E&P Primer JPM

North America Equity Research
18 November 2005
E&P 101: A Primer

Oil and Gas Exploration & Production
Everything You Wanted to Know About E&P, But Exploration & Production
Were Afraid to Ask: Shannon Nome
(1-713) 216-1918
• Glossary of energy terms shannon.nome@jpmorgan.com
Phillips Johnston, CFA

• The oil & gas value chain
(1-212) 622-6491
jphillips.johnston@jpmorgan.com
• Conversion factors
Scott Arndt, CFA
• Basic industry statistics and key facts (1-713) 216-6218
scott.d.arndt@jpmchase.com
• E&P stocks as investments
Rodney C Clayton
• Interpretation of hypothetical E&P press releases (1-212) 622-2873
rodney.c.clayton@jpmorgan.com
J.P. Morgan Securities Inc.

See page 46 for analyst certification and important disclosures, including investment banking
relationships. JPMorgan does and seeks to do business with companies covered in its research reports.
As a result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Shannon Nome North America Equity Research
(1-713) 216-1918 18 November 2005
shannon.nome@jpmorgan.com
Table of Contents
The Basics: Term & Definitions...............................................3
Oil and Gas ..................................................................................................................3
Prices............................................................................................................................5
Reserve Terms .............................................................................................................7
Production Terms.......................................................................................................13
Oil & Gas Value Chain: Think of a River...............................14
Upstream Segment.....................................................................................................14
Midstream Segment ...................................................................................................15
Downstream Segment ................................................................................................15
Conversions and Statistics ...................................................15
Conversion Exercise ..................................................................................................16
Putting Statistics into Perspective........................................16
Crude Oil Market: A Global Market..........................................................................16
Natural Gas Market: Primarily a Regional Market, but LNG Is Changing This........18
E&P Stocks as Investments ..................................................23
Types of E&P Companies..........................................................................................24
What Matters to Investors..........................................................................................25
Asset Intensity: The “Holy Grail” of the E&P Business? .........................................29
Macro Data to Watch .................................................................................................31
Valuation....................................................................................................................32
Why Earnings Are Less of a Concern to E&P Investors ...........................................34
A Word on Hurricanes............................................................34
Liquefied Natural Gas: A Brief Primer ..................................35
Appendix: Hypothetical E&P Press Releases .....................38
Exploration Discoveries.............................................................................................38
Successful Appraisal Well .........................................................................................40
Unsuccessful Appraisal Well .....................................................................................41
Reserve Write-down ..................................................................................................41
Farm-in Agreement....................................................................................................42
Downspacing Approval .............................................................................................43
New Unconventional Play .........................................................................................43
Onshore Acquisition ..................................................................................................45
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The Basics: Term & Definitions

Oil and Gas
Hydrocarbons: a compound of carbon and hydrogen. Includes crude oil,
natural gas, natural gas liquids (NGLs), coal, and others.
Oil = Petroleum = Crude Oil: unrefined liquid mixture of hydrocarbons that

can be refined to yield oil products such as gasoline, naphthas, jet fuel, diesel
fuel, heating oil, fuel oil, asphalt, etc. Oil is also used as feedstocks (inputs)
for chemical manufacturers in the production of commodity chemicals,
plastics, etc. If crude is high in sulfur content, it is a sour crude; otherwise it
is a sweet crude. Crude oil may also be referred to as heavy or light
according to its API gravity, which is the American Petroleum Institute's
measurement of the specific gravity of crude oil (ranging from 9° to 55°), the
lighter oils having the higher gravities (closer to 55°).
Table 1: The Oil Barrel
Products Uses
Liquefied Petroleum Gas (LPGs) Ethane, Propane Heating, cooking
10% Butane Chemical feedstocks, Motor gasoline blending
Light Ends Naphthas Petrochemical feedstocks

Gasolines Reforming into gasoline, Automotive fuel
35%
Middle Distillates Jet Kerosene Aviation fuel

Diesel Automotive fuel
Heating/Gasoil Domestic heating fuel
Vacuum Gasoil Distilled to lighter product
35%
Heavy Distillates Cracked Fuel Oil Power generation, Ship fuel

Straight-Run Fuel Oil Lighter products, Fuel oil
Asphalt Road surfacing, Roofing
Bitumens, Coke Manufacturing of steel
20% Sulfur Chemical industry
Source: Bloomberg. Note: Percentages are approximate and vary by crude and refinery type.
Natural Gas: a clean burning, odorless, colorless, highly compressible

mixture of hydrocarbons occurring naturally in gaseous form. Primarily
comprised of methane, but can also include ethane, propane, butane, and
natural gasoline. If these latter components (called NGLs) are high in
content, the gas is considered wet, and the NGLs may be separated from the
methane in a processing plant to be sold separately. Producers will often
vary the amount of NGL extraction depending on the current market pricing,
as NGL pricing is benchmarked off of crude. Uses for natural gas (inputs)
include space heating, water heating, cooking, etc (residential and
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(1-713) 216-1918 18 November 2005
commercial); steam generation, melting, and use as feedstocks for chemical

manufacturing (industrial) and use as fuel for electricity generation (electric
utility and independent power producers). See Figure 8, pg. 20 for a
breakdown of U.S. supply and demand.
Table 2: The Natural Gas Mcf
Products Uses
Dry gas Methane (aka pipeline-quality gas) Space heating, water heating, cooking
Steam generation, melting
Petrochemical feedstocks
Power generation
95%
Wet gas (Natural Gas Liquids) Ethane, propane, butane, Space heating, water heating, cooking
iso-butane, and natural gasoline Petrochemical feedstocks, Refining feedstocks,
5% Motor gasoline blending
Source: JPMorgan estimates. Note: Percentages vary by region and basin.
Natural Gas Liquids (NGLs): hydrocarbons that are originally in gaseous

form underground, but turn into liquid form when either brought to the
surface or processed in gas processing plants. NGLs include ethane,
propane, butane, and natural gasoline. Many refer to crude oil and NGLs
interchangeably (often as liquids), and most companies group NGL
production and reserves together with oil production and reserves. NGLs
should not to be confused with LNG (see below).
Liquefied Natural Gas (LNG): natural gas that has been cooled to very low
temperatures (-259 degrees) and turned into liquid form for transportation
(usually by ship or vehicle). The LNG is turned back into gas form before it
reaches the end-user. The ramp of LNG imports is expected to have a
significant effect on the North American natural gas industry (see "Liquefied
Natural Gas: A Brief Primer," pg. 38).
Gas-To-Liquids: process of converting "stranded gas" (gas without a

readily available market) to liquids products to facilitate transportation to
markets. Examples: diesel, naphtha, waxes.
Liquefied Petroleum Gas (LPG): propane gas or butane gas that has been
compressed into a liquid. LPG is used in rural areas for home heating and
cooking and has industrial, agricultural, and commercial applications.
Principal source is natural gas, from which the liquefied petroleum gases are
separated by fractionation.
Liquids: general term that refers to crude oil and/or natural gas liquids
(NGLs).
Deep Gas: natural gas located 15,000 feet or more below the earth's surface.
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Unconventional Resources = Resource Plays: hydrocarbons contained in

low-permeability reservoirs that often require fracturing or other advanced
completion techniques to extract.
Tight Gas: natural gas located in rock with low permeability (ability for
fluids to flow through pore spaces of a reservoir). Enhanced recovery
techniques like fracture stimulation must be performed to efficiently produce
tight gas reserves. Tight gas includes both shale gas and basin-centered gas,
and is often found the mid-continent, Rocky Mountain, and Appalachian
regions.
Coal Bed Methane (CBM): natural gas located in coal deposits. CBM is
formed during coalification, the natural process of turning organic matter into
coal under high pressure and heat. It usually consists of methane—the
purest, driest, and most environmentally friendly form of natural gas. CBM
wells tend to produce at negligible rates at first as the coal seam dewaters,
followed by a ramp in production once the water cut begins to decline.
Oil Sands: sandstones that contain oil (bitumen) that is too heavy to
transport under normal temperatures. In order to be captured in commercial
quantities, the oil is mined using heat or solvents. Once extracted, lighter oil
must be injected into the bitumen in order for it to flow through pipelines.
North American oil sands are concentrated in Canada, primarily in Alberta.
Prices
Henry Hub Price: the benchmark natural gas price measured in $/MMbtu or
$/Mcf (these two are essentially interchangeable). Natural gas futures
contracts that trade on the NYMEX physically settle at Henry Hub, a vast
intersection of natural gas pipelines located in Louisiana. Henry Hub prices
can refer to spot or futures prices.
Bid-Week Price: the period of time, up to five days, at the end of the month
when prices are set for gas deliveries the following month. Pricing
corresponds to the futures contract, which is used to price next month's
deliveries. Bid-week pricing can remove some of the volatility embedded in
the futures market for producers. Most producers sell some gas at bid-week
pricing, and thus, realized prices can often differ significantly from the
average daily NYMEX price over a period of time.
Basis Differentials: a premium or discount to Henry-Hub pricing. Natural

gas is physically traded at market "hubs" across the U.S. Hub prices are not
consistent across the country as each hub has its own supply/demand and
transportation constraints. The most famous "hub" is Henry Hub in
Louisiana, where NYMEX futures contracts are settled for physical delivery.
Other hubs, such as CIG, Opal, AECO, and Houston Ship Channel will trade
at a premium or discount to Henry Hub. This premium or discount is known
as the basis differential, and can represent transportation costs and local
supply/demand dynamics. Thus, while producers can hedge away
commodity price risk, they can still face basis risk, defined as the risk that
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basis differentials widen relative to Henry Hub (representing NYMEX

contracts). Producers can enter into derivative contracts settled at NYMEX
+/- the appropriate basis differential to hedge this risk. Figure 1 below
illustrates how the expansion of the Kern River pipeline narrowed Rockies
gas differentials. The expansion created greater access to market for the gas
and effectively increased demand.
Figure 1: Kern River Pipeline Expansion and Rockies Differentials

$/MMbtu Opal/Henry Hub Differential
$0.50
$0.00
($0.50)
($1.00)
($1.50)
($2.00)
Kern River Pipeline Expansion
($2.50)
($3.00)
Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04
Source: JPMorgan estimates, Bloomberg
WTI Price: the benchmark crude oil price in the U.S. measured in $/barrel.
WTI stands for West Texas Intermediate, which refers to a type of high
quality, light in gravity crude oil. Curiously, WTI crude oil futures contracts
that trade on the NYMEX physically settle at a storage facility in Cushing,
Oklahoma, rather than in Texas. WTI prices have historically traded at a $1-
2/barrel premium to Brent prices.
Brent Price: the benchmark crude oil price in Europe, as traded on the
International Petroleum Exchange in London. Brent crude refers to a
particular grade of crude found in the Brent field located in the North Sea.
Brent crude is slightly heavier than WTI crude (lighter oil is generally more
desirable than heavier oil because it is easier and less costly to refine).
Strip Price: the market's expectation of average prices over a certain amount
of time in the future. The strip price is calculated by taking the average of all
monthly futures prices for the specific time period. For instance, the 12-
month strip price calculated in November 2005 is an average of 12 futures
prices (beginning with the near-month contract that settles in December 2005
and ending with the contract that settles in November 2006).
Contango vs. Backwardated: refers to the shape of the commodity futures

curve at a point in time. Just as the shape of the interest rate curve can offer
insight to the economy and investors' expectations of the future, the shape of
energy futures curves can offer insight to the state of the market and
expectations for future changes in fundamentals. Contango refers to a price
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(1-713) 216-1918 18 November 2005
strip in which the prompt or near-month contract is higher than the spot price,
or futures prices at the more distant end of the curve are higher than nearby
futures prices. A price curve in contango would indicate that investors
expect increasing prices, and would provide an incentive for inventory
builds. Consumers can buy on the spot market while selling a futures
contract. They commodity is then stored and delivered to satisfy the futures
contract at a higher price. If the price discrepancy is larger than the storage
costs, an arbitrage opportunity exists. In contrast, a price strip in which the
cash price is higher than the prompt month or nearby futures contracts are
higher than more distant contracts is backwardated. A backwardated price
curve would indicate the investors expect declining commodity prices, and
would encourage inventory withdrawals. Figure 2 below shows that the
current gas curve is backwardated, while the current crude curve is in
contango.
Figure 2: Natural Gas and Crude Oil 12-Month Futures Curve
13.00 61.00
12.50 60.50
12.00 60.00
11.50 59.50
$/MMbtu
Natural gas curve
$/Bbl
11.00 is backw ardated 59.00
10.50 58.50
10.00 Oil curve is in 58.00

