By any financial measure, fiscal 2003 was an outstanding year for the top 20 major integrated oils. Net sales revenues for the group were up 26% last year versus 2002 as net income and earnings per share soared 79%, according to London-based Evaluate Energy, a supplier of financial, operating and strategic-planning data to the oil and gas industry, consulting firms and investment banks worldwide. Return on average capital employed (ROACE) for the top 20 majors, meanwhile, climbed to 15.5% from 9.2% the prior year as return on equity jumped to 21% from 12.2%. "Most of these increases were due to higher oil and gas price realizations by the group," says Richard Krijgsman, Evaluate Energy chief executive officer. He points out that, buoyed by an average 2003 West Texas Intermediate price of $31 per barrel, the group's average oil-price realizations rose by $4 per barrel last year while gas-price realizations upticked by an average $1.28 per thousand cubic feet (Mcf). Reflecting this trend were the gas-price realizations of ExxonMobil, which moved up to $4.02 per Mcf in 2003 from $2.77 in 2002. Concurrently, those of BP went to $3.39 from $2.46; ChevronTexaco, to $3.96 from $2.55; ConocoPhillips, to $4.07 from $2.77. Krijgsman notes that the upstream business, which accounts for 77% of the group's earnings, sported a modest 1.6% gain in production volumes in 2003. This, coupled with higher commodity prices, resulted in improved ROACE. Equally notable was the fact that the downstream sector, which accounts for 16% of the group's earnings, leapfrogged in profitability from 2002 levels. ExxonMobil's downstream earnings rocketed to $3.5 billion in 2003 from $1.3 billion the prior year. ChevronTexaco's refining and marketing earnings, meanwhile, jumped to $1.67 billion from a 2002 loss of $367 million as ConocoPhillips saw segment earnings catapult to $1.27 billion from $143 million. The trigger for these gains: higher margins due to tighter markets, mainly in the U.S. "Despite these impressive year-over-year strides in 2003 financial and operating performance, one shouldn't be lulled into thinking there aren't some real challenges facing the integrated oils," Krijgsman cautions. "True, total oil and gas production for the group was up 1.6% last year; however, taking purchases out of the equation, reserves for the top 20 majors grew by only 1% in 2003-and this excludes Shell's dramatic downward proved reserve revisions. "Another negative is that the group's upstream production costs last year increased 10%, to $4.69 per barrel from $4.25 in 2002. In short, output is outstripping reserve replacement while production costs are headed up." On a more upbeat note, Krijgsman observes that the top 20 majors are doing a good job of lowering pure finding costs. Last year, those costs in the U.S. were $2.27 per barrel of oil equivalent (BOE), down from a 2002 average of $3.22. Comparatively, the average 2003 finding costs of U.S. independents were $2.39 per BOE versus $2.60 the prior year; for Canadian independents, the average was $1.70 per BOE in 2003, down from $2.22 in 2002. The outlook for integrated oils this year and next? That depends on the analyst talking. "We're in the tightest energy environment we've seen since the 1970s," says Steven A. Pfeifer, first vice president and global oil coordinator, equity research, for Merrill Lynch & Co. in New York. The amount of growth in non-OPEC oil supply since then has been significantly less than most people expected, he says. Also, finding and development costs for the integrateds have increased substantially, from $4 per barrel in the mid-1990s to a current $7 per barrel. "In effect, the majors are spending the same amount of money but are finding smaller fields and fewer barrels." Merill Lynch's modeling shows that during the next five years, output by the integrated oils-and non-OPEC supply in general-will grow by only 1.5% to 2% per year, or about 700,000 barrels per day. Daily global oil demand, meanwhile, is growing by 1.5 million barrels. "This implies that OPEC's market share will be stable to increasing going forward," says Pfeifer. "We therefore expect continued high oil prices-on the order of $31.50 this year and longer-term, at least $28 on a more normalized basis." Accordingly, the analyst is recommending an Overweight portfolio position in the integrated oils-a sector he believes will continue to outperform the broader market. "Wall Street underestimated the underlying earnings power of these companies in first-quarter 2004, and