Exploration and production (E&P) reserve life, calculated as developed and undeveloped proven reserves divided by the last 12 months production, offer investors more assurance of superior long term production growth over the traditional finding and development (F&D) costs, according to a report by Southwest Securities’ analysts.

Compared with its study a year ago, which analyzed 2000-2002, reserve life now is showing more importance, said analysts John Gerdes and Chris Clark, because it is an “implicit indication in longer-lived reserves of a lower production decline and more assured undeveloped reserve potential.”

The value of F&D costs have lost their esteem likely because of the “increasingly debatable reliability in determining proven undeveloped reserves and their timing of development,” said the analysts. Investors also are gaining proficiency in differentiating between the value creation potential of various exploration and production (E&P) business models.

The analysts offered examples of their theory by looking at several of the smaller “top performing” E&Ps, which have attributes in common. Ultra Petroleum, Quicksilver Resources, Petroleum Development and Patina Oil & Gas “have appreciated on average (excluding dividend) by 428% since Dec. 31, 2000.” Among other things, these four companies share “far superior reserve replacement (679% versus industry median 205%) and F&D costs ($0.84/Mcfe versus industry median $1.49/Mcfe).”

The four producers also have a predominantly unconventional natural gas asset base — coalbed methane — with a lower production decline rate and “significant” undeveloped drilling inventory. And, they share a “low risk onshore North American natural gas development-oriented strategy.”

Overall, Gerdes and Clark noted that companies that achieve highly competitive operating results “should and do” receive premium relative valuations.” However, “relative equity out-performance going forward appears likely to have as much to do with financial leverage as operating performance.”

E&Ps covered by Southwest Securities that have the “likelihood” of competitive future operating performance include Magnum Hunter Resources, Devon Energy, Chesapeake Energy, XTO Energy, Pioneer Natural Resources and Apache Corp.

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