contango
9.50 57.50
9.00 57.00
b
t
n
n
r
c
p
r
v
Ju
y
Oc
Ap
Ma
Ja
Ju
Fe
De
Au
Se
No
Ma
Source: Reuters.
Reserve Terms
Reservoir: a single continuous deposit of oil and/or gas in the pores of a rock
layer. Most reservoirs contain gas, oil, and water. A reservoir has a single
pressure system and does not mix with other reservoirs. Major reservoir
characteristics include thickness, porosity (a measure of the reservoir rock's
storage capacity for fluids), permeability (a measure of the ease in which
fluid flows through the reservoir), and saturation (the volume percentage of
different fluids like water, oil and gas in the pore spaces of the reservoir).
Proved/Proven Reserves: quantities of oil or natural gas that are recoverable

in future years from known reservoirs under existing economic and operating
conditions. Proved reserves are highly certain, with a 90% chance that actual
reserves will be larger and a 10% chance that they will ultimately prove to be
smaller. It usually takes a discovery well to book proved reserves, and the
SEC allows only reserves economic at year-end commodity prices to be
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booked as proved. The year end pricing convention can lead companies to
impair reserves previously booked under higher prices. Note: proved
reserves are the only type of reserves that a company can report in SEC
filings.
Proved Developed Reserves: proved reserves that are expected to be

produced from existing wells. These can be classified into two categories:
proved developed producing (PDP), or proved developed non-producing
(PDNP).
Proved Undeveloped Reserves (PUDs): proved reserves that are expected

to be produced from new wells drilled or recompletions of old wells. PUDs
are often booked as offset locations to a producing (PDP) well (see Figure 3).
Note: conversion of PUDs or PDNPs to PDP will usually require a capital
outlay.
Probable Reserves: quantities of oil or natural gas not proven by geological

information, but likely present due to the proximity of proven reserves and
can be produced if located. Probable reserves are less accurate than proven
reserves. Note: companies cannot report probable reserves in SEC filings.
Possible Reserves: quantities of oil or natural gas that is inferred to be

present by speculative geological information and can be produced if located.
Possible reserves are less accurate than proven reserves and probable
reserves. Note: companies cannot report possible reserves in SEC filings.
2P Reserves: the sum of proved and probable reserves.
3P Reserves: the sum of proved, probable and possible reserves.
Figure 3: Producing Well with Offset Locations
PROB PROB PROB PROB PROB
PROB PUD PUD PUD PROB
PDP
PROB PUD PUD PROB
PROB PUD PUD PUD PROB
PROB PROB PROB PROB PROB
EUR: “estimated ultimate recovery,” projected total reserves.
OOIP/OGIP: “original oil in place / original gas in place." Due to tight rock
properties, not all of the oil or gas originally present may be recoverable.
OOIP * recovery factor = EUR.
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Reserve Life: reserve to production ratio (R/P ratio). The theoretical amount
of time in years it would take to fully produce or deplete oil and gas reserves
at current production rates.
Reserve Impairment: non-cash charge to earnings representing the

See pg. 34 for more on difference between the book value of a company's reserves on the balance
successful efforts vs. full cost
accounting.
sheet and the estimated discounted future net cash flows of those reserves,
based on currently prevailing commodity prices.
Companies that utilize the full cost method of accounting must capitalize all
costs related to their oil and gas properties (both productive and non-
productive properties). These capitalized costs are amortized on an aggregate
basis via DD&A expense over the estimated lives of the properties using the
units-of-production method. At the end of each quarter, full cost companies
must conduct a "full cost ceiling test" which limits the book value of these
capitalized costs to the present value of future net revenues attributable to
these reserves discounted at 10% (using prevailing oil and gas prices at that
date), plus the lower of cost or market value of unproved properties. If the
book value of the capitalized costs exceeds the ceiling test, the company must
write-down its capitalized costs that are in excess of the present value
calculation. Restoration of a quarterly write-down following an
improvement in oil and gas prices is not allowed.
Under the successful methods method of accounting, a ceiling test is not

formally required, primarily because FASB did not expect capitalized costs
to normally exceed the underlying value of the reserves since successful
efforts companies can only capitalize costs related to discovered reserves.
Reserve Audits: the term “audit” is commonly misused in oil and gas
circles, as it carries the connotation of an independent verification of a
company’s oil and gas reserves (as a financial statement audit would imply).
There are several different levels of third-party involvement in company
preparation of oil and gas reserve estimates, among which audits and
procedural audits are included. Unlike financial audits, there is no
requirement that a firm engage a third-party engineering review for any level
of reserve audit.
The most rigorous level of external reserve evaluation is the independent

reserve evaluation—or “determination”—which involves extensive client
visits, collection of any and all required geologic, geophysical, engineering
and economic data, and a complete external preparation of reserve
estimates. In the case of a determination, the third party engineer’s estimates
are used in the public company’s year-end financial disclosures.
An “audit” also involves company visits, data collection, and independent

calculations of estimated reserve estimates, but unlike the case of a full
determination, it is the producer’s own estimates that are disclosed in year-
end financial statements. In addition, and audit often only examines a
percentage of the reserves.
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A “procedural audit” is an overview of the internal processes only. The

consultant sits in on the producer’s internal meetings, learns about the
methodologies and processes used to ascertain and book proved reserves, and
may review selected data. This type of audit does not involve generating an
independent, third-party estimate of reserve quantities. As such, it is
considered a notch below the straight “audit.”
Finally, “review letters" examine a field or specific asset area only. Limited
in scope, these assignments are not considered an aggregate endorsement of a
company’s proved reserves or overall methodologies.
PV-10 Calculation = SEC-PV10 = Standardized Measure of Discounted

Future Net Cash Flows: discounted cash flow calculation that the SEC
requires every publicly-traded company with significant oil and gas
producing activities to disclose in annual financial statements. The
calculation measures the present value of estimated future cash flows
(revenues less development costs, production costs, and taxes) from the
companies proved reserves, discounted at 10%. The PV-10 calculation is
somewhat subjective in that companies provide their own assumptions
regarding future development costs, future production costs, how fast the
production base is declining, etc. Furthermore, companies must take
whatever the prevailing commodity prices and costs were at the end of a
reporting period and assume these levels are held constant throughout the life
of the reserves. This leads to significant volatility in the PV-10 calculation
from one year to another simply because of fluctuating commodity prices.
The PV-10 value is often referred to as the “liquidation value.” Note: The
PV-10 calculation excludes the effects of hedges.
Exploration Terms
Exploration: all of the activities associated with finding new reserves of
hydrocarbons (oil and gas). Includes acquiring acreage, shooting 2-D or 3-D
seismic surveys, studying the geology and geophysics of a particular area,
obtaining drilling rigs, and drilling exploration wells.
Prospect = Exploration Prospect: a potential drilling location.
Log: curve or set of curves that records physical, electrical, and radioactive
properties of rocks and fluids in rocks in a wellbore in order to determine the
presence of hydrocarbons in the wellbore.
Exploration Well = Wildcat Well: a well drilled to find a new reservoir,

formation, or deposit of hydrocarbons. If successful, the well may be
referred to as a discovery well.
Appraisal Well = Step-Out Well = Delineation Well: a well drilled after a

discovery well to gain more information about the reservoir. Most are drilled
to help determine the size or extent of the reservoir or field.
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Flowtest = Drillstream Test: an initial production test conducted under

various pressures and chokes used to determine optimal production
conditions and estimate initial ranges of production.
Sidetrack: to directionally drill around broken drill pipe, junk, or casing that
has become permanently lodged at the bottom of an in-progress well.
Dry Hole: an unsuccessful exploration or development well. Well costs can

range from tens of thousands of dollars all the way up to $100 million.
Successful efforts companies expense dry hole costs while full cost
companies capitalize dry hole costs.
Seismic: an exploration method used to map subsurface geological structures

in order to locate potential hydrocarbon-bearing reservoirs (e.g., 2-D and 3-D
seismic data).
Acreage: land held under lease for the purposes of exploration and
production of oil and gas. Can also be used to refer to a concession, typically
in international settings.
Authority for Expenditure (AFE): an estimate of all the related costs

associated with drilling a well under two scenarios: a producer and a dryhole.
Concession: a legal agreement between a government and an oil company

whereby the company is granted a permit for the right to explore, drill and
produce oil and gas in a certain area for a fixed period of time. If proved
reserves are discovered, the permit is usually held through the productive life
of the area. Today, most concession agreements are structured so that the
government receives a bonus and royalty payments. The government does
not usually participate in operations or marketing.
Production Sharing Contract (PSC): an arrangement that is similar to a

concession agreement, except the company is required to spend a specified
amount of money each year for a specified time period. Furthermore,
discovered reserves are owned by the government rather than the company
with the company receiving a specified share of production, usually 15-20%.
Royalty: the fractional share of the gross (free of costs, except taxes)
production revenues from a well or lease that is retained by the owner of the
mineral rights. In the U.S., the landowner generally receives a royalty on
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onshore leases, and the Federal government receives a royalty on offshore

leases and some onshore leases (most notably in the Rocky Mountains). In
most foreign countries, royalties are paid only to the government. Note:
mineral rights may be owned separately from the surface rights or
together with the surface rights.
Royalty Interest (RI): an economic interest retained by the mineral interest

owner when that owner leases the property to another party. The RI receives
a specified fractional share of the gross (free of costs, except taxes)
production revenues from a well or lease. A royalty takes preference over all
other payments from lease revenue. A typical royalty interest would be
12.5% of gross production revenues, but can run significantly higher in “hot”
exploration areas. The RI is a nonoperating or nonworking interest, meaning
that it is passive.
Working Interest (WI): the economic interest remaining after deducting all
nonworking interests, including the royalty interest. The working interest
must pay all of the costs of exploring for, developing and producing oil and
gas. The working interest may be divided among several parties (for
example Party 1 may have a 75% working interest and Party 2 may have the
other 25% working interest).
When one refers to costs “to the Farm In: the process of obtaining an interest in a lease by agreeing to
8/8ths,” it means total gross
costs to all the interest holders
assume some or all of the costs of exploring for, developing and producing
in a project. oil and gas. Often times, major oil and gas companies will "farm out"
acreage to smaller independents in order to keep from losing the lease for a
lack of drilling. If the major is able to farm out all of the costs, but still retain
an interest in the revenue from production, the major is said to be “carried.”
Net Revenue Interest (NRI): the share of production revenue after all
royalties and other nonworking interests have been paid. For example, a
company owning a 100% working interest on a lease will have a lower net
revenue interest (87.5% would be typical, assuming a 12.5% royalty) after
royalty payments are paid to the owner of the royalty interest.
Reversionary Interest: a share of production revenue that becomes

effective after a third-party receives a predetermined amount of production.
Reversionary interests are often used by capital constrained producers to
finance the development of a large project. Typically, the producer will
forego production volumes for a period of time to allow a third-party E&P or
service company to receive the producer's share of production as
reimbursement or compensation for development of the project. Once the
third-party has received a pre-determined amount of production volumes, the
producer begins to receive its share of production. A “back-in” is a related
concept.
Volumetric Production Payment (VPP): represents the sale of a fixed-

term of oil or gas production volumes to a buyer in exchange for a certain
amount of up-front proceeds. The proceeds are determined by the net present
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value of future revenues from those production volumes over the VPP term,
and since the price risk is typically "removed" via hedging those volumes at
NYMEX prices, it enables a producer to effectively capture future strip prices
today. In instances when E&P stocks do not discount current strip prices,
this apparent market inefficiency affords an interesting arbitrage opportunity.
Reserves sold in a VPP transaction must be removed from the seller’s books,
although all reserves remaining after the term of the VPP revert back to the
producer.
APO/BPO = “After Payout / Before Payout”: the conditions associated

with an interest in a well or project. Often times a producer’s interest in a
well will change upon payout of drilling costs. For example, a producer may
cite a 25% BPO, falling to a 15% APO.
Production Terms
Development: the process of producing oil and/or gas from an area that
contains proved reserves. This area may or may not be already under
production, but typically connotes drilling new wellbores.
Exploitation: basically another word for development but also connotes

activity in a more mature area and may not involve drilling new wells. May
involve enhanced oil recovery techniques including secondary recovery and
tertiary recovery. These include stimulating production levels through
techniques like water flooding, steam injection, or fracturing the sands or
rock in the reservoir in order to produce the reserves faster and/or more
efficiently. Exploitation can also include refracs (fracturing or stimulating a
previously fractured zone), recompletions (completing a well in a new zone
or formation), and workovers (cleaning out a wellbore in order to increase
production).
Development Well: a well drilled in an area where proved reserves already

exist in order to bring on new production.
Horizontal Well: a well that is initially drilled vertically, then by directional

drilling, it curves at an angle and is drilled horizontally, or at another non-
vertical angle. Horizontal wells have recently been shown to increase
recovery in shale plays such as the Barnett Shale.
Infill Drilling = Downspacing: drilling wells between producing wells to

increase production and possibly the ultimate recovery from the reservoir.
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Completion: the process of bringing a new well onto production. Includes

adding steel casing (pipe) to the well (often using cement), perforating the
casing, adding flow control equipment, etc.
Fracture Stimulation = Fracture Treating = Frac Job: a well-stimulation

process in which fluids and proppants are pumped into the reservoir at high
pressure to artificially fracture it and increase permeability and production.
F&D costs = costs incurred for Finding Cost = Finding & Development (F&D) Cost: capital spent in order
exploration and development
divided by the sum of drillbit
to add new reserves or to initiate new production from an area containing
extensions & additions and proved reserves either through exploration or development activities. These
revisions, stated on a $/boe or expenditures are capitalized on the balance sheet as plant, property and
$/mcfe basis. equipment (PP&E) and eventually flow through the income statement in the
DD&A expense line item.
All-in Finding Cost = Finding, Development and Acquisition (FD&A)

