Oil Gas Presentation - Bear

Equity Research
MARCH 2007
Energy Perspectives
How to Analyze Oil and Refining Stocks
An Essential Primer on Energy
OUR GUIDE TO KNOWLEDGEABLY INVESTING IN THE ENERGY SECTOR. This report is meant to be an essential guide to understanding and investing in major oil and independent refining stocks. It explains how to analyze the fundamentals of oil and gas exploration and production and refining and marketing. FACT VS. FICTION. We dispel such myths as bigger is better and there is seasonality to refiners stock price performance. Also, what are the cues to determine how a company might perform in the intermediate term? What differentiates an efficient operator from others? How should an investor evaluate a companys growth? VALUATION MATTERS. Upside and downside risk is assessed on historical valuation parameters and current fundamental conditions. We show how to determine what commodity price is reflected in an oil companys stock price, and the upside or downside potential of different outcomes. INFORMATION CENTRAL. We offer tips on how and where to find pertinent information. We provide a guide to important publications, Web sites, Bloomberg symbols, and sources for news retrieval.
Research Analysts Nicole L. Decker (212) 272-3962

ndecker@bear.com
Eric Richards, CFA (212) 272-8946

erichards@bear.com
Raymond Sulentic (212) 272-6813

rsulentic@bear.com
Bear Stearns 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. Customers of Bear Stearns in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.bearstearns.com/independentresearch or can call (800) 517-2327 to request a copy of this research. Investors should consider this report as only a single factor in making their investment decision. PLEASE READ THE IMPORTANT DISCLOSURE AND ANALYST CERTIFICATION INFORMATION IN THE ADDENDUM SECTION OF THIS REPORT.
Table of Contents
Page
Executive Summary............................................................................................................................................................5 Section 1.............................................................................................................................................................................7 The Integrated Oil Company .......................................................................................................................................9 Upstream, Downstream, and Midstream ................................................................................................................9 Exploration and Production Basics............................................................................................................................11 Exploration .........................................................................................................................................................12 Appraisal and Development .................................................................................................................................14 Production ...........................................................................................................................................................16 Drivers of Integrated Oils Upstream Performance ...................................................................................................17 Oil and Gas Prices ...............................................................................................................................................17 Hedging ..............................................................................................................................................................18 Crude Oil Characteristics .....................................................................................................................................19 Operating Costs and Field Reliability...................................................................................................................20 Exploration Expense............................................................................................................................................21 Tracking Industry Fundamentals ...............................................................................................................................22 Fundamental Data Sources ..................................................................................................................................22 Worldwide Crude Oil Inventory Levels ...............................................................................................................23 Supply: Non-OPEC Production ...........................................................................................................................24 OPEC ..................................................................................................................................................................25 Capacity Utilization .............................................................................................................................................28 Strategic Reserves ...............................................................................................................................................29 Worldwide Oil Demand .......................................................................................................................................31 A Walk Through Our Worldwide Oil Supply/Demand Model ..............................................................................34 Geopolitical Developments ..................................................................................................................................35 Investing in the Integrated Oils..................................................................................................................................37 Sensitivity to Changes in Oil and Gas Prices ........................................................................................................37 Oil Is a Commodity .............................................................................................................................................39 Two Key Operating Measures: Reserve Replacement and Finding and Development Costs ..................................40 Company Strategy: Acquirer or Explorer? ...........................................................................................................44 Pointers and Rules of Thumb ...............................................................................................................................45 Section 2...........................................................................................................................................................................47 Independent Refiners .................................................................................................................................................49 The Downstream Industry ................................................................................................................................49 The Refining Process ...........................................................................................................................................49 Refined Products .................................................................................................................................................51 Drivers of Refiners Financial Performance ..............................................................................................................53 Refining Margins ................................................................................................................................................53 Refinery Complexity ...........................................................................................................................................56 Light/Heavy Spreads and Product Yields .............................................................................................................57 Operating Costs ...................................................................................................................................................59 Plant Reliability...................................................................................................................................................59 Financing and Overhead Costs.............................................................................................................................59
BEAR, STEARNS & CO. INC.
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Tracking Industry Fundamentals ...............................................................................................................................60 Interpreting DOE Inventory Reports ....................................................................................................................60 Refinery Utilization .............................................................................................................................................64 Product Imports ...................................................................................................................................................66 Gasoline Demand ................................................................................................................................................68 Distillate Demand ................................................................................................................................................70 Crude and Product Prices vs. Refining Margins ...................................................................................................71 Forecasting Light/Heavy Spreads ........................................................................................................................72 Environmental Regulations ..................................................................................................................................73 Investing in Refining Stocks......................................................................................................................................74 Investing in Refiners............................................................................................................................................74 No Seasonal Trade in Refining Stocks .................................................................................................................76 Refinery Acquisitions Are Part of Most Refiners Growth Strategy ......................................................................77 Pointers and Rules of Thumb ...............................................................................................................................78 Section 3...........................................................................................................................................................................83 Valuation....................................................................................................................................................................85 The Size Factor: Does It Matter? .........................................................................................................................87 Valuation for Independent Refiners .....................................................................................................................88 Section 4...........................................................................................................................................................................91 Industry Resources.....................................................................................................................................................93 Publications.........................................................................................................................................................93 Books ..................................................................................................................................................................94 Web Sites ............................................................................................................................................................95 Bloomberg Ticker Symbols .................................................................................................................................96 Reuters News Symbols ........................................................................................................................................97 Consensus Oil and Gas Price Estimates on First Call............................................................................................98 Surveys ...............................................................................................................................................................98 Glossary of Terms......................................................................................................................................................99
All pricing is as of the market close on February 22, 2007, unless otherwise indicated.
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ENERGY PERSPECTIVES
Executive Summary
The oil and gas business encompasses several operational segments, including exploration and production, transportation, trading, refining and marketing, and oil services and equipment. In our coverage universe, the integrated oils and independent refiners, the focus is on exploration and production and refining and marketing, respectively. In this report, we explain how these businesses work, describe the financial drivers, and explore ways to evaluate financial and operational performance and gauge fundamentals. Lastly, we describe several approaches to valuation. We have used a two-part approach to introduce investors to the business. Section 1 of the report covers the exploration and production segment of the business, the dominant focus of the integrated oil companies. Exploration is the process of searching for oil and gas resources a risky, capital-intensive business. Production entails extracting hydrocarbons from the ground, processing it, and transporting it to customers (usually refiners). In Section 2, we discuss how to analyze the refining and marketing business, with an emphasis on the independent refiners. Refining is the process of converting crude oil into fuels such as gasoline, diesel fuel, jet fuel, and heating oil. Marketing entails selling these products to middle- and end-users. Macro trends greatly influence oil and gas prices and refining margins, given oil companies leverage to prices and margins. An investment in the industry most often hinges on some assumption of how macro conditions will evolve. We walk through the sources of information, fundamental indicators, and how to read and apply them to investing in the sector in the first two sections of this report. The third section of the report addresses valuation. It examines trading and valuation history encompassing several different techniques, including earnings, cash flow, and EBITDA multiples. We have also observed a strong positive correlation between a companys return on capital employed (ROCE) and the multiples applied to its stock. If we can identify companies with improving ROCE, then we might make a case for upward revaluation of the share price through a higher multiple. All of this is helpful in setting share price expectations. The final section lists data sources and industry publications that we believe are must-reads for anyone that is interested in analyzing and investing in the oil industry. Essentially, this section is a guide to where to find information on prices, margins, and macro events that influence oil and refining stocks. This section also includes a glossary, which provides a brief explanation of common industry terms.
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Section 1
Page 7
The Integrated Oil Company

UPSTREAM, DOWNSTREAM, AND MIDSTREAM
Integrated oil companies are engaged in all phases of the oil business: exploration, production, refining, and marketing. Some companies also are large manufacturers and marketers of petro- and specialty chemicals, and generate and sell power. The exploration and production phase is commonly referred to as the upstream. For most integrated oil companies, the upstream part of the business dominates the companys attention and resources, as profit margins typically are higher. Exploration is the process of searching for oil and gas resources. E&P is a risky business, as drilling a single wildcat well can cost tens of millions of dollars, and success rates often are below 50%. In Graham and Dodds well-known book, Security Analysis, the E&P business was described as speculative. Production entails taking the oil and gas out of the ground and selling it usually to refiners. Refining and marketing is referred to as the downstream. Refining is the process of converting crude oil into fuels such as gasoline, diesel fuel, jet fuel, and heating oil. Marketing entails selling these products to the end-user. Many of the integrated oil companies have branded retail gasoline outlets and product lines. To the public, this is the most visible and identifiable part of the oil company; however, it is the smallest, lowest-margin portion of most integrated oil companies business.
Exhibit 1. Four Phases of the Oil Business
Upstream:
(1) Exploration
(2) Production
Downstream:
(3) Refining
(4) Marketing
Source: Industry sources.
There is one additional area of the oil business a step in between the upstream and downstream phases referred to as the midstream. The midstream entails transportation and storage of oil, gas, and refined products. We will not focus on the midstream business. Most integrated oil companies own pipeline and storage facilities, particularly at production operations in remote areas. But elsewhere, particularly in the U.S., pipeline infrastructure is operated by independent pipeline companies. For most integrated oil companies, transportation and storage is a cost, rather than a profit center. These costs are included in most companies upstream financial results.
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Interestingly, many integrated oil companies do not attempt to integrate their upstream and downstream businesses directly. They do not necessarily move their own oil production through their own refineries, or their own refining output through company-owned stations, since it is usually more efficient and profitable to buy and sell crude and refined products locally, to avoid transportation costs. The benefit of being integrated is twofold: first, it allows companies to capture margins throughout the value chain, and, second, earnings volatility may be mitigated, as large moves in one segment may be muted or even partially offset by moves in the other sector. Nevertheless, earnings are volatile (see Exhibit 2). The most influential factor on integrated oil company earnings is the price of oil. Refining margins are the largest driver of earnings in the refining and marketing segment.
Exhibit 2. Major Oil Companies Earnings in E&P and R&M
100000
80000
Operating Earnings ($mil)
60000
40000
E&P
20000
R&M
0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
WTI ($/bbl) GC Refining Margins ($/bbl)
$22.14 $20.17 $14.48 $19.15 $30.36 $25.44 $26.02 $31.06 $41.29 $56.51 $66.03 $3.34 $3.63 $2.97 $2.40 $5.64 $5.29 $3.75 $4.98 $6.97 $10.35 $9.76
R&M
E&P
Source: Company reports.
Investors wishing to focus specifically on E&P or on refining and marketing may consider an investment in an independent exploration and production company or an independent refiner companies whose operations are solely in the upstream or downstream portion of the oil business. This section of the report covers the upstream portion of the business (refining and marketing is covered in Section 2). In this section, we describe how oil and gas is found and how reserves are developed. We describe the financial and operational drivers of the business and how to measure them. In addition, we show how to evaluate the integrated oil companies. The exploration and production business is risky and capital-intensive. Large sums of money can be spent with the risk of a complete loss (i.e., a dry hole). In some cases, it can take decades before the investment generates any revenue, given long lead times between exploration and production. Success in this business requires high technical capabilities, capital discipline, good operational execution, and some luck.
Exploration and Production Basics

