Like a storm-tossed sailor who finally has the home port in sight, most exploration and production companies were seeking a safe harbor in 1999. The year began with becalmed $10 oil and ended with a brisk $30. Buoyed in the second half by oil and natural gas prices that exceeded everyone's expectations, most firms unfurled their sails and produced all out in order to take advantage. In this Gauging the Oils, our annual tally of financial and operating results for the largest publicly traded E&P companies, we focus on fiscal 1999. We relied on 10-K data compiled by EvaluateEnergy Plc (which recently changed its name from Petrocompanies). The London firm's interactive database contains information on more than 230 public companies. We chose to rank companies by their market capitalizations at yearend 1999. Just for fun, we've also included the proforma numbers for BP Amoco as if it had merged with Arco in 1999. What's noticeable is that although high oil and gas prices pushed up 1999 cash flows from the disastrous 1998 lows, production and reserve numbers fell, or remained flat, for about half the companies (if mergers and large acquisitions are omitted). Asset sales are partly to blame. And some companies were making strategic changes that could lead to higher growth ahead. BP Amoco, for example, explained recently that its oil output may be unchanged in the next few years while it hikes natural gas production by 50% to 9 billion cubic feet per day from 1999 numbers. But still, with gale force commodities at their backs, why aren't E& P companies sailing faster? The U.S. rig count and underlying capital budgets are still fairly low given that oil prices have tripled and gas prices have at least doubled since early 1999. It's worse internationally, where the rig count is stuck in the doldrums for a third year. Throughout 1999 and so far in 2000, companies have been sailing very cautiously, but it's no wonder, given the cross-currents. The Street demands that they deliver higher returns on capital employed; the banks are asking for spending discipline. Out of self-imposed caution, the majors seem to drill as if low oil prices will prevail. In addition, many companies are reducing debt and buying back stock. Growth for growth's sake seems like last year's news. Get off the treadmill of replacing reserves at all costs, and step onto the new treadmill of replacing $1 spent with $1.30 returned. "We think the industry has gotten the message [about returns], through the erosion in value of its equity," say the analysts at RBC Dominion Securities' new office in Houston. The Canadian investment bank recently began covering 32 U.S. independent producers, led by analyst John Selser. "In 1999, we saw commodity prices increase 24% on an equivalent basis, resulting in a cash flow increase of 39% for our universe, [yet] capital spending on exploration and development declined in 1999 by 28%," says Selser. That cautious stance may be about to change, however. "As evidenced by the free cash flow generated in the first quarter, we look for about 10% to 20% of the total cash flow this year to be used to reduce debt. We believe our group is 'under spending' and the second half of 2000 could be very active," Selser says. "If the group were to spend 90% of its projected cash flow in 2000 on exploration and development, then their spending would be up 60% over 1999 levels, and up to a level even above the activity of 1998." "The more people act as if $14 Brent is the base [and drill fewer wells], the less likely it is that we'll ever see that price," says analyst Stephen A. Smith of Dain Rauscher Wessels in Houston. Smith recently began covering the majors and integrated oils along with his regular universe of large independents. His top picks currently include BP Amoco at $69, Chevron at $120, ExxonMobil at $103 and Royal Dutch/Shell at $80. Volumetric growth has not necessarily been the key to success in the past. The focus must now be on return on capital and much less on growth of production and reserves, notes analyst Edward E. Maran, who follows the majors for A.G. Edwards & Sons Inc. in St. Louis. If oil were to average $17 to $18 per barrel, a company should be able to deliver an unleveraged, after-tax return on capital of 12% to 14%, Maran says. "Most of the majors are testing their projects at $14. The market doesn't want a company to grow production and yet deliver unattractive returns. Look at the history of ExxonMobil in particular. It hasn't really grown its reserves in a decade (see chart), yet it consistently delivered a high return and is widely respected for being well-managed." Maran likes Conoco and Phillips Petroleum these days. Both should show good volumetric growth and decent returns as well. He especially likes Conoco's penchant for being one of the first companies to enter new places, as it did in Siberia and Venezuela. He thinks as soon as countries such as Libya and Iran open up to the West, Conoco will be there. It also has a meaningful deepwater position. Conoco has told investors it will generate a 22% production increase from 1998 to 2001. Maran says it doesn't matter whether a company grows through drilling or acquiring. Again, he comes back to value. "What's important to me is the cost of an acquisition relative to the value," he says. "I'd rather see a company buy reserves for $5 a barrel than drill for them at $7, and vice versa. Phillips has added value and income to the bottom line [with its dramatic purchase of Arco Alaska]. When the impact of Alaska for a full quarter hits, people are going to say 'Wow.'" Despite the heightened focus on returns, analysts haven't forgotten that an E&P company exists to find oil and gas. They are quick to point out the flat to declining production trends among companies in 1999 and first-quarter 2000. Salomon Smith Barney analyst Robert Morris said in a recent report that for 17 of the 18 companies he follows, first-quarter production declined 1% versus the year-ago quarter and was flat compared to 1999's final quarter. That was despite cash flow per share being up an average 128% versus a year ago. "An upturn in gas deliverability is still not in sight," says Morris, even though the U.S. gas rig count reached a new high of 662 by the end of May, surpassing its previous peak attained in 1997. "Dissimilar to the 1990s, E&P companies appear to largely lack the 'drill-ready' inventory of economic projects and quality acquisition opportunities to expand capital outlays to match cash flow," he says. This all