The adage is all too familiar: if the shoe fits, wear it. But what happens when the foot keeps getting bigger and bigger? As many independents have found, the answer isn't simply to find bigger shoes, but shoemakers who know how to keep an operator in step with shareholders' expectations as that company's market footprint grows. Take the case of Midland-based Parker & Parsley Petroleum Co. Between 1985 and 1997, that operator had grown like Topsy through acquisitions and development in the oil-rich Spraberry Trend of West Texas-to the point where it had reached $1.5 billion in total enterprise value. That's when it realized, after studying the strategies and successes of the patch's bigger players, that for a company its size, the acquisitions game, by itself, was no longer going to work-not if it expected to achieve real growth in net asset value, per-share value and returns over the long haul. Thus, in the summer of 1997, Parkey & Parsley combined with Mesa Inc. to form Irving, Texas-based Pioneer Natural Resources Co. (NYSE: PXD). "One of the reasons for the merger was to add long-life natural gas reserves to our existing asset base, and Mesa certainly had that in its Hugoton and West Panhandle fields," says Scott D. Sheffield, Pioneer chairman and chief executive officer and former head of Parker & Parsley. "But the other reason for creating a larger company was to take about 25% of our capital and build from scratch an exploration component to add to our strategy, to improve our growth rate and return on investment." In the year that followed, Pioneer embarked on an aggressive recruiting campaign to pull together a top-flight exploration staff. Ultimately, it hired some 60 geoscientists, primarily from major oil companies like Exxon, Mobil, Shell and Conoco. At the same time, the company began pruning its Mesa-related debt-as high as $2.2 billion at the end of 1998-by putting some $500 million worth of noncore assets up for sale, centralizing its operations, consolidating staffs and reducing overhead. The net result: between year-end 1998 and year-end 2000, debt was reduced by $600 million. Meanwhile, the new core group of Pioneer explorationists pulled together a large inventory of seismic data and drilling prospects. Some in the group zeroed in on drilling locations in the deep-shelf Gulf of Mexico-looking for 50- to 200 billion-cubic-foot (Bcf) natural gas targets at total drilling depths greater than 15,000 feet. Others focused on deepwater Gulf of Mexico prospects with higher-potential reserves in 3,000 to 7,000 feet of water. The rest of the geoscientist team turned its attention internationally, taking aim at drillable, mainly oily, prospects offshore South Africa and Gabon. After prospects were risked and rerisked rigorously by the geoscientists, exploratory drilling began in earnest in late 1999. The result? Pioneer, now one of the top 10 U.S. E&P companies with total reserves of 671 million barrels of oil equivalent (BOE), has a virtual banquet on its table, in terms of projected gains in output this year and next. "We're looking at 4% to 5% production growth in 2002, but by the end of 2003, our daily output should be up 55% to 60% versus where it is today," says Sheffield. Major projects Most of this growth will come from the development of three major deepwater Gulf of Mexico exploration successes the company drilled up in the past three-plus years. Canyon Express, a large gas project coming onstream in July, should deliver at its peak about 110 million cubic feet (MMcf) per day of gas net to Pioneer. Falcon, a gas discovery coming online in second-quarter 2003, should deliver another 75 MMcf per day of gas, net. Says Sheffield, "Currently, we're producing about 220 MMcf per day of gas in the U.S. So just from those two projects alone, we expect to nearly double daily domestic gas output, to more than 400 MMcf." Development of a third deepwater Gulf of Mexico discovery, Devil's Tower-also due to come online in second-quarter 2003-will boost the company's current 35,000 barrels of daily oil production by some 10,000 barrels by the end of that year. In addition, first oil from Pioneer's offshore Sable Field discovery in South Africa, being developed with Soeker-the government-owned oil company of South Africa-is expected to come onstream by year-end 2002. This will add another 12,000 to 13,000 net barrels per day of oil to current output. Also on its offshore acreage in South Africa, the company has a gas drilling program under way which it hopes, over time, will add another 500 billion cubic feet (Bcf) to its reserves. These projects represent just the near-term growth engines for a company that last year replaced 208% of production. "The big challenge for us is to sustain the level of production gains we already have in hand for 2002 and 2003 with the development of other exploration successes in 2004 and 2005," explains Sheffield. Recently, Pioneer made another deepwater Gulf of Mexico strike, the Ozona Deep oil discovery just south of Shell's Auger Field. Gross reserve potential at Ozona is estimated at 50- to 225 million BOE. The company expects to have this project approved for development by late 2002 or early 2003, with first production in late 2004 or early 2005. One of the more enticing long-term growth prospects, however, is offshore Gabon, where the company recently made an oil discovery on its 100%-owned, 315,000-acre Olowi Block. The initial exploration well tested at 2,000 barrels per day, with the mean reserve potential for the prospect 300 million BOE. But the best-case reserve upside of the prospect is much greater-as much as 600 million equivalent barrels. This year, the company will drill two appraisal wells and another exploration well on the block. The hope is to have the project approved for development by year-end 2002, with first production coming on line by 2004. Another arrow in Pioneer's long-term growth quiver is the deep-shelf Gulf of Mexico. There, the company holds more than 200,000 net acres, possesses some 7,000 square miles of seismic data and has acquired 25 to 30 exploration prospects. "We'll be drilling two or three prospects a year, looking for 100-Bcf-type gas targets," says Sheffield. Most recently, the company entered onshore Tunisia, partnering with Anadarko Petroleum in the southern part of that country, and