Exploration and production (E&P) is a multipart process oil companies undertake to locate oil and gas resources (land acquisition, surveying, and drilling), determine commerciality (appraisal), install the necessary equipment and infrastructure to commence production (development), and, finally, remove the oil and gas (producing it) from the ground for sale. This section provides an introductory, nontechnical description of each phase of the business. Additional resources are provided in the appendix of this report for further reading. First, the following background points may be helpful: How Were Oil and Gas Deposits Formed? It is widely believed that oil and gas was formed from material derived from dead plants and animals that lived millions of years ago, transformed by heat and pressure into oil and gas. Where Are These Deposits Found? Oil and gas deposits can be found in a variety of environments: on land or offshore, at shallow or deep depths, in temperate or harsh climates. Oil deposits are common in river deltas (or, in some cases, former river deltas transformed to dry land or sea over time), where the rivers flow deposited large amounts of organic sediment. How Do Oil Companies Look for Oil and Gas Deposits? To find oil and gas, geologists look for the following combination of rocks below the earths surface: rock that contains organic remains (source rock); rock that the oil can flow into (reservoir rock); and a layer of impermeable rock to prevent the oil and gas from flowing away (cap rock). Locating prospects is done through a combination of data surveys such as seismic imaging, and gravitational and magnetic surveys. Is the Business Different Today than It Used to Be? It has been argued that the easy oil has been found and produced, that is, oil in shallow wells in a temperate operating environment. However, in the approximately 140-plus years since oil was first produced commercially, new technologies have made it possible to drill deeper, and to operate in the harshest climates, such as Siberia, Russia, and deep in the tempestuous North Sea and at low cost. Advances in seismic imaging and sophisticated reservoir modeling capabilities provide more comprehensive data on drilling prospects, and new drilling technologies have extended exploration to deeper, more complex reservoirs. The industry has risen to the challenge of more than replacing production, and of keeping pace with rising demand for oil and gas. The goal of an exploration and production company is to add oil and gas reserves, the primary assets of the company, at a cost that provides the best return on capital.
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EXPLORATION
Exploration is the effort to add new oil and gas reserves by drilling in an area where oil and gas has not been discovered. Exploration drilling differs from development drilling, which is undertaken to produce reserves which are known to exist. Exploration is perhaps the riskiest yet most critical phase of an oil companys operations risky because of the high cost associated with drilling a well, oftentimes several thousand feet into the ground, and critical because companies assets deplete each day that oil and gas is produced. If production is not replaced by new resources, the company will shrink and eventually run out of reserves. Organic growth occurs when the company discovers more recoverable oil than it is producing. Lease Agreements, Concessionary Agreements, and PSCs The first step in the exploration process is acquiring the rights to explore for and develop oil and gas, usually accomplished through execution of a lease with the landowner. Landowners may be private individuals, such as ranchers and farmers. This is common in areas of the U.S. and Canada, where the landowner also owns the mineral rights. Lease terms can differ, but, in general, in addition to a bonus typically paid to the landowner upon signing, terms may cover the following: Duration. Duration is the amount of time given to the oil company to establish commercial production. Royalty Payments. Royalty payments are usually a fraction of the revenue from oil and gas produced from the property. Most commonly, private landowners receive approximately one-eighth of the revenue, but royalty payments may be as high as 50% in certain areas. Drilling Commitment. In some cases, the oil company commits to a certain number of exploratory wells. Surface Access. The oil company is granted rights to conduct operations on the surface, such as build roads, etc. Outside the U.S. and Canada, the government typically holds mineral rights, requiring a contract called a concessionary agreement between the government and the oil company. In a concessionary agreement, mineral rights are transferred to the oil company. Terms of a concessionary agreement are much like the lease agreement outlined above, but various types of taxes, such as income tax, a production tax, or a value-added tax (VAT), may also apply. In some countries, the government retains mineral rights, and if reserves are discovered, the government would maintain ownership of these reserves. In this case, the arrangement between the government and the oil company is called a production-sharing contract (PSC). Under a PSC, the oil company (known as the contractor) essentially bears all the risk and cost of exploration and development. Contract terms allow the contractor to recover these costs if oil is discovered. It is important to note that, originally, PSCs were set up to protect the oil companies investment in the event that oil prices decline. Under the PSC, the contractor recovers exploration and development costs by retaining a portion of the production, known as cost oil. This portion can vary depending on oil prices. Profit oil is the amount of oil left after deducting royalties, taxes, and
cost recovery. This is typically shared between the partners based on proportions agreed upon in the contract. Identifying and Drilling Prospects Next, an oil company undertakes an information-gathering process, conducted largely by geologists, to identify possible drilling prospects. What are the geologists looking for? They are taking clues from surface and subterranean surveys to determine whether the necessary characteristics exist for a commercial-sized accumulation of oil and gas (hydrocarbons) beneath the surface of the earth. The surveys help geologists to determine the presence of a source rock, reservoir rock, and a cap rock to keep the hydrocarbons in place. These, at a minimum, are necessary in order for a reservoir of hydrocarbons to exist. Geologists also look for a combination of rock layers that may trap oil deposits. A trap occurs naturally when rocks have moved or folded beneath the Earths surface. One type of trap is known as an anticline trap, which, shaped like an upside down bowl, is a layer of impermeable cap rock holding oil in place. Another type of trap is a fault trap, which is created when rock layers slide past each other underground. An impermeable rock layer then acts as a dam, allowing a reservoir to accumulate. Salt domes are another form of trap. Salt domes are formed when rock movements and pressure thrust salt from deep deposits upward through the layers of rock. If a layer of porous rock containing oil and gas meets the salt dome, which is impenetrable, the oil and gas is trapped.
Exhibit 3. Oil Traps
Anticline Fault Salt Dome
gas
. . . . . . . ... ..
OIL
gas
Salt
gas
OIL
..
... . .. . . . ... ... .
. .
OIL
Even with todays advanced technology, interpretation of survey data can be difficult and uncertain, and until a well is drilled to the target area, there is no guarantee of the existence of an oil deposit. Typically, oil companies accumulate a portfolio of prospects, ranked according to potential size and risk. Selection of prospects to advance to the drilling phase is much like selection of stocks for a portfolio. Drilling prospects may have a variety of characteristics that distinguish them in terms of risk, complexity, estimated drilling costs, and potential size, among other factors. High-risk wells are often those with potentially higher rewards a large reservoir of hydrocarbons. Oil companies might select a variety of types of prospects to drill each year to diversify risk.
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The highest-risk prospect is known as a wildcat well a well drilled in an area where no hydrocarbons have been discovered. The cost of drilling a single, deepwater exploration well averages about $30 million, but some may exceed $100 million. The success rate (success meaning an oil or gas discovery) for such wells in a frontier, or unexplored region, is less than 15%. Most integrated oil companies engage in some frontier, or wildcat, exploration activity, in search of large discoveries of new resources. A discovery of 200 million-plus barrels of oil equivalent (boe) would be considered significant by the industry, though smaller discoveries can be developed economically. In the past ten years, several discoveries have exceeded this size, mostly in offshore deepwater regions, such as Angola, Malaysia, Brazil, in the Gulf of Mexico, and in the Former Soviet Union. To reduce risk, oil companies often take on partners, or farm out a portion of the interest in a prospect. One company, usually the largest interest holder, acts as the operator of the project. Drilling costs are shared and, if successful, the partners share the development costs. Production revenues are allocated in proportion to each partners interest. Not all exploration drilling is in search of an elephant, as large discoveries are called in the industry. Oil companies typically undertake exploration in areas of producing fields, or in the vicinity of an undeveloped discovery, as in a satellite well. There are two advantages to drilling a satellite well. First, more is known about subsurface properties, given drilling has already occurred in the area; and second, production from a successful satellite can usually be tied in to infrastructure at nearby fields, reducing development costs and cycle time. This might allow for development of a smaller discovery that would otherwise be noncommercial as a stand-alone development. Another type of exploration well is known as an extension well, where a company drills a well in hopes of extending the boundaries of a producing field. Another type of exploration well is a delineation, or appraisal, well, which is drilled to determine the extent or boundaries of a new field. Drilling at these types of wells typically achieve a significantly higher success rate than a wildcat well. There are two ways a company can account for the cost of drilling an exploration well: successful efforts and full cost accounting. The integrated oils all use successful efforts accounting. With this method, if a well is successful, the associated costs are capitalized, and development plans are made. If unsuccessful, the costs are expensed in the time period in which they were incurred charged as dry hole expense on the income statement. These expenses can swing from quarter to quarter, depending on the companys drilling schedule and success rate. Under full cost accounting, used by about half of the independent E&P companies, all exploration costs are capitalized.
APPRAISAL AND DEVELOPMENT
Oftentimes, the commerciality of a reservoir cannot be determined after drilling just one well. If hydrocarbons were found in the first well of a prospect, a company will drill one or more (sometimes as many as five or six) additional appraisal wells in order to assess the size and properties of a field. After the appraisal process, if the field is deemed to contain sufficient quantities of recoverable oil and/or gas, the field undergoes its most expensive phase development. During development, after extensive engineering and design work, the company will drill wells from which the
oil and gas will be produced, and production equipment is fabricated and installed at the site. Development costs vary, depending on the size and location of a well, but on average, we estimate development costs run $5.00 per barrel of oil equivalent (boe) of proved reserves (onshore wells typically run below this figure, while deepwater offshore wells could exceed this figure). So, development of a moderatesized field, of say, 100 million boe, can cost approximately $500 million, in addition to exploration costs of, perhaps, $100-$200 million. All the while, the field has yet to produce any revenue for the company. All development costs are capitalized. In essence, exploration and development costs for a field will become the carrying value of the reserves in the field. Finding and development (F&D) costs, as these costs are known, are a key performance metric in the oil industry, as they help dictate the return on capital for a field. In general, development costs comprise approximately two-thirds of F&D costs, though this proportion can drift higher when services costs are higher, typically when oil prices are high. The carrying value will be depreciated once production begins. The F&D costs for a particular field are an indicator for the depreciation, depletion, and amortization (DD&A) rate at a field once production begins. The engineering and planning phase of the development process is crucial to the economic success of a field. Engineers are concerned with reservoir quality porosity (a measure of the fraction of the rock containing the oil that is pore space, expressed as a percentage), permeability (a measure of how well fluids flow between the pores), and well flow rates (measured in boe per day [boe/d]) not only today, but throughout the life of the field. A greater level of porosity and permeability are desirable, as this facilitates recovery of the oil, which helps keep production costs down. A field can start out with very promising characteristics, which can deteriorate rapidly once production begins. For this reason, much effort is given in making sure a field will perform consistently through extensive well testing before the high frontend development costs are incurred. The appraisal and testing process for some offshore deepwater fields can take years. Oil companies have an array of options on development configurations. Location of the well is usually the largest factor in determining the type of production equipment installed. The simplest to develop are onshore wells often the discovery well is completed and put on production, a relatively quick process. If the well performs as expected, additional development wells, or step-out wells, may also be drilled and completed. Development of wells in shallow water (less than 15 feet) is carried on in the same manner, except the drilling rig is mounted on a barge. The top of the wellhead, which has been installed beneath the water line, extends above the water. Development in deeper water requires that a platform, either bottom-supported or a floating platform, be installed. The platform must be a large structure to support multiple wells, as well as drilling and production equipment, including pumps, compressors, a gas flare system, cranes, helicopter pad, and crew living quarters. The topside the portion resting on top of the structure, can weigh up to 40,000 tons. During the development phase, a drilling rig is moved around the platform on skids. Development wells are completed as they are drilled. A platform in a deepwater, inhospitable climate (such as the North Sea) can cost $3 billion or more.
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PRODUCTION
Production begins when a well is completed, and the infrastructure for delivery has been fully installed. A wellhead is installed on the surface, which connects piping in the well to pipes above the ground. A valve system known as a Christmas tree is installed on the wellhead to manage the flow (see exhibit below).
Exhibit 4. Christmas Tree and Wellhead Installation
When a field enters the production phase, the oil companies focus shifts to reservoir management to assure maximum oil or gas production over the life of the reservoir. No reservoir can be drained completely, but poor management will result in inefficient production and a shortened reservoir life. Oil companies may consider a variety of options to help lift oil and gas to the surface, as in most fields only a fraction of the oil can be produced by natural reservoir pressure. Production at most wells often includes some form of artificial lift, or pumping equipment. When a pump can no longer maintain stable oil flow, an oil company may further increase recovery using techniques that restore pressure and flow in reservoirs. This entails injection of water, gas, chemicals, or heat into the reservoir. A common enhanced recovery procedure for onshore fields is called infill drilling. As a reservoir becomes depleted, the company may drill a new well in between producing wells. In many producing fields, it is common for a mixture of oil, gas, and water to reach the wellhead. At the wellhead, the mixture is sent through a pipeline gathering system to a treatment facility, where oil, gas, and water are separated. The oil is then sent on to storage or markets through pipelines or by truck.
Drivers of Integrated Oils Upstream Performance

We believe the following items are the most important drivers of oil companies financial performance: Oil and Gas Price. More than any other factor, all oil companies revenues are affected by commodity prices. Crude Oil Characteristics. The price the oil company receives is dependent upon the oils density and sulfur content, which affect the grade of the crude oil. Lighter (less-dense) and sweeter (containing less sulfur) crude oil is more valuable than heavy, sour grades, because less processing is required at the refining level to create lighter products. Operating Costs. Operating costs are also called lifting costs, or production costs. Based on the many possible production configurations described in the previous section, operating costs can vary by field. An oil companys profitability will be affected by the cost of extracting oil and gas from the ground. Operating costs include labor and energy costs, maintenance, repair, taxes, insurance, and depreciation. Field Reliability. Unplanned downtime can have a meaningfully adverse effect on profitability through loss of productivity as well as by well workover expense. Exploration Expense. As described in the previous section, drilling costs for unsuccessful exploration wells are expensed by integrated oil companies in the period in which they were incurred. The high cost of drilling can take a toll on earnings for an integrated oil company if the exploration program is unsuccessful.
OIL AND GAS PRICES
Oil and gas prices are the most influential factor on oil company revenues and earnings. Oil prices are dictated by a variety of macro conditions, which are covered in a later section of this report. Because of this sensitivity, oil company stock prices often move in tandem with changes in oil prices. This is particularly true when oil stock performance is measured relative to the broader market (see Exhibit 5).
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Exhibit 5. Integrated Oils Relative Price Performance vs. Changes in Oil Prices
60 50 40 $/bbl 30
1.9 1.7 1.5 1.3 1.1

Relative Performance
20 10 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0.9 0.7 0.5
WTI Price (left)
Integrated Oils Relative Performance to S&P (right)
Source: Platts; Standard & Poors.
HEDGING
To help manage their exposure to commodity price fluctuations, some oil companies undertake hedging to lock in commodity prices, usually by selling production forward through derivative instruments, including swaps and collars. Several sets of circumstances may prompt hedging activity. The most obvious reason to hedge is to lock in high prices in a favorable price environment. Another situation that may promote hedging is the anticipation of exceptionally heavy spending, say, to fund the development of a large field. Oil companies have also hedged production of acquired assets, assuming a certain return on investment near term and cash flow to offset the purchase price. There are also compelling reasons not to hedge. First, it is difficult to know when prices are at the top, leaving companies vulnerable to hedging losses, particularly when fees are factored in. Second, although the market for derivative instruments used for hedging is expanding, it is still limited, making it difficult for major oils to hedge large volumes of production. Recently, some oil companies have arranged forward sales of a portion of their oil and gas reserves and used proceeds to repurchase their stock. The idea is to try to close the gap between the medium-term futures market for oil and gas, and the implied oil and gas price that belies the companys stock price. In 2005, Pioneer Natural Resources, through a series of volumetric production payments (VPPs) transferred title on just under 28 million boe and used the proceeds to repurchase stock and reduce debt. Activist Carl Icahn prompted Kerr-McGee to sell oil and gas production forward and repurchase stock.
We have observed that investors generally view the impact of hedging as a onetime gain or loss, rather than as a part of sustainable earnings. Therefore, the stock market rarely rewards a company for hedging. If oil prices rise, management is held accountable for missing the move. If oil prices fall, the opportunity to sustain earnings from hedging activities is seen as fleeting.
CRUDE OIL CHARACTERISTICS
Crude oil comes in many different grades, depending upon the amount of carbon, sulfur, and other metals, or other impurities, such as wax (paraffin), it contains. Crude oil is made up of hydrocarbon molecules, a combination of hydrogen and carbon atoms. The size and type of molecule (as well as the nature and volume of contaminants it contains) determines the oils characteristics. Oftentimes, when an oil company announces completion of a well, or a successful appraisal, it will release data on the gravity and quality of the crude. This is because higher-quality crudes can fetch prices that are an average $2.00/bbl-$15.00/bbl above those of lowerquality crudes. The price spread between high- and low-quality crude depends on the various characteristics of the crude, as well as supply/demand for each type of crude. Light vs. Heavy. Crude oils generally are characterized by their density, or weight per volume of oil measured as American Petroleum Institute (API) gravity, expressed in degrees. API gravities range from ten to 50 degrees, with the higher end of the range representing lighter crudes. Most fall in the 20- to 45degree API gravity range. The API gravity of freshwater is ten degrees (recall that oil floats on water; in other words, water is heavier than oil). Density classifications for crude oil include light, medium, and heavy (also extra light and extra heavy). The industry defines light crude oil as having an API gravity higher than 31.1 degrees, medium oil as having an API gravity between 31.1 and 22.3 degrees, and heavy oil as having an API gravity between 22.3 and ten degrees. Extra-heavy oil (i.e., bitumen) has an API gravity of less than ten degrees. Lighter crudes are more valuable because they have a higher energy content. West Texas Intermediate (WTI), the U.S. benchmark crude, has an API gravity of 40 degrees. The formula for determining API gravity is as follows: Degrees API Gravity = (141.5/Specific Gravity at 60 F) 131.5 Sweet vs. Sour. Crude oil is also classified as sweet or sour, depending upon its sulfur content. Sweet crude has less than 0.5% sulfur content, while sour crude has more than 0.5%. Sweeter crude oils are more valuable, as they are less expensive to refine. Sulfur and other impurities must be removed from the crude oil to manufacture gasoline and other refined products. WTI is a sweet crude oil, with a sulfur content of 0.3%.
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Exhibit 6. Crude Oil Grades

Crude Oil Heavy Maya Oriente Bow River/Hardisty Intermediate/Light Alaska North Slope Cano Limon Dubai Cabinda Urals West Texas Sour Arab Light Basrah Light Bonny Light Minas Brent West Texas Intermediate Extra Light Forties Griffin
Source: Platts.
Source
API Gravity
Sulfur Content
Mexico Ecuador Canada
22o 25o 25.7

o
3.30% 1.30% 2.10%
Sour Sour Sour
U.S. Colombia United Arab Emirates Angola Russia U.S. Saudi Arabia (Ghawar) Iraq Nigeria Indonesia U.K. North Sea U.S.
29o 29.5
o
1.10% 0.50% 2.01% 0.13% 1.25% 1.60% 1.66% 2.00% 0.10% 0.08%
o
Sour Sweet Sour Sweet Sour Sour Sour Sour Sweet Sweet Sweet Sweet
31.2o 32.5o 32.5 33o 34o 34

o o
34.5o 36o 38.5 40o
0.40% 0.30%
U.K. North Sea Australia
40.4o 55o
0.35% 0.03%
Sweet Sweet
Wax Content. The wax content in oil affects its viscosity, which measures the oils resistance to flow. The less wax present, the easier the oil flows. Highly viscous oil is thick and/or sticky, and of lower value. Wax may be removed during the refining process, and sold as petroleum wax, the most common type of wax found in candles. Viscous oil is also the feedstock for base oils used to make lubricants.
OPERATING COSTS AND FIELD RELIABILITY
Operating costs, also called production or lifting costs, are an important driver of oil companies profitability. Measured in unit cost per barrel of oil equivalent, average production costs for the major oils have typically averaged in the $9.00/boe$11.00/boe range, including historical average DD&A costs of approximately $4.00$5.00/boe (DD&A costs are noncash costs). Production costs typically rise when oil prices rise. For instance, average total production costs for the major oils rose to approximately $14.00/boe in the 2005 high oil price environment. Cash operating costs, also called lease operating expense, include a high proportion of fixed costs, including labor and insurance, semi-fixed costs (such as those incurred for gathering, field processing, and storage), and variable costs such as energy costs. Historically, average cash production costs for the industry were consistently in the $4.50/bbl$7.00/bbl range (see Exhibit 7); however, costs have risen alongside the increase in oil prices beginning in 2004.
Exhibit 7. Cash Production Costs