begs the question: Can the industry have it both ways, delivering growth and return? In the end, these two goals should go hand in hand. "The difficulty arises when a company stretches to achieve growth by taking on too much debt, or by drilling some prospects that are too risky or too expensive," says Larry Benedetto, analyst with Howard, Weil, Labouisse, Friedrichs in New Orleans. "The strategy now, with capital discipline, is to seek that balance between growth and return." Call it smart growth. "It's not necessarily either or," says Dain's Smith. "But then, you can't really find a strong correlation between production growth and share price performance over the last five or 10 years. Divesting high-cost production to cut costs is the right thing to do, as far as return goes, but it slows volume growth...Using any single measure is misleading." In an upturn such as the industry is currently enjoying, talk inevitably will turn from capital discipline to managing the prospect portfolio, and that means having enough of the right kind of projects in inventory. "At $3 or $4 gas, investors want to know where your next gas projects are," says Shannon Nome, E&P analyst for Banc of America Securities in Houston. "But discipline through the cycle means you don't plan based on $3 gas or mark-to-market prices." Like all investment banks, B of A focuses on companies that show relatively good growth potential versus their peers. The firm's top stock picks currently include Royal Dutch/Shell Group, Chevron and Conoco among the largest companies, and Anadarko Petroleum, Ocean Energy, Triton Oil and Devon Energy among the independents. Whether aiming for growth or return, most companies have ambitious plans. In its 1999 annual report, Chevron said "...it has targeted a 15% annual growth rate in earnings per share to 2002, supported by worldwide oil and gas production growth of 4% to 4.5% per year, and a minimum 12% return on capital employed. But the E&P sector as a whole may be limited by the projected 1% to 2% growth in global oil demand, notes Tyler Dann, E&P analyst with B of A in Houston. "We look for three things: above-average growth, consistent and reliable management, and stocks that are trading cheaper than the average relative valuation." The amount and quality of projects available may limit companies' growth. At an analyst meeting recently, EOG Resources said its 2000 capital budget of $425 million is nearly $400 million below its full-year projected discretionary cash flow. "Management confirmed it does not have projects in hand to spend more than this in 2000," says Salomon Smith Barney's Morris. Nome says analysis depends on how growth is defined. "The average growth rate of the sector-that's growth of liquidation value per debt-adjusted share-has been about 2% per share, if you calculate the PV-10 with a flat price deck, and adjust for debt. If you look at only reserve growth, the number would be larger, but if you look at it with debt factored in, then it's less." According to her data, the top performers over the last five years have been EOG Resources, showing 9% growth, and Apache Corp., Devon and Anadarko at 6% each. "The large-caps averaged 2%, although Burlington Resources averaged a negative 4%, actually destroying liquidation value. The smaller caps fared better overall at 4% for the group. Stone Energy was tops, however, with 13% growth and Cross Timbers Oil was 12%. One of Nome's top picks is Ocean Energy Inc., a turnaround boasting new management and a different strategy since the downturn caught it off guard with too much debt. "A redirection in exploration strategy is the key here," she says. "Instead of trying to be in the driver's seat in everything they do overseas, with 80% to 100% working interests, they are willing to bring in major partners. They are leveraging the asset base and they are going to live within cash flow." Her price target is $21 per share by mid-2001. Burlington Resources seems a prime example of a large independent whose growth rate has slowed since its 1997 acquisition of Louisiana Land & Exploration and 1999 purchase of Poco Petroleums Ltd. But volumes do not equal value. So declared chairman and chief executive officer Bobby S. Shackouls during the annual Howard, Weil conference in April. "From 1990 to 1996, our return on capital averaged 6%. In 1997, we made a major decision to populate our inventory with growth opportunities, so we bought LL&E and then, Poco. We recognized organic growth would take far too long. We brought capital to the opportunities that these two companies could not have done on their own." Now, Shackouls hopes to raise the return on capital by 200 basis points over the next year and deliver a return that's competitive with the majors. To do so, he is assembling an inventory of opportunities that can be tapped as needed. "We are spending large sums of capital in projects that won't bear immediate fruit, but possess tremendous potential for future value creation. We have de-emphasized production growth in order to concentrate on value enhancement," he said in Burlington's 1999 annual report. The traditional correlation between commodity prices, rig count and resulting production can be difficult to measure if attitudes toward growth have changed. Most companies will report substantially higher earnings and cash flow this year than they did in the record year of 1997, analysts say. How will they use that? "All of the E&P companies will have higher cash flows this year, so they do have the ability to raise their capex budgets, but we are still seeing capital restraint, which is good," Benedetto says. "We expect production for most companies will rise in 2001 on a percentage basis as they increase spending. So much of the growth in the 1995-99 cycle was from acquisitions (unfortunately, too often fueled by debt), but now we'll see more growth from drilling." Even so, "there are no indications yet of companies' willingness to spend beyond their cash flows [as they did in the 1995-97 boom]," point out Donatello Pitts and Subash Chandra at Morgan Keegan & Co. in Houston. "Cash flows will rise materially in sympathy with prices, but few companies are eager to 'chase' deals already pricing in $3-$4 gas. As long as this is the case, irrational behavior leading to a cyclical bust can be avoided...[but] at some point, prospect inventories must be replenished at whatever cost..." It appears that industry observers may not have to wait much longer for the time that companies tack in a new direction.