Cost: same as above but includes capital spent on acquisitions of proved
reserves from other parties.
Production/severance taxes vary Operating Costs = Lease Operating Costs (LOE) = Production Costs =
directly with prevailing oil & gas
prices. There are no production
Lifting Costs: the direct cash costs incurred to operate and maintain wells
taxes in Gulf of Mexico federal and related equipment and facilities. Included are labor costs; gathering and
waters. transportation costs, repairs and maintenance; materials, supplies and fuel
consumed and services utilized in operating the wells and related equipment;
property taxes and insurance premiums; and finally severance and ad
valorem taxes (a.k.a. production taxes), which are state and local taxes on the
volume or value of oil or gas produced and sold.
Oil & Gas Value Chain: Think of a River

Upstream Segment
Involves all operations associated with finding and extracting oil and gas
from the subsurface.
Exploration & Production Sector

The first step of exploration often involves leasing land from a private owner
or government and studying it (geology, geophysics, 2-D and/or 3-D
seismic). This will help boost chances of exploration success. Next step is to
drill an attractive prospect(s). Most E&P companies contract out the actual
drilling activities to oilfield services companies. If the well is successful and
new reserves are encountered, next step is to produce the reserves (a.k.a.
develop the reserves) out of the ground and sell them to a third party. The
timing of both the development process and achieving first oil or gas
production following a successful discovery varies significantly and can take
days, up to several years, depending on the complexity of the required
engineering and the availability of infrastructure. E&P company fortunes
are tied directly to oil and natural gas prices. As producers of commodities,
14
(1-713) 216-1918 18 November 2005
E&P companies are price takers, unless the company has locked in prices
via hedging contracts or long-term supply contracts.
Oilfield Services Sector

Includes rig construction, rig leasing, drilling, seismic, well logging,
cementing, stimulation, etc. (e.g. Schlumberger). Oilfield services company
fortunes are tied directly to capital spending in the E&P sector.
Midstream Segment
Involves all operations associated with transporting oil and gas from the
wellhead to refineries, processing plants, and/or end-users (e.g. Kinder-
Morgan). Oil can be transported by pipelines, trucks, and oil tankers.
Natural gas midstream operations include gas pipelines and storage facilities.
Operators usually carry little commodity price risk, and instead typically
charge a transportation fee or tariff. Midstream sector fortunes are tied to
demand from end markets and supply from commodity source.
Downstream Segment
Includes refining crude oil into crude oil products (gasoline, jet fuel, heating
oil, diesel, fuel oil, asphalt, etc), marketing the crude oil products (retail
gasoline stations and convenience stores), and/or chemicals divisions. An
example of a pure-play downstream company is independent refiner Valero
Energy. Downstream natural gas operations mostly involve local distribution
companies (LDCs), a.k.a. natural gas utilities (e.g., KeySpan, Sempra).
Fortunes of the downstream sector are tied to refining margins, chemicals
businesses, and consumer demand.
Conversions and Statistics

1 barrel (bbl) of oil = 42 gallons
1 Mcf of natural gas = 1,000 cubic feet
1 MMcf = 1 million cubic feet
1 Bcf = 1 billion cubic feet
1 Tcf = 1 trillion cubic feet
1 Btu (British Thermal Unit) refers to heating value, rather than volume, but
as a rule of thumb, 1 MMBtu (1 million Btus) = 1 Mcf (1,000 cubic feet) of
natural gas. Btu content can be slightly higher if the gas is “wet,” or
contains NGLs.
Oil and gas can be statistically converted into one another based on
heating values, or Btus
Approximate Conversions
1 barrel (bbl) of oil = 6 Mcf of natural gas

1,000 bbls of oil = 6 MMcf of natural gas
1 MMbbls of oil = 6 Bcf of natural gas
15
(1-713) 216-1918 18 November 2005
1 billion bbls of oil = 6 Tcf of natural gas
• Converting all of a company's reserves or production into crude oil

gives you barrel oil-equivalent (boe) units
• Converting all of a company's reserves or production into natural gas

gives you thousand cubic feet-equivalent (Mcfe) units
Conversion Exercise
Company XYZ has 1,200 MMcf of natural gas reserves and 200,000 barrels
of crude oil reserves. How many boe's does it have? How many Mcfe's does
it have?
Oil-equivalent answer:
1,200 MMcf = 1,200,000 Mcf
1,200,000 Mcf / 6 = 200,000 boe
200,000 boe + 200,000 bbls = 400,000 boe (can also be written as 400 Mboe)
Natural gas-equivalent answer:

200,000 bbls x 6 = 1,200,000 Mcfe
1,200,000 Mcfe + 1,200,000 Mcf = 2,400,000 Mcfe
2,400,000 Mcfe = 2,400 MMcfe (can also be written as 2.4 Bcfe)
Putting Statistics into Perspective

Crude Oil Market: A Global Market
• World produces and consumes roughly 80 MMbbl/d (million barrels
per day).
• OPEC produces about 33 MMbbl/d (million barrels per day), or 41%
of world supply.
• United States produces about 7 MMbbl/d (million barrels per day), or
only 9% of world supply.
• United States consumes over 20 MMbbl/d (million barrels per day),
or 25% of world supply.
• All global oil transactions occur in US dollars.
Crude oil is a not consumed directly, but is refined into other products such
as gasoline, heating oil, lubricants, plastics, and jet fuel. There are many
grades of crude oil with different qualities and pricing characteristics. Light
sweet crude has a high API gravity and a low sulphur content, while heavy or
sour crudes tend to be just the opposite. Light/sweet crudes typically trade at
a premium to heavy/sour crude, as refiners can generally produce a higher
yield of high quality refined products, such as gasoline, by running
light/sweet crudes. The U.S. has far more refining capital for light/sweet
crudes.
16
(1-713) 216-1918 18 November 2005
While crude oil is a global commodity and is produced all over the world, the
vast majority of the world's oil reserves are located in the Middle East.
Figure 4 below shows a breakdown of the world’s consumption and oil
reserves as of 2004. The top consumers of oil largely consist of developed
nations. As nations’ economies grow, so does their thirst for oil. The last
couple of years have included a boom in oil consumption from India and
China that largely tested the world's oil capacity, sending prices to largely
unprecedented levels.
Figure 4: World Reserves and Consumption
YE2004 Proved Reserves 2004 Consumption
USA
Russia 3%
8%
Venezuela Saudi Arabia USA
9% 30% 25%
Other
UAE 43%
11% China
8%
Kuwait Iran
Iraq 15%
11%
13%
Total Middle East
Canada 7%
Japan
3% FSR
S. Korea 7%
5%
3%
Source: 2005 BP Statistical Review of World Energy
While crude prices are determined through global supply and demand
interaction, OPEC's policies have a large influence on prices. OPEC does not
set prices, but does set production quotas, thereby influencing the supply-side
of the equation. Currently, 10 of OPEC's 11 cartel members are subject to
group quotas, with Iraq being exempt. Saudi Arabia is by far the largest and
most influential member of OPEC. Contrary to popular belief, it is not to
OPEC's advantage to target as high an oil price as possible. The cartel wants
to maximize revenues, but needs consumers as much as consumers need
OPEC oil. At very high prices, OPEC runs the risk of hampering economic
development (demand) or encouraging non-OPEC producers to increase oil
producing investments (supply), both of which can have a negative impact on
OPEC’s ultimate revenues.
While E&Ps tend to have a higher exposure to gas prices, investors should be
aware of the oil markets as gas prices tend to be closely related to oil prices
are there is some degree of substitution between the two fuels.
17
(1-713) 216-1918 18 November 2005
Figure 5: World Crude Production
90,000
80,000
70,000
Thousand Barrels Daily

60,000
50,000
40,000
30,000
20,000
10,000
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
N. America S. Central America Europe & Eurasia Middle East Total Africa Asia Pacific
Source: 2005 BP Statistical Review of World Energy
Table 3: A Perspective Of World Oil Reserves

Proved % of total
oil reserves world reserves
World oil reserves (YE2004) 1,189 billion bbls 100%

World oil reserve life (YE2004) 40.5 years -
By Producer Group
OPEC oil reserves (YE2004) 890 billion bbls 75%
OPEC oil reserve life (YE2004) 74 years -
Former Soviet Union oil reserves (YE2004) 121 billion bbls 10%
FSU oil reserve life (YE2004) 29 years -
OECD oil reserves (YE2004) 83 billion bbls 7%

OECD oil reserve life (YE2004) 11 years -
Other world oil reserves (YE2004) 95 billion bbls 8%
By Country (examples)
Saudi Arabia oil reserves (YE2004) 263 billion bbls 22%
Saudi Arabia oil reserve life (YE2004) 68 years -
Iran oil reserves (YE2004) 133 billion bbls 11%
Iraq oil reserves (YE2004) 115 billion bbls 10%
Kuwait oil reserves (YE2004) 99 billion bbls 8%
UAE oil reserves (YE2004) 98 billion bbls 8%
Venezuela oil reserves (YE2004) 77 billion bbls 7%
Russian Federation oil reserves (YE2004) 72 billion bbls 6%
US oil reserves (YE2004) 29 billion bbls 3%
US oil reserve life (YE20042) 11 years -
Source: 2005 BP Statistical Review of World Energy. Note: Figures have been rounded.
Natural Gas Market: Primarily a Regional Market, but LNG Is

Changing This
• North America produces about 73 Bcf/d of natural gas, or about 26.5
Tcf per year
• United States produces about 54 Bcf/d of natural gas, or about 19 Tcf
per year.
18
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• Canada is a net exporter of natural gas to the U.S., as U.S.

consumption is over 60 Bcf/d.
• Liquefied natural gas (LNG) has made major strides in recent years
in bringing stranded natural gas to developed markets. We expect
the gas market will move to a more global market as a result of
advances in LNG. Please see “Liquefied Natural Gas: A Brief
Primer,” page 35.
Demand for North American natural gas has increased at a compounded

average annual growth rate of about 1% since 1995. Figure 6 below
illustrates increasing demand coupled with higher prices.
Figure 6: Total Gas Consumption vs. Annual Wellhead Price
25,000 7.15 $8
24,500 $7
24,000 5.49
$6
Wellhead price ($/Mcf)

