Fiscal 2000 was an unusually good year for large U.S. independents. They set records in financial performance and basked in happy times. Fiscal 2001 was horrible, however. The economy slumped, demand for energy dropped, and oil and natural gas prices declined sharply. Added to these problems were the many asset write-downs that companies of all sizes had to take when 2001 year-end commodity prices closed substantially below those of December 2000. 2002 was a year of subdued recovery for many oil and gas producers, but business did not surge back anywhere close to 2000 levels. Consequently, comparisons of financial performance from 2000-02 for U.S. E&P firms are quite grim. London-based Evaluate Energy, a business intelligence company that supplies data to the energy industry, tracked the 2000 versus 2002 performances of 28 of the largest U.S.-based independents, based on market capitalization. The numbers of shares on March 31, 2003, and the stock price on May 30, 2003, were used to calculate market cap. (See the July 2003 issue of Oil and Gas Investor for a companion article, "Tracking the Majors.") As a group, oil-price realizations went down 8% for the companies in the three-year period under review, says Richard Krijgsman, Evaluate Energy chief executive officer. Gas-price realizations dropped even more drastically, by 17%. "For our group of 28 companies, the average oil-price realization in 2002 was $22.71 per barrel, and gas was $2.91 per thousand cubic feet (Mcf). In 2000, companies averaged price realizations of $24.65 per barrel and $3.52 per Mcf." During the same time, however, many of the firms in the survey increased their production and their reserves dramatically. Oil production rose 19% for the group between 2000 and 2002, and gas volumes grew 28%. As a whole, the group added a combined total of 2.8 billion barrels of oil equivalent (BOE), says Krijgsman. Natural gas was the commodity of choice: 12.84 trillion cubic feet (Tcf) in gas reserves were added, to just 626 million barrels in oil reserves. In detail, the independents produced 2.9 billion BOE and discovered 3.5 billion during the three-year period. They also purchased 3.2 billion and sold 1 billion. When the numbers are netted out, it's clear that acquisitions accounted for the bulk of the reserve and production growth. Setting aside the net purchases of 2.2 billion BOE, the 28 U.S. independents in the survey increased their produced reserves by just 600 million BOE. New oil and gas reserves are being discovered, but the impressive jumps in reserves and production are mainly due to consolidation. Nonetheless, the rising volumes were still not sufficient to overcome the lower price realizations, and net income for the group as a whole dropped 65% from 2000 to 2002. Furthermore, oil and gas production costs for the group rose 6% in the past three years, which affected returns as well. Equally troubling, the weighted-average return on capital dropped by two-thirds, declining from 15.8% in 2000 to 4.6% in 2002. "That return is below the companies' cost of capital," says Krijgsman. In another measure, market cap for the group took a hit, falling from $95 billion in 2000 to $80 billion at year-end 2002. "If you take that market cap and divide it through by reserves, companies' reserves were valued at $7.03 for each BOE in 2000, and at $4.90 per BOE in 2002." Investors were placing substantially less value on reserves in the ground at the end of the period, obviously wary of embracing the stock of an industry that is struggling with growth issues, fluctuating prices and creeping cost escalation. Even now, in times of strong prices, investors seem skeptical that producers can effectively spend the abundant cash coming in their doors. The bird's-eye view reveals that, aside from a lot of hustle and bustle, the U.S. industry is basically flat. It has not been growing overall, even given all the wonders of technology. That said, from an investment point of view, individual companies are certainly doing good things and adding value for their shareholders. XTO Energy Fort Worth-based independent XTO Energy Inc. tops several of the ranking categories of the past three years. It posted 61.5% growth in net income, climbing from $115.2 million in 2000 to $186.1 million in 2002. During that time, XTO also grew its earnings per share 37.8%, from $0.81 in 2000 to $1.12 in 2002. Additionally, it raised its gas reserves by 1.11 Tcf, second only to Devon Energy's addition of 2.79 Tcf. XTO's strategy has been to acquire and exploit properties in the U.S. It has interests in the East Texas, Arkoma, San