$9 $8
Cash Production Costs ($/boe) $8.79
$7 $6 $5 $4 $3 $2 $1 $0
199 3 199 4 199 5 199 6
$5.97 $5.38 $4.53 $4.76
$6.48 $5.66
$6.12
$6.16
$6.23
$6.64 $6.14
$6.99
199 7
199 8
199 9
200 0
200 1
200 2
200 3
200 4
EXPLORATION EXPENSE
Exploration costs are those associated with the cost of exploring a property for oil or gas, including non-drilling costs such as geological and geophysical expense (G&G) and drilling cost. These expenses are accounted for by two generally accepted methods in the event of unsuccessful wells successful efforts, whereby unsuccessful wells are expensed as incurred, and full cost, whereby unsuccessful wells are capitalized. These accounting treatments were discussed earlier. Earnings of a company using successful efforts accounting can be significantly affected by exploration expense. As discussed earlier, exploration costs can vary, given a wide range of depths, environment, geological structures, etc. The amount expensed will also depend on the oil companys working interest in the prospect. Oil companies may manage the exposure to exploration expense by spacing the timing of the drilling of expensive and risky wells and/or by farming out partial interests in potential high-cost wells. If a well is successful, a company using the successful efforts method may capitalize the costs associated with drilling the well. G&G costs are expensed regardless of the outcome of the drilling. Development costs on a successful well are capitalized.
Page 21
200 5
Tracking Industry Fundamentals

Oil companies earnings are most influenced by oil and gas prices. As with any commodity, oil prices are driven by supply and demand. An oversupplied market usually will dampen oil prices (the relationship broke down in 2004), and vice versa. Investors and analysts usually pay close attention to the following fundamental data: worldwide crude oil inventory levels; non-OPEC production; OPEC production; capacity utilization of swing producers; strategic reserves; worldwide oil demand; and geopolitical developments. In the past, oil prices have closely tracked these fundamental indicators. Lately, however, as we will explain in more detail, oil prices have diverged from indicated levels. We think this is temporary, but it does introduce the notion that for short periods, non-fundamental factors (in this case, speculation of a possible price spike due to a disruption in supply) can also impact the commodity price. Over time, we expect fundamental indicators to come back into focus.
FUNDAMENTAL DATA SOURCES
Two factors make oil prices difficult to forecast: 1) OPEC, which attempts to influence oil prices by changing supply, and 2) unreliable data. Statistics on oil supply are voluminous, perhaps more so than for any other commodity or industry. Yet, much of the information is incomplete or just plain wrong. For example, no attempt is made to count more than half of the worlds oil inventories secondary (that held by distributors) or tertiary (that held by consumers) stocks. Many emerging countries, which recently have had a large impact on demand, do not report statistics in a timely manner. Some do not report accurate figures. Even in the U.S., where two reputable authorities the Department of Energy (DOE) and American Petroleum Institute (API) report weekly oil inventory, production, and import figures, the weekly releases often show vastly different trends. Both reports are revised frequently. A widely used source for worldwide oil industry statistics is the International Energy Agency (IEA), the main organization that represents a 26-member consortium of oilimporting nations based in Paris, France. Membership consists predominantly of Organization for Economic Cooperation and Development (OECD) nations, although the agency also has relationships with non-OECD nations. In particular, the IEA is working with China, India, and Russia to formalize reporting procedures. The agency publishes a monthly statistical report, which is available by subscription, but is made available for no charge on a delayed basis (see www.IEA.org). The report contains extensive and detailed analysis of oil supply, demand, and inventories, and
includes forecasts. However, despite the IEAs level of statistical detail, which sometimes involves supply projections on a field-by-field basis, its data are revised frequently and significantly. It is not unusual for the agency to add or subtract millions of barrels from historical supply, demand, or inventories. Oftentimes, supply, demand, and inventory figures do not reconcile, leading to a mystery of missing barrels. Reporting in the U.S. is more timely than elsewhere. The DOEs statistical arm, the Energy Information Administration (EIA), publishes inventory data on a weekly basis (10:30 a.m. on Wednesdays), and demand data are published monthly (see www.eia.doe.gov). Oil and gas operators, refiners, storage, and distribution companies are all required to submit information to the government weekly. Falsified information is punishable by a civil fine and lots of embarrassment. This is why we prefer the EIA weekly reports to those published by the API, whose survey is less thorough (participation is voluntary). Though not perfect owing to timing issues (i.e., shipments of crude from very large vessels are not on a regular schedule, so one week may contain more deliveries than the one before or after), we believe the EIA data provide a reasonable picture of supply, demand, and inventories over time. We believe that, in many cases, it is reasonable to extrapolate U.S. inventory trends, gleaned from EIA reports, to the rest of the world. After all, oil is a worldwidetraded commodity. If oil is in oversupply (demonstrated by large builds in EIAreported stocks week after week), it is unlikely that inventories are building only in the U.S. and not everywhere else, too. We believe that it is more important to spot trends in fundamentals, using source data as a tool, rather than relying on specific forecasts. An extensive list of industry data sources is presented in Section 4.
WORLDWIDE CRUDE OIL INVENTORY LEVELS
Changes in oil inventories around the world are an indicator of supply/demand balance. In an oversupplied market, worldwide inventories build. Rising inventories are usually accompanied by falling prices, and vise versa. Exhibit 8 below illustrates the historical relationship between oil inventories in the U.S., the worlds largest energy consumer, and oil prices. In the chart, the right-hand axis showing oil inventories is reversed to show a positive relationship (and to display the strong correlation between oil prices and inventories an r-square of 0.87 between 1995 and 2004). Low inventories typically translate into high oil prices, and rising inventories usually accompany declining prices. Note that the relationship broke down beginning in January 2004, when we believe nonfundamental factors such as speculation over terrorist fears overshadowed fundamentals. As seen in the chart, oil inventory levels throughout much of 2005-06 were consistent with an oil price in the $10/bbl-$20/bbl range, versus the actual spot price in the high $50s/bbl. While terrorism fears and speculation played a role in this disconnect relative to historical trend, we now believe that underlying fundamentals for light/sweet crude oil were very tight, and this contributed to a surge in prices for this type of crude. In 2004, demand for refined products rose sharply in the Asia/Pacific region. To meet this demand, idle refining capacity capacity that had been built in the 1990s in anticipation of this demand was called into service. However, the refining
Page 23
capacity was outdated, in that it required light/sweet crude oil as feedstock. Prices for light/sweet crude oil such as WTI began to rise. To stave off the increase in crude oil prices, OPEC, the world swing producer, increased production. However, the incremental production from OPEC was lower-quality crude, for which there was no added demand. Incremental supplies of low-quality crude filled worldwide inventories. These factors all contributed to the trends that began in 2004 rising WTI prices, increasing worldwide oil inventories, and all-time wide light/heavy spreads.
Exhibit 8. Relationship Between Oil Inventories and Oil Prices
80 175,000
70
60
WTI Spot Prices ($/bbl)
225,000
50
250,000
40
275,000
30
300,000
20
325,000
10
Ja n Ma -95 y Au -95 g De -95 cAp 95 r-9 Ju 6 l No -96 vMa 9 6 rJu 97 nOc 9 7 tFe 97 b Ma -98 y Se -98 pJ a 98 n-9 Ap 9 rAu 99 g De -99 cMa 9 9 r-0 Ju 0 l No -00 vMa 0 0 rJu 01 nOc 0 1 tFe 01 b Ma -02 y Se -02 pJ a 02 n-0 Ap 3 r Au -03 g De -03 c-0 Ma 3 r-0 Ju 4 l No -04 vF e 04 bJu 05 nOc 0 5 tJa 05 n Ma -06 y Se -06 p-0 6
350,000
WTI Spot Oil Prices
Crude Oil Inventories
Source: Energy Information Administration; Platts.
SUPPLY: NON-OPEC PRODUCTION
Non-OPEC production comes from publicly traded oil companies (such as the integrated oils in our coverage universe), from national oil companies (NOCs) of non-OPEC nations, such as Pemex, the national oil company of Mexico, and, particularly in the U.S., from privately held independent E&P companies.
Crude Oil Inventories (000s bbls)
Since January 2004, the correlation between crude oil prices and inventory levels has broken down.
200,000
Exhibit 9. Non-OPEC Production

60 50 40
Million b/d
~2% per year
30 20 10 0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Non-OPEC production
Source: International Energy Agency.
Supply from non-OPEC producers has increased steadily. Since 1988, we estimate oil production from non-OPEC sources to have risen by an average of 2% per year.
OPEC
The Organization of the Petroleum Exporting Countries, or OPEC, was formed in 1960. Made up of 12 member nations (in the early days, membership was 13 Ecuador and Gabon dropped out, and Angola was added in 2007), the organization was first formed to provide a large unified voice on oil industry issues. The group evolved into a cartel in 1973. This was about the same time that production in the U.S., which until then was the worlds largest oil producer, began to decline.
Exhibit 10. OPEC Member Nations
Country Iran Iraq Kuwait Saudi Arabia Venezuela Qatar Libya Indonesia United Arab Emirates Algeria Nigeria Angola Ecuador Gabon
Source: OPEC.
Membership history September 1960 Founder Member September 1960 Founder Member September 1960 Founder Member September 1960 Founder Member September 1960 Founder Member Member since December 1961 Member since December 1962 Member since December 1962 Member since November 1967 Member since July 1969 Member since July 1971 Member since January 2007 Joined November 1973; left OPEC in 1992 Joined December 1973; left OPEC in 1996
Page 25
As the U.S. became a net importer, OPEC realized its dominant position in world oil supplies and its ability to influence oil prices. In October 1973, OPEC initiated an embargo (to protest U.S. and other Western nations support of Israel during the Yom Kippur War), and in a matter of weeks, world oil prices tripled. Gasoline rationing occurred in the United States. The embargo was lifted in 1974, but the industrialized world became acutely aware of its dependence on oil from the Middle East. Until the early 1970s, oil operations outside the U.S. were conducted on a concession basis, giving oil companies the right to explore for, own, and produce oil in oil-rich regions such as the Middle East. But, beginning in about 1971, a movement among oil exporting nations for sovereignty over their natural resources evolved. Countries such as Libya, Algeria, Iraq, Saudi Arabia, and Venezuela increased their governments participation in their countries oil operations, with a gradual movement toward complete nationalization. This unraveled relationships between oil-exporting nations and oil companies, and further increased OPECs influence in the marketplace. Since 1973, other price shocks have occurred. Oil prices reached their highest level ever, in real terms, in 1979, as the Iranian Revolution ravaged many of Irans producing fields, disrupted supplies, and caused a tightening of oil supplies. Oil prices held up owing to an eight-year war between Iraq and Iran, starting in 1982, which led to frequent production outages in those two countries. In fact, to this day, oil production in Iraq and Iran has not reached pre-1978-79 levels. Oil prices surged again in 1990, when Iraq invaded Kuwait in an attempt to control its oil fields. Coalition forces led by the U.S. ended the Iraqi occupation, and oil prices fell. Although OPEC has struggled to maintain its market share (Exhibit 11), it is still a powerful influence in world oil markets. OPEC nations are estimated to contain twothirds of the world proven reserves. The organization generally meets at its headquarters in Vienna, Austria, twice a year, although it has met more frequently in the past year. At these meetings, among other things, the organization sets production quotas for member nations, which it believes will achieve targeted price levels.
Exhibit 11. OPEC Market Share
35 30
Million Barrels per Day
55% 50% 45% 40%
25 20
35% 15 10 5
20 07 E 19 88 19 90 19 89 19 94 19 96 19 92 19 91 19 98 19 93 20 00 19 95 20 02 20 06 19 97 20 04 19 99 20 01 20 03 20 05
30% 25% 20%
OPEC Crude Production
% of World Production
Source: International Energy Agency.
% of World Production
While most OPEC oil ministers describe stable oil pricing as a desired goal, we believe price stability would undermine the organization. In our view, what is best for OPECs long reserve life producers is high price volatility. This is the only way to obtain high revenues and maintain market share over the countries reserve lives. In order to maintain a balance between these opposing objectives, we believe OPEC deliberately causes price volatility that allows the pendulum to swing from satisfying one objective to the other. High prices bring high revenues; however, they also work to reduce market share. On the other hand, OPEC has been seen raising production in a low-price environment, discouraging new investment by non-OPEC producers, thereby increasing market share. Market share is critical to OPEC, given the countries dependency on this one commodity for revenue and the producers long oil reserve lives. If market share is pegged, oil prices will fluctuate more. Increased oil price volatility creates uncertainty for planners and works to slow drilling activity. Just as importantly, high price volatility will slow development of alternative and nonconventional energy such as gas-to-liquids conversion (GTL), oil sands, and oil shale. Over the next 30 years, GTL has the potential to displace a large portion of oils share of the worlds energy market. Furthermore, there are more reserves of tar sands and oil shale in Canada and the U.S. than there is conventional oil in Saudi Arabia. This is threatening to large oil exporters like Saudi Arabia, given its 100-plus years of oil reserves. In addition to slowing energy development, high price volatility can result in an average oil price that allows Saudi Arabia to realize revenues above those necessary to balance the countrys budget. In the recent past, OPEC has viewed itself as the swing producer, with a selfappointed task of altering production to balance world oil supply and demand. For instance, in 2000, the organization set a price band to monitor and respond to changes in world prices. The price band was based on a basket of seven crudes. According to the price band mechanism, production adjustments would result if OPEC basket prices rose above $28/bbl for 20 consecutive trading days, or below $22/bbl for ten consecutive trading days. The price band proved to be more symbolic than real, since member countries often cheated on quotas and prices frequently moved below and above the band, accompanied by lip service, but little action. The OPEC basket price has traded above $28/bbl since December 2003 without triggering the price band mechanism. At its January 2005 meeting, OPEC temporarily suspended the price band mechanism, deeming it unrealistic given volatility in the market. Since then, OPEC actions appear to support a price that is well above the historical band. While OPEC appears diligent about setting production quotas in response to market conditions, members consistently produce more than their allocation (see Exhibit 12). For this reason, in terms of influencing oil prices, OPECs production policy has been somewhat secondary to its actual production. Members cheat on production quotas, particularly when prices are falling, as lower production means lower revenue for the country. For instance, in January 2001, oil prices fell from $36/bbl to $28/bbl in a six-week period, a signal that the markets were oversupplied. The OPEC-10 (OPEC10 production excludes Iraq, to which recent quotas do not apply) cut its production
Page 27
quota by 1.5 million barrels per day (b/d) in February 2001, and by another million b/d in April 2001. While production was cut by 1.3 million b/d in February, through August 2001, it had reduced production by only 430,000 b/d more. As one might imagine, OPEC members tend to be more responsive to increases in production quotas than they are to decreases.
Exhibit 12. OPEC-10 Production vs. Quotas
29000 28000 27000
Thousands b/d Average production above quota: 824,000 b/d
26000 25000 24000 23000 22000 21000 20000

