U.S. independents’ earnings could drop despite higher prices

Analysts expect fourth quarter earnings to decrease by 12%

Petroleum News

Analysts expect the leading U.S. exploration and production independents to report 2003 fourth quarter earnings roughly 12 percent below the third quarter, a surprise considering prices for natural gas rose 12.7 percent and oil 3.5 percent during the same period.

However, the consensus among analysts who follow the 15 independents tracked by Petroleum News also is that 2003 fourth-quarter earnings should increase about 40 percent compared to the same period in 2002 when commodity prices began to strengthen.

Early consensus for the 2004 first quarter projects that earnings will increase 5.6 percent from the 2003 fourth quarter, due largely to normal seasonal demand for energy.

Because independents are heavily dependent on income from production, oil and natural gas prices generally play a crucial role in shaping quarterly financial results. And with just a few trading days remaining in the 2003 fourth quarter, U.S. gas prices were averaging $5.42 per thousand cubic feet compared to $4.82 in the third quarter. Oil prices during the same period averaged $31.15 per barrel versus $28.01 in the prior quarter.

Despite the increase in commodity prices quarter-over-quarter, the consensus among analysts is that many independents will make less profit in the 2003 fourth quarter than in the previous quarter.

That could be because of declining production, a problem that has plagued industry in the United States for several years, or to hedging production at oil and gas prices that ended up being lower than average spot market prices for the quarter. Gas prices also increased dramatically during the first weeks of December, following a period of declining prices due to a rapid build in storage that began to wane in the final month of the year.

Natural gas surplus declined rapidly

Companies tracked by Petroleum News for the purpose of gauging earnings in the independent sector are Pioneer Natural Resources, Kerr-McGee, Anadarko Petroleum, Devon Energy, Unocal, Apache, Chesapeake Energy, XTO Energy, EOG Resources, Noble Energy, Burlington Resources, Newfield Exploration, Forest Oil, Tom Brown and Evergreen Resources.

According to consensus estimates among analysts polled by Thompson/First Call, only Kerr-McGee, Chesapeake and Tom Brown were expected to post earnings increases in the final quarter of 2003. However, earnings estimates are adjusted as reporting day approaches, and generally there are companies that regularly miss or beat consensus estimates.

Investment bank Lehman Brothers argues that investors today tend to penalize companies that spend their excess cash on drilling and reward those that curtail spending and use their extra cash for debt reduction, acquisitions, stock buy backs and shareholder dividends.

“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,” Lehman said, adding that these days investor focus is on “capital discipline.”

“If 2003 is a guide, investors may reward those companies that generate the most cash flow in the new year,” Lehman said. “Our expectations,” Lehman said, are that XTO, Pioneer, Apache and Burlington stand to generate the most free cash flow among U.S.-based independents in 2004.

Lehman’s analysis supports other studies showing that U.S. natural gas production, the mainstay of most independents, has been shrinking at the rate of 2 to 3 percent a year, ushering in a growing import market for liquefied natural gas.

Nevertheless, “this indicates to us that companies that have exhibited capital restraint have actually performed better in delivering volume growth results on a per share basis,” Lehman concluded.