buyside today? Dutt For the first time in years, we're seeing more longer-term money coming into the sector versus quick-money hedge funds. People are now buying not just for the next three months, but for the next six months or the next six years. Investor But isn't your own company a hedge fund? Dutt Yes, but we're a predominantly long hedge fund. We generally don't trade in and out of stocks a lot. Usually, we stay with investments anywhere from six months to three years. Investor Nikos, your take on the current mood of the buyside? Monoyios Veterans who have been investing in the oil and gas business for many years are happy, but not irrationally exuberant. At the same time, we're seeing a lot of investors with relatively little experience in the oil and gas business, interested in learning more about it. They realize this is a sector that has real companies with real assets, real cash flows, real production, and real growth opportunities.