with Canada-based producer Eurogas on acreage to the north. During the next several years, it will be drilling large oil and gas prospects in both areas. "With the drilling prospects and production growth we're already looking at, we believe we're one of the few U.S. producers that's going to be able to significantly grow net asset value and cash flow on a per-share basis during the next five years-all through the drillbit," says Sheffield. "We don't really see the need to merge or acquire, except for maybe allocating $25- to $50 million annually for small acquisitions in core areas." With cash capital spending of $550 million last year and $375 million this year-primarily earmarked for its four major development projects-Pioneer isn't allowing these investments, or the returns on them, to be exposed to the vagaries of the commodity-price markets. "For 2002, we've locked in about 60% of our North American gas production at an average price of $4.30 per thousand cubic feet," says Sheffield. Meanwhile, on the oil side, the company has locked in $25.40 on 45% of its total 2002 crude production, and a $24.02 price on a like volume for first-half 2003. Says Sheffield, "Obviously, it was a good idea to hedge to protect against the recent down cycle, but we'll also be hedgers in the next up cycle in 2003 and 2004, to maintain stability in our earnings and cash flow." With the mention of hedging these days comes the question: any exposure to Enron? "At year-end 2001, the total value of our hedges was $185 million, and of that amount, $7.5 million, or about 4%, was with Enron," he says. "However, working with the existing creditor committees of Enron, we expect to recoup 25 cents on the dollar, or about $1.8 million of that $7.5-million loss." Part of Pioneer's growth strategy also includes attention to costs and the balance sheet. For the past three years-1999 through 2001-the company's finding costs averaged $4.74 per BOE while its operating costs and G&A averaged $4.80. Looking ahead, the producer is eyeing significant balance-sheet improvement. "When we reach peak production in 2003 and 2004 from the exploration successes we've had so far, we'll be generating considerable excess cash flow. At that point, I see us lowering debt to total capitalization from a current 55% to about 45%. Concludes Sheffield, "Today, we're truly an E&P company focused on adding long-term value on a per-share basis. We're not going to go out and spend a lot of capital buying short-life production just to increase immediate cash flow and get a higher stock price. We're more patient and disciplined than that." Favorable ratings Shawn Reynolds, senior equity analyst for Petrie Parkman & Co. in Denver, likes E&P companies that are capable of showing annual double-digit production growth from large-scale, fairly low-risk development programs already in hand, that have high-impact exploration portfolios and strong year-to-year hedging programs. "When you apply those three criteria, Pioneer really stands out atop its peers," says Reynolds. He notes that Pioneer, whose stock he rates Buy, has big development projects coming onstream that by mid-2003 should increase its current daily production by an estimated 55%, to about 175,000 BOE. Second, he notes Pioneer's discoveries offshore Gabon, the deepwater Gulf of Mexico and South Africa that should add to production growth in 2004 and 2005. "Third, most of its 2002 North American gas production is hedged at $4.30. That's outstanding, given that recent natural gas prices have been sub-$2.50 and don't look like they're going to extend much above that for quite some time." The analyst points out that during the past decade, Pioneer has undergone a dramatic transformation. "It used to be a long-life-reserve, but low-growth, low-margin West Texas and Midcontinent E&P company. That's a nice legacy asset that chugs out a lot of cash flow, but it doesn't do anything for you longer-term. So Pioneer used the downturn of 1998-99 to pick off some very highly qualified geoscientists and create an aggressive exploration staff. That team has enabled the company to build a high value-added global exploration effort that's now starting to bear fruit, in terms of production growth this year and next." In addition, Pioneer's Olowi exploration prospect in Gabon could be a real companymaker, says Reynolds. "The reserve upside of the block is as much as 600 million BOE. That's nearly what the company's total reserve base was at year-end 2001." His 12-month target price for the stock is $25 to $27 per share. Robert Morris, managing director and E&P equity research analyst for Salomon Smith Barney in New York, has a Market Outperform rating on PXD, with a 12-month target price of $20. The reason? Near-term, he has a cautious stance on the whole E&P group, given his firm's gas-price outlook. "Since last fall, we've been using a $2.25 composite, spot-gas price forecast for 2002 because we feel that not only will gas-storage levels be at record highs coming out of this winter, but they're likely to still approach full going into next winter." Pioneer, however, is well-geared to withstand these gas-price doldrums. Unlike a lot of independents that are also capital-constrained, the company has an inventory of major development projects that will drive exceptional production growth, beginning in 2003, says Morris. "In addition, it has done an outstanding job of hedging-much better than most E&P companies-to protect the economics of these major projects, as well as its capex budget and cash flows going forward. With 60% of its 2002 gas production hedged at an average $4.30 and 45% of its crude output this year locked in at an average $25-plus, Pioneer has a major advantage in the $2.25 gas-price and $18 to $22 oil-price environment we're forecasting for this year." A protected capex budget and stable cash flows also bode well for an active exploration program, the analyst says. "This, plus its record of exploration successes during the past 18 months, should hopefully enable Pioneer to deliver even more discoveries-particularly in the deepwater Gulf of Mexico-that will allow it to continue its current production growth profile beyond 2003." Morris looks for per-share earnings of 50 cents and $1.85 for 2002 and 2003, respectively, as Pioneer's cash flow per share climbs from $3.25 to $5.05.