Ma y-9 No 8 v-9 Ma 8 y-9 No 9 v-9 Ma 9 y-0 No 0 v-0 Ma 0 y-0 No 1 v-0 Ma 1 y-0 No 2 v-0 Ma 2 y-0 No 3 v-0 Ma 3 y-0 No 4 v-0 Ma 4 y-0 No 5 v-0 Ma 5 y-0 No 6 v-0 6
Quotas Production
Source: Platts.
CAPACITY UTILIZATION
Until recently, capacity utilization was not a factor that influenced oil prices, as supplies were more than ample to meet worldwide demand with an adequate cushion for further demand growth. Remember, in the past, OPEC has had to withhold substantial volumes of oil from the market to keep oil prices above high teens/low $20s per barrel. It seems that times have changed. Demand growth in 2004 was extraordinary, estimated at 4.0%, fueled by economic expansion in China, India, and the United States. In addition, post-9/11 terrorism, the increased possibility of a supply disruption, and unstable civil and political situations in some producing areas have raised concerns about another oil shock. Capacity utilization is difficult to measure. This is part and parcel of the bad data problem that was discussed earlier. By definition, non-OPEC producers have no spare capacity, since OPEC is the swing producer. OPEC has spare capacity, but it is impossible to know what a country can produce. There is no official documentation, and oil ministers seem to give inconsistent estimates of capacity. Reserves in nations such as Saudi Arabia are plentiful and inexpensive to develop ($2/bbl-$5/bbl), but even the Saudis have given different reports of production capacity in their own country. We have raised our estimates of OPEC capacity several times in the past two years as member nations production climbed above our capacity estimates (see Exhibit 13).
While it is generally agreed that worldwide oil production capacity needs to increase, from precisely what level is a little vague. Spare capacity is determined in part by how much OPEC is currently producing. In 2004, OPEC began to raise production, causing concerns about shrinking spare capacity at a time when it was feared that terrorist activity could disrupt significant amounts of supply anywhere in the world. OPECs rising production, in this respect, had a bullish effect on prices. As of December 2006, we estimate OPECs spare capacity in excess of three million b/d, higher than 2004 and 2005, when spare capacity shrunk to below two million b/d, but still below the estimated 2002 level of approximately five million b/d. However, OPEC nations have boosted development activity, and spare capacity appears to be on the rise once again.
Exhibit 13. Estimated OPEC Spare Production Capacity (b/d in thousands)
Algeria Indonesia Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates Venezuela Total OPEC Dec-06 Capacity 1,400 1,150 3,900 3,000 2,400 1,700 2,500 800 11,000 2,600 2,800 33,250 Dec-06 Production 1350 860 3850 1900 2460 1700 2230 800 8790 2500 2460 28,900 4,350 (1,250) 3,100
Estimated spare capacity Less: shut in capacity in Iraq, Venezuela, Nigeria Spare Capacity
Source: Platts; Bear, Stearns & Co. Inc. estimates.
STRATEGIC RESERVES
Strategic reserves are nations emergency oil stockpiles. Many countries have talked about building strategic reserves in the past three to four years, spurred on by fears of supply shortages owing to terrorist activity or political turmoil in producing countries. In the U.S., after the September 11, 2001, terrorist attacks, President George W. Bush pledged to fill the Strategic Petroleum Reserve (SPR) to its maximum of 700 million barrels as an insurance policy in the event of another oil shock. Germany, Japan, South Korea, and Taiwan also have strategic reserves. China and India, two of the fastest-growing nations in terms of oil demand, have also taken steps to establish a reserve. The SPR in the U.S. was created in the aftermath of the oil embargo of 1973-74. On September 11, 2001, the reserve contained approximately 544 million barrels of oil. Since then, the U.S. government has filled the SPR at an average 850,000 barrels of oil per week, or approximately 121,400 b/d.
Page 29
Oil for the U.S. SPR is stored at four sites, in salt caverns on the coast of Louisiana and Texas. The government takes the oil in place of royalty payments oil companies would otherwise make to produce on federal land. However, imported crude is also purchased, so that the reserve comprises a variety of crude blends. In the past, the DOE has released small amounts of oil from the reserve in response to temporary supply disruptions, as it did after Hurricanes Ivan, Katrina, and Rita knocked out production at some oil production platforms in the Gulf of Mexico. The U.S. imports approximately ten million barrels of oil per day, so at capacity of 700 million barrels, the reserve would provide 70 days, or less than two-and-a-half months, of crude imports. However, in all likelihood, even under extreme circumstances, it would be unlikely that all of the imported supply to the U.S. would be disrupted. A significant disruption of two million b/d of production at a facility outside the U.S. would likely reduce availability of oil imports to the U.S. by 500,000 b/d (the U.S. consumes approximately one-fourth of global oil production). In such a case, the SPR would cover the shortfall for more than three-and-a-half years. The program was criticized, in part due to the cost, as prices rose to the high-$50s/bbl in 2005 from the $22/bbl-$23/bbl range in September 2001. Building the SPR was viewed as bullish for oil prices. A recent proposal by the Bush Administration to double the capacity of the U.S. reserve by 2027 is controversial. Although the oil being added to the reserve is not consumed, it does take oil off the market that would otherwise be consumed, causing supplies of oil for consumption to tighten, and apparent demand to appear artificially high.
Exhibit 14. U.S. Strategic Petroleum Reserve Inventory
700,000 Authorized capacity
000's Barrels
650,000 600,000 550,000 500,000 12/29/1995 12/29/1996 12/29/1997 12/29/1998 12/29/1999 12/29/2000 12/29/2001 12/29/2002 12/29/2003 12/29/2004 12/29/2005 12/29/2006
U.S. SPR Stocks

Source: Energy Information Administration.
We believe the current perception of tight world supply/demand balance has been exacerbated by the building of reserves around the world.
WORLDWIDE OIL DEMAND
In industrialized nations, demand growth has been closely correlated with GDP growth. Oil demand in OECD countries accounts for approximately 60% of worldwide demand, but recently, non-OECD GDP growth has been the principal driver of global oil demand growth. In the past 16 years, world oil demand has risen at an average annual rate of 2.4%. Annual growth has averaged 1.2% and 2.1% in OECD and non-OECD countries, respectively. In the past five years ending 2006, non-OECD oil demand growth has accelerated to an average of 3.3%, while OECD growth has slowed to 0.7%.
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Exhibit 15. Year-over-Year GDP Growth vs. Oil Demand Growth

OECD
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 OECD Real GDP OECD Oil Demand Growth
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Estimated Non-OECD GDP Growth Non-OECD Oil Demand Growth
Non-OECD
P e rc e n t
Source: Energy Information Administration; International Energy Agency; Bear, Stearns & Co. Inc. estimates.
Future global oil demand growth forecasts are mostly determined by regional macroeconomic trends. It is easier to think of regional oil demand in terms of demand for refined products, the end-use for crude oil. For instance, a healthy economy in an industrialized nation may lead to robust manufacturing activity. This typically stimulates demand for on-road diesel fuel (used by the trucking industry), or other transportation fuels used for shipping products. In addition, a healthy economy usually stimulates leisure and business travel, supporting demand for gasoline and jet fuel. Economic growth in many less-mature nations is, in many cases, supported by economic health in industrialized nations, although GDP growth in these regions can be volatile. In mature economies, such as in the U.S., oil demand may also be influenced by absolute levels of oil prices, as high oil prices are typically passed on to consumers through higher prices for gasoline, petrochemicals used in manufacturing, distillates used to heat homes and in industrial applications, and air travel, among other things. Therefore, demand may be curtailed as consumers and businesses feel the pinch of high transportation and materials costs. An additional factor influencing demand is a countrys taxation. In most countries, consumption of gasoline and diesel fuel is highly taxed. In Europe, where transportation fuels are heavily taxed, demand is less sensitive to changes in product prices than in countries where there is a smaller tax component in the price, such as the United States. Currency fluctuations can also affect demand for crude oil, although it is difficult to quantify the impact. Economists have differing views on the topic, in part because swings in currency valuations are commonly accompanied by a variety of other macroeconomic conditions. In general, we believe the impact of currency fluctuations on worldwide demand to be insignificant relative to the impact of a change in the absolute price of crude oil. For example, the dollars weakness is often cited as one of the reasons why oil prices strengthened in 2004. There are two aspects for oil that stem from currency movements, given that oil is priced in dollars: 1) the impact on demand for petroleum products outside the U.S., and 2) the influence on OPEC supply policy.
P e rc e n t
A weak dollar can lead to relatively lower petroleum prices outside the U.S., and, therefore, stimulate higher demand. But this did not happen in 2004. Prices in Europe in local currency did not increase as much as they did in the U.S. during the past year, but they did rise, owing to the sharp increase in dollar-denominated oil prices, higher excise taxes, and higher refining margins. According to the IEA, from February 2004 through January 2005, end-user gasoline and diesel prices rose an average of 3.1% and 4.6%, respectively, in France, Germany, Italy, Spain, and the United Kingdom. In comparison, gasoline and diesel prices in the U.S. increased 10.1% and 23%, respectively. End-user prices rose more in Japan, up 17.1% for gasoline and up 14.8% for diesel. We believe dollar weakness may have resulted in a less depressive effect on petroleum demand in Europe, but it does not appear to have bolstered demand. The second aspect of a weak dollar is that in order to preserve its purchasing power as the dollar falls, OPEC needs to raise oil prices. This can be accomplished by cutting oil production. Yet, instead, throughout 2004, OPEC did the exact opposite. It increased oil production. However, OPEC cited the weak dollar as a reason to support higher oil prices above the band of $22/bbl-$28/bbl that it had previously advocated. In the end, in 2004 and 2005, the effect on supply and demand for oil from dollar weakness was not apparent, other than it contributed to the bullish psychology in the oil markets. Over time, we believe sustained periods of high or low prices will affect demand in any region. In mature economies such as the U.S. and Europe, sustained high prices often lead to conservation measures, including shifts by consumers in the type of vehicle that they buy. We believe a structural shift in auto purchases is occurring in the U.S., with consumers moving away from gas-guzzling sports utility vehicles (SUVs) toward more fuel-efficient cars and hybrids. History suggests that once the shift gets under way, it takes time to reverse, even if gasoline prices fall. In emerging economies, high energy prices strain fragile fiscal regimes and discourage new investment. Non-OECD countries oil demand growth patterns are difficult to predict. Historically, swings in demand have less impact on global demand due to the smaller scale. But, looking forward, growth in demand in Asia/Pacific regions will play a larger role in the future in the worldwide supply/demand balance. Chinas oil demand demonstrates unpredictability, and the rising influence of non-OECD growth. Average demand in China for the past five years ending in 2006 has been approximately 6.1 million b/d, about one-third of U.S. demand of 20.8 million b/d, and about 7% of worldwide demand. Five years ago, the rolling five-year average demand in China was just 4.3 million b/d, or less than one-quarter of U.S. demand, and 5% of worldwide demand. Today, a 10% increase in Chinese demand would boost worldwide demand by approximately three-quarters of a percentage point. Historically, oil demand growth in China, estimated at approximately 6%-7%, has been about three times the worldwide average. The pace has accelerated recently, but, as seen in Exhibit 16, demand growth in China is erratic. Aberrations in
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reporting often lead to indications of very strong demand, followed by a collapse in demand. Some would argue that extraordinary growth in emerging economies such as China is not sustainable year after year, as rapid industrial growth usually bumps up against existing infrastructure. However, recent growth trends have raised concerns about the markets ability to serve the increasing needs of non-OECD nations.
Exhibit 16. China Oil Demand Growth
25 20 15
11.07
Average = 6.5%
19.2 15.3
Percent
10 5 0
7.52 5 4.76 4.54 0
8.69 6.45 4 0
9.09
8.33 5.13 4.89
6.98 2.17
5.74 1.5
6.1
1986 1987 1988 1989 1990 1991 1992
Source: International Energy Agency; Bear, Stearns & Co. Inc. estimates.
Directional trends in oil prices usually boil down to the supply/demand balance. Oversupplied markets tend to increase inventories and pressure prices, and vice versa. Earlier, we discussed the market players on the supply front, and we explained how and why OPEC is the swing producer. When we put our assumptions for supply against our demand outlook, as shown in our supply/demand model below, we start to get a picture of how of the balance might look in the near future.
A WALK THROUGH OUR WORLDWIDE OIL SUPPLY/DEMAND MODEL
Most oil analysts supply/demand models attempt to determine what OPEC should produce. We forecast world oil demand, non-OPEC supply, and then adjust inventories upward or downward to a normal level. The volume that remains is referred to as the call on OPEC i.e., the amount that the swing producer should produce to balance supply, demand, and inventories. We begin with demand assumptions, using Bear Stearns regional GDP forecasts, and examining macro indicators that may affect demand, as well as the regions history of oil consumption to GDP. From this, we formulate projections of future demand growth. Next, we forecast non-OPEC supply, based on our research and public information on developments around the world. The difference between our global demand estimate and non-OPEC supply is referred to as the call on OPEC oil, or, how much oil OPEC (the swing producer) must produce in order to balance the market. Comparing this figure with current OPEC production, we then estimate whether OPEC will be able to balance the market. To the extent that OPEC will or will not be able to balance the market, inventories will rise or fall.
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
yoy growth
For instance, in the example model shown in Exhibit 17, we compare the call on OPEC oil of 27.7 million barrels in 2005 to current OPEC production of 30.0 million b/d (as of April 2005). We note that OPEC must cut production by 2.3 million b/d in order to balance the market. Given the magnitude of the oversupply, and OPECs propensity to produce above quotas, we conclude that inventories are likely to rise, and that oil prices will experience downward pressure. We have talked about nonfundamental factors that have influenced oil prices. However, we believe that, over time, prices will stabilize at levels indicated by the fundamentals.
Exhibit 17. World Oil Supply and Demand Model (b/d in millions)
2003 Year Demand OECD North America Europe Pacific Total OECD Non-OECD Demand Outside FSU Supply (1) OECD FSU Net Exports China Other Non-OECD Processing Gains Total Non-OPEC Call on OPEC Oil OPEC NGL Total OPEC Total Production Inventory Build (Draw)
(2)
2004 1Q 2Q 3Q 4Q Year 25.0 15.8 9.4 50.2 28.8 79.0 21.8 7.3 3.4 12.1 1.9 46.5 27.9 4.3 32.2 78.7 (0.3) 24.9 15.4 8.0 48.3 29.2 77.5 21.5 7.4 3.5 12.2 1.8 46.4 28.1 4.3 32.4 78.8 1.3 25.2 15.7 8.3 49.2 29.0 78.2 20.7 7.7 3.5 12.4 1.8 46.1 29.2 4.3 33.5 79.6 1.4 25.5 16.1 8.9 50.5 29.8 80.3 21.1 7.6 3.4 12.6 1.9 46.6 29.6 4.4 34.0 80.6 0.3 25.2 15.8 8.6 49.5 29.2 78.7 21.3 7.5 3.5 12.3 1.9 46.4 28.7 4.3 33.0 79.4 0.7
2005 1Q 2Q 3Q 4Q Year 25.2 15.8 9.4 50.4 29.5 79.9 21.4 7.7 3.6 12.6 1.9 47.2 27.8 4.7 32.5 79.7 (0.2) 25.2 15.5 8.1 48.8 30.2 79.0 21.4 7.9 3.5 12.8 1.9 47.5 27.0 4.7 31.7 79.2 0.2 25.5 15.9 8.2 49.6 30.2 79.8 21.3 8.2 3.5 12.9 1.9 47.8 27.7 4.7 32.4 80.2 0.4 25.8 16.2 9.0 51.0 30.5 81.5 21.5 8.3 3.5 13.0 1.9 48.2 28.2 4.7 32.9 81.1 (0.4) 25.4 15.9 8.7 49.9 30.1 80.1 21.4 8.0 3.5 12.8 1.9 47.7 27.7 4.7 32.4 80.1 0.0
2006 Year 25.7 16.1 8.8 50.6 31.0 81.6 21.6 8.4 3.5 13.5 2.0 49.1 27.7 4.8 32.5 81.6 0.0
24.6 15.5 8.8 48.9 27.4 76.3 21.6 6.7 3.4 11.9 1.8 45.5 26.8 3.9 30.7 76.1 (0.2)
(1) OECD production includes NGLs and nonconventional. (2) Includes condensates. Notes: Historical OPEC production is actual. Projected OPEC production is derived from our estimates of demand and non-OPEC production. Projected OPEC production is the same as the projected call on OPEC. Numbers may not add due to rounding.
Source: International Energy Agency; Bear, Stearns & Co. Inc. estimates.
GEOPOLITICAL DEVELOPMENTS
It is important to note that disruptions in oil supply are routine. Each year, the industry experiences labor strikes, mechanical problems, foul weather, civil unrest, war, and government policy shifts. Recently, outages in the normal course of business have drawn increased attention from traders, given terrorist fears and perceived tightness in the supply and demand balance. As discussed earlier, terrorist fears played a role in the markets view on supply, which helped drive an unusually rapid increase in oil prices in 2004. Likewise, civil unrest in oil-producing countries such as Nigeria and Venezuela disrupted supply through periodic labor strikes in 2004 and 2005. Production in Iraq has yet to recover from insurgent attacks following the allied invasion in March 2003. Russia could potentially be the largest exporter of oil in the world, as the government works to ramp up its oil exporting business. However, recently, the Russian government has reversed some earlier actions that were aimed at stimulating drilling and foreign investment. Limitations on foreign investment have been proposed, and contracts have been abrogated. In addition, export taxes have been increased significantly. These actions could slow down the rate of supply expansion.
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For the intermediate term, we believe geopolitical factors will continue to play a role in the influencing oil prices. When oil prices are high, governments and civil groups have a keener interest in domestic oil production activities, and social issues such as wealth distribution. This perpetuates a hot geopolitical climate, and helps to support the premium that has been built into oil prices to reflect the uncertainty of reliable and consistent supply.
Investing in the Integrated Oils

