SSB: Independents Limited Only by Projects, Personnel

The majors are focusing more of their spending attention on the domestic natural gas market, gobbling up gas-rich acquisitions, which has lowered their finding and development costs. Meanwhile, the independents' spending is limited only by the lack of "drill ready" projects and experienced geoscience personnel, according to the latest exploration and production study by Salomon Smith Barney's analysts Robert Morris and Michael Schmitz.

Speaking with the investment community on Tuesday, the analysts reviewed their Exploration and Production: 2000 Operating Trends and Finding Cost Study, which looked at E&P by 55 independents last year. The growth, they said, was "not surprising," and independents had their best year ever, rolling with the sky-high commodity prices.

Like the majors, the independents are not pocketing all of their excess cash, and in fact, the aggregate fully loaded finding cost for its group was up almost 35% in 2000. "Interestingly, the cost to acquire proven reserves was once again lower than with the drill bit for both the independents and majors," the study said.

Domestic natural gas reserve replacement for the independents and majors combined also jumped, totaling 140% in 2000, compared with less than 100% in the previous five years, and "the independents continued to strongly outpace the majors in this category."

But it was not a complete knockout punch. Reserves added per well drilled in 2000 "dropped 9% for the independents and 6% for the majors, despite only a slight drop for the independents and a strong rise for the majors on exploration success."

Morris told analysts that "a lot of companies shifted to easier reserves" in 2000, so that "even though it looked like finding and development costs were flat last year," the F&D costs for independents actually rose about 35%. Acquisition costs also rose, noted by recent North American acquisitions, including Tuesday's announced bid by Conoco for Gulf Canada Resources Ltd. (see related story), where Conoco offered a 34% premium to Gulf Canada.

The majors have it over the independents with their cash flow in more ways than one, they noted. "Spending for the independents is limited by the lack of projects and keeping experienced personnel," said Morris. "They are running as hard as they can and even at that are not being able to stay ahead of cash flow."

Notably, per-unit lease operating expenses were up 17% last year, while general and administrative costs increased 13%. Morris said that there is more pressure on the independents to raise salaries and offer incentives to keep their experienced personnel and to find new ones.

Nonetheless, overall results point to solid economic returns. The "independents are really thriving in natural gas," because they are focused on the drill bit, while the majors are more focused on acquisitions. Independents, Morris said, are "strongly outpacing the majors" when it comes to economic returns and reserve replacement costs, which he said was "stronger than any time we've seen in the past."

The largest spending increase came in the unproved property acquisition category, which represented 13% of the total capital outlays in 2000 compared with 5% in 1999. "The independents apparently took advantage of strong commodity prices and ample excess cash flow in 2000 to lay the groundwork for future exploration activities by boosting spending on undeveloped acreage."

The analysts said they expected the independents that picked up acreage last year to begin "stepping back up the risk curve in an attempt to unearth discoveries that can augment future production and reserve growth."

For the majors, total capital expenditures actually increased 90% in 2000, "underscored by several prominent acquisitions," notably BP acquiring ARCO; Occidental Petroleum purchasing Altura Energy, and Phillips Petroleum Corp. acquiring ARCO's Alaskan properties.

For the future, the analysts said that a "key variable" would be commodity prices. "The E&P group's reserve replacement efficiency (RRE) reached its highest level in 2000 due primarily to strong commodity prices. In 1999, the group's RRE was 1.34, and in 1998, it was only 0.72 due to abnormally low crude oil prices that year, combined with a strong rise in finding and development costs. During the past five years, RRE for this group has averaged 1.58."

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