It was a great year for independent producers-the group of companies tracked by Petroleum Finance Week saw its operating income rise 172.3% over 2002, on revenues that were 46.6% higher. For the fourth quarter, income was up 84.4% on revenues that were 27.4% higher. Commodity prices obviously played a role, but for most of these companies, volumes were higher as well. 2003 gas production increased 8.2% year over year, and fourth-quarter gas production was up 11.5%. Oil production rose 4.6% for the year and 13.7% for the quarter. Devon Energy topped the charts for income, revenues and gas production. While its quarterly earnings beat consensus estimates, analysts noted that costs last year were high, and reserve replacement was led by the merger with Ocean Energy, not the drillbit. Good mergers are becoming more difficult to find. "As the company has grown significantly through acquisition, target companies, and, more specifically, poorly managed ones, are less available," says Friedman Billings Ramsey analyst David Khani. "As a result, Devon has recognized that it must become a more balanced company and, at a minimum, replace reserves through the drillbit and keep its powder dry to layer on accretive transactions." In 2003, Devon made significant strides in both tasks, making discoveries in the deep water and deleveraging its balance sheet. However, Khani notes the company is building up a "war chest" of cash-some $1.3 billion, and heading to an estimated $2.7 billion by year-end 2004. The main risk to owning Devon shares is that management may make a dilutive transaction if it is not able to book meaningful reserves from its large projects in 2004, he says. "We hope the company will exhibit patience in executing its strategy and use some of the proceeds to buy back stock in a falling market," he says. Devon's depreciation, depletion and amortization (DD&A) expense rate increased 22% in 2003, to $7.87 per barrel of oil equivalent (BOE). Its all-in finding and development (F&D) costs were $10.82 per BOE for the year, increasing its five-year average F&D costs by about $1 per BOE, says Morgan Stanley analyst Lloyd Byrne. The company revised its 2004 DD&A estimates higher as well. "The real issue, from our perspective, is whether Devon's relatively new higher-risk/higher-reward exploration strategy can lower F&D costs going forward," Byrne says. "Devon has historically relied more on acquisitions versus drilling to achieve reserve growth, but given the increased breadth of the prospect portfolio-post Mitchell Energy, Anderson Exploration [and] Ocean Energy acquisitions-there will be greater reliance on exploration to drive reserve growth going forward, in our view." 1Apache Corp., which topped the list in oil production, was praised by analysts for its healthy balance sheet. "During the year, Apache acquired assets in the Gulf of Mexico shelf and the North Sea valued at approximately $1.3 billion, while reducing its long-term debt by nearly $300 million and [its] net-to-book capitalization ratio to 25% from 35% at year-end 2002," says Friedman Billings Ramsey analyst Rehan Rashid. The company's all-in F&D costs were $6.07 per BOE, and its organic F&D cost was $6.29 per BOE in 2003, Byrne adds. That should place the company toward the top of its peer group, he says. Investors should watch for Apache to put its dry powder to work in asset acquisitions, he adds. They also should keep an eye on operations, especially drilling results from the North Sea, Australia and Egypt, and progress on development in China and Egypt. Ranking in the top three in all categories was Anadarko Petroleum. The company's F&D costs were stellar-hitting an all-in rate of $6.95 per BOE in 2003, compared with $10.55 in 2002, according to Byrne. However, for 2004, operating costs have been guided 5% to 12% higher, general and administrative costs are expected to be higher than originally estimated, and production is now expected to grow between 1% and 4%, down from a previous forecast of 4% to10%, says RBC Capital Markets analyst Andrew Lees. "Even in an industry plagued with rising costs and diminishing marginal returns, Anadarko stands out," Lees says. "Anadarko has clearly not tamed its cost structure, and we believe it will generate below-average returns until it does." Last year, Anadarko began to address costs with its first lay-offs of personnel. Lees said production growth targets have been lowered due to weather-related start-up delays at Marco Polo in the Gulf of Mexico, and from water encroachment at the Kent Bayou property on the Louisiana coast. Byrne notes another reason as well-new chief executive James Hackett's desire to set prudent and achievable targets. Commodity prices helped push Noble Energy's fourth-quarter results ahead of consensus expectations. And analysts are watching to see what the company does now that its restructuring is behind it. "Noble is moving forward from its transition year, with four of its five planned asset packages having sold, and having completed its capital-intensive international projects," Khani says. He expects Noble to target prospects throughout its deep-shelf and deepwater inventory in 2004, and "while mounting cash from asset sales and free cash flow generation will continue to be used for debt reduction, we believe Noble could be bulking up for a possible U.S. property purchase." Byrne says he would prefer Noble management use free cash for debt repayment and/or acquisitions rather than a share buyback program. "Noble continues to scour the acquisition market, but we get the sense that management considers prices of recent U.S transactions prohibitive," he says. Byrne commends Noble for shedding higher-cost properties during 2003, but remains concerned with domestic reserve replacement trends. "In 2003, Noble estimates it replaced [about] 48% of domestic production from all sources at a disappointing cost of $19.56 per BOE," he says. The company's 2004 U.S. capital program takes on added importance now that projects in China, Ecuador and Israel are complete. "How Noble reinvests domestically-drilling or acquisition-and at what returns will be a key intermediate and longer-term driver of relative stock performance, in our view." Another company that may want to consider a restructuring is Stone Energy, Rashid says. The company's fourth-quarter production and earnings came in above estimates, but its emphasis on the Gulf of Mexico-the home of 91% of the company's proved reserves-is causing a valuation gap with its peers, he adds. "For a company of Stone's size, we believe that a concentrated Gulf of Mexico asset base is a broken business model, and that the current valuation discount reflects investor distaste for this strategy," he says. Stone could acquire other companies or begin a grassroots exploration program to diversify, but Rashid believes that selling the company would be the least risky means of closing the valuation gap. He speculates that the Gulf asset base could be synergistic for a company such as Newfield Exploration or Pogo Producing , which have a significant presence in that area. Or, mid- and large-cap companies with a diversified base could benefit from the valuation arbitrage.