23,500 4.88
23,000 4.00 $5
3.68 R 2 =0.56
22,500
Bcf
$4
2.95
22,000 2.32 $3
2.17 1.96 2.19
21,500 1.55
$2
21,000
20,500 $1
20,000 $-
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E
Total Consumption Gas Price
Source: EIA, Bloomberg, JPMorgan estimates
Natural gas has emerged as the fuel of choice for new power plants and is
also used as a preferred fuel for home heating. Demand is very much
dependent on the weather as LDCs tend to inject natural gas into storage in
periods of low demand (generally April through October) in order to
withdraw gas to meet home heating needs when demand peaks in the winter.
Storage levels are watched closely by investors as an indication of both
supply and demand; however, there is some evidence that the relationship
between storage and natural gas prices breaks down in periods of unusually
high crude prices as natural gas serves as substitute fuel in some cases.
Figure 7 illustrates historical storage fluctuations over time.
19
(1-713) 216-1918 18 November 2005
Figure 7: Historical Seasonal Storage Levels
3700
3200
2700
2200
bcf 1700
1200
700
200
1
1
1
2
2
2
3
3
3
4
4
4
5
5
/01
/02
/03
/04
1 /0
4 /0
7 /0
1 /0
4 /0
7 /0
1 /0
4 /0
7 /0
1 /0
4 /0
7 /0
1 /0
4 /0
10
10
10
10
5 Yr Range 5-Yr Avg Actual
Source: EIA
Demand for North American gas can be categorized as electrical generation,

residential and commercial, industrial, and other. Industrial demand is
considered the swing demand as it tends to fall in periods of high prices, only
to return when prices moderate. Figure 8 below illustrates the changing
demand mix as higher prices have eroded industrial demand.
Figure 8: Industrial Demand Destruction

Share of 2005E Total Demand
Industrial Gas Consumption vs. Annual Wellhead Gas Price
Other: 3%
10,000 $8
7.15
9,500 $7 Electric
Generation:
9,000 5.49 $6 21% Residential &
R2 =0.68 Commercial:
Wellhead price ($/Mcf)
4.88
8,500 $5 41%
4.00
3.68
Bcf
8,000 $4 Industrial:
2.95
34%
7,500 2.32 2.19 $3
2.17
1.96
7,000 1.55 $2
6,500 $1
6,000 $-
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E
Industrial Gas Demand Gas Price
Source: EIA, Bloomberg, JPMorgan estimates
North American natural gas supply has declined over the last few years,
despite increased drilling. This is due in large part an industry shift from
more prolific offshore Gulf of Mexico wells to unconventional onshore
resources that tend to produce less gas per well, but have a much flatter
decline rate. As the traditional Gulf of Mexico producing basins have
20
(1-713) 216-1918 18 November 2005
matured, the industry has been forced to look for unconventional resources in
areas such as the mid-continent, the Rocky Mountains, and Appalachia.
Figure 10 below illustrates the industry's struggle to grow or even maintain
production. North American production has declined year over year since
2001 and is expected to dip significantly in 2005 as an unusually active
hurricane season caused significant damage to the Gulf of Mexico producing
basins. A continuation of rising demand and flat to falling production is
expected to put the burden on LNG to fill the gap.
Figure 9: Total U.S Gas Supply
LNG
Net Imports 3%
13%
US Production
84%
Source: EIA
Figure 10: Total U.S Gas Production
21,000
20,500
20,000
19,500
19,000
18,500
Bcf
18,000
17,500
17,000
16,500
16,000
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E
Source: EIA
21
(1-713) 216-1918 18 November 2005
Table 4: A Perspective Of World Natural Gas Reserves

Proved % of total
gas reserves world reserves
World gas reserves (YE2004) 6,337 Tcfe 100%
World gas reserve life (YE2004) 67 years -
By Country or Producer Group (examples)

Former Soviet Union gas reserves (YE2004) 2,065 Tcfe 33%
FSU gas reserve life (YE2004) 79 years -
Russian Federation gas reserves (YE2004) 1,694 Tcfe 27%
Iran gas reserves (YE2004) 971 Tcfe 15%
Qatar gas reserves (YE2004) 910 Tcfe 14%
Saudi Arabia gas reserves (YE2004) 238 Tcfe 4%
UAE gas reserves (YE2004) 214 Tcfe 3%
US gas reserves (YE2004) 187 Tcfe 3%
US gas reserve life (YE2004) 10 years -
Nigeria gas reserves (YE2004) 176 Tcfe 3%
Algeria gas reserves (YE2004) 160 Tcfe 3%
Canada gas reserves (YE2004) 57 Tcfe 1%
Canada gas reserve life (YE2004) 9 years -
Source: 2005 BP Statistical Review of World Energy. Note: Figures have been rounded.
Table 5: A Perspective Of Reserves By Company, Field and Well

Proved reserves Proved reserves
Comment (oil-equivalent) (gas-equivalent)

By Company (Examples)
Exxon Mobil - YE2004 Largest Supermajor 21,711 MMboe 130,266 Bcfe
EnCana Corp. – YE2004 Largest-cap E&P 2,245 MMboe 13,470 Bcfe
Apache Corp. – YE2004 Large-cap E&P 1,937 MMboe 11,622 Bcfe
Chesapeake Energy - YE2004 Large-cap E&P 817 MMboe 4,902 Bcfe
Noble Energy – YE2004 Mid-cap E&P 524 MMboe 1,578 Bcfe
Forest Oil – YE2004 Small-cap E&P 222 MMboe 1,332 Bcfe
McMoRan Exploration – YE2004 Micro-cap E&P 8 MMboe 48 Bcfe
By Field or Well (Examples)

Prudhoe Bay Largest oilfield in N. America 39 billion boe 234 Tcfe
Thunder Horse Largest oilfield in GOM 1-3 billion boe 6-18 Tcfe
Standalone successful Deepwater GOM field (range) 75 MMboe - 3,000 MMboe 450 Bcfe - 18,000 Bcfe
Standalone successful Deepwater GOM field (average) 100-150 MMboe 600-900 Bcfe
Successful Deep Shelf GOM target (range) 3-33 MMboe 20-500 Bcfe
Successful Deep Shelf GOM target (average) 3 MMboe 20 Bcfe
Successful Conventional GOM Shelf well (range) 0.5-3.3 MMboe 3-20 Bcfe
US onshore conventional well (range) 125 Mboe-17.0 MMboe 750 MMcfe-100 Bcfe
Coal Bed Methane well (range) 50 Mboe-0.2 MMboe 250 MMcfe-1 Bcfe
Source: Company reports, MMS, Netherland, Sewell & Associates, Alaska Department of Natural Resources, and JPMorgan estimates.
22
(1-713) 216-1918 18 November 2005
Table 6: A Perspective Of Production By Company, Field and Well

Production Production
Comment (oil-equivalent) (gas-equivalent)

By Company (Examples)
Exxon Mobil - YE2004 Largest Supermajor 1,591 MMboe 9,546 Bcfe
EnCana Corp. – YE2004 Large-cap E&P 279 MMboe 1,674 Bcfe
Chesapeake Energy - YE2004 Large-cap E&P 60 MMboe 360 Bcfe
Apache Corp. – YE2004 Large-cap E&P 164 MMboe 984 Bcfe
Noble Energy – YE2004 Mid-cap E&P 39 MMboe 234 Bcfe
Forest Oil – YE2004 Small-cap E&P 29 MMboe 174 Bcfe
McMoRan Exploration – YE2004 Micro-cap E&P 0.4 MMboe 2.4 Bcfe
By Field or Well (Examples) Initial Production Initial Production

Deepwater GOM field (range) 25-250 Mboe/d 150-1,500 MMcfe/d
Deepwater GOM field (average) 50 Mboe/d 300 MMcfe/d
Deep Shelf GOM target (range) 3-58 Mboe/d 10-350 MMcfe/d
Deep Shelf GOM target (average) 2-7 Mboe/d 10-40 MMcfe/d
Conventional GOM Shelf well (average) 1 Mboe/d 5 MMcfe/d
US onshore conventional well (range) 0.4 Mboe/d 2.5 MMcfe/d
Coal Bed Methane well (range) 8-833 boe/d 50 Mcfe/d-5MMcfe/d
Source: Company reports, MMS, Netherland, Sewell & Associates, and JPMorgan estimates.
E&P Stocks as Investments

E&P stocks represent a "pure play" investment on oil and gas prices.
Most investors prefer to invest in E&P stocks rather than oil and gas futures
as many institutional investors are prohibited from futures trading, futures
have margin requirements, and futures contract sizes are large.
Figure 11: Correlation Between Commodity Prices and E&P Stocks
12.00 400
Blend 12-Month Strip S&P 500 E&P Index
50% Gas, 50% Oil 350

10.00 80% R-Squared
300
8.00
250
6.00 200
150
4.00
100
2.00
50
- 0
4 5 6 7 8 9 0 1 2 3 4
c- 9 c- 9 c- 9 c- 9 c- 9 c- 9 c- 0 c- 0 c- 0 c- 0 c- 0
De De De De De De De De De De De
Source: Bloomberg; Factset
23
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Exposure to oil versus natural gas varies widely among E&P companies.
In general, the average E&P company is more exposed to gas than oil. As a
result, most E&P investors focus more on natural gas prices and
fundamentals than oil prices and OPEC, but the latter is obviously still quite
important.
Types of E&P Companies

• Pure Exploration Companies: Rely solely on the drillbit (i.e.,
drilling exploration wells) for growth in reserves and production.
Requires highly skilled exploration technical staff. May command a
premium because not beholden to M&A market for growth.
Example: Bill Barrett Corp.
• Acquire and Develop Companies (a.k.a. Acquire and Exploit

Companies): For the most part, these companies take the "E" out of
E&P, as exploration activity is either not very significant or non-
existent. Instead, the strategies of these companies involve acquiring
mature properties and reserves from other companies and developing
or exploiting the reserves. In the past 10-20 years, the majors in
general have been slowly shedding lower return, mature assets in the
U.S. in search of higher returns abroad. Many E&Ps have found a
niche in acquiring such properties (both from majors, integrateds,
and even larger E&Ps), and paying closer attention to the properties
in order to add value. This may involve enhanced oil recovery
techniques including secondary recovery and tertiary recovery.
These include stimulating production levels through techniques like
water flooding, steam injection, or fracturing the sands or rock in the
reservoir in order to produce the reserves faster and/or more
efficiently. The major drawback for these types of companies is the
fact that they are beholden to M&A market as a source of growth.
The M&A market is highly competitive and can be quite efficient, so
it is often hard to truly add value. Example: Encore Acquisition
Company, XTO Energy
• Combination of Both: Most E&P companies employ a combination

of both strategies discussed above. This approach is a little more
flexible. Companies often like to concentrate on exploration and
development drilling when commodity prices are high and acquiring
reserves when commodity prices (and therefore asset prices) are low.
Example: Most E&P companies
• Unconventional Producers: Unconventional or resource plays have

come into their own as an important source for future of U.S. energy
supply, as production from conventional supply basins such as the
Gulf of Mexico shelf has stalled and entered a relatively pronounced
decline phase. Given USGS estimates that low-permeability, deep
gas reservoirs in the U.S. may contain upwards of 135 Tcf of
technically recoverable gas, these plays are logically viewed as the
24
(1-713) 216-1918 18 November 2005
"last growth frontier" in what is otherwise a relatively mature U.S.

producing basin. When compared to conventional resources,
unconventional resource plays tend to offer long-life, low-decline
reserves, reliable production growth and lower costs over time.
Example: EnCana Corp., EOG Resources, Quicksilver Resources,
Ultra Petroleum, Southwestern Energy
Virtually every top-performing E&P stock over the past three years
could be characterized as resource play producer. We think the
underlying reasons that longer life assets have gained so much favor
are North American basin maturity, rising commodity prices, and to a
lesser extent, falling interest rates. Among these factors, we think the
significant lift in long-dated energy futures prices has been the single
most important. Much in the way falling interest rates push up the
value of long-duration bonds, rising commodity prices and lower
discount rates have driven up the value of long-lived unconventional
assets.
What Matters to Investors