Important points for investors in integrated oils: Integrated oils earnings are sensitive to changes in oil and gas prices. Hedging activity may alter a companys earnings near term. Oil is a commodity, with prices historically averaging $20/bbl-$25/bbl. Oil prices have moved above and below this range, but $20/bbl-$25/bbl had been the conventional thinking for mid-cycle prices. Given the surge in prices in 2004, to well above these levels, and the factors behind that surge, a new view of a midcycle price is evolving. We believe there is intermediate-term support for oil prices in an average range of $45/bbl-$55/bbl. Two key operating measures help to gauge the health of the upstream business: reserve replacement ratio and finding and development costs. Growth strategy: Is the company an acquirer or an explorer? Historical mid-cycle valuation for the integrated oils:
EV/EBITDA International Oils: Domestics Oils: 5.5x-7.5x 4.5x-6.5x P/E 14.9x-20.9x 13.3x-19.7x P/CF 8.2x-11.4x 4.2x-6.3x
International oils include large-cap multinationals such as BP, Chevron, Eni, Exxon Mobil, Repsol, Royal Dutch Shell, and TOTAL. Domestic oils include Hess, ConocoPhillips, Marathon Oil, Murphy Oil, and Occidental Petroleum. Company valuation analysis can be found in the third section of this report. At the end of this section, under the headline, Pointers and Rules of Thumb, we have provided tips on calculating what oil price is reflected in the stocks, and other helpful exercises.
SENSITIVITY TO CHANGES IN OIL AND GAS PRICES
All oil companies earnings have a measurable sensitivity to changes in oil and gas prices. Typically, we measure changes in oil prices using WTI, and in the Natural Gas Week composite spot wellhead prices for gas. Oil companies actual oil and gas price realizations will vary from these proxies, depending on production profiles and quality of the crude production slate. We measure oil companies operating leverage in terms of earnings per share. We calculate a companys operating leverage to a $1.00/bbl change in oil prices by multiplying the total number of barrels of oil produced in a year by one minus the tax rate, and dividing the product result by the number of shares outstanding. Likewise, sensitivity to a $0.10/mcf change in gas prices is the amount of gas produced in the U.S. per year, multiplied by 0.10, times one minus the tax rate, divided by the shares outstanding. We find it best to look at operating leverage as a percentage of projected earnings when ranking companies price sensitivity.
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Leverage to oil/gas prices in EPS: To a $1.00/bbl change in oil price = (daily oil production x 365 x $1) x (1 - tax rate) Shares outstanding To a $0.10/mcf change in gas price = (daily U.S. gas production x 365 x $0.10) x (1 - tax rate) Shares outstanding
We use U.S. gas production to calculate sensitivity to natural gas prices given the high volumetric concentration in the U.S. for several of the companies that we cover. Although U.S. gas prices are influenced by oil prices, the market is somewhat contained given transportation limitations (this is slowly changing with the growth of liquid natural gas [LNG] supplies). International gas production is sold predominantly into local markets, where market prices usually are tied to oil prices with a time lag. Exhibit 18 below shows the impact on EPS of a $1.00/bbl change in oil prices for the major oils.
Exhibit 18. Oil Company Earnings Leverage to Changes in Oil Prices(1) $ Change in % Change in 2007E Net 2007E EPS 2007E EPS Crude Oil from $1/Bbl from $1/Bbl 2007E Operating Production Change in Oil Change in Oil (mm bbls) EPS Price Price
Murphy Oil Occidental Petroleum Hess Corp. BP Chevron TOTAL S.A. Royal Dutch Shell Exxon Mobil Marathon Oil ConocoPhillips Weighted Average
$3.80 3.80 5.75 6.60 7.35 7.05 6.85 6.05 10.00 8.45
39 175 97 972 696 609 787 1025 89 356
$0.12 0.12 0.18 0.18 0.18 0.15 0.13 0.11 0.15 0.11
3.3% 3.3% 3.2% 2.7% 2.5% 2.1% 1.9% 1.9% 1.5% 1.3% 2.1%
(1) Does not account for potential impact on refining, marketing, and chemical earnings.
Source: Company reports; Bear, Stearns & Co. Inc. estimates.
Exhibit 19 shows the impact on earnings per share of a $0.10/mcf change in U.S. natural gas prices for the major oils.
Exhibit 19. Oil Company Earnings Leverage to Changes in Gas Prices

$ Change in % Change in 2007E 2007E Net U.S. 2007E EPS from 2007E EPS from Operating Natural Gas $0.10/mcf Change $0.10/mcf Change EPS Production (bcf) in Gas Price in Gas Price Marathon Oil ConocoPhillips Occidental BP Murphy Oil Chevron Hess Corp. Royal Dutch Shell Exxon Mobil TOTAL S.A. Weighted Average
10.00 8.45 3.80 6.60 3.80 7.35 5.75 6.85 6.05 7.05
331 906 217 881 23 675 42 456 602 237
0.06 0.04 0.02 0.02 0.01 0.01 0.01 0.01 0.01 0.01
0.6% 0.4% 0.4% 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 0.2%
OIL IS A COMMODITY
Historically, oil prices have experienced cyclicality in response to oversupply or undersupply, and to changes in demand. These cycles may last for two or so years, but in the past, prices have gravitated back to the mean level around $23/bbl after periods of volatility, as the supply and demand adjusts and responds to market conditions. We believe the cyclicality in oil price movements will persist, though we believe the mid-cycle level is above the historical average in the intermediate term, and a mid-cycle price has yet to be determined. A higher mid-cycle price is supported by higher costs for the marginal barrel, OPEC action to support higher prices, proportionally stronger demand out of non-OECD nations, and a more active geopolitical climate.
Exhibit 20. WTI Spot 36-Month Moving Average Oil Prices 1983-2004
90 80 70 60 Frequency 50 40 30 20 10 0
<16 16-18 18-20 20-22 22-24 24-26 26-28 28-30 >30
Source: BP; Platts.
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Prior to 2004, periods when oil prices rise above $30/bbl (in nominal terms) had been highly unusual. As Exhibit 20 shows, oil prices have spent little time above $30/bbl (using a three-year moving average) during the past 20 years. Oil exploration, development, and production is a long-term undertaking. Oil companies must make some long-term pricing assumptions to determine the economic feasibility of development projects. Most have used a planning price of $20/bbl-$25/bbl for WTI in the past, but those assumptions have been raised in light of recent development in the oil market. New assumptions range from $35/bbl to $50/bbl.
TWO KEY OPERATING MEASURES: RESERVE REPLACEMENT AND FINDING AND DEVELOPMENT COSTS
Two widely followed operating performance measures in the industry are reserve replacement and finding and development costs. Reserve replacement is an annual measure, expressed as a ratio of how much of the oil and gas that was produced by the company was replaced with new reserves. A ratio above 100% indicates growth in reserves. F&D costs, expressed in dollars per barrel of oil equivalent ($/boe), measure the cost of newly booked reserves. Each spring, Bear Stearns publishes a comprehensive report on industry trends as indicated by these metrics, and companyby-company rankings and commentary (see our annual publication, Reserve Replacement and Finding Costs: Trends in the Oil Industry). A company with a well-managed upstream program is one that consistently replaces more than 100% of its production at a reasonable cost (until recently, industry finding and development costs, on average, have been in the $6.00/bbl-$7.00/bbl range). Poor reserve replacement, or high F&D costs, may be a sign of a weak exploration program that will hurt the company competitively through low or no production growth, and/or substandard returns. Timing issues can lead to erratic annual performance. For this reason, it is important to look at a companys reserve replacement and F&D costs over a multiyear period. We believe a five-year time frame or longer is appropriate. How a company books its reserves warrants some discussion, given the attention drawn to the topic following a disclosure by Royal Dutch Shell in 2004 that it removed more than 20% of its reserves from its books due to overaggressive bookings in the past seven years. There are three categories of reserves: proved, probable, and possible. The distinction of reserve categories is important in oil and gas accounting. Only proved reserves are reflected on oil companies balance sheets. Proved reserves, which we discuss below, are those believed, with reasonable certainty, to be recoverable in the future. Probable and possible reserves, or, broadly speaking, unproved reserves, are less certain than proved reserves. A high percentage of probable reserves are usually ultimately booked as proved. Oftentimes, development plans for the probable reserves have not reached a level of maturity that would allow a company to call them proved. Most companies do not provide estimates of probable reserves (some Canadian companies do). This is unfortunate, as these assets clearly have value that is unrecognized in the companies financial statements. In our valuation work, we attempt to estimate probable reserves based on our research work and company publications. Possible reserves are less certain than probable reserves, and may require different economic conditions in order to be categorized as proved.
Proved reserves are usually just a small part of a companys true assets. For instance, Exxon Mobil, which had approximately 21.6 billion boe of proved reserves as of year-end 2005, says that its proved reserves represent just one-quarter of its total resource base. In the U.S., the Securities and Exchange Commission (SEC) is the regulatory agency that issues guidance on when reserves may be booked. Reserves are reported annually in the companys 10-K. Booked reserves refer to proved reserves, or reserves that, per guidance from the SEC, the company has discovered and is reasonably certain will be developed and produced. The phrase, reasonably certain is somewhat ambiguous, and opens the process to subjectivity. The SECs guidelines to determine reasonable certainty include production and well test data, core analysis, and well log data, but often test results are subject to interpretation by geologists and engineers, which is sometimes correct, and sometimes not. Generally, our observation has been that an oil company will book oil and gas reserves at approximately the time that funding for the development has been approved by the board of directors, although, technically, this is not a required criteria. A conservative company will typically not book the entire resource estimate initially, but only the portion that it knows it can produce. As additional data on the field are learned, the company will revise its estimates upward. For natural gas reserves outside of North America, reserves may only be booked after a sales contract for the produced gas has been signed. The SEC requires companies to classify proved reserves into two subcategories: proved developed reserves (PDs) and proved undeveloped reserves (PUDs). When a company makes a discovery that it is reasonably certain that it will develop, the reserves will be booked initially as PUDs. As the field is developed, the reserves are moved to the PD category. The SEC requires companies to disclose both categories of reserves. A large proportion of PUDs to total reserves could be an indication that the company books reserves aggressively. We also view a history of negative revisions as a red flag. A low ratio could be an indication of a weak exploration program. A small development portfolio bodes poorly for future production growth, unless the company makes an acquisition. Most large integrated oil companies have a reputation for conservative booking practices. In 2005, the integrated oils ratio of PUDs to total reserves was 39%.
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Exhibit 21. 2005 Proved Undeveloped Reserves as a Percentage of Total

60% 50% 40%
Percent
30% 20% 10% 0% XOM MUR RDSA CVX HES OXY COP MRO BP TOT
PUD Reserves/Total Reserves

Calculating Reserve Replacement Oil companies often announce reserve replacement performance for the prior year in a press release. This headline number may differ from the number that we will derive below, because companies include new reserves from all sources, including acquisitions. In our calculation, we exclude the impact of purchases and sales, to focus solely on the companys operational performance. Most often, the reserves table is found near the end of the 10-K, in a section providing supplementary data on operations. There are two reserve tables, one for oil and one for gas. The tables usually contain seven lines for each year as follows: Beginning Reserve Balance. The top line shows the reserve level at the end of the prior year. This includes both proved developed and proved undeveloped reserves. The four lines that follow show reserve additions for the year by category: 1. Revisions. From time to time, reserves at a field have already been booked, but new data have caused the company to revise its view on how much oil or gas can be produced from the field. These revisions can be upward or downward. Given the integrated oils conservative booking practices, we usually see a positive revision. At most companies, internal and external auditors review reserves at regular intervals to determine whether a revision is appropriate. 2. Improved Recovery. Reserves booked in this category are at a producing field, and, through application of technology or an enhanced recovery technique, more reserves are deemed recoverable.
3. Purchases/Sales. These are the changes in reserves levels attributable to purchases and sales of assets during the year (sometimes purchases and sales are stated on separate lines). We do not consider these reserves as part of the organic progress of the company, and therefore we exclude them from our calculation of reserve replacement. 4. Extensions and Discoveries. These are reserves that are booked from a new discovery, satellite well, or from a well drilled on the boundary of a field that extends the perimeter of the field. Production. This is the total amount of oil or gas produced by the company during the year. Ending Reserve Balance. The companys reserves at the end of the year, equal to the sum of the six lines above it. Reserve replacement calculation: To calculate oil and natural gas reserve replacement for the company, add the lines from each of the two tables. To convert gas, which is usually stated in billions of cubic feet, to barrels of oil equivalent, we divide by six.
Reserve Replacement = Revisions + Improved Recovery + Extensions and Discoveries Production
Calculating Finding and Development Costs Finding and development costs measure the unit cost of newly added reserves. As with reserve replacement, we exclude the cost of acquisitions (proved property acquisitions, described below), so as to ascertain the pure operating performance. Costs are disclosed in a table in the 10-K entitled, Costs Incurred, or Costs Incurred for Property Acquisition, Exploration, and Development, usually located near the reserves tables. The table contains four lines for each year: unproved property acquisitions, proved property acquisitions, exploration, and development. Proved property acquisitions are purchases of producing properties, which we do not include in our analysis. However, acquisition of unproved properties is included in our cost analysis. These are costs associated with acquisition of mineral rights, lease bonuses, real estate broker fees, etc., on properties for future exploration. The costs are capitalized as incurred, and for a company using successful efforts accounting, the company may take an impairment allowance if no oil or gas is found on the property. Exploration costs include those costs that were incurred on exploration, including G&G costs, whether they were expensed (for a company using successful efforts accounting) or capitalized. Development costs, which are capitalized, include all costs associated with development drilling, or building and installing production, gathering, or storage facilities associated with future production.
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Finding and development cost calculation:

