Independents told to reorient in order to grow

Steven Poruban
Staff Writer

U.S. independent natural gas producers will have to reorient their businesses, bolster their returns on equity, and essentially regain control over the flow of their commodity to ensure a stronghold in the industry for the foreseeable future.

This was at the core of a speech given last month by John E. Olson, senior vice-president of Sanders Morris Mundy's natural gas group to members of the Independent Petroleum Association of America (IPAA). Sanders Morris Mundy is a Houston brokerage firm.

Olson also stressed the need for producers to pay particularly close attention to the ever-increasing demand for gas from the rapidly growing North American cogeneration/independent power plant (IPP) market. In addition, Olson noted that the emerging group of integrated energy conglomerates will provide fresh opportunities for independents-as asset buyers as well as for the chance for independents to avail themselves of downstream energy opportunities.

E&P outlook

Olson noted that U.S. natural gas production has grown about 1.1%/year over the past 10 years. In recent years, increasing demands have been placed on natural gas producers by consumers, government, and investors. Even under the constraints of today's market-very low oil prices and moderately low gas prices, the continued decline of wellhead revenues, and a steep drop in drilling activity-the expectations, nevertheless, remain the same: "They want you to grow production effortlessly at 3%/year," Olson said.

These same groups expect producers' earnings to increase in the not-too-distant future as well, with Wall Street expectations for overall U.S. corporate earnings growth to average about 6%/year.

By 2020, said Olson, U.S. natural gas demand is expected to jump to 27 tcf/year from 19 tcf/year in 1998. About 3 tcf of that incremental demand will be met by volumes from the Gulf of Mexico, while 5 tcf is expected to come from U.S. Lower 48 onshore areas. But exactly how those U.S. supplies will come about, he admitted: "I don't have a clue how you're going to come up with those numbers effectively."

The present profile of exploration and production companies has probably seen better days, according to Olson. The average E&P stock price in 1998 was down 41% with many companies earning nothing for the year-a trend Olson warns may repeat itself in 1999.

Many E&P firms had yearend ceiling test write-downs and are having to sell assets to pay down notes. "You're currently working for the banks," said Olson.

Drilling budgets also are down. "We are looking at maybe 25-30% lower drilling budgets in 1999," said Olson. "You can expect 5-20% natural declines in your production simply because you are not drilling, and, unfortunately, we are losing thousands upon thousands of stripper wells that may never come back," he warned.

Returns on equity

"Everything you do on Wall Street has to have a return on equity (ROE)," said Olson. High earners, such as Dell Computers, with an 80-90% ROE last year, and Coca Cola, with a 60% return, are "the stocks that crowd out investment in exploration and production," he said.

"The average producerellipsefrom 1993-97 delivered about 10.7%/year total return on equity, the stock market (overall) delivered about 24%/year, pipe- lines delivered about 28%/year, and oil service companies delivered about 26%/year," he said.

Taking a look at profitability, Olson compared the E&P business with local gas distribution companies and with pipelines. He said that, because pipelines and distribution companies have a higher ROE, that affords them a "cash flow anchor" from which to take off and ramp up dramatically. He cited Enron Corp., which had $10 billion in assets 5 years ago and now has $30 billion. "Over the next 5 years, just to keep up the momentum, they (would) have to become a $60-70 billion asset company," said Olson. Such integrated energy conglomerates are seeking any acquisition that will make money for them, said Olson, and, they hope, a 15% or better ROE.

Return to power

Olson singled out the growing gas-fired power generation market, especially New England, as a potential "silver lining" in the seemingly cloudy outlook for producers. "Any forecast you look at out there is saying that there's going to be a tremendous amount of generation capacity, first of all, and secondly, it's mostly going to be gas-fired," he noted.

If all of the recently proposed cogeneration and IPP plants ran at 100% load factor, said Olson, it would create incremental demand of about 37 bcfd. Olson cut this amount in half twice-once, because most units would run about half the time and then again, due to the fact that a lot of plants will be peaking units-and arrived at a net increment of 9 bcfd in new gas demand growth. "Over the next 10 years, 97% of (incremental growth in) power demand is going to be fueled by natural gas," said Olson.

"And a lot of the energy conglomerates, like Duke (Energy) and Enron, are building plants left and right," notes Olson. "In the merchant market, I think there's 36,000 MW of projects that were just announced in the third quarter alone and more in the fourth quarter."

Commodity flow

"So, life is going to be very, very good. The key isellipseto regain control over how that commodity is flowing," he advised. "The one thing I learned early and after many, many mistakes is this: In any commodity business, those who control the flow of the commodity make all the money.

"If you all can begin to reconfigure your market and look at this as a real opportunity-probably the only opportunity since the spring of 1983, when they implemented pipeline marketing affiliates-this is the one place this industry can make not only a major contribution but (also) make incremental money by moving downstream.

"(The larger energy conglomerates) have to grow through acquisition. It's not a choice. It's not an option. They have to grow. Every one of the companies in the energy conglomerate area have committed to Wall Street toellipse10-15%/year earnings growth.

"With average energy demand growing (at a rate of) 2%/year, and you want (your company) to grow 10-15%/year, it's mathematically impossible to get those kind of numbers. It's easy to grow 2-5%/year, if you're a regulated utility, but 10-15% is a stretch.

"Maybe when you start to show some good numbers again down the road, you are going to come back to Wall Street and be a success one more time," said Olson.