• Cash Flow Growth: Although more emphasis is being placed these
days on returns and profitability metrics like ROCE, the typical E&P
investor is more focused with the rate companies grow their cash
flow (a.k.a. discretionary cash flow or cash flow from operations
before changes in working capital). Over the long run, companies
cannot grow cash flow without growing production, so there is a
huge emphasis on production growth. On that note, companies can't
sustain production growth without finding or acquiring new reserves,
so reserve growth is also highly important.
• Production & Reserves Growth: Growing production and reserves

is easier said than done, as natural decline rates can be difficult to
offset. In order to grow organically, a company really needs to add
new assets that are yielding initial production at a rate faster than its
base is declining. This is easy enough to do in a given year, except
that adding faster-decline production has the effect of "turning up the
treadmill" over time. As the new, rapid-decline assets become a
bigger part of the base, it becomes tougher and tougher to find new
projects to offset the accelerated decline rate. We think this is why
significantly above-average organic growth has, without exception,
proven to be unsustainable in this industry.
• Cost Control: Keeping costs in check is challenging in an

environment where costs are creeping up across the industry (see
Figure 12). Finding, development and acquisition costs (FD&A
costs) include capital spent in order to add new reserves either
through exploration and development activities, or through
acquisitions of new properties or companies. These expenditures are
capitalized on the balance sheet as plant, property, and equipment
25
(1-713) 216-1918 18 November 2005
(PP&E) and eventually flow through the income statement in the

DD&A expense line item. FD&A costs are especially important
because they usually represent the greatest portion of a company's
cost structure. Production costs (a.k.a. lifting costs, operating costs,
lease operating expense, or LOE) are also important. We note that
the characteristics of particular fields or basins (geology,
infrastructure, oil field service costs, politics, etc) can vary
significantly, which can meaningfully affect FD&A and operating
costs. G&A and interest expenses are usually a smaller portion of
the cost equation.
Figure 12: Cost Creep

Average all in costs, $/Mcfe
4.50 $4.25
4.00
$3.69
3.50
$3.16
3.00 $2.89
$2.53
$2.43 $2.41
2.50
$2.15 $2.20
$2.04
2.00 $1.84 $1.82 $1.81
$1.72
1.50
1.00
0.50
-
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E
Source: Company reports and JPMorgan estimates. Note: We define all-in costs as FD&A, LOE (including production/severance taxes
and transportation costs, net interest (including preferred dividends), and G&A expenses.
• Return and Profitability Metrics: More emphasis is being placed

on return and profitability metrics like return on capital employed
(ROCE) and profit margins. Although commodity prices have
generally been strong in the past few years, bolstering the top line,
the phenomenon of "cost creep" has hampered returns on capital
employed (see Figure 13).
26
(1-713) 216-1918 18 November 2005
Figure 13: Generating Mid-Cycle ROCEs Requires Much Higher Prices Today
18%
9.50
16%
We estimate that it now requires 8.50
$6.50-$7.00/Mcfe pricing for the 14%
average producer to cover a 9- 7.50
10% WACC. 12% 10-yr average: 9% on
av'g px of $3.80/Mcfe 6.50
10%
8% 5.50
6% 4.50
4% 3.50
2% 2.50
0% 1.50
95 96 97 98 99 00 01 02 03 04 05E 06E
ROCE Commodity Px Index ($/Mcfe)
Source: Company reports, JPMorgan estimates. Note: ROCE is defined as recurring earnings plus tax-effected interest (~NOPAT)
divided by stockholders' equity plus debt. Commodity price index is a 50/50 oil/gas weighted index, stated in Mcf-equivalents
converting at 6:1.
• Catalysts: Investors often look for catalysts that can move a stock.
Positive catalysts would include successful results of a key

exploration well, first production from a key development project;
successful results from a downspacing pilot which could lead to
reserve additions, an accretive acquisition at an attractive price, a
boost in production guidance, a well-executed divestiture, a share
repurchase program, or any macro factors that positively affect oil
and gas prices.
Negative catalysts would include a dry hole announcement at a key

exploration well, delays at a key development project, disappointing
reservoir performance or characteristics of a development field or
project versus original expectations, a dilutive merger or acquisition,
a reduction of production guidance, an asset impairment charge
(a.k.a. reserve writedown), or the announcement of an equity
offering.
• Hedging: Strategies among management teams vary, and investors

have varying opinions as to whether or not companies should hedge.
Some investors want full and complete exposure to commodity
prices (remember the pure-play concept), while others prefer some
degree of hedging, which can be used by management to protect its
balance sheet, protect a capex program (thus helping ensure
production growth), or lock-in the economics of a particular
acquisition or a large development project coming online. As the last
couple of years have brought a period of dramatic increases in
27
(1-713) 216-1918 18 November 2005
commodity prices, many producers are stuck with large writeoffs

associated with underwater hedges. Thus, producers seem to be
hedging less, but this could change if commodity prices fall into a
prolonged slump. Producers with large hedge positions must also be
cautious of potential supply disruptions that could leave them
"overhedged" on their production and required them to effectively
buy production in the open market to satisfy hedges. Note:
JPMorgan publishes a Quarterly Hedging Survey which includes
summary hedge positions for each producer under coverage. The
following Figure 14 is taken from our Q3-05 Hedging Update.
Figure 14: Summary E&P Hedge Positions, 2006E
Average hedge protection: 26% of 2006E Production

1,000 $80
75.37
76.40
900
67.94 $70
25%
800
57.32
55.00
$60
700 54.10
Weighted Average Hedged Price ($/boe)

Average 2006E Production (Mboe/d)
50.40
0% 49.36
47.74 $50
46.30 45.00
600 44.94
42.46
46.68
6% 40.51
4% 1% 39.40 44.26 38.82 39.43
37.27 43.55 38.28
500 41.63 $40
35.16 39.43
39.89 38.93
32.26 32.75 38.56
37.07 31.36
400 35.16
33.75
32.28
$30
30.62 25.92 30.39
29.43
28.92
300 25.62
0% 72% 1%
28% $20
20.74 23%
200
17%
17%
30% $10
100 26%
1% 65%67%
51% 7% 27% 7% 12% 0% 37% 36% 0%
40% 0%
0%
- $-
ECA DVN APA BR APC EOGKMG XTO CHK NBL PXD NFX PPP FST VPI PXP THX RRC SGY UPL SM COG WTI WGRKWK SFY EAC SKE MMR
Hedged Volumes Unhedged Volumes Avg. Floor and Ceiling Prices
Source: Company reports and JPMorgan estimates. Note: Data Current as of August 2005.
• Balance Sheet: Financial flexibility is crucial in the E&P sector,

especially considering most E&P companies rely on acquisitions for
meaningful growth. When commodity prices fall from peak to
trough levels, stocks with higher financial leverage tend to
underperform the group. The average net debt to capital ratio in our
coverage universe stood at 33% at the end of Q3/05. The average net
debt to EBITDAX ratio in our coverage universe stood at 0.8 at the
end of Q3/05. As a result of record cash flows over last couple of
years, many producers are finding themselves with the attractive
28
(1-713) 216-1918 18 November 2005
“problem” of swelling cash balances. As acquisitions are currently

both expensive and difficult to come by, many producers are using
cash to repurchase shares. As the E&P business tends to be cyclical,
producers generally prefer repurchase plans over the relative
permanence of increased dividends.
Asset Intensity: The “Holy Grail” of the E&P Business?

The business of oil and gas exploration and production is a challenging
one. Producers face a daily and perpetual decline in their base assets, and
must constantly redeploy cash flow in order to offset natural depletion.
Growth becomes doubly challenging in a rising cost environment within a
mature basin, as more cash flow is eaten up by efficiency losses and rising
expenses. In the end, it would seem that those companies having more cash
flow available after base declines are offset should be able to deliver higher
and more sustainable growth over time.
Our work suggests that a producer's finding efficiency and asset

characteristics can be combined into a single metric that captures a
producer’s ability to “pedal uphill.” We originally introduced this concept
back in May 2003, calling this metric “asset intensity,” and this has been the
dominant consideration in our stock-picking efforts since that time. We
define asset intensity as the proportion of discretionary cash flow required in
order to maintain flat production in a given period. There are two main
components to our "asset intensity" metric: maintenance capital spending, or
that investment required to keep production flat on an annual basis; and
projected discretionary cash flow (operating cash flow before working capital
changes).
Figure 15: Definition of Asset Intensity

Lower is Better
Maintenance Capex*
Asset Intensity =
Discretionary Cash Flow
* Note: Maintenance capex is defined as [ (Production Volumes * 3-yr Avg. FD&A) + non-E&P segment maintenance
capex ]
Source: JPMorgan.
Maintenance capex is a function of the decline profile of a producer’s asset

base and that producer’s finding efficiency. Discretionary cash flow, on the
other hand, is a function of revenues generated relative to cash costs. We
think because these broad measures encompass so many "moving parts" that
are critical to the E&P value proposition, they do a reasonable job of
capturing differences in competitive advantage, and combined they yield a
metric that appears to be a strong indicator of sustainable growth potential.
We originally approximated maintenance capex by multiplying projected

production volumes by a company’s projected unit cost to find and develop.
29
(1-713) 216-1918 18 November 2005
The F&D cost assumption was guided mostly by each company's three-year
average historical unit drillbit finding costs, normalized for unusual revisions
or other items. As time went on, we refined this methodology to also
accommodate differing intrinsic decline rates among the various companies,
so our maintenance capex estimates are now hopefully more precise than
what a more simplistic “production times F&D” approach might generate. As
before, we add in estimated "maintenance capex" for non-E&P businesses
(such as chemicals, midstream, or R&M) where appropriate.
Additionally, for companies who use property acquisitions as a recurring and

essential component of their strategy (companies like XTO and CHK, for
example), we incorporate more of an all-in (FD&A) cost component. Even if
their sizeable prospect inventories in place don’t require acquisitions, those
particular companies have stated they will, nonetheless, continue to purchase
new properties in order to help stabilize what would otherwise be
accelerating natural declines. We reason that either one has to use F&D
(drillbit-only) costs, and assume accelerating natural declines, or else hold
intrinsic decline rates stable but assume (typically higher) all-in FD&A
costs.
Once we have a reasonable approximation for maintenance capex, we divide

that amount by estimated discretionary cash flow for the period in question to
generate an asset intensity percentage. In Figure 16 below, we have ranked
the companies according to their 2006 estimated ratios, as of our November
2005 estimates.
Figure 16: Lower Asset Intensity Indicates Greater Growth Potential

39%
UPL 8%
WGR 19%
PXP 25%
SWN 26%
KWK 26%
RRC 27%
XTO 28%
NBL 35%
More Attractive
EOG 36%
BR 36%
COG 36%
EAC 36%
BBG 36%
APC 38%
APA 39%
SM 40%
CHK 41%
FST 43%
PXD 43%
46%
Less Attractive
THX
SFY 46%
ECA 46%
NFX 48%
DVN 50%
PPP 50%
SGY 55%
KMG 59%
SKE 64%
VPI 70%
WTI 88%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Source: Company reports and JPMorgan estimates.
30
(1-713) 216-1918 18 November 2005
Macro Data to Watch

• Weekly Natural Gas Storage Levels (see Figure 17): Weekly
storage reports are published every Thursday at 10:30 Eastern by the
Energy Information Administration (EIA), a division of the US
Department of Energy (DOE). Because a large proportion of natural
gas demand is weather-driven (used for heating), production in the
spring, summer and fall exceeds demand, so there are net gas
injections into storage facilities. Storage levels typically peak on or
around October 31. From early November to late March, demand
significantly exceeds production, so there are net gas withdrawals
from storage. Storage levels typically trough on or around March 31.
Investors watch storage levels closely because natural gas prices are
highly correlated with the tightness of storage levels. Prices tend to
drop as storage levels move above average, and prices tend to rise
when storage levels fall below average.
• Weekly Crude Oil Reports: Weekly crude oil reports are published
every Wednesday at 10:30 am ET by the EIA. The report details
U.S. oil and oil product statistics including inventories, imports,
demand, refining utilization, etc. E&P investors watch this report for
much the same reason that they watch the weekly natural gas storage
report. Crude oil prices are in part driven by the tightness of
inventory levels. Prices tend to drop as inventories move above
average, and prices tend to rise when inventories fall below average.
• Weekly Rig Counts: Baker Hughes publishes weekly rig counts

every Friday. When rig counts rise, drilling activity is picking up.
This is bearish for E&P stocks for two reasons. First, it signals that
new supply (production) may increase. Second, it indicates that
demand for rigs is increasing, which may boost E&P drilling costs.
• Quarterly Gas Production Figures From North American

