Capital Discipline: A Continuing Mantra for E&P Firms

It was easy to take notes at the 32nd annual Howard Weil Energy Conference. All the E&P firms emphasized capital discipline as free cash flow rains down upon the industry. While investors like the story, they really want to know how the sector determines reserves. Analysis:
In the spring, the poet wrote, a young man's fancy lightly turns to thoughts of love. In New Orleans, though, those springtime thoughts were focused on energy for those in the buyside financial business.

The Howard Weil energy conference convened for the 32nd time in New Orleans during the last week in March with more than 120 company presentations and 400 fund managers, stock buyers, and institutional investors.

The major theme, at least for the E&P companies, can be summed up in bumper sticker philosophy: you know, the one that says: 'Dear Lord, give me one more boom. I promise not to mess it up this time.'

That bumper sticker has been shortened to "capital discipline," or how E&P firms are not going to squander the billions of dollars in free cash flow that was swelling the sector's coffers in early 2004.

While that was the official theme, an unofficial issue surfaced in breakout sessions and company dinners where CEOs were peppered with questions surrounding their reserves. The specter of reserve additions from Royal Dutch Shell and El Paso has unnerved investors as the financial community discovers that the process of oil and gas reserve classification is as much art as science.

It is why both the Securities and Exchange Commission and the oil and gas industry always add the term "estimates" to "reserves" in public filings.

It was not uncommon to hear CEOs veer from prepared presentations to affirm that their reserves were audited or compiled by third-party engineering firms. But that hardly provided comfort after Anadarko Petroleum Corporation CEO Jim Hackett noted that third-party entities had a vested interest in presenting positive news to their employers.

"Management is the main insurer of reserve quality," Mr. Hackett emphasized. "The SEC knows that's the issue, and that's why outside engineers don't sign the financial statements, corporate officers do. In the case of outside engineers, their risk is they lose a client if they have bad estimates. Ours, as a management team, is we lose our jobs, potentially our careers, potentially our reputation, and potentially our freedom."

But E&P management stayed on message for the most part, which was a discussion on the biggest challenge facing the oil and gas industry: namely, what to do with the large volumes of free cash flow accumulating in E&P portfolios thanks to high commodity prices.

Conversely, most operators seemed blissfully oblivious to the fact that their cost structures will be changing soon. Oilfield pipe manufacturers such as Maverick Tube Corporation or Grant Prideco outlined the sudden jump in steel prices over the last 90 days that has created surcharges, which the manufacturers are passing directly through to customers. Those surcharges impact about 15 percent of average well costs.

Nor are rising prices confined to Oil Country Tubular Goods (OCTG). BJ Services took the opportunity presented by the conference forum to announce a seven percent increase in prices for pressure pumping services. Similarly, Halliburton's management noted that the company's cementing and fracture stimulation divisions were about 50 to 75 units away from full capacity utilization, which implied higher rates just over the horizon.

Even the land drillers outlined expectations that day rates were about to move as the last bits of incremental fleet capacity are absorbed in a hot drilling market.

Optimistic is a better term to characterize E&P sector attitude this year than euphoria, though it was not hard to detect a hint of the latter as company after company pointed to growing volumes of free cash.

As for ideas on what to do with the monies, operators are reducing debt to capitalization ratios into the 30 percent range, buying back undervalued stock, boosting the dividend, and picking up extra reserves through acquisitions, though these are getting harder to find since commodity pricing has inflated property values.

In fact, an air of pervasive optimism explains why no one put out an all-points bulletin on the one topic missing from the Howard Weil energy conference this year, which was last year's main theme: the "lack of quality prospects." In the 2003 conference more than a dozen companies cited "lack of quality prospects" as an industry challenge before going on to solicit investment in their company because the E&P firm had a portfolio of really great prospects.

Apparently they are drilling those prospects this year.

Of interest for this year's conference is the fact that E&P firms are adopting higher price decks to determine potential drilling programs. No more $2.50 natural gas. Instead the base threshold has risen above $3.35 for figuring economics, though everyone expects that $5 gas is here to stay for awhile.

As for WTI, the price deck has moved into the mid-$20 level, even for major integrated oil companies such as ConocoPhillips. This is evidence of the quiet revolution underway in which E&P managements admit privately that they are gaining confidence in commodity pricing which in turn implies programs are going to expand as 2004 matures.

Things change at Howard Weil. In years past Halliburton spent a major part of its corporate presentation reviewing technological innovation in its energy services division. Typically the Kellogg Brown and Root construction services division merited a slide or two that surfaced in passing towards the end of the presentation. Now KBR is the main topic of conversation with its $20 billion in government service revenues globally. Similarly, time normally spent discussing oilpatch technology is currently consumed outlining the steps the company is taking to overcome the asbestos issue it inherited from the merger with Dresser Industries. Look for mid-May to generate a pre-packaged bankruptcy that will produce settlement monies and free Halliburton from one more contentious issue.

Still it was KBR that produced an impassioned oration from company CEO David Lesar who told attendees: "despite what you have been reading, Halliburton has the system, processes, controls, and ethics to operate in today's environment and the laws of the United States. While we will continue to have headline risk, we're going to stay the course, serve our customers, and we are going to get through this."

Getting through all this was a major goal for the buysiders, who patiently listened to three days of 20-minute presentations and braved the festive streets of New Orleans at night for the more than 50 company-sponsored dinners.

Laissez les bon temps rouler.