By almost any yardstick, fiscal 2000 was a banner year for the top 20 major integrated oils, as ranked by net sales revenues. Most reported 30% to 40% gains in revenues that year versus fiscal 1999 and triple-digit growth in net income and earnings per share. And their return on capital employed-a key measure of financial efficiency watched closely by Wall Street analysts-ranged from 30% at the low end to highs of 138% and 139%. That's a hard act to follow. So Oil and Gas Investor asked London-based Evaluate Energy, a supplier of key financial, operating and strategic-planning data to the oil and gas industry, consulting firms and investment banks worldwide, to track the fiscal 2002 versus 2000 performance of the same top 20 major integrateds. "What we found was that the financial performance of the leading major integrated oils generally deteriorated during 2000-2002-between 10% and 20% in many cases," says Richard Krijgsman, Evaluate Energy chief executive officer. "This was due primarily to the trend toward lower realizations from subsequently weaker oil and gas prices since 2000." In that year, West Texas Intermediate prices averaged $29.31 per barrel and Henry Hub gas prices averaged $3.60 per thousand cubic feet (Mcf). Indeed, the world's largest oil company, ExxonMobil, saw the realizations on its worldwide crude output drop from $25.59 per barrel in 2000 to $22.55 in fiscal 2002 while realizations on its gas production dipped from $3.12 per Mcf to $2.77. One would think, of course, that lower oil prices and hence, lower feedstock costs, would tend to favor the downstream businesses of the integrateds. But that didn't happen in fiscal 2002. "The downstream tended to perform as poorly as the upstream," explains Krijgsman. "Because of the volatility in crude prices last year, refiners couldn't sustain healthy margins." Looking at the reserve and production profiles of the top integrateds oils during 2000-02, there appears to be sound growth. But that growth, in large measure, was due to acquisitions, he points out. Shell, for instance, took over Enterprise Oil, which added about 200,000 barrels per day to its oil output. Meanwhile, Italy's ENI bought Finland's Fortum Petroleum, adding about 40,000 barrels to its daily oil production. Similarly, the 2000-02 gains in reserves and production for ConocoPhillips reflect the merger of those two companies, while EnCana's growth in inventory and output during that period is largely attributable to its merging of Alberta Energy and PanCanadian Petroleum. There are, however, some notable exceptions to this trend-and they are most noticeable at the top of the pack. "During the past five years, ExxonMobil added 3.7 billion barrels of oil reserves and 9.3 trillion cubic feet (Tcf) of gas reserves-solely through the drillbit," says Krijgsman. That's double Shell's drillbit additions of 1.6 billion barrels of oil and 4.7 Tcf of gas during the same period-the latter relied heavily on acquisitions for growth, adding 1.2 billion barrels of oil and 5 Tcf of gas through purchases. Meanwhile, BP, reflecting both growth strategies, added 3.2 billion barrels of oil through the drillbit and another 1.8 billion barrels through purchases during the past five years; concurrently, it added 20.6 Tcf of gas through the drillbit and another 8.9 Tcf through acquisition. Krijgsman cautions that the recent financial and operating performance of the top integrated oils should be viewed from the standpoint that 2000 was an exceptional year for the worldwide oil and gas industry. The outlook for the top integrated oils this year and next? "We're currently in a very different industry environment compared with what we saw in the 1980s and 1990s, which were periods of cost-cutting, consolidation and continual declines in real oil prices-periods where you had excess capacity that prompted a reduction of investment," says Steven A. Pfeifer, first vice president and global oil coordinator, equity research, Merrill Lynch, New York. "With this reduction in investment and only half the number of industry employees we had in the 1980s-currently 350,000 versus 700,000 then-we're now seeing very tight inventories," he says. On top of this, as oil companies continue to recycle and replace reserves, they're having a more difficult time keeping their finding and development costs low because they're finding fewer and fewer reserves, he adds. "In short, they're becoming more challenged to replace reserves and grow production. The result: we're going to see disappointing non-OPEC supply growth as demand for crude oil escalates during the next five years." Meanwhile, OPEC's market share will actually increase and allow it to maintain oil prices within its targeted range of $24 to $30, he says. Merrill Lynch expects crude prices to average $28.50 this year, retreating to an average $24 in 2004 and beyond. Based on estimated 2003 earnings, the integrated oils are currently trading at about a 35% price/earnings (P/E)-multiple discount to the S&P 500, says Pfeifer. "Historically, that discount has only been around 10%. This means that, if we're correct about projected $24 oil prices in the long term, these stocks are very inexpensive. In fact, our analytical work shows that the integrated oils, as a group, are currently discounting an oil price of only $20." In such a market environment, the analyst's top integrated oil picks for 2003 are ConocoPhillips and ChevronTexaco. ConocoPhillips is very attractively valued, trading at only nine times estimated 2003 earnings, he says. "Second, the company is highly levered to refining and marketing margins and, although we saw very weak downstream conditions last year, the company is significantly increasing its earnings out of this segment." He expects the company will earn $5.80 per share this year and $6.20 in 2004. Third, it should show improved returns on capital employed-from 8% to as much as 10% to 11%-as it continues to cut costs following the merger, starts to sell off lower-return parts of its businesses and reallocates cash flow into higher-return areas, he adds. His 12-month target price for the stock is $69. ChevronTexaco is also attractively valued, Pfeifer says, trading at a P/E multiple of about 11-a sizeable discount to that for ExxonMobil, which trades at around 14 times 2003 estimated earnings. In 2002, the company had the albatross of investor concerns about Dynegy hanging around its neck. ChevronTexaco had a large stockholding in Dynegy and share prices were declining precipitously. Pfeifer thinks that issue is now behind it. In addition, ChevronTexaco was restricted, because of the pooling-of-interests accounting method used in its merger, from doing any major asset divestitures until this October. "Once it's beyond that point, we should see the company take aggressive steps to divest itself of lower-return assets and restructure its asset base." The analyst looks for ChevronTexaco to achieve per-share earnings of $5.80 this year, a 13.5% return on capital employed and a 12-month target price of $78. Gene Gillespie, senior energy analyst, Howard Weil, New Orleans, believes commodity prices are at unsustainably high levels and looks for crude prices to trend down to an average of $23 for 2004 while gas prices retreat to an average $3.75. "With Iraq back in the oil market, that's going to cause OPEC greater problems, in terms of supply management. Meanwhile, $5 gas will be short-lived as the result of fuel switching, demand destruction and, further down the road, larger volumes of LNG and gas coming from the Mackenzie Delta and Alaska's North Slope." Against this backdrop, Gillespie sees second-half 2003 earnings for the major integrated oils falling 15% to 20% below first-half 2003 levels. And for 2004, he anticipates earnings for the majors to remain 15% to 20% below full-year 2003 levels. This aside, the analyst looks for a sequential quarterly earnings rebound for the integrateds, beginning in first-quarter 2004, as worldwide economics improve. "The integrated oils, as a group, are moderately attractive due to the long-term outlook for improved earnings and dividend growth," he says. "These companies, in general, have solid-gold balance sheets and are generating high levels of free cash flow. This allows them to raise dividends at an above-average rate, as well as buy back stock. So the financial characteristics for this group are a 'go'-even in a lower commodity-price environment." Gillespie points out that most integrateds are no longer chasing "empty barrels," that is, spending aggressively to generate production growth. "Unrealistic production targets have been replaced with production discipline, and return on capital employed is the mantra of the day. That's what investors are demanding; that's what they're willing to pay for. If one does an analysis, there's a strong correlation between balance-sheet strength and valuation, as well as between profitability-as measured by return on capital employed-and valuation. There's virtually no correlation between production growth and valuation." Like Pfeifer, Gillespie believes ChevronTexaco and ConocoPhillips are poised to do better than their peer group this year. "When the pooling-of-interests accounting restrictions fade away this fall, ChevronTexaco will begin making significant asset divestitures. Between now and then, we should see the outline for a major asset-rebalancing program, under which the company will be able to sell noncore assets and focus its funds on strengthening the balance sheet, reducing debt/capitalization and increasing return on capital employed. These steps will benefit the relative valuation of the stock." As for ConocoPhillips, the company has a lot more catching up to do, given that its stock is selling at a more significant valuation discount versus the composite average for the larger integrateds, he says. "We would expect some major noncore asset divestitures by ConocoPhillips to drive up their valuation. In addition, the company has estimated that it could begin realizing, on an annualized basis, $1.25 billion of merger-related synergies by year-end 2003. This would further improve their debt/capitalization ratio-which it would like to see reduced to 30%-and also improve market valuation."