Producers: The JPMorgan North American Natural Gas Supply
Monitor is a bottom-up survey that attempts to estimate changes and
trends in North American natural gas production by the industry,
based on quarterly results from producers. Decline in supply is
bullish for gas prices, and growth in supply is bearish for gas prices.
• Government Natural Gas Supply and Demand Data: Each month,

the EIA releases gas supply and demand data, but these are of
questionable value because the data lags significantly and is typically
subject to later revisions.
• OPEC-Related News: OPEC represents roughly one third of

worldwide oil supply, and thus has a major influence on prices.
31
(1-713) 216-1918 18 November 2005
Figure 17: Henry Hub Spot Natural Gas Prices and Working Gas Storage Levels
14 3,700
12 3,200
10 2,700
$/MMBTU
8 2,200
bcf
1,700
6
1,200
4
700
2
200
0
J F M A M J J A S O N D
Ja 3
Ja 4
Ja 5
96
Ja 7
Ja 8
99
Ja 0
Ja 1
02
Ja 3
Ja 4
05
9
9
9
9
9
0
0
0
0
5 Yr Range 2004 2005 5-Yr Avg

n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
Ja
Ja
Ja
Ja
Source: Natural Gas Week, EIA, Bloomberg.
Valuation
Six Most Widely Used E&P Valuation Metrics:
• Price/Cash Flow (P/CF): Stock price divided by discretionary cash

flow (cash flow from operations before changes in working capital).
In times of low commodity prices, multiples expand and in times of
strong commodity prices, multiples contract. This metric, while
easily calculated, can be misleading in cases of above-average or
below-average financial leverage.
• Enterprise Value/EBITDAX: A better metric than P/CF, in our

opinion, because it adjusts for financial leverage (i.e., a highly-
leveraged company may look cheap on a P/CF basis but more
average or even rich on a EV/EBITDAX basis). The "X" in
EBITDAX stands for the exploration expense for successful efforts
companies (see discussion on page 34 entitled Why Earnings Are
Less of a Concern to E&P Investors). In times of low commodity
prices, multiples expand, and in times of strong commodity prices,
multiples contract. The E&P sector has traded at 5.0 times forward
EBITDAX on average during the past five years, with a high of 7.2
and a low of 3.2.
• EV/FCF: This multiple captures important differences in

maintenance capex/finding efficiency among the companies, and thus
should be a better indicator of sustainable growth potential. Free
cash flow, as we define it, is unlevered cash flow (i.e. discretionary
CF less cash taxes and interest expense) minus maintenance capex
(expenditures required to keep production flat). The underlying
concept with EV/FCF is to assess what an investor is paying for the
sustainability of a given asset base’s growth profile, which we have
32
(1-713) 216-1918 18 November 2005
shown to be a direct function of its free cash flow. EV/FCF is

closely related to our asset intensity concept described above.
• Enterprise Value/normalized EBITDAX: Same calculation as

EV/EBITDAX, but the EBITDAX is based on a theoretical
normalized value that is estimated assuming mid-cycle commodity
prices defined as the level of oil and gas pricing would have enabled
the sector on average to earn its cost of capital in a given year.
Unlike the plain vanilla EV/EBITDAX multiple, this multiple
contracts in times of low commodity prices and expands and in times
of strong commodity prices. The E&P sector has traded at 5.0 times
forward normalized EBITDAX on average during the past five years,
with a high of 7.9 and a low of 3.6.
• Enterprise Value/normalized Asset Value: A discounted cash flow

analysis that assumes mid-cycle commodity prices defined as the
level of oil and gas pricing that would enable the sector on average to
earn its cost of capital in a given year. The DCF analysis mimics the
SEC present value calculation (PV-10) that is required to be
disclosed in the reserve section of companies' 10-Ks. The SEC
calculation requires the assumption of whatever the prevailing
commodity prices were at the end of a reporting period. This leads to
significant volatility in the PV-10 calculation from one year to
another, simply because of fluctuating commodity prices. Unlike the
SEC approach, our calculation assumes that the normalized or mid-
cycle price prevailed in every given year. Stocks can trade at
discounts or premiums to their normalized asset values, depending
on the commodity price cycle. The E&P sector has traded at 93% of
normalized asset value on average during the past five years, with a
high of 135% and a low of 65%.
• Enterprise Value/Reserves: A simplistic valuation tool that requires

no estimates or assumptions. In general, this metric should not be
used as a primary valuation multiple, as not all reserves were created
equal, but it can serve as a useful point of reference. This metric is
often used to evaluate the valuation of property acquisitions, when
little is known about the specific cash flow generating potential of
the acquired reserves. Companies also sometimes prefer to
repurchase stock if the shares are trading below the EV/ Reserve
multiples of potential corporate or property acquisitions. In general,
the longer the reserve life of a company or property, the lower the
EV/Reserve multiple, all other things being equal. This is because
reserves with a longer reserve life (reserves/production ratio, or R/P
ratio) take longer to produce and are therefore worth less on a time-
value-of-money basis. The proportion of proved undeveloped
reserves (PUDs) in the reserve base also affects this multiple. In
general, the greater the proportion of proven undeveloped reserves,
the lower the EV/Reserve multiple, all other things being equal.
33
(1-713) 216-1918 18 November 2005
Reserves that are less prolific will also trade at a discount, all other
things being equal.
Why Earnings Are Less of a Concern to E&P Investors

• Successful Efforts Versus Full Cost Accounting: Companies are
given a choice between two methods to account for dry holes
(unsuccessful exploration wells). Companies that employ the
successful efforts method of accounting must expense the cost of the
well immediately through the income statement. By contrast,
companies that use the full cost method of accounting must
capitalize the cost of the dry hole onto the balance sheet, and
eventually amortize it through DD&A expense. Therefore, earnings
from successful efforts companies can be very erratic, compared to
those of full cost companies. The two accounting methods produce
apples and oranges when looking at relative P/E ratios within the
sector.
• Negative Earnings Are Common in Years of Low Commodity

Prices: The fortunes of E&P companies are largely tied to oil and
gas prices, which are cyclical. In times of weak prices, many E&P
companies have negative earnings, making P/E ratios not
meaningful. The integrated oil companies and majors have other
businesses that usually do well when oil and gas prices are weak (like
refining, marketing, and chemicals businesses).
A Word on Hurricanes
As the bulk of North America’s oil and gas infrastructure is still
concentrated in or near the Gulf of Mexico, the energy industry is highly
susceptible to storm-related disruptions. NOAA data suggests a steady
pickup in Atlantic/GOM tropical storm activity over time, and most notably
over the past ten years. Over the long haul (i.e., since 1944), the “average”
tropical storm season involves 10 named storms, including 6 hurricanes, 3 of
which prove to be “major” (i.e., Category 3, 4 or 5) hurricanes, though, the
past ten years have been quite a bit more active than this. In fact, the high
level of activity since the mid-1990s and various climatic indicators have led
some forecasters to call for a 20-25 year cycle of increased tropical activity.
Hurricanes can have a two-fold effect on exploration and production

companies. Depending on the size and severity of a hurricane, producers
will be forced to shut-in their Gulf of Mexico production well ahead of the
arrival of a storm, and often leave platforms abandoned for several days after
the storm passes. This results in a deferral of production to subsequent
periods. While producers are forced to forego or delay production, they often
receive an offset to lost revenue in the form of higher commodity prices. The
cumulative shut-ins across the industry can add up to a significant loss of
34
(1-713) 216-1918 18 November 2005
supply, forcing prices higher. E&P producers are then able to capture higher
prices for production elsewhere.
While hurricane season really covers the second half of the year, some of the
more servere storms of late have caused production shut-ins that have
persisted for more than a year. In some cases, the shut-ins were due to
damaged production infrastructure, while in other cases, shut-ins persisted
due to damages to third-party pipeline systems. Some producers carry
insurance to cover both damaged infrastructure and lost production, but terms
and the extent of coverage vary widely. Figure 18 below summarizes the
effects of three recent major hurricanes that traveled through the producing
region of the Gulf of Mexico.
Figure 18: Gulf of Mexico Shut-ins from Recent Hurricanes
100%
88%
90% 83%
73% 80%
80% 75%
70% 66%
52% 66%
60% 57% 52% 55% 50%
45%
50% 53% 40% 40%
KATRINA / RITA '05
40% 42% 34% 33%
36%
30% 30%
20% 24%
20%
19% 17%
10% 14% 14%14%
IVAN '04 12%11%
10% 6%
0% 6%
ll
1
y8
fa
y1
y2
y3
y4
y5
y6
y2
y5
y7
nd
Da
Da
Da
Da
Da
Da
Da
Da
Da
Da
La
Source: Minerals Management Service
Liquefied Natural Gas: A Brief Primer

The declining outlook for domestic natural gas production has thrown
LNG into the industry spotlight. According to the EIA, U.S. natural gas
consumption is forecast to increase from 22.3 Tcf in 2004 to 25.4 Tcf in 2010
and to 30.6 Tcf by 2025. Domestic production of natural gas will likely not
be sufficient to keep pace with consumption, with the production shortfall
versus consumption rising from 3.3 Tcf in 2004 to an estimated 4.9 Tcf in
2010 and to 8.7 Tcf in 2025, according to EIA. Canadian natural gas imports
are expected to steadily decline from 3.0 Tcf in 2005 as Canadian demand
increases and gas fields mature. These developments raise the question of
where the United States will find adequate supply to satisfy its growing
demand.
35
(1-713) 216-1918 18 November 2005
Natural gas has remained a relatively regional business because of the

inherent difficulty in transporting it over long distances, but LNG is
quickly changing the dynamics of natural gas into a global enterprise.
The process of liquefying gas involves cooling it to 259 degrees below zero,
at which point it becomes a liquid and its volume is reduced 600 times. It
can then be stored and transported by tanker across long distances. Before
the gas is consumed, however, it must be regasified. Existing LNG proposals
differ, but this can be done on the tanker or, more commonly, at a
regasification facility.
Many foreign nations have natural gas supplies that more than satisfy
their levels of domestic demand and therefore can be readily
commercialized and exported to the United States and other nations with
demand in excess of supply. The top exporters of LNG to the United States
include Trinidad and Tobago, Algeria, Australia, and Nigeria.
While awareness of LNG has been heightened in recent years, there are
currently only four LNG importation facilities operating in the
continental U.S., and a new facility has not opened in roughly two
decades. The two primary deterrents to more development of domestic LNG
importation capacity have been safety/regulatory concerns and economics.
The latter issue appears to no longer be a factor with natural gas prices at
historically high levels and a supply/demand picture, as illustrated above,
which suggests that prices could stay somewhat elevated over the long term.
Most industry experts believe long-term gas prices of at least $3.50/Mcf are
needed to keep a LNG project commercially viable. JPMorgan projections
call for gas prices to stay well above that level through 2007.
Safety and regulatory concerns continue to be an issue for expanding

domestic LNG capacity. The actual liquefied gas is believed by most to
be non-toxic, non-flammable, and non-explosive. In fact, LNG technology
has been around for over 40 years, with a strong safety record. There was a
notable explosion, however, at an Algerian LNG liquefaction facility, and an
indisputable cause of the incident has not been determined. As a result of
this and other reported LNG accidents, it is common for the local public to
demonstrate strong resistance upon the identification of an onshore site near a
populated area for a potential LNG facility. Regulatory bodies continue to
study the environmental impact of LNG but to date have made no substantial
disclosures that raise serious concern. An energy-friendly Bush
administration could lead to regulatory entities being pressed to approve
LNG proposals more quickly going forward.
Today, there are proposals for nearly 40 new LNG regasification facilities in
North America over the next several years, with the next U.S. terminal
projected to open in the Gulf Coast in 2007.
36
(1-713) 216-1918 18 November 2005
Table 8: Projections of U.S. Natural Gas Consumption and Production Growth

figures in Tcf
2004 2010E 2025E
Consumption 22.3 25.4 30.6
Production 19.0 20.5 21.9
Differential 3.3 4.9 8.7
Source: EIA.
37
(1-713) 216-1918 18 November 2005
Appendix: Hypothetical E&P Press