F&D costs = Cost of : Purchase of unproved properties + Exploration costs + Development costs Reserves from: Revisions + Improved Recovery + Extensions and Discoveries
The Value-Added Ratio The value-added ratio (VAR) is a measure of the value creation of a companys exploration and development program. Over time, it can be used as a proxy for return on investment. Reserve replacement figures measure the growth or depletion of a companys reserve base, but they do not recognize the economic value of the reserves added. The VAR measures the effectiveness of a companys capital spending by distinguishing between reserves of greater and lesser value. The ratio, therefore, can be used to identify companies that discover and develop more profitable oil and natural gas reserves. We calculate VAR by dividing the discounted present value created in a year (before acquisitions) by the investment made to generate that value. The present value data are compiled from the Statement of Changes in Standard Measure of Discounted Future Net Cash Flows provided in each companys 10-K. This statement is based on a year-end oil price, and applies a discount rate of 10%. Therefore, a VAR of 1.0, would indicate that expenditures in the given year achieved an overall rate of return of 10%. Value-added ratio calculation:
Value-added ratio = Change in Standardized Measure of Discounted Future Net Cash Flows from Proved Reserves (Excluding Acquisitions) Cost of Purchase of Unproved Property+ Exploration Costs+ Development Costs
For example, in the last ten years, we estimate Murphy Oils value-added ratio at 1.53. This implies a 15.3% return on investment, based on an average oil price of $25.60/bbl for WTI (the average year-end price over the last ten years). Murphys VAR is consistent with the industry average. BP, Chevron, and Exxon Mobil have the highest VAR ratios, at an average of 1.8-2.0 over the last ten years.
COMPANY STRATEGY: ACQUIRER OR EXPLORER?
Most oil companies maintain asset management programs, whereby maturing fields are sold off, providing capital for reinvestment in the business. Many will also acquire producing properties, usually in areas where the company has existing operations a core area that would provide synergistic benefits. Often, companies engage in asset swaps as part of their portfolio management program. This, for most of the large integrated oils, is in addition to the exploration program, which is designed to add new reserves through the drill bit. By our observation, a company will look to acquire producing assets under three circumstances: 1) the company has a hole in its development pipeline (often because it has not discovered enough oil or gas) that it needs to fill with an acquisition to maintain production growth; 2) the company does not have an exploration focus, but has instead elected to grow through acquisition; or 3) an opportunity presents itself, perhaps in a core or desirable area, which would enhance the companys existing portfolio.
We touched on the first reason why companies might be seeking an acquisition in our discussion of reserve replacement. A company whose reserves have been depleted by production (reserve replacement less than 100%) over a multiyear period may look to make an acquisition to replace those reserves, in order to maintain or grow production. The second reason is more characteristic of a smaller independent E&P company than of a large integrated oil company. Exploration is capital-intensive and risky, so some companies elect to emphasize acquisition of reserves rather than drill. Most integrated oils have large exploration programs, with the scope, financial depth, and expertise to explore for oil and gas. A company that is dependent upon acquisitions for future growth may be disadvantaged when oil and gas prices are high, as acquisition costs would likely be higher than industry F&D costs. An acquirer must be disciplined in order to achieve the same returns as an efficient explorer.
POINTERS AND RULES OF THUMB
We are often asked what oil price is implied in an oil stocks current price. There are two ways of answering this question. The first would be to determine the near-term oil price reflected in stock prices by looking at what oil price is reflected in consensus estimates. The second answer is what is the implied long-term oil price reflected in a stocks current price. Arriving at this answer is beyond the scope of this introductory primer it requires some discounted cash flow (DCF) analysis, and making some assumptions on an oil companys long-term cash flow sensitivity to changes in oil prices. However, we bring it up because we believe that it is applicable when oil prices are well above or below mid-cycle for valuation purposes, to identify acquisition candidates, or for evaluating a merger or acquisition. What Oil Price Is Reflected in an Individual Companys Consensus Earnings Estimate? We can approximate the oil price reflected in consensus earnings estimates using the companys sensitivity to a $1.00/bbl change in the price of oil, and our earnings estimate based on an oil price assumption of $50/bbl. For example, what oil price is reflected in Exxon Mobils stock price? We estimate that every $1.00/bbl change in the price of oil changes Exxon Mobils earnings by $0.11 per share (see the methodology for this calculation on page 37). Our earnings estimate for Exxon Mobil in 2008, based on a $50/bbl oil price assumption, is $4.90 per share. Consensus is $6.00 per share. The difference is $1.10 per share, implying a difference of $10.00/bbl in the oil price assumption from our estimate based on $50/bbl. Therefore, consensus estimates reflect an oil price of approximately $60.00/bbl in 2008 (this exercise does not take into account differences in other assumptions, such as natural gas prices and refining and chemical margins).
Exxon Mobils sensitivity to a $1.00/bbl change in oil price = $0.11 per share Our earnings estimate: $4.90 per share; our oil price assumption: $50/bbl Consensus earnings estimate: $6.00 per share Implied oil price = (($6.00-$4.90) / 0.11) + $50/bbl = $60.00/bbl
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What Is a Stocks Upside/Downside if Actual Oil Prices Differ from Consensus? What is Exxon Mobils stock price upside if oil prices average $70/bbl next year? Following on from the previous example, the implied consensus oil price assumption for Exxon Mobil is $60.00/bbl next year. First, we would derive an earnings estimate based on an oil price of $70/bbl. The difference of $10.00/bbl in the oil price assumption implies additional earnings upside of $1.10 per share. Adding this to consensus earnings of $6.00 implies earnings of $7.10 per share. At $75, Exxon Mobil currently trades at 12.5x consensus earnings (or substitute a historical average P/E multiple, if appropriate, as P/E multiples generally do not remain constant), which, using the same multiple on upside earnings, implies a stock price of $90.
Exxon Mobils sensitivity to a $1.00/bbl change in oil price = $0.11 per share Projected change in oil price from consensus: $70.00 - $60.00 = $10.00/bbl Estimated earnings impact of oil price change = $0.11 x 10.00 = $1.10 per share New estimated consensus earnings estimate: $6.00 + $1.10 = $7.10 per share Forward P/E based on old consensus = $76 / $6.00 = 12.7x Implied upside price: 12.7 x $7.10 = $90.00 per share
Section 2
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Independent Refiners
THE DOWNSTREAM INDUSTRY
An independent refiner is engaged exclusively in refining crude oil into lighter petroleum products such as gasoline, diesel fuel, heating oil, and jet fuel, and in the marketing of these products. Some independent refiners operate retail outlets, which may include a merchandising component through convenience stores. Others, known as pure-play refiners, have no retail operations, selling refined products into wholesale or bulk markets. Independents operate 39 of the 132 refineries in the U.S., accounting for 5.3 million b/d, or 31% of domestic refining capacity. The publicly-traded independent refining sector has evolved only in the past 15-20 years. Prior to that, refining was predominantly part of the integrated oil companies operations. But refining has long been a low-margin business, and as fuel specs, particularly in the U.S., have grown more rigid, the integrated oils have been downsizing their refining operations in favor of the more lucrative upstream. This is how independent refiners came to be. The group of publicly-traded independent refiners consists of Alon USA, Delek, Frontier Oil, Holly Corporation, Giant Industries, Sunoco Inc., Tesoro Corporation, Valero Energy Corporation, and Western Refining. Together, they comprise 31% of U.S. refining capacity (see Exhibit 22). These companies have emerged through acquisition, IPOs of privately owned businesses, and restructuring. Though a relatively young group of companies, the industry has already seen consolidation. Valero, which owns 17 refineries serving the U.S. market, operated only a single unit up until 1997. Valero acquired fellow independent refiner, Premcor, in 2005. Tosco, once the largest U.S. independent refiner, was purchased by Phillips Pete in 2001. Sunoco, formerly Sun Company, was an integrated oil company up until 1988, when it spun off its E&P business to focus on its downstream business. The integrated oil companies continue to own the largest portion of U.S. refining capacity (approximately 47%), and privately owned refineries make up the balance of the U.S. refining system.
Exhibit 22. Independent Refining Industry
Company Alon Refining Delek Frontier Oil Holly Corporation Giant Industries Sunoco Inc. Valero Tesoro Western Refining Total: Stock Symbol ALJ DK FTO HOC GI SUN VLO TSO WNR Price $26 17 30 56 75 65 59 89 28 Market Cap (in millions) $ 3,016 850 3,300 3,136 1,050 7,995 35,636 5,963 1,904 $ 62,850 No. of Refineries 1 1 2 3 3 5 17 6 (1) 1 (2) 39 Refining Capacity (in b/d) 70,000 21,000 151,000 90,900 96,200 900,000 3,300,000 560,000 117,000 5,306,100
Note: Stock prices are as of 2/22/07. (1) Does not include proposed acquisition of Shells 100,000 b/d Wilmington, California, refinery. (2) Western Refinings proposed merger with Giant Industries is scheduled to close during the first quarter of 2007. Source: FactSet Research Systems Inc.; U.S. Energy Information Administration.
THE REFINING PROCESS
The refinery process begins with a barrel of crude oil the raw material input into a refinery. With the help of heat, pressure, and chemicals, crude oil molecules are cracked and rearranged to form lighter products predominantly gasoline, diesel fuel, heating oil, and jet fuel. We will discuss this process in this section. But first, some basic U.S. refining industry facts might help.
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The U.S is the largest refined product consumer in the world, at approximately 20.5 million b/d. Of this, nearly half of the demand is for gasoline. Transportation fuels comprise the vast majority of U.S. demand, though demand for heating fuels boosts overall refined product demand in the winter months. Total U.S. refining capacity is 17.4 million b/d. The U.S. is reliant upon imports to meet daily refined product demand. A large portion of the imports are from Western Europe. Refining is a low-margin business, with ROCEs generally in the 9%-12% range at mid-cycle. The main driver of profitability is the refining margin, which is the difference in price between the crude feedstock and the refined products produced. Refining margins are cyclical, typical of a manufacturing business. In 2004-06, high refining margins boosted returns to well above the norm. U.S. refineries are among the most sophisticated and efficient in the Approximately one-half of the refining capacity in the U.S. is located Gulf Coast. An extensive pipeline system helps transport product Midwest and the Northeast. The West Coast and the Rocky Mountain are isolated, with local refineries serving local market needs. world. on the to the region
No new refineries have been built in the U.S. since the 1976. New builds are costly and the permitting process is daunting. Environmental concerns have spawned a not in my backyard mentality. However, refiners have effectively added new capacity through expansion and de-bottlenecking projects. These are far less costly in terms of dollars per daily barrel of refining capacity, so refiners have no real incentive to build a refinery from the ground up. Environmental regulations in the U.S., which were achieved through tighter fuel specs, were disruptive to supplies in 2004-06, and helped drive refined product prices to very high levels. This contributed to unusually high refining margins and profitability throughout this period. The are three primary phases of the process, which are described below. Step No. 1: Separation The input to refineries primarily is crude oil. The first step typically is a distillation process to separate molecules by size. Each range of molecule size is specific to a particular refined product (see Exhibit 23). For instance, the lightest molecules may be gases such as butane and propane. The heaviest molecules, or residual, may be used for asphalt production or bunker fuel. The most valuable refined petroleum products are middle of the barrel products e.g., gasoline, diesel fuel, jet fuel, and heating oil.
Exhibit 23. Distillation Tower
Source: U.S. Energy Information Administration.
Step No. 2: Conversion During the conversion process, molecules are further split, or cracked, through the use of heat, chemicals, and pressure to transform streams from the separation process into finished product. Cracking units include the fluid catalytic cracker (FCC), hydrocracker, and cokers. Alkylation units and reformers also alter molecule sizes. All of these units have specialized functions that convert certain-type molecules into gasoline and middle distillates. A refinery, depending on its level of complexity, is typically configured with one or more of these units. Step No. 3: Treatment Finally, streams from the processing units are purified and blended according to customer specifications and government standards. For instance, in gasoline, octane levels are adjusted, and performance additives may be blended in to create different brands or grades of gasoline. Typical units for the treatment process include hydrotreaters, desulfurization units, and isomerization units.
REFINED PRODUCTS
Exhibit 24 lists the principal refined products that are derived from a barrel of oil for an average U.S. refinery. Each product has its own supply and demand fundamentals that sets its price. Gasoline comprises approximately 46% of the barrel, and is typically one of the highest-valued products. Refineries with sophisticated conversion units have the flexibility, when the economics warrant, to boost production of high-valued products, such as gasoline or distillate, and to lower the yield of low-valued products.
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Exhibit 24. What a Barrel of Crude Oil Makes(1)

Product Gasoline Distillate fuel oil (includes both home heating oil and diesel fuel) Kerosene-type jet fuel Redisual fuel oil (heavy oils used as fuels in industry, marine transportation and for electric power genration) Liquefied refinery gasses Still Gas Coke Asphalt and road oil Petrochemical feedstocks Lubrincants Kerosene Other Gallons per Barrel 19.5 9.2 4.1
2.3 1.9 1.9 1.8 1.3 1.2 0.5 0.2 0.3
(1) Figures based on 1995 average yields for U.S. refineries. One barrel contains 42 gallons of crude oil. The total volume of products made is 2.2 gallons greater than the original 42 gallons of crude oil. This represents processing gain. Source: American Petroleum Institute.
Drivers of Refiners Financial Performance

