E&P and related companies outperformed the Dow in 2002, according to John S. Herold Inc.'s annual year-end assessment. All 15 industry subgroups beat the broad market-a first time in the seven years Herold analysts have conducted the review. "However, with the giant oils shedding more than $100 billion in value, the victory seems a bit hollow," the analysts add in the report. The average 2002 return by the 304 publicly traded oil-industry companies reviewed was 4.0%. "One might have expected better in light of the strong commodity prices for the year, but any gain is hard to come by when capital is fleeing the equity markets," write Nicholas D. Cacchione, Robert E. Gillon and Mark Caruso. The best performer was Canada-based up-start Cequel Energy (up 358% from year-end 2001). It was recapitalized in January 2002 by the founders (and sellers) of Cypress Energy and is off to a roaring start, Cacchione et al. write. Harvest Natural Resources finished second (up 348%). "Meanwhile, a record nine stocks managed to cost investors 90% of their money-a remarkable dubious achievement, particularly in a year of rising prices." Non-U.S.-based producers did well a second year while U.S.-based independents lagged: only the largest producers achieved gains. "The gap between actual performance and what might have been expected could be a caution flag, implying the group could be vulnerable if commodity prices head south." Meanwhile, royalty trusts-U.S., Canadian and Australian-had double-digit gains a fourth consecutive year. "There is a lesson here that is being lost on corporate managements." Large independents posted an average total return, which includes dividends, of 15.1%. "However, the gains merely offset two-thirds of [2001] capital losses and were not very broad-based, to boot. More than 60% of the advance in market value came from two companies, one based in India and the other in China...With revenue so strong, the stocks should have done much better, and they would have if costs hadn't ballooned, pulling down return on capital employed." Stock in the India-based independent, Oil & Natural Gas Corp. (ONGC), which is approximately 90% owned by the Indian government, nearly tripled on anticipation that government privatization programs will recommence. ONGC may gain some downstream assets, becoming an integrated oil company. Meanwhile, fresh from a 2001 initial public offering, stock in China's CNOOC Ltd. improved 38%. Looking forward, the Herold analysts expect acquisitions of reserves and private companies to pick up. "Lacking the option of going public, sellers will opt to take the paper of existing, successful producers." Other prognostications: • "Investors and analysts will pay more attention to industry profitability, particularly return on capital employed, and focus less on production and cash flow growth. Whatever his motives, John Browne of BP was absolutely correct in saying that the company could only have achieved its production target by spending money unwisely." • This brings up the subject of royalty trusts. "We are confident that no U.S.-based company will convert to trust form, or distribute fully developed assets to its shareholders in the form of an income-producing vehicle. We make this prediction despite the fact that doing such is demonstrably the right thing to do. Royalty trusts, or vehicles of their ilk, are extremely efficient at returning capital to their owners, and having less capital at their disposal will make management more prudent in how it is deployed." • Further weakness in the U.S. dollar "could lead to another year in which overseas-based companies that trade in ADR-form provide superior investment returns, when measured in dollars." • Oil prices will decline within the year and natural gas prices could as well. Refiners could be in the best position for gains. • "Domestic integrated oils should also have a better year-worse seems hard to imagine. E&Ps always struggle when oil and gas prices drop, and sometimes that is unreasonable since finding costs often drop faster, but so it is." -Nissa Darbonne