Releases
All of the following scenarios are for fictitious companies.
Exploration Discoveries
Example 1: Deepwater Gulf of Mexico Discovery Press Release:
Orange Resources reported today that an exploratory well testing the
Humphrey Bogart Prospect on Garden Banks Block 782 in the Gulf of
Mexico encountered over 360 net feet of pay in four intervals. The Garden
Banks Block 782 #1 exploratory well, located in 4,642 feet of water, was
drilled to a true vertical depth of 15,717 feet. Each pay zone was
encountered at the predicted depth and generally met or exceeded the
anticipated thickness. The rig Ocean Victory will stay on location to conduct
subsequent appraisal drilling at Humphrey Bogart that will target several
additional shallow and deep objectives that could not be penetrated from the
initial wellbore location. Orange owns a 20 percent working interest in the
Humphrey Bogart Prospect on Garden Banks Block 782 as well as in
adjacent blocks 826 and 827 and nearby block 785. Purple Exploration holds
an 80 percent working interest in these same blocks and serves as operator.
Interpretation
QUESTIONS TO ASK
Unless unrisked (total potential) pre-drill reserve estimates were disclosed
MANAGEMENT: prior to drilling this well, it is difficult to estimate the size and value of this
• What were the predrill
discovery. However, one can deduce a few takeaways:
reserves estimates?
First, Orange believes there is a chance the deepwater discovery is
• Is there any nearby
infrastructure with spare commercial, otherwise, it would not conduct appraisal drilling, and the well
capacity? would likely be plugged and abandoned.
• How many appraisal wells
will be necessary to justify Second, it is unlikely that there is any nearby infrastructure with spare
sanction? capacity that could be utilized to more efficiently and more cheaply develop
the discovery, otherwise, the press release would have likely mentioned this.
This means that in their ultimate evaluation of the potential economics of the
discovery, Purple and Orange will likely need to assume that a new
production facility will need to be built in order to develop the reserves.
Finally, because the well was drilled in very deep water (in the Gulf of
Mexico, any depth greater than roughly 655 feet of water is considered
deepwater) in an area with no nearby available infrastructure capacity, one
can safely deduce that the target size of the reservoir was likely above 100
million boe. As a rule of thumb, undeveloped deepwater Gulf of Mexico
discoveries have around $5/boe worth of net present value. Therefore, if this
discovery is ultimately declared commercial, we would peg its NPV to be
between around $500 million on a gross basis, or $100 million net to Orange.
38
(1-713) 216-1918 18 November 2005
Investors should be aware that for cost reasons, flowtests are not commonly
conducted on apparent discoveries in the deepwater. Instead, extensive
logging and other reservoir tests are run to bracket in a range of recoverable
reserve estimates, in order to justify project sanction. For this reason, new
deepwater fields can occasionally encounter production problems in their
first six months onstream, as a reservoir quality and/or the extent of
compartmentalization comes to light.
Example 2: Deepwater Gulf of Mexico Discovery Press Release:

Violet Energy today announced a natural gas discovery at its James Cagney
prospect in the Eastern Gulf of Mexico. The discovery well is located in
Atwater Valley 349, and was spudded in 8,800 feet of water, about 200 miles
southeast of New Orleans. It encountered a total of 83 feet of net pay and
was drilled to the target depth of 18,310 feet using the Deepwater
Millennium drillship. Estimated field size is 40 million to 50 million barrels
of oil equivalent. Violet holds a 100 percent interest in the James Cagney
discovery and adjacent blocks. The company believes James Cagney could
be commercially produced when hub facilities are established in the area.
Toward that goal, Violet will soon begin drilling its high-potential Spencer
Tracy prospect located at Lloyd Ridge Block 360 in 9,100 feet of water.
Interpretation:
QUESTIONS TO ASK This is technically a discovery, but we would not necessarily call it a
MANAGEMENT:
successful discovery, given its size (40-50 MMboe), water depth, and the
• What would be the lack of available infrastructure capacity. As a rule of thumb, companies
minimum threshold size drilling in deepwater in an area with no nearby available infrastructure
for a collection of fields
here to justify a hub capacity are targeting at least 100 million boe of gross reserves to justify a
development? standalone commercial development project. These results therefore likely
• How many similar
came in below the company's expectations. Furthermore, the company
prospects does the admits that the find is not commercial, unless other discoveries are found in
company have in the area that will augment economics. Until that occurs, the market will
inventory here? likely ascribe little-to-no value to James Cagney.
Example 3: Deep-Shelf Gulf of Mexico Discovery Press Release:

Pink Exploration today announced its first shallow-water, deep-shelf gas
discovery at its Jimmy Stewart prospect at High Island 115 in 44 feet of
water. The #1 well was drilled to 19,800 feet and tested 20 million cubic feet
of gas per day. The company anticipates first production in seven to eight
months, pending construction of facilities. Pink Exploration has a 50 percent
working interest in the project. The well is operated by Beige Oil and Gas as
a part of the previously announced joint-venture agreement between both
companies.
39
(1-713) 216-1918 18 November 2005
Interpretation:
QUESTIONS TO ASK Unless unrisked (total potential) pre-drill reserve estimates were disclosed
MANAGEMENT:
prior to drilling this well, it is difficult to estimate the size and value of this
• What are expected discovery. However, one can use the production test rate data to back into an
reserves? approximate gross reserve size. One could assume that, as a rule of thumb, a
• Do you have any “look-a- deep-shelf well will likely produce roughly half of its reserves in the first
like” prospects nearby? year, given the steep hyperbolic decline rates of shelf wells, and the other
half over the next three or four years. Therefore, a well that initially
produces 20 MMcf/d will likely produce around 7 Bcf of gas in year 1,
implying total gross reserves of about 14 Bcf. Assuming these undeveloped
gas reserves have a NPV of $1.00-1.25/Mcfe (worth more than deepwater
undeveloped reserves because they can be brought onto production at much
faster rates, sometimes through existing infrastructure), we would peg the
NPV of the discovery between $14-17.5 million on a gross basis, or $7-8.8
million net to Pink.
Successful Appraisal Well

Example 1: Successful Deepwater Appraisal Well Press Release:
Grey Land & Exploration and its partners today announced another
successful deepwater subsalt appraisal well on their Clark Gable discovery,
located in the Gulf of Mexico on Green Canyon Block 562, about 180 miles
south of New Orleans. "We're pleased to discover the potential field size of
Clark Gable could be larger than Grey's previous estimates," said Grey's
Chairman, President and CEO John Q Smith. "The Clark Gable No. 3
appraisal well was intended to confirm the northwestern edge of the field, but
the field extends even deeper and farther beyond what we had predicted. In
fact, the outermost limits of Clark Gable are still unknown." The Clark
Gable No. 3 well was spudded by Black Gold Petroleum Co. in February
2005 in about 3,900 feet of water. The well reached a total depth of more
than 27,000 feet and encountered a total of 208 feet of oil pay in two sands
with no oil-water contact. The findings confirm the prior estimated gross
reserves of about 100 million barrels of oil equivalent, and the lack of an oil-
water contact suggests additional reserve potential. The well extended the
limit of the proven oil column down dip an additional 800 feet on the Clark
Gable structure. Grey holds a 52.5 percent working interest in the project;
other partners include Black Gold (operator - 18.2 percent), Aqua Energy
(16.8 percent) and Indigo Hydrocarbons (12.5 percent). The Clark Gable
partner companies expect to make a decision on development plans as early
as this summer. They are considering options including a separate structure
or a tie-back to the nearby Gregory Peck facility, which will be installed late
this year and operated by Grey. First production from Clark Gable could be
late 2006 or early 2007.
40
(1-713) 216-1918 18 November 2005
Interpretation:
QUESTIONS TO ASK From previous press releases, we know that Clark Gable was originally
MANAGEMENT:
discovered in 2001, and an appraisal well was drilled in September 2004.
• When will the next The latest No. 3 well thus represents the second successful appraisal well
appraisal well be drilled? drilled in the area. While the success of this well is obviously good news, the
• If the project is deemed impact on Grey's stock price will be limited by the fact that the partners had
sizable enough to justify a already provided a 100 million boe estimate for the size of Clarke Gable.
standalone platform, what
will that mean to the initial
Most of the NPV of Clarke Gable was likely already discounted into the
onset date? stock prior to the drilling of the No. 3 well. However, there may be a modest
to moderate amount of upside in the stock, given the CEO's comments that
Clarke Gable may be larger than previously estimated due to the lack of an
oil-water contact.
Unsuccessful Appraisal Well

Example 1: Unsuccessful Deepwater Appraisal Well Press Release:
Ewing Bank Block 994 (Marlon Brando Discovery)—The initial exploratory
well drilled at this location encountered 185 feet of pay. A delineation well
failed to encounter hydrocarbons of sufficient commercial quantities to
justify further development of this discovery. Brown Exploration &
Production has a 40% working interest. The company’s proved reserves as
of December 31, 2001, included 7.2 million barrels of oil and 13 billion cubic
feet of natural gas attributable to Marlon Brando.
Interpretation:
QUESTIONS TO ASK While this field was relatively small to begin with given the amount of
MANAGEMENT:
reserves the company has booked, this is not good news and it will likely
• How much capital was tied negatively impact Brown's stock, considering Brown is a small-cap E&P
up in this project? company. Brown had already booked reserves at Marlon Brando, so this will
• Does this condemn any result in negative reserve revisions in the company's year-end financial
other exploratory statements. Furthermore, Brown's stock price likely accorded some value to
prospects or
developments nearby?
the Marlon Brando reserves. Assuming the market valued these undeveloped
reserves at $5/boe, around $47 million of NPV could be wiped out of the
company's market capitalization. The downside could be even lower
considering the negative effects on production growth estimates and financial
leverage.
Reserve Write-down
Example 1: Reserve Write-down Press Release:
During the third quarter, Blue Offshore conducted an internal reserve review
by a third party outside engineering firm to review several of its largest Gulf
of Mexico fields. Based on this review, Blue estimates that its proved
reserves as September 30, 2005 were approximately 670 billion cubic feet
equivalent (Bcfe). A full reserve report by a third party engineering firm will
be performed at year end.
The following is a reconciliation of Blue’s December 31, 2004 estimated

proved reserves with its current estimated proved reserves:
41
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Proved reserves as of December 31, 2004 1,100 Bcfe

Revisions of previous estimates (210)
Extensions, discoveries and other additions 50
Purchase of producing properties 10
Production (50)
Estimate of proved reserves as of June 30, 2005 900 Bcfe
The revisions are not expected to have a material impact on Blue's near term
production volumes. Approximately 50 Bcfe and 40 Bcfe of the downward
revisions were attributable to Blue's Garden Banks 123 and High Island 123
fields, respectively. Blue expects the revisions to result in an increase in the
depletion rate for future periods. The timing and amount of such increase has
not yet been determined. No determination has been made as to the impact,
if any, on prior periods.
Interpretation:
QUESTIONS TO ASK This is a negative event for Blue and will likely lead to slide in the
MANAGEMENT:
company’s stock price. The company is writing off 210 Bcfe from YE2004,
• How widespread were the a 19% reduction to proved reserves. The remaining line items in the
reserve revisions at the reconciliation are normal recurring items that reconcile the 2004 total to the
other fields?
current total. A write-down of this magnitude could lead to a restatement of
• What originally prompted prior-periods.
a third-party reserve
review during the middle
of the fiscal year? Of the 210 Bcfe, less than half is attributable to two individual fields,
indicating that the reason for the reserve revision is unlikely to be isolated or
simply due to well performance in a couple of fields. The revision is more
likely to be a widespread problem with company reporting and/or controls,
perhaps indicating overly-aggressive reserve recognition procedures.
To gain a rough estimate of the loss of value, one could calculate the market
value per Mcfe by dividing the company's enterprise value by the previous
reserve estimate of 1,100 Bcfe. This multiple could then be applied to the
210 Bcfe being written off to arrive at an estimate of the value that the
market was affording to the lost reserves.
Blue’s DD&A rate will go up in future periods because the costs of these
reserves will remain in the cost pool (the numerator of the DD&A
calculation), while the reserves will never be produced (the denominator of
the DD&A calculation).
Farm-in Agreement
Example 1: Press Release Announcing Farm-in Agreement to Develop
Acreage:
Black-Gold Resources announced today that it has executed an agreement
with Major Oil Company to develop acreage in the Piceance Basin in
northwest Colorado.
Under the terms of the deal, Black-Gold will farm-in approximately 100,000
gross acres of Major’s Prolific Gas Field in the Piceance Basin. Black-Gold
42
(1-713) 216-1918 18 November 2005
will operate and earn 50% working interest ownership in the entire leasehold
position by drilling six wells beginning before year-end.
Interpretation:
QUESTIONS TO ASK This is likely a positive development for both companies. Black-Gold is able
MANAGEMENT:
to gain access to highly competitive acreage at an attractive price, while
• What are well costs and Major Oil Company is able to hold its leasing rights by commencing drilling
anticipated average on the land. The Piceance basin is a low-risk resource play characterized by
reserves per well?
thick gas accumulations in the Willams Fork formation. Press releases from
• Any chance of expanding other operators have indicated well economics of 1.1-1.3 Bcfe/well for about
the arrangement in the
future?
$1.2-$1.9MM/well. Assuming the midpoint of $1.6MM/well, we estimate
Black-Gold's cost is attractive at less than $95/acre. Future expansion of the
agreement is likely possible if Major Oil Company has a substantial acreage
position in the Piceance.
Downspacing Approval
Example 1: Press Release Announcing Approval to Downspace Existing
Field:
Orange Petroleum announced that the Wyoming Oil and Gas Conservation
Commission today approved Orange’s request for five 10-acre pilot programs
on Orange’s Wyoming acreage. These pilot programs consist of a total of
128 ten-acre wells.
“This decision enables Orange to proceed with gathering the data requested
by the Commission in anticipation of final approval of field-wide 10-acre
downspacing on our Wyoming acreage," stated Orange's CEO.
Interpretation:
QUESTIONS TO ASK Downspacing approval can often be a significant positive catalyst for a
MANAGEMENT:
producer’s stock. Operators wish to downspace fields when they discover
• What is the timing for this that the current spacing of their development wells is not recovering the
pilot and when will the optimal amount of oil and gas in place. Typically the decision of whether to
field-wide downspace
request go to the allow downspacing is rested in a government agency charged with balancing
commission? environmental concerns with realizing the full potential of the state's natural
• What results have other
resources. Downspacing can increase the recovery of hydrocarbons, but
operators experienced comes at the expense of a larger "footprint" on the environment. The
with similar pilots? government typically conducts hearings in which the producers will present
engineering evidence (typically well pressure data) that downspacing will
indeed increase recovery without unnecessarily harming the environment.
The committee must be satisfied that incremental wells would truly recover
hydrocarbons that would not otherwise be recovered by existing wells.
Successful downspacing will lead to additional locations and ultimately
reserves.
New Unconventional Play