We believe the following items are the most important drivers of refiners financial performance: Refining Margins. Refining margins are the most influential factor; all refiners earnings are highly leveraged to changes in refining margins. Refinery Complexity. Plants that are more sophisticated, with capabilities to process cheaper feedstocks, are typically more profitable. Light/Heavy Spreads. Wide price differentials between light, sweet crudes and heavy, sour crudes benefit refiners with complex refining capacity. Operating Costs. The low-cost operator has a competitive advantage. Plant Reliability. Unplanned downtime can have a meaningfully adverse affect on profitability. Financing and Overhead Costs. Efficiency and financial flexibility are crucial due to the volatile nature of the business.
REFINING MARGINS
The refining margin is the difference between the price for refined products manufactured (e.g., gasoline and diesel fuel) and the cost of the feedstock (crude oil). Refining margins are calculated in terms of $/bbl. In our modeling work, we calculate a proxy 3-2-1 crack spread to approximate the gross profit margin for a refinery. A commonly used term, 3-2-1 refers to the proportion of gasoline and heating oil produced i.e., for three parts of oil, two parts are converted into gasoline, and one part into heating oil. For a 42-gallon barrel of oil, the 3-2-1 implies that a refiner produces 28 gallons of gasoline and 14 gallons of heating oil. For some refineries, it might be more appropriate to use a 4-3-1 spread (three parts gasoline, one part heating oil), or a 6-3-2-1 spread (three parts gasoline, two parts heating oil, one part residual fuel). The 3-2-1 is the most commonly used configuration for calculation of a proxy margin, using any selection of spot prices for crude and refined product quoted on Bloomberg, Reuters, or Platts (see Appendix for tickers and data resources). A 3-2-1 proxy refining margin calculation would look like this:
Oil price = $40/bbl Gasoline spot price = $1.27/gal Heating oil spot price = $1.05/gal Refining Margin = ([$1.27 x 28 gallons]+[$1.05 x 14 gallons]) - $40/bbl = $10.26/bbl
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Leverage to Refining Margins Refiners earnings are highly sensitive to changes in refining margins. We calculate a companys leverage to a $1.00/bbl change in the refining margin by taking the total number of barrels refined in a year, multiplying it by one minus the tax rate, and dividing it by the number of shares outstanding. Earnings can swing widely, depending on refining margins. For the integrated oils, the overall leverage is diluted by the large upstream operations, which serve as a natural hedge. For the independent refiners, the exposure is far greater. For instance, the capacity of the average-size refinery in the U.S. is 105,000 b/d, or 38.3 million barrels per year. A $1.00/bbl change in refining margins affects the pretax operating profit of the average refinery by $38.3 million per year. Most independent refiners have more than 105,000 b/d of refining capacity, and lately, movements in refining margins have been far greater than $1.00/bbl. Exhibit 25 below shows the impact on earnings per share of a $1.00/bbl change in refining margins for the independent refiners and major oils under our coverage.
Exhibit 25. Oil Company Earnings Leverage to Changes in Refining Margins
2008E Operating EPS Sunoco Tesoro Corp. Valero Energy Corp. Western Refining Frontier Oil Corp. Marathon Oil Royal Dutch Shell Murphy Oil Exxon Mobil Hess Corporation ConocoPhilips TOTAL S.A. BP Chevron Weighted Average $5.10 4.75 4.50 1.65 1.85 8.50 5.60 4.45 4.90 5.35 7.40 5.95 5.35 6.60 2008E Refining Runs (Bbls/share) 2.9 2.9 2.0 0.7 0.6 1.1 0.5 0.4 0.4 0.3 0.5 0.4 0.3 0.4 Estimate $ Change in 2008E EPS per $1/Barrel Change in Refining Margins $1.91 1.76 1.36 0.43 0.38 0.68 0.29 0.22 0.23 0.22 0.30 0.23 0.18 0.19 % Change in 2008E EPS 37.5% 37.1 30.1 25.8 20.3 8.0 5.2 4.9 4.6 4.1 4.1 3.9 3.4 2.9 5.2%
Regional Proxy Refining Margins The nation is divided into refining centers by Petroleum Administration for Defense Districts (PADDs) (see Exhibit 26). PADDs were created during World War II to facilitate oil allocation.
Exhibit 26. Petroleum Administration for Defense Districts
Each PADD has characteristics that are unique to the markets they serve. For this reason, refining margins may also vary by PADD. Therefore, proxy margins are typically calculated by region in order to assess the environment and best estimate of refiners profitability. Below, we summarize key characteristics by PADD. PADD 1 (East Coast). Approximately 10% of the nations refining capacity is located in PADD 1, although the region accounts for a higher proportion of product demand. We estimate that 35%-40% of the nations gasoline is consumed in PADD 1, and that 85%-90% of heating oil is used in New England and the Mid-Atlantic region. PADD 1 is well connected to the Gulf Coast by pipeline. Also, the East Coast is the primary destination of exports from Europe, and a popular destination from Asia. PADD 2 (Midwest). The Midwest region is home to approximately 20% of the nations total refining capacity. The region is product short, and reliant upon the Gulf Coast to make up the shortfall, particularly for gasoline. However, recently, cities and states in the Midwest have designated specific standards for gasoline in certain markets in the Midwest. Known as boutique fuels, this has created a challenge for suppliers outside of these regions. As a result, supply has tightened in the last two to three years, and product prices have become more volatile. PADD 3 (Gulf Coast). The largest and most competitive refining center, this region accounts for almost one-half of the nations refining capacity. Refineries on the Gulf Coast are larger than the nationwide average, and most are sophisticated. The Gulf Coast is a destination for refined product exports from Asia and Europe. Thanks to an extensive pipeline system, Gulf Coast refineries can supply most markets east of the Rockies. PADD 5 (West Coast). Almost 20% of the nations refining capacity is located on the West Coast, the majority of which is in California. The West Coast is known as an isolated market for several reasons. First, it was not connected to any other refining area in the U.S. by pipeline until recently. In late 2004, the
BEAR, STEARNS & CO. INC. Page 55
Longhorn pipeline was completed, which transports fuel from the Gulf Coast to the Southwestern United States. This pipeline should shift supply manufactured in the Southwestern U.S. to Southern California; however, the full impact of this pipeline remains to be seen. Second, stringent standards for gasoline in California, set forth by the California Air Resources Board (CARB), make it more difficult and costly to manufacture gasoline for California, and fuels from other parts of the country cannot be used there. As a result, gasoline in California typically commands a higher price and refiners there enjoy higher margins than other areas of the country. While the market is self-sufficient, the supply/demand balance is quite delicate. Unplanned refinery outages can cause large swings in product prices. PADD 4 (Rocky Mountains). This area accounts for only 3% of the countrys refining capacity. The refineries here are small, at an average of 35,000 b/d, and serve local markets. Benchmark margins are harder to find for these markets given their small size and isolation. In general, refining margins here are above the nationwide average, and somewhat less volatile.
REFINERY COMPLEXITY
All Refineries Are Not Alike In the U.S., there are approximately 132 operating refineries. Product yields from these plants can vary significantly, depending on their configuration, and complexity. More complex refineries are typically able to produce higher yields of gasoline and middle distillate than simple refineries. In addition, complex refineries can process cheaper, lower grades of crude oil, which can enhance the plants margins. Units needed to produce higher yields of gasoline or process cheaper grades of crude oil include hydrocrackers and cokers, and can cost $10,000-$20,000 per barrel of daily refining capacity. However, upgrading projects can pay off quickly, depending on refined product price spreads and light/heavy price differentials on crude oil. Refineries in the U.S. are among the worlds most complex, particularly those on the Gulf Coast and on the West Coast, where refiners have access to a variety of low-quality crudes. The industry uses two measures to rate the complexity of a refinery, with a higher number indicating higher complexity. Nelson Complexity Rating. The Nelson Complexity Rating (NCR) is a measure of secondary conversion capacity in comparison to the primary distillation capacity of any refinery. It is an indicator of not only the investment intensity or cost index of the refinery, but also the value-added potential of a refinery. The index was developed by Wilbur L. Nelson in 1960 to originally quantify the relative costs and throughput of the components that constitute the refinery. Mr. Nelson assigned a factor of one to the primary distillation unit. All other units are rated in terms of their costs relative to the primary distillation unit, also known as the atmospheric distillation unit. The average NCR for refineries in the U.S. is approximately 9.5.
Solomon Complexity. The Solomon Complexity rating was developed in a proprietary survey produced by Solomon Associates, Inc. It is an industry measure of a refinerys ability to produce higher-value products from a lowervalue feedstock, with a higher rating indicating a greater capability to produce such products from such feedstocks. The average Solomon Complexity rating of a U.S. refinery is 14.0.
LIGHT/HEAVY SPREADS AND PRODUCT YIELDS
Realized Refining Margins and Refinery Configuration Sophisticated refineries have the capability to process lower-quality crudes due to the hardware configuration of the plant. Typically, these refiners can realize a higher refining margin because of the discounted price of lower-quality crudes to light, sweet crudes. Crude density is commonly measured by API gravity and classified as light (API of 31 degrees or higher), medium (API between 22 and 31 degrees), or heavy (API of 22 degrees or less). The higher the API number, the lighter the crude. Sulfur content is also a characteristic of crude oil. The higher the sulfur content, the more sour it is and the more processing is needed to meet regulatory specifications. Generally, sulfur content that is less than 0.5% is considered sweet, and sulfur content that is greater than 0.5% is considered sour. West Texas Intermediate is the U.S. industry benchmark crude oil with an API gravity of 40 degrees and sulfur content of 0.3%. Examples of lower-quality crude oils are illustrated in Exhibit 27.
Exhibit 27. Types of Lower-Quality Crude Oils
Name of Crude Oil Maya (Mexico) Arab Heavy (Saudi Arabia) Canadian Bow River (Canada) West Texas Sour (U.S.)
Source: Platts; Bloomberg.
API Gravity 22 degrees 27 degrees 25.7 degrees 33 degrees
Sulfur Content 3.30% 2.80% 2.10% 1.60%
Characteristics Used by many Gulf Coast refiners Used by many Gulf Coast and Midwest refiners Used by many Midwest and Rocky Mountain refiners Used by many Gulf Coast refiners
Product yields also are affected by refinery configurations. The most efficient plants produce roughly 75%-80% gasoline, gasoline blendstocks, and distillate products (such as diesel fuel, heating oil, and jet fuel). Less-efficient plants produce a higher quantity (more than 25%) of lower-valued by-products such as petrochemicals, lubes, asphalts, petroleum coke, and residual fuel oil (typically used as industrial boiler fuel). Refining margins at complex refineries will be higher than the proxy margins for the refining district, because most conventional spread calculations assume WTI, a light, sweet crude, as the feedstock. The amount by which the margin is above the proxy will vary, depending on the light/heavy spread and refinery yield. In contrast, margins at refineries with a sweet crude slate that produce mostly middle of the barrel products will approximate the proxy margins. For example, Exhibit 28 shows fourth-quarter 2004 results for two U.S. refineries owned by Premcor Inc. (now part of Valero) in the United States. The Port Arthur, Texas, refinery has a coker, allowing it to use heavy Maya crude as 80% of its crude feedstock slate. Lima is a Midwestern refinery (Ohio), which processes primarily sweet crude. Our fourthquarter 2004 proxy margins for the Gulf Coast and Midwest were $5.51/bbl and $4.73/bbl, respectively.
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Exhibit 28. Operating Results at Valero Refineries (in millions b/d)

Port Arthur Throughput (mb/d) Gross Margin ($/bbl) Operating Expense ($ in millions) Operating Expense ($/bbl) Operating Profit ($ in millions) Operating Profit ($/bbl)
Source: Valero company reports.
4Q04 257.5 15.28 96 4.05 265.98 11.23
Lima Throughput (mb/d) Gross Margin ($/bbl) Operating Expense ($ in millions) Operating Expense ($/bbl) Operating Profit ($ in millions) Operating Profit ($/bbl)
4Q04 147.9 5.02 38.3 2.81 30.01 2.21
Exhibit 29 shows average spreads between light (WTI) and lower-quality crude oils.
Exhibit 29. Average Spreads Between WTI and Lower-Quality Crude Oils
WTI/WTS WTI/Arab Heavy WTI/ Lloydminster WTI/Maya WTI/Bow River
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average 1996-2006
Source: Platts; Global Insights.
1.23 1.68 1.55 1.30 2.16 2.81 1.38 2.71 3.93 4.65 5.14 2.59
3.98 3.41 3.49 2.88 5.17 3.99 2.69 4.58 9.96 10.35 9.25 5.43
0.43 3.56 3.50 -0.95 -3.96 1.80 3.25 8.92 13.83 21.67 22.41 8.03
4.80 5.66 5.68 4.78 7.49 8.68 5.21 6.81 11.33 15.61 14.82 8.37
3.90 5.47 4.74 3.51 7.06 9.95 6.06 8.14 12.83 15.50 12.00 8.11
Heavy or sour crudes require more processing than light, sweet crude oil. Therefore, operating costs at the more complex refineries can be high. We estimate most complex refineries in the U.S. have operating costs that are $1.50/bbl above the average sweet crude refinery. When light/heavy spreads are wide, complex refineries may have a significant price advantage over sweet crude refiners. However, when light/heavy spreads are narrow, the price advantage can be diminished, or mitigated completely, by higher operating costs. Exhibit 30 shows the leverage to the heavysour crude oil spread for the independent refiners.
Exhibit 30. Heavy-Sour Crude Oil Leverage
Heavy-Sour Crude as a Pecent of Total Feedstock Slate Frontier Valero Tesoro Sunoco Western 69% 55% 11% 9% 10% Heavy-Sour Crude Leverage Impact on EPS to $1/bbl Change in the Light/Heavy-Sour Spread $0.24 $0.72 $0.20 $0.16 $0.04 % Change to 2007 EPS Estimates 13.6% 11.7% 2.9% 2.2% 2.4%
OPERATING COSTS
Operating costs vary by refinery. However, a high percentage of a refiners operating costs are fixed. Energy costs represent the largest portion of operating costs at midcycle conditions (see Exhibit 31). These costs are also the most variable, due to swings in crude oil, electricity, and natural gas prices.
Exhibit 31. Components of Operating Costs Energy Employee Labor Maintenance and Repair Other
Source: Bear, Stearns & Co. Inc. estimates.
40%-50% 35%-40% 10%-15% 5%-10%
Because of the high ratio of fixed costs, the best way to minimize per-barrel operating costs is to use the plants capacity efficiently and avoid unplanned disruptions in operations. The independent refiners refinery utilization rate is near 100%.
PLANT RELIABILITY
Refineries run 24 hours a day, 365 days a year. Generally, refineries need to undergo extensive plant-wide maintenance lasting for approximately 30 days once every four years, although the work on particular units within the refinery may be staggered so that parts of the plant are running at all times. Planned maintenance can be managed to minimize revenue losses by building inventories and by refining around units that are down. However, excessive plant maintenance or unplanned outages in a refinerys operations result in lost income. This can meaningfully impact a companys financial results, particularly smaller companies with relatively low throughput levels. For example, a company with refining capacity of 200,000 b/d might earn net income of $150 million at mid-cycle conditions. A 10,000 b/d (5%) reduction in throughput would reduce this refiners net income by an estimated 6%. As with most businesses, excessive financing and overhead costs can erode profit margins and are more of a concern for smaller refining companies, which cannot allocate these overhead costs across extensive refinery systems. For example, in 2004, the percentage of financing and overhead costs to operating profit ranged from a high of 34% for Frontier Oil, a two-refinery company, to a low of 17% for Sunoco, the second-largest independent refiner. Given the strong refining margins for the industry in 2004-06, financing costs have fallen dramatically as companies have paid down debt with free cash flow. In 2003, financing and overhead costs for the group accounted for approximately 52% of operating profits; however, they declined to 15.7% of operating profit in 2006. When refining margins are low, high financing and overhead costs can cause refiners earnings to fall below breakeven. Depending on the efficiency of the company and the plants, earnings breakeven margins requirements will vary by company, with low-cost operators faring better than less efficiently run companies.
FINANCING AND OVERHEAD COSTS
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Tracking Industry Fundamentals

