Financially, the independent oils have been making slow but steady improvements during the past few years, but in 2004 they were practically unstoppable. Free-flowing cash and commodity prices were working in the independents' favor, and the stage was set for a surge in exploration efforts. Yet instead of deploying large amounts of E&P capital into more drilling, many independents turned to lower-risk methods of growth that offered limited production, but far less strain on the balance sheets. Net sales revenues for the group jumped 25% to $87 billion last year, compared with $70 billion the year before and $51.7 billion in 2002, according to Evaluate Energy, a London-based firm that offers strategic, financial and operating analysis of companies in the energy space. Net income growth managed to outpace revenue growth, climbing a whopping 57% in 2004 to $16.5 billion. Return on equity rose to 20.3% from 13.7% the prior year, and return on capital for the group grew to 15%, up from 11% in 2003 and 7% in 2002. For the first time in the group's history, these figures are close to those typically generated by the integrated majors, says Richard Krijgsman, Evaluate Energy chief executive officer. From a financial standpoint, the group is breaking old records and, more importantly, setting the stage for new financial trends. "The financial strength of the group increased very significantly in 2004," Krijgsman says. "[It] has steadily been getting better and this year, for the first time in many years, it is enjoying more inbuilt financial flexibility." Market capitalization was up 38% at $192 billion, with the smaller players showing the fastest growth. This group included Berry Petroleum Co., Denbury Resources Inc. and Vintage Petroleum Inc. Though larger companies with international projects-such as Apache Corp., Anadarko Petroleum and Unocal-grew also, their rate of growth was below average, Krijgsman says. A company's debt capacity, or how much money a company could raise if it sustained its ratio of net debt to capital employed at 35%, is one measure Evaluate Energy uses to gauge financial strength. In 2004 the independents managed to bring their debt capacity up to $5.9 billion. This is a significant climb out of a previous hole: in 2003 the group's debt capacity sat at a negative $7.2 billion; in 2001, it was an eye-popping negative $13.1 billion. While the cost of West Texas Intermediate (WTI) oil rose 32% to more than $41 in 2004, crude price realizations for the group grew at a much slower rate. Krijgsman says this is partly due to hedging activities. "In addition, the overall level of crude-price realizations for these companies is about $8 lower than WTI, reflecting quality differentials in the crudes actually produced by the group. In gas, price realizations for the group in 2004 at $5.44 are much closer to the Henry Hub average for the year of $5.85." Though it's a positive sign to see the independents establish such a strong foundation financially, it's equally important for investors to pay attention to where the capex is going. Total capital spending, including asset and corporate acquisitions, was up 8.5% in 2004 to $29.4 billion, a slowdown in growth from 2003 when capital spending grew 36% and was less than the peak $34 billion spent by the group in 2001, when Devon Energy purchased Anderson Exploration, Anadarko purchased Canadian companies Gulfstream and Berkeley, and Burlington Resources bought Canadian Hunter, Krijgsman says. In exploration, the group pulled back a bit on spending, falling from $4.8 billion in 2003 to $4.7 billion in 2004. While the number of drilled wells in the U.S. increased, it fell for many individual companies in North America and beyond. Though the number of exploration drilled wells was falling, the rates of successful wells improved to 61%, up from 58% the year before and 55% in 2002. By contrast, development and property acquisitions received much more of the independents' cash than in prior years. In 2004 the group's development spending climbed 34% to almost $18 billion, unlike the U.S. integrateds such as Shell, which saw marked dips in development spending. Acquisition spending in the U.S. reached $10.2 billion on proved reserves and $2.3 billion on unproved in 2004, up 35% and 55% respectively. The group outpaced the integrateds in this category as well. "Companies may not have been spending much more on exploration in the U.S. in 2004, but the money they did spend was more effective than in 2003 and finding costs there actually fell in 2004." Krijgsman adds that the differences between companies were wide. Anadarko managed to cut its U.S. finding costs in half in 2004 to just $1.14 a barrel of oil equivalent (BOE) and Occidental Petroleum reduced costs to a mere $0.79. In contrast, Kerr-McGee's costs skyrocketed to $9.69 per BOE from half as much the year before. Debt reduction and share buybacks were also popular with the group. Buybacks reached $2.7 billion, marking their highest level in five years, compared with $800 million in 2003, due largely to $1.3 billion of buybacks by Anadarko and stepped-up activity from Burlington, Devon, Houston Exploration and Unocal. "Only a few companies currently have ratios of more than 40% of net debt to capital employed and this tends to be the smaller companies," Krijgsman says. "The group as a whole has cut its debt ratio to just 31% at year-end 2004 compared with 40% in 2003 and 45% in 2002." With the group's solid financial performance and strong commodity prices as the foothold, there was a natural expectation for an increased appetite for exploration-but this was not the case. Instead, the independents opted to go the acquisition route in 2004, buying assets flat out, developing the ones they already owned and pushing hard for growth through the drillbit. As a result, the group's growth in production volumes and reserves is most impressive next to the integrateds, which had even less growth during the same period. The independents grew their U.S. crude production 5% to 1.2 million barrels per day while gas output grew at the same rate to hit 12.8 billion cubic feet per day. "These were modest growth rates but [they] look great when you compare [them] with integrated companies. U.S. crude production by the integrateds fell 8% and gas production fell by 13%." Due to increased oil production outside the U.S., there was a 10% rise in crude output for the independents as a group. Reserves growth was lackluster. Proved crude reserves increased just 3% to 9.1 billion barrels at year-end 2004, from 8.9 billion in 2003 and 8.3 billion at year-end 2002. Gas reserves saw faster growth, climbing to 76.8 trillion cubic feet (Tcf) from 69 Tcf at the end of 2003 and 62.4 Tcf in 2002. While reserves didn't show drastic growth, the good news is that the market valued the group's