Once super-independents reach a certain point in their growth cycle, it becomes increasingly more difficult to generate good returns. This conundrum makes disciplined portfolio management very important for these companies, and some are even mulling a "shrink to grow" strategy to boost their returns. That was the message from Claire S. Farley, chief executive officer of A&D advisory firm Randall & Dewey, speaking at the recent Deloitte oil and gas conference in Houston. "'Keeping on keeping on' is just not going to be an option for them," Farley said about the super-independents. Looking at this particular breed of independents-Devon Energy, Apache, Anadarko Petroleum, Burlington Resources, Kerr-McGee, Amerada Hess and Unocal-Farley found that the group averaged 15% annualized returns when growing their enterprise value from $5- to $10 billion. But the group's average annualized returns fell to a negative 5% when growing their size beyond the $10 billion mark. For the past two years, incremental capital spending has outpaced incremental production for the large-cap E&P firms, Farley said. "What companies can do with free cash is still a question." As companies grow beyond the $10-billion enterprise value threshold, it is very difficult to find acquire-and-exploit opportunities of substantive scale. And, any exploration with serious upside has long lead times and is generally focused overseas, she said. What some companies have done is engage in "mergers of equals," such as the Devon/Ocean amalgamation, or pay premiums for the prime assets that they want, such as Chesapeake Energy's recent purchase of South Texas assets from Laredo Energy LP et al. for $200 million. Chesapeake estimates the purchase price at $1.41 per thousand cubic feet of gas equivalent of proved reserves. What does Farley suggest for companies trying to boost returns? "Only aggressive asset-portfolio management will allow the super-independents to move beyond just a proxy for commodity investment," she said. Buying assets constantly ensures exposure to deals at low prices, she said, and hedging, asset sales and large-scale volumetric production payments can help independents sell high. However, buying and selling is not enough. Successful exploration can create value throughout the cycle, she said. One company that has embraced aggressive portfolio management is Occidental Petroleum Corp., which has experienced a turn-around that has been profitable to shareholders. The Los Angeles-based company's total return-stock-price improvements plus dividends-has been 97.5% from October 31, 2000, to October 31, 2003, according to John W. Morgan, executive vice president, worldwide production, who also spoke at the Deloitte conference. Shareholders faring second-best in the same period were owners of Apache, which produced 48.9% total returns; shareholders faring worst were those owning Anadarko shares, which produced a negative 30.6% total return. Morgan, who spoke on another panel, echoed many of Farley's comments on portfolio management. Occidental embarked on a major asset-rationalization program in 1997 that has since transformed its global production base and growth potential. Proven reserves, which totaled 1.35 billion barrels of oil equivalent (BOE) in 1999, grew to 2.3 billion at year-end 2002. Production replacement was 140% in 2001 and in 2002, Morgan said. The company's managers set out to focus on large, cost-competitive core assets in the U.S., Latin America and the Middle East, and kick out assets-via sale or swap-that didn't leap growth and cost hurdles. Divestments were made in Argentina, Bangladesh, Indonesia, Malaysia, the Netherlands, Peru, the Philippines, Venezuela and in the U.S. (east Texas, the Gulf of Mexico and elsewhere). Purchases were made in Colombia, Yemen and the U.S. (the Altura joint venture in the Permian Basin, the Elk Hills property in California from the U.S. government, and additional California assets from other sellers.) Occidental's proven reserves were 57% U.S. in 1999; at year-end 2002, they were 76% U.S. And, production is expected to increase from 515,000 BOE per day to 620,000 per day. Most of that growth is expected from its assets in the Middle East and Latin America, although more than half of its production will continue to be from U.S. operations. "We focus on a suite of metrics," Morgan said. These include profitability per BOE, costs per BOE, reserve replacement, finding and development costs, and capital efficiency. "We think they're all important." Poor performance is possible in one area from time to time, but a failure to achieve each goal cannot be overlooked for long, he added. Occidental's all-sources finding and development costs have grown from $3.80 per BOE in 2000 to $4.65 in 2002, but its 2000-02 average of $4.09 per BOE is its 13-company peer group's lowest. Others range from $4.14 per BOE for ConocoPhillips to $12.17 for Amerada Hess. Occidental's 2000-02 average profitability was $9.64 per BOE, also the best in its peer group. Second-best was $6.92, posted by Apache; the worst, $3.18 by Devon. 2000-02 average free cash flow was $9.37 per BOE, compared with second-best performer Amerada Hess' $6.01, and the worst, Anadarko's 15 cents. Occidental was also No. 1 in 2000-02 average return on equity at 22.2%. No. 2 was ExxonMobil (NYSE: XOM) at 20.4%; in last place, ConocoPhillips, 6.5%. On the measure of 2000-02 average return on capital employed, Occidental was No. 2 at 13.7% next to ExxonMobil's 17.9%. Worst was ConocoPhillips' 4.7%. "What did we do with all that money? We paid down debt," Morgan said. Occidental's total debt in 2000 was $6.35 billion; in third-quarter 2003 it was $4.63 billion. Its debt-to-market-cap ratio declined to 38% in third-quarter 2003, from 57% in 2000. -Jodi Wetuski and Nissa Darbonne