Rising oil and natural gas prices have not translated into strong growth rates for exploration and production companies, and while 2003 results were an improvement over the previous year, overall results were good but not great, Lehman Brothers analyst Thomas Driscoll said Friday.

On a conference call to discuss his latest report on E&Ps, Driscoll said that investors now are rewarding companies that are curtailing their spending and devoting excess cash to debt reduction, acquisitions, share buybacks and dividends.

According to Lehman statistics, debt-adjusted production per share grew between 5-6% in 2003, following a 6% decline in 2002 — equally no growth over two years. Debt-adjusted reserves per share grew an estimated 14% in 2003, following a 5% decline in 2002, making the two-year total growth rate about 9%.

“How much value did E&P companies create?” Driscoll asked. “We would argue that, holding oil and gas price expectations constant, the implication of this data is that the companies ‘earned’ a real return of 0-5% per year, plus about 1% for dividends, in a period when oil and gas prices were very strong.”

The analyst noted that if 2003 is a guide, investors may reward those companies that generate the most free cash flow in the new year. Expectations for 2004 are that XTO Energy, Occidental Petroleum, Pioneer Natural Resources, Apache Corp. and Burlington Resources will generate the most free cash flow while EnCana, Canadian Natural Resources and EOG Resources generate the least.

“We believe that E&P companies are now being rewarded by investors for ‘capital discipline,'” said Driscoll. “In the past, investors were focused on production growth, even if that growth was uneconomic and if it came at the cost of rising debt and increased shares outstanding.” According to his figures, there is an “extremely strong relationship” in 2003 between “capital discipline” and shareholder returns for both large cap Canadian and large cap U.S. E&Ps.

“The companies spending the smallest share of cash flow, in an often failed pursuit of growth, are on average earning lower returns. Investors in 2003 have begun to reward those companies that are generating free cash flow. We expect 2004 to bring more of the same.”

The negative correlation between capital spending as a percentage of cash flow and debt adjusted production per share will continue into 2004, Driscoll said. “We believe that investors will reward companies that exhibit financial discipline while generating better than average production per share performance,” when adjusted for debt level changes. “Once again, Pioneer, Apache, XTO, Occidental and Burlington emerge as the companies that are expected to generate above par production per share performance while spending less than the average E&P company on drilling budgets.”

Combined 2002 and 2003 results imply that the large E&Ps built asset value at 0-5% a year over the two year period. Results were significantly better in 2003 than the previous year, said Driscoll, because of higher oil and gas prices; better investment choices; timing; and changes in the share of spending on long-lead time projects.

“For almost four years now natural gas prices have remained at substantially higher levels than those in the 1990s,” said Driscoll. The positive impact from higher prices appears to have been more than offset by rising unit costs — especially in the more mature areas such as North America…the increase in unit costs comes more from declining reserve sizes than from increases in absolute costs.”

Questioning whether capital discipline was improving, Driscoll said that spending levels, as a percentage of cash flow, were reduced in 2003. “In 2002, E&P companies spent 110-120% of their cash flow on oil and gas acquisition and drilling activity and saw debt-adjusted production drop 6%,” he said.

“In 2003, we calculate that the same set of companies will spend 80-90% of cash flow but production adjusted for changes in debt levels is likely to be higher by 5-6%. This appears to indicate that E&P companies are beginning to realize the benefits of curtailing the portion of their cash flow spent on capital expenditures in order to protect the economics of their drilling activities.” The trend “needs to continue and companies that follow this trend are likely to be rewarded by better than average stock price appreciation.”

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