oil and gas reserves at $8.80 per BOE last year, up almost 30% from 2003. Of the 1.4 billion barrels of oil that the independents replaced in 2004, 43%-or 587 million barrels-of it was added through extensions and discoveries and 45%-or 617 million barrels-was added by acquisitions. As for gas, the group replaced about 16.7 Tcf in 2004. Two-thirds of it was replaced through the drillbit and 35% was through purchases. Production costs are steadily rising. In the U.S., 2004 costs increased an average of 15% to $6.60 per BOE, which is $0.90 cents higher than in 2003. "Higher energy costs, only modest increases [5%] in oil and gas volumes, tighter rig and labor markets and moving into higher cost-exploration and development environments probably accounted for most of this increase," Krijgsman says. Production costs for the integrated companies grew at around the same rate during 2004. Outside the U.S., production costs are lower but steadily rising year-on-year. Future challenges In looking ahead, there are definite challenges on the horizon for the independents. One of the biggest is the deployment of free cash flow, says Mark Friesen, an analyst with Calgary-based FirstEnergy Capital Corp. "The large independents have undertaken the easy stuff-that is debt reduction, small dividend increases, a responsible level of capex increases to cover cost inflation and some share repurchases, to the extent that acquisitions continue to be considered expensive, possibly because of a lack of faith in long-term commodity prices...." Jeff Hayden, an analyst with Houston-based Pickering Energy Partners, says increased competition is another roadblock for today's independents. "In recent years, the E&Ps have faced competition from the large international oil companies [IOCs] overseas but have not seen much stiff competition onshore North America, as most of the large IOCs have focused elsewhere. "The [recent] CNOOC offer for Unocal highlights the increased competition that we think the industry will see from the national oil companies [NOCs]. This result will be two-fold: E&P companies will have to compete with NOCs and large IOCs internationally, and large IOCs may increase their domestic focus, intensifying competition here as well." Friesen says that staying true to economic discipline through cost control, capital discipline and rigorous acquisition evaluations in the current environment of robust commodity pricing is another big hurdle for the group, along with the ability for all of the independents to keep growing. "The macro environment would suggest that not everybody can grow, especially profitably." His other concern is becoming increasingly familiar: the challenge that exists in finding and retaining skilled people to keep the industry moving forward. Hayden says, "For the industry to continue to expand, E&P companies will need to continue to increase their staffs. This is easier said than done as there do not appear to be enough students studying petroleum engineering to meet the expected need." He adds that looming equipment shortages may also be in the future, which would hamper not just the independents but the entire upstream energy sector. Friesen also anticipates increased finding, development and acquisition costs, modest growth in production-excluding divestitures-and increasing cash flow per share due to continued strength in commodity prices and large share repurchases among the large-cap E&Ps. Hayden forecasts 5% to10% production growth next year, with the small-caps growing faster than the large-caps-at 10% to 15% versus about 5%. Reserve growth during the same period should be similar, Hayden says. "A key driver of the growth during the next few years will be high commodity prices. At current prices, E&P companies generate more cash flow than most managements ever expected. The high prices have also made a number of prospects and plays that were marginally attractive at best three years ago very economic today. The combination of increased cash flow and increased inventory has driven E&Ps to increase drilling activity, resulting in the forecast production growth." Earnings may take a dip in 2006, as he expects commodity prices to fall next year, he adds. "However, some of the smaller E&Ps with strong forecast production growth should still be able to deliver earnings growth in 2006." When its comes to exploration, both analysts agree that the independents are still playing it safe. "The trend is most definitely toward low-risk repeatable resource-play-type concepts," Friesen says. "Companies favor this because of its predictable, low-risk characteristics that by virtue provide large project inventories. The lower-risk predictable nature of these assets makes it easier for the market to assign value to the stocks." Hayden says, "The big buzz words seems to be 'resource plays,' which are usually characterized as high-probability-of-success, statistical plays. The Barnett Shale [in North Texas] and the various coalbed-methane plays are some examples. Typically, these wells have a high initial decline rate, which then flattens out into a long tail, often 20-plus years." Another reason the independents are favoring these projects is because investors are paying for them. "The investor frenzy over these types of projects has gotten to the point where companies have outperformed peers just by announcing an incremental acreage position in one of these plays," Hayden says. "Just look at three of the top performers year-to-date: Southwestern Energy Co., Quicksilver Resources Inc. and EOG Resources Inc. Each has run [upward] due to their interest in emerging shale plays in the Barnett or Fayetteville. "Second, most companies believe the long-term supply and demand fundamentals are strong and higher prices are here to stay. As a result, taking long-term price risk seems more attractive than near-term exploration risk in the current environment." For investors with an eye on energy and specifically the independents, the analysts say selectivity remains important. "It's key," says Friesen. "[Also key are] positions in companies that have reasonable targets, strong economic controls, strong management and multi-year prospect inventories. Migrating toward liquidity is also not a bad strategy if current commodity prices make you nervous." Hayden adds, "Selectivity is critical at this stage as group valuations are no longer cheap. Investors should overweight the group, as the E&Ps should outperform the market during the next year, even if that just means the E&Ps fall less than a sloppy market. "The main macro element investors should watch closely is demand. At current high-price levels, we worry more about demand destruction than supply growth as the cycle killer. Early signs of demand erosion should be a signal for investors to reevaluate their E&P weightings."