as we move through the year, it will scramble to raise quarterly earnings estimates as the integrateds continue to outperform [the market]." The analyst believes that the major oils are still attractively valued since they're trading as though oil prices were $25. Looking at the group's valuation another way, the integrateds are trading at a 20% discount to the S&P 500. Says Pfeifer, "Production growth of 1.5%, when combined with strong dividends in the 2.4% to 4% range, annual share-buybacks as great as 3% of outstanding shares and stock prices that are discounting $25 oil, adds up to a compelling investment case." Among the analyst's top picks for 2004 is ChevronTexaco. He notes that the merger is now starting to translate into increased profitability. In first-quarter 2004, the company's earnings of $2.40 per share exceeded consensus estimates by 20%. In addition, its domestic downstream operations are the most levered of the majors to the tight West Coast market while its international refining and marketing operations have the highest earnings sensitivity and exposure to Asia-the fastest-growing region in the globe in terms of demand for petroleum products. The company, meanwhile, is involved in some of the more attractive upstream projects in the world, including the Tengiz Field in Kazakhstan and the deepwater offshore West Africa-an area that could become as large as the North Sea, he says. ChevronTexaco is also now starting to divest itself of lower-return assets, recently announcing a $1.1-billion asset sale to XTO Energy, adds Pfeifer. "For 2004, we're looking for this company to earn $8.20 per share, with an 18% return on capital employed. Our 12-month target price for the stock is $100." Frederick P. Leuffer, senior managing director and senior energy analyst for Bear Stearns & Co. in New York, contends that recent $40 oil prices reflect a terrorist premium of at least $10 per barrel. The analyst points out that recent U.S. oil industry crude inventories have built up to around 300 million barrels-a level usually consistent with a West Texas Intermediate oil price of $25 to $28 per barrel. In addition, stockpiles in the Strategic Petroleum Reserve have increased to about 660 million barrels. "What this tells us is that supply exceeds demand." The terrorist premium in crude prices has been supported by an all-time-high net-long position by speculative interests on the Nymex, observes Leuffer. However, he believes a significant stoppage in crude supply, while possible, is unlikely, and that as inventories continue to build through the third quarter, crude traders are likely to once again shift their focus back to fundamentals. "As that occurs, the terrorist premium will likely come out of crude prices," the analyst says. "Accordingly, we're cautious and are recommending an Underweight position in the stocks of major integrateds. As history shows, when crude prices fall, oil stocks usually underperform the market." This sector outlook aside, Leuffer expects BP to outperform its peer group. "This is a story of strong oil and gas production growth-7% annually during the next four to five years-and significant free cash flow generation-some $4 billion this year and as much as $3.5 billion annually beyond that, even at oil prices as low as $20. Importantly, management has clearly stated that free cash flow will be returned to the shareholders." The analyst says that BP's projected growth in output-the strongest of any of the super-majors he covers-will come principally from Russia, Azerbaijan, offshore West Africa and the deepwater Gulf of Mexico. The company, which has a debt/total cap ratio of only 20%, has entered a sweet spot, Leuffer explains. "As it completes major development projects, capital expenditures will drop by $1.5 billion in 2005-at the very time those projects are providing the company higher production and cash flow levels." One of the most efficient of the integrateds, BP's average annual reserve replacement through the drillbit during the past six years was 150% versus a peer-group average of 115%. "Meanwhile, the company's finding and development costs were less than $4.50 per barrel of oil equivalent-the lowest of any of the majors." Says Leuffer, "Since the company has indicated that it's not looking to make acquisitions, we expect it to raise dividends further and to continue an aggressive share-repurchase program. In first-quarter 2004 alone, it bought back $1.5 billion worth of its own shares." The analyst's 12-month target price for BP: $60.