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E&P Economics
Searching for profits in the oil patch

Brian Graney (TMFPanic@aol.com)

ALEXANDRIA, VA (Dec. 15, 1998) -- Last week, we left off on our discussion of the oil and gas industry right smack dab in the middle of our introduction to the exploration and production end of the business. Oil industry veterans refer to these business segments as the "upstream." We're not veterans of anything, so we'll stick to the less-flashy "E&P" when referring to these operations. It's easier to remember, in my opinion, and requires fewer keystrokes to boot.

After spending a few days examining the technologies used in E&P, we're ready to shift gears and determine just how profitable the business is. In trying to determine the economics of the E&P business, we're going to concentrate on return on assets (ROA) and return on equity (ROE). Both of these concepts have been well discussed in Fooldom. Before reading further, it may be useful to review the differences between the two measures by reading this series on ROE, derived from Dale Wettlaufer's commentary in Fool on the Hill.

We're going to look at three different types of E&P companies, all of which have a unique exposure to the business. First is Enron Oil & Gas (NYSE: EOG), an E&P "pure play," which is 86% leveraged to natural gas production and 14% leveraged to oil, according to Merrill Lynch. Next up is fellow E&P firm Apache (NYSE: APA), which is 56% leveraged to gas and 44% leveraged to oil. Finally, we've also included Chevron (NYSE: CHV), which has E&P operations in oil and gas, as well as interests in refining, transportation, and marketing (Jeff will get into those "downstream" aspects of the oil and gas business next week.)

Here are the ROA and ROE figures for our three guinea pigs over the past eight quarters. Note that the data is courtesy of Zacks, rather than Fool generated. If it wasn't for my laziness (and the fact that I wrote this on a deadline), I would have crunched these numbers myself. Don't follow my slacker example -- do your own work.

      9/98  6/98  3/98  12/97  9/97  6/97  3/97  12/96
Enron Oil & Gas
ROA    NA   0.48  0.99   1.58  1.19  0.97  0.94   1.43
ROE    NA   1.02  2.08   3.37  2.45  1.96  1.85   2.77

Apache
ROA    NA   0.22  0.42   1.10  0.83  0.72  1.51   1.49
ROE    NA   0.49  0.91   2.63  1.90  1.62  3.37   3.37

Chevron
ROA   1.26  1.59  1.39   2.62  2.05  2.35  2.38   1.33
ROE   2.62  3.26  2.86   5.32  4.26  4.97  5.15   2.97

Avg. oil
price($)14.14 14.71 15.98 20.00 19.79 19.94 22.99 24.54

It is interesting to track how the three companies have reacted to the fluctuating price of oil. Even as oil prices gradually trended downward throughout 1997, all three companies were able to post increasing ROA and ROE figures. The exception to this trend was Apache, whose results suffered more than Enron or Chevron's during 1997 due to its higher relative exposure to oil production.

However, things changed suddenly for all three firms between the fourth quarter of 1997 and the first quarter of 1998. Lower Asian demand, higher OPEC production, and bizarre winter weather took their toll, sending the average closing price of oil down 20% in just three months. The economics of all three of the E&P firms in our example deteriorated in no time.

Through the rest of 1998, things continued to get worse until oil prices got into the $13 to $14 per barrel range in the third quarter of 1998. Subsequently, Enron and Apache's net earnings -- the numerator in both the ROA and ROE equations -- dried up and the valuation ratios approached negative territory. Chevron, with its size advantage and extensive downstream operations, has fared better this year than its E&P pure play peers.

Two general observations can be made using our little example to shed some light on the nature of the E&P business. The first is that when oil prices are toward the high end of their historical range, E&P companies are great performers. The ROE and ROA figures did not move in lockstep with high oil prices, which actually trended down in 1997. Instead, ROE and ROA continued to expand so long as oil prices stayed above the $20 a barrel mark.

Thus, there is a lag to when high oil prices start showing up in E&P firms' results in the form of higher net earnings. One possible explanation for this lag may be that the E&P companies were trying to "lock in" the existing high prices by selling a greater amount of oil in the forward market rather than in the spot market, ensuring higher earnings in future quarters when oil prices might not be quite as favorable.

Another insight we can take away from our example is how quickly profitability can disappear when oil prices turn south. The 20% decline in average oil prices between the fourth quarter of 1997 and the first quarter of 1998 was reflected right away in our three companies' results, without any lag time. It is also interesting to note the level of profitability that the sole integrated company, Chevron, has been able to maintain in the low oil price environment. Based on the two data points we have selected to examine, our results appear to support the argument that size and diversity of operations may in fact be desirable general economic traits in the oil and gas business, as the recent Exxon-Mobil and BP-Amoco mergers have further suggested.

We will have more to say about profitability when we start examining individual oil and gas companies on a case-by-case basis in the coming weeks. Remember, we are still learning here and every incremental nugget of knowledge that we can pick up about the industry along the way will benefit us when the time comes to make our ultimate investment decision. Fortunately, Fools are sharing their ideas about the oil and gas business around the clock on the Drip Companies message board. Drop by and find out what everyone is talking about today.

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12/15/98 Close
Stock Close Change JNJ 80 3/4 +1 7/8 INTC 115 15/16 +4 3/8 CPB 55 +3/8 MEL 66 5/8 +1 11/16
Day Month Year History Drip 2.44% 2.49% 30.80% 11.39% S&P 500 1.90% (0.07%) 19.83% 22.23% Nasdaq 2.32% 3.23% 28.16% 26.28% Last Rec'd Total # Security In At Current 11/02/98 8.055 CPB $52.880 $55.000 09/01/98 9.727 INTC $80.238 $115.938 11/09/98 8.578 JNJ $74.090 $80.750 10/07/98 1.000 MEL $48.560 $66.625 Last Rec'd Total # Security In At Value Change 11/02/98 8.055 CPB $425.95 $443.03 $17.08 09/01/98 9.727 INTC $780.50 $1127.76 $347.26 11/09/98 8.578 JNJ $635.55 $692.67 $57.13 10/07/98 1.000 MEL $48.56 $66.63 $18.07 Base: $2200.00 Cash: $262.88** Total: $2592.97

The Drip Portfolio has been divided into 93.111 shares with an average purchase price of $23.628 per share.

The portfolio began with $500 on July 28, 1997, adds $100 on the 1st of every month, and the goal is to have $150,000 in stock by August of the year 2017.

**Transactions in progress:
10/24/98: Sent $40 to buy more INTC.
11/24/98: Sent $100 to buy more MEL


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