Example 1: Press Release Announcing New Unconventional Play:
Red Energy Co. today announced that it is currently testing a new shale gas
play in southern Kansas. The company is drilling test wells targeting the
43
(1-713) 216-1918 18 November 2005
Prolific Shale, an unconventional gas reservoir, ranging in depths from

1,500-8,500 ft. The Prolific Shale is a Mississippian-age shale that is the
geologic equivalent of the Abundant Shale found on the Oklahoma side of
the Arkoma Basin and the Fruitful Shale found in north Texas. The company
has increased its acreage position in the area from 200,000 net undeveloped
acres at December 31, 2003 to approximately 500,000 net undeveloped acres
today. Of the 500,000 net undeveloped acres, 150,000 is held by
conventional production. The undeveloped acreage was acquired at an
average cost of approximately $40.00 per acre and the average primary lease
term is over 10 years.
Red has recently drilled and completed four vertical wells in the Prolific
Shale. The Prolific Shale was present as predicted and appears to be range in
thickness from 75 to 400 feet. The four wells have responded to fracture
stimulation treatments and have shown preliminary production rates in the
range of 150-500 Mcf per day.
Interpretation:
QUESTIONS TO ASK While it is still early in terms of production history, this is a positive
MANAGEMENT:
development for Red Energy and the announcement will likely be met with a
• How much gas-in-place positive market reaction. Shale plays are characterized by long-life
per section (square mile) production, low-decline reserves, reliable production growth and low costs
and what is the envisioned
well spacing? over time.
• When will the first
horizontal tests take
This release indicates that the shale is rather thick at 75-400 ft, indicating that
place? there should be significant gas in place. To this point, Red has only drilled
standard vertical wells to test for the presence of hydrocarbons. Red will
• What other producers
hold acreage nearby? likely drill more vertical wells to delineate the field, but will then begin to
test horizontal wells and more advanced completion techniques to maximize
recovery. The 150-500 Mcf production rates tell us that the shale is likely
economic, but are not a good indicator of future IP rates. More
technologically advanced horizontal wells will likely yield a significantly
greater production rate.
Red is a first mover in the play having accumulated a very sizable position of
500,000 acres. As a first mover, Red was able to find acreage for roughly
$40.00 an acre, an attractive price compared to current acreage prices in the
Barnett running anywhere from $200-$1,500/acre. Moreover, a 10-year lease
term is favorable when compared to the much shorter terms being offered in
better-established shale plays (i.e. 2-5 years). The fact that Red is issuing
this press release discussing the location of the play and production data
indicates that Red is likely satisfied with the size of its position. An
announcement of this nature will undoubtedly increase demand for acreage
and drive up per acre lease rates. The 150,000 acres held by production is
significant in that producers can be contractually forced to relinquish
leasehold that is not producing after a certain period of time. Red can
concentrate drilling in non-producing areas in order to keep as much acreage
as possible held by production. This can be a significant issue for capital-
constrained companies or in a particularly tight rig environment.
44
(1-713) 216-1918 18 November 2005
Onshore Acquisition
Example 1: Press Release Announcing the Purchase of Mid-Continent
Producing Properties:
Green Resources today announced that it has entered into an agreement to
purchase oil and gas properties in the Anadarko Basin for $200MM. Green's
internal engineers have estimated total proved reserves to be 12 MMboe,
which are 95% oil and 70% proved developed producing. The properties are
long-lived with current production of approximately 2,600 boe/d and a
reserves to production ratio of 9 years. Lease operating costs are $14.00/boe.
Green has identified 4.0 MMboe of proved undeveloped opportunities on the
properties with total capital requirements of $25MM. Brown has entered into
swaps for approximately 50% of the acquired proved developed producing
volumes with the following fixed prices: $63.00 for 2006, $60.00 for 2007,
and $58.00 for 2008.
Interpretation:
QUESTIONS TO ASK Green is paying $16.67/boe for the proved reserves, or $2.78/Mcfe. Because
MANAGEMENT:
only 70% of the proved reserves are developed, additional capital of $25MM
• What are probable and will be needed to develop the PUDs, bringing the total or "fully developed"
possible reserve purchase price to $225MM, or a more expensive $18.70/boe. The properties
estimates for the
purchased assets? have a developed reserve life of nearly nine years, calculated by dividing the
proved developed reserves of 8.4 MMboe by the estimated annual production
• Is there significant
potential to reduce costs?
of 949,000 boe.
The LOE of $14.00/boe represents the costs associated with producing the
reserves. LOE of $14.00/boe is rather high, but is consistent with more oil
weighted properties as oil tends to be more expensive to produce. Depending
on the Green’s current rate, the acquisition may result in higher company-
wide LOE. Green is able to hedge production in 2006-2008 at attractive
prices; however, the declining swap rate indicates that the futures curve is
backwardated. By hedging a portion of the production, Green is locking in a
the economics of the deal by guaranteeing a realized priced that will result in
a positive cash margin when LOE, production taxes, and finding costs are
subtracted.
45
(1-713) 216-1918 18 November 2005
Analyst Certification
The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies
(or in a case where multiple research analysts are primarily responsible for this research, the research analyst named first in
each group on the front cover or named within the document individually certifies, with respect to each security or issuer
that the research analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or
her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's
compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst in this research.
Important Disclosures:
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Explanation of Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight
[Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the
analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock
will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.]
Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the
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Coverage Universe: Shannon Nome: Anadarko Petroleum (APC), Apache (APA), Bill Barrett Corporation (BBG),
Burlington Resources (BR), Chesapeake Energy (CHK), Devon Energy (DVN), EOG Resources, Inc. (EOG), EnCana Corp
(ECA), Forest Oil Corporation (FST), Kerr-McGee (KMG), Newfield Exploration Company (NFX), Noble Energy (NBL),
Pioneer Natural Resources (PXD), Pogo Producing Company (PPP), Southwestern Energy Company (SWN), Spinnaker
Exploration Company (SKE), Swift Energy Company (SFY), W&T Offshore Inc (WTI), XTO Energy (XTO)
Phillips Johnston, CFA: Cabot Oil & Gas (COG), Cheniere Energy (LNG), Encore Acquisition Company (EAC), Houston
Exploration (THX), McMoRan Exploration Company (MMR), Plains Exploration & Production (PXP), Quicksilver
Resources Inc (KWK), Range Resources Corp (RRC), St. Mary Land & Exploration (SM), Stone Energy (SGY), Ultra
Petroleum Corp (UPL), Vintage Petroleum (VPI), Western Gas Resources (WGR)
JPMorgan Equity Research Ratings Distribution, as of September 30, 2005

Overweight Neutral Underweight
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JPM Global Equity Research Coverage 40% 42% 18%
IB clients* 46% 45% 39%
JPMSI Equity Research Coverage 34% 49% 17%
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For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category, our Neutral rating falls into a hold
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46
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North America Equity Research

E&P 101: A Primer

Phillips Johnston, CFA

J.P. Morgan Securities Inc.

The Basics: Term & Definitions

Oil = Petroleum = Crude Oil: unrefined liquid mixture of hydrocarbons that

Table 1: The Oil Barrel

Light Ends Naphthas Petrochemical feedstocks

Middle Distillates Jet Kerosene Aviation fuel

Heavy Distillates Cracked Fuel Oil Power generation, Ship fuel

Natural Gas: a clean burning, odorless, colorless, highly compressible

commercial); steam generation, melting, and use as feedstocks for chemical

Table 2: The Natural Gas Mcf

Source: JPMorgan estimates. Note: Percentages vary by region and basin.

Natural Gas Liquids (NGLs): hydrocarbons that are originally in gaseous

Gas-To-Liquids: process of converting "stranded gas" (gas without a

Unconventional Resources = Resource Plays: hydrocarbons contained in

Basis Differentials: a premium or discount to Henry-Hub pricing. Natural

basis differentials widen relative to Henry Hub (representing NYMEX

Figure 1: Kern River Pipeline Expansion and Rockies Differentials

Source: JPMorgan estimates, Bloomberg

Contango vs. Backwardated: refers to the shape of the commodity futures

Figure 2: Natural Gas and Crude Oil 12-Month Futures Curve

Natural gas curve

10.00 Oil curve is in 58.00

Proved/Proven Reserves: quantities of oil or natural gas that are recoverable

Proved Developed Reserves: proved reserves that are expected to be

Proved Undeveloped Reserves (PUDs): proved reserves that are expected

Probable Reserves: quantities of oil or natural gas not proven by geological

Possible Reserves: quantities of oil or natural gas that is inferred to be

2P Reserves: the sum of proved and probable reserves.

3P Reserves: the sum of proved, probable and possible reserves.

Figure 3: Producing Well with Offset Locations

PROB PROB PROB PROB PROB

PROB PUD PUD PUD PROB

PROB PUD PUD PUD PROB

PROB PROB PROB PROB PROB

EUR: “estimated ultimate recovery,” projected total reserves.

Reserve Impairment: non-cash charge to earnings representing the

Under the successful methods method of accounting, a ceiling test is not

The most rigorous level of external reserve evaluation is the independent

An “audit” also involves company visits, data collection, and independent

A “procedural audit” is an overview of the internal processes only. The

PV-10 Calculation = SEC-PV10 = Standardized Measure of Discounted

Prospect = Exploration Prospect: a potential drilling location.

Exploration Well = Wildcat Well: a well drilled to find a new reservoir,

Appraisal Well = Step-Out Well = Delineation Well: a well drilled after a

Flowtest = Drillstream Test: an initial production test conducted under

Dry Hole: an unsuccessful exploration or development well. Well costs can

Seismic: an exploration method used to map subsurface geological structures

Authority for Expenditure (AFE): an estimate of all the related costs

Concession: a legal agreement between a government and an oil company

Production Sharing Contract (PSC): an arrangement that is similar to a

onshore leases, and the Federal government receives a royalty on offshore

Royalty Interest (RI): an economic interest retained by the mineral interest

Reversionary Interest: a share of production revenue that becomes

Volumetric Production Payment (VPP): represents the sale of a fixed-

APO/BPO = “After Payout / Before Payout”: the conditions associated

Exploitation: basically another word for development but also connotes

Development Well: a well drilled in an area where proved reserves already

Horizontal Well: a well that is initially drilled vertically, then by directional

Infill Drilling = Downspacing: drilling wells between producing wells to

Completion: the process of bringing a new well onto production. Includes

E&P Primer JPM

E&P Primer JPM