Juan, Anadarko, Green River and Permian basins, as well as in Hugoton Field, Kansas; Cook Inlet, Alaska; and Louisiana. It mainly focuses on natural gas. Between 2000 and 2002, XTO spent $632.1 million on property acquisitions. Recently, it has been targeting San Juan Basin properties. Between July 2002 and June 2003, the company has bought $369.3 million in properties from Marathon, J.M. Huber Corp., Williams and MarkWest Hydrocarbon. In the MarkWest purchase, XTO is acquiring 50 billion cubic feet of gas equivalent (Bcfe) of San Juan Basin gas reserves for $60.5 million. "Strategically, the fit of the transaction is the latest example of XTO's tactic of augmenting proven core areas of long-lived natural gas reserves," says Morgan Stanley analyst Lloyd Byrne. Others agree that XTO has an excellent outlook for the future. Analysts at J.P. Morgan recently introduced a measure known as "asset intensity." This indicator takes into account production declines, finding efficiency and the cash generation of the production base. XTO Energy also floats to the top when measured with this stick, which seeks to gauge future growth potential. The company has enjoyed very low finding costs and has a significant inventory of prospects, says J.P. Morgan analyst Shannon Nome. Future growth depends both on the depth of a company's prospect inventory and at the extent that its production base is declining. The amount of money that a company will require to maintain its annual production is divided by its discretionary cash flow, highlighting those firms that will have money to invest in reserve growth. Among the largest firms, Murphy Oil, Apache Corp., Pioneer Natural Resources and Burlington Resources ranked well on J.P. Morgan's asset-intensity screen. "Those producers overcame somewhat steeper base decline characteristics by virtue of their finding efficiency and/or lean cash costs," Nome says. Devon Energy No large independent has added more reserves during the three-year period between 2000 and 2002 than Devon Energy Corp. At year-end 2002, Devon had 5.83 Tcf of gas reserves, up 91.6% from 2000 reserves of 3.04 Tcf. Its oil reserves rose from 456 million to 636 million barrels, a gain of almost 40%. During that time, Oklahoma City-based Devon initiated three major mergers and acquisitions: in 2000, it merged with Santa Fe Snyder in a transaction valued at $3.5 billion; in 2001, it completed the $4.6-billion purchase of Anderson Exploration Ltd.; and, it acquired Mitchell Energy in 2002 for $3.5 billion. It is still on track for vigorous performance. This year, Devon completed its $5.3-billion merger with Ocean Energy, creating what it says is the largest U.S.-based independent producer of oil and gas. Its reserves now stand at 2.2 billion BOE. "The marriage of Devon's gas-levered North American profile and Ocean's higher-impact deepwater exploration portfolio makes strategic sense to us," says Byrne. Pre-merger, Devon had a 25% interest in 71 deepwater Gulf of Mexico blocks. Thanks to Ocean, Devon has gained a considerable prospect inventory and interests in 380 additional deepwater blocks. Interestingly, Byrne says that although Devon has traditionally grown through acquisitions, it now has sufficient prospects to achieve an organic production growth of 4% to 6% per year. That's a powerful hook for investors concerned about flat or declining production in the sector. Another analyst, Shawn Reynolds with Petrie Parkman & Co., likes firms that can demonstrate multi-year production growth, a balanced drilling program with impact, and reasonable valuations. He says E&P firms absolutely must grow their production to offset the large level of risk in the sector brought by such outside factors as weather and politics. Those firms that can generate significant and continuing growth in their volumes each year really stand out. "We continue to have Buy ratings on Apache Corp., Devon Energy, Noble Energy, Pogo Producing, Pioneer Natural Resources and XTO Energy," he says. Thankfully, the industry is currently enjoying an upturn. Today, many companies are in great shape financially, with solid balance sheets, healthy returns and plentiful free cash flow, he says. Independents appear to be investing their capital wisely, spending their money reasonably on drilling programs and acquisitions. Certainly, 2003 is progressing quite favorably for independents, and is on track to best 2002 by a fat margin. The key concern is whether the companies will be able to invest the bounty from this year's high commodity prices into solid business projects that will provide their investors with favorable returns.