Refining is a cyclical and sometimes volatile business. Because refiners profitability is so dependent upon refining margins, the key to investing in an independent refining company is determining the direction, magnitude, and sustainability of moves in margins. The following factors influence refining margins: crude and product inventory levels; refinery utilization rate; product imports; refined product demand outlook; feedstock costs and product prices; light/heavy spreads; and environmental regulation. It is important to monitor inventory levels, refinery utilization, import levels, and refined product demand in order to assess the health and status of the refining industry (see Exhibit 32). Examining these data points in relationship to one another may help to determine sustainable trends in refining margins.
Exhibit 32. Bullish/Bearish Indicators Bullish Refining Indicators Low/Declining Inventories and High Refinery Utilization Average/Below-Average Imports Wide Light/Heavy Spreads Gradually Declining Crude Prices Robust Worldwide Economies Strong U.S. GDP Strong Refined Product Demand
Source: Bear, Stearns & Co. Inc.
Bearish Refining Indicators High/Rising Inventories and Low Refinery Utilization High Imports Narrow Light/Heavy Spreads Rising Crude Prices Sluggish Worldwide Economies Falling U.S. GDP Weak Refined Product Demand
INTERPRETING DOE INVENTORY REPORTS
In general, product prices are inversely correlated to changes in inventory levels (see Exhibit 33). Inventory levels are influenced by a variety of factors, including demand, refinery utilization rates, and imports.
Exhibit 33. Gasoline Prices Versus Gasoline Inventories

230.00 180.00 130.00 80.00 30.00
1/6/1995 8/18/1995 3/29/1996 11/8/1996 6/20/1997 1/30/1998 9/11/1998 4/23/1999 12/3/1999 7/14/2000 2/23/2001 10/5/2001 5/17/2002 12/27/2002 8/8/2003 3/19/2004 10/29/2004 6/10/2005 1/20/2006 9/1/2006
230,000 220,000 210,000 200,000 190,000 180,000
Gasoline Price
Gasoline Inventories
Source: Platts; Global Insights; U.S. Energy Information Administration.
U.S. data on crude and product inventories are the most accurate and timely in the world. Figures are reported on a weekly basis (Wednesdays at 10:30 a.m., Eastern Time) by both the Department of Energy and the American Petroleum Institute. Traders and industry analysts watch the data, as changes in inventories can be a leading indicator of longer-term trends. Bear Stearns analysis also includes a section that excludes movements in PADD 5, because the district is an isolated region where one extra shipment or fewer shipments from Alaska can cause large fluctuations in the inventories. We classify inventory builds and draws for crude oil or refined products in Exhibit 34.
Exhibit 34. Classification of Movements in Inventory Levels Amount of Build/Draw Builds of five million barrels or greater Builds of less than five million barrels but greater than one million Builds or draws of less than one million barrels Draws of less than five million barrels but greater than one million Draws of five million barrels or greater
Classification Bearish Moderately Bearish Neutral Moderately Bullish Bullish
Inventory levels are a good indicator of how supply and demand match up (see Exhibit 35). There tends to be a strong negative correlation between refining margins and inventory levels. When inventories are low, refining margins typically are high. When inventories are high, refining margins are often depressed (see Exhibit 36). However, during the period from 2005 to 2006, this relationship broke down. During this time, there were both high inventory levels and, counterintuitively, high refining margins. We believe higher refining margins were largely driven by nonrecurring supply-side events, including the effects of Hurricanes Katrina and Rita, which shut in approximately 10% of U.S. refining capacity for a prolonged period, as well as the introduction of more stringent fuel regulations, both of which contributed to abnormally high product prices, during this time period.
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Gasoline Inventories (000s bbls)
240,000 Gasoline Price (cents gal)
Exhibit 35. Average Inventory Levels by Year

250
207 219 200 198
210
Inventories (millions bbls)
200 150 100 50 0

1995
125
198
205
209
203
204
208
210
137 105 119
136 108
118
128
116
117
119
132
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Gasoline
Distillate
Exhibit 36. Refining Margins Versus Gasoline Inventory Levels
US Gulf Coast 3-2-1 ($/bbl)
$21.50
235
$16.50
215
$11.50
195
$6.50
175
$1.50
1995 1996 1997 1998 1999 1999 2000 2001 2002 2003 2004 2005 2006
155
USGC 3-2-1
Source: Platts; Global Insights; U.S. Energy Information Administration.
Gasoline Inventory
Typical Inventory Levels Vary by Season Gasoline inventories usually are at their highest in the spring the beginning of the driving season and deplete throughout the year into the following January. Distillate inventories typically reach their highest levels of the year in the fall, as the heating season gets under way, and fall from late January through April (see Exhibit 37).
Gasoline Inventories (million bbls)
Exhibit 37. Gasoline and Distillate Inventories

235 225
Million Barrels
215 205 195 185

Mar 10-Year Range 10-Year Av erage 2006 Jun Sep Dec
Distillate Inventories
160 150 140 Million Barrels 130 120 110 100 90 80 Mar 10-Year Range 10-Year Av erage
Jun
Sep
Dec
2006
Days Supply of Inventory It is helpful to look at inventory levels in relation to demand. Days supply gives a measure of how many days of inventory are available given current or projected demand. This is calculated by taking the amount of inventories of a particular product and dividing it by the daily demand for that product. Exhibit 38 shows inventories on a days supply basis for gasoline and distillate.
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Exhibit 38. Gasoline and Distillate Inventories on a Days Supply Basis

28
38 36
Days of Supply of Gasoline
Days of Supply of Distillate
26
34 32 30 28 26 24 22
24
22
20
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.
2003 2004 2005 2006
20
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.
2003 2004 2005 2006
REFINERY UTILIZATION
Refinery utilization is refinery throughput (barrel of oil input into the distillation unit) expressed as a percentage of the nations operable refining capacity (utilization = throughput divided by 17.4 million b/d of operable refining capacity for the U.S., according to the U.S. Energy Information Administration). Typically, the industry runs at a utilization rate of 90%-95%, depending on the season (see Exhibit 39). The highest run rates are seen during the spring and summer, when gasoline demand is strongest. An unplanned refinery outage or planned maintenance work decreases the refinery utilization rate because the DOE and API do not adjust available capacity for maintenance downtime. So, for example, in September 2005, when Hurricanes Katrina and Rita hit the Gulf Coast and reduced refinery operations, utilization rates temporarily plummeted. Another situation that may cause refinery utilization rates to decline is voluntarily run cuts when refining margins are weak. Likewise, strong refining margins usually prompt higher utilization rates. Refinery utilization rates are an important indicator of the health of the industry. Low refining margins coupled with low refinery utilization rates is a signal that supplies are plentiful, relative to demand. High utilization rates typically mean high margins. If fundamental industry conditions are supportive, margins can be sustained for several months, until the supply response balances the market.
Exhibit 39. U.S. Refinery Utilization

100 95 % Operated 90 85 80 75 70
Ju n S ep t D ec M ar
2005 Hurricanes:
10-Year Range 2006 2007
10-Year Average
Contrary to popular belief, utilization in the U.S. has not changed much despite rising demand and refinery closures (see Exhibit 40). One would expect utilization to be at historical high levels, but utilization has dropped off since the late 1990s. This is largely because of capacity creep and rising imports. The term capacity creep refers to capacity expansions through de-bottlenecking investments that effectively create additional refining capacity from the same physical structure. While difficult to measure, because investments may be small and unpublicized, we estimate that capacity creep averages approximately 1%-2% of total domestic capacity annually. As a result, despite a lack of new refineries and refinery closures over the last ten years that shut down approximately 700,000 b/d of capacity, overall domestic refining capacity has grown at an average rate of 0.7% per year through capacity creep and expansion projects. An increasing supply of imports have also kept utilization rates below their peak in 1998 (see Exhibit 43 on page 67). Since 1995, gasoline imports in the U.S. have more than tripled, to approximately one million b/d. Today, gasoline imports account for an estimated 10% of U.S. gasoline supplies versus 4% in 1995.
Exhibit 40. U.S. Refinery Utilization by Year
96.0 95.0 94.0 93.0 92.0 91.0 90.0 89.0 88.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
% Operated
U.S. Refinery Utilization

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The spread between light/heavy crude oil prices also can affect utilization. Typically, when light/heavy crude oil differentials widen, the spread between gasoline and residual fuel prices widens as well. Complex refiners usually run their units at as close to full as they can, given superior product yield and margins. Simple refineries represent marginal supply in the industry. These less-sophisticated refineries produce a higher proportion of bottom, or residual, fuels. These by-products are often sold at a loss. When light/heavy spreads are wide, losses on residual fuel production are steeper, prompting the simple refineries to reduce runs. When light/heavy spreads narrow, the loss on residual fuel sales usually declines, eventually by enough to restore profitability on the entire refined barrel for unsophisticated refiners. Occasionally, residual fuel prices are higher than crude oil feedstock costs. As profitability improves for the simple refinery, runs are increased. This can lead to a confusing picture industry utilization may increase sharply as light/heavy spreads narrow and crack spreads fall. It can look like the industry is increasing supply the more margins weaken. Such was the case in 1998. As oil prices plummeted (light/heavy margins also fell), refinery utilization climbed, and crack spreads fell sharply. By looking only at crack spreads (the industry barometer for profitability), we can miss the key factor that changes marginal production the spread between residual and crude oil prices.
PRODUCT IMPORTS
The refining business is increasingly becoming a global business. While no new refineries have been built in the U.S. for more than 30 years, several large units have been built around the world, primarily in Asia, representing several million barrels of refining capacity. Exhibit 41 shows worldwide utilization rates. Although the trend appears to show utilization rates increasing, approximately 15% excess capacity exists.
Exhibit 41. Worldwide Refinery Utilization
87.0% 86.0% % Operated 85.0% 84.0% 83.0% 82.0% 81.0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Worldwide Utilization
Source: BP Statistical Review of World Energy, June 2005; Purvin & Gertz; Oil & Gas Journal (for 2006).
No market is truly isolated when it comes to refined products. The unique CARB gasoline formulations, required to be sold in California, are made in the Caribbean, U.S. Gulf Coast, Europe, and Asia. Stronger product prices in any given part of the world attract imports from other regions. Refiners in Europe and Asia will take advantage of opportunities to sell refined products in the U.S. when the pricing is attractive.
Exhibit 42. Gasoline Imports and Import Margin

1800 25 20 15 1400 1200 1000 800 600 (15) 400 200 1/1/1999 9/7/2001 8/8/2003 7/8/2005 9/13/1996 1/31/1997 6/20/1997 11/7/1997 3/27/1998 8/14/1998 5/21/1999 10/8/1999 2/25/2000 7/14/2000 12/1/2000 4/20/2001 1/25/2002 6/14/2002 11/1/2002 3/21/2003 5/14/2004 10/1/2004 2/18/2005 12/26/2003 11/25/2005 4/14/2006 9/1/2006 (20) (25)
Weekly Imports (000 b/d) - 4-Week Lag
1600
5 0 (5) (10)
Gasoline Imports
Import Margin
Recently, gasoline prices in the U.S. compared to other regions have been high. Exhibit 42 above shows the import margin for gasoline to New York from Northwest Europe. The import margin is the difference in pricing for gasoline in New York Harbor and Rotterdam, adjusted for transportation costs. For most of the last several years, the margin has been positive, providing incentive for refiners to send product to the United States. Typically, imports rise when the margin is high. In addition, European demand for transportation fuels has been shifting away from gasoline toward diesel fuel due to the more desirable economics, freeing up supply of gasoline for export. As Exhibit 43 shows, gasoline and distillate imports in the U.S. have been rising.
Exhibit 43. Gasoline and Distillate Imports
700 600
Thousands b/d
500 400 300 200 100 0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Gasoline Imports Distillate Imports
Source: Global Insights; Platts; U.S. Energy Information Administration.
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Import Margin (cpg)
10
GASOLINE DEMAND
Demand for gasoline in the U.S. has grown at an average annual average rate of 1.5% over the past 20 years. The range for the year-over-year rate of change in demand is a high of 3.0% in 1986 to a low of negative 1.3% in 1990. Demand for gasoline is influenced by a variety of factors, including the strength of the economy and gasoline prices. Demographic trends and fuel efficiency initiatives also affect demand. In 2003 and 2004, a strong economy and the prevalence of SUVs boosted gasoline demand. However, recent high prices appear to have dampened gasoline demand, which is seasonal, peaking in July or August. January is typically the month in which demand is lowest (see Exhibit 44). Swings in gasoline demand can have a meaningful effect on the supply/demand balance for refined products. For instance, in the first half of 2004, demand rose by 2.4% year over year, but slowed to just 0.6% growth in the second half. In that time, gasoline inventories went from being 600,000 barrels below the ten-year average at the beginning of 2004 to being 12 million barrels above the ten-year average at the end of the year.
Exhibit 44. U.S. Gasoline Demand by Month
10,000
Demand (000s b/d)
9,500 9,000 8,500 8,000 7,500 7,000 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
There is a correlation between gasoline demand and GDP growth, but the relationship is circular (see Exhibit 45). A strong economy stimulates demand. In the last 20 years, each time real GDP grew by 4% or more, gasoline demand grew on average 2.0%, above the average annual growth rate of 1.5%. Strong demand can deplete inventories and boost prices. Inventory levels were below average in both 2003 and 2004, resulting in high gasoline prices, often in excess of $2.00 per gallon. In turn, high fuel prices dampen the economy by reducing consumers disposable income, and increasing costs for businesses (see our discussion on price elasticity below).
Exhibit 45. U.S. GDP Versus Gasoline Demand
7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0%
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Percentage Change
Gasoline Demand
Source: U.S. Bureau of Economic Analysis; U.S. Energy Information Administration.
Real GDP
Gasoline demands price elasticity is relatively low, except when prices reach high levels. Exactly how high the levels must be to dampen demand came into question in 2006, when gasoline prices topped $3.00 per gallon. Historically, we have observed that seasonally adjusted gasoline demand has fallen from the previous month 65% of the time that prices rise above $1.60 per gallon (see Exhibit 46). However, since September 2004, the markets response to this level of gasoline price seems to have changed. We believe consumers may become used to a higher price level after experiencing it for several months. The price trigger for demand deterioration likely has increased. Today, gasoline prices below $2.25 per gallon seem like a bargain. The new trigger point may be higher than $2.25 per gallon. However, we believe that at some price level, demand should soften as consumers alter their driving patterns. Indeed, structural changes are under way in response to high gasoline prices that may alter demand. For example, sales of SUVs in the U.S. have fallen while hybrids and other fuel-efficient cars gain in popularity, and the use of alternative fuels has increased.
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Exhibit 46. Demand Elasticity Results

All Months When Retail Prices Were Above $1.60 per Gallon Jun-00 Jul-00 May-01 Jun-01 Feb-03 Mar-03 Aug-03 Sep-03 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Dec-06 Monthly Retail Price per Gallon $1.63 1.55 1.70 1.62 1.61 1.69 1.62 1.68 1.65 1.74 1.80 1.98 1.97 1.91 1.88 1.87 2.00 1.98 1.84 1.83 1.91 2.08 2.24 2.16 2.16 2.29 2.49 2.90 2.72 2.26 2.19 2.32 2.28 2.43 2.74 2.91 2.89 2.98 2.95 2.56 2.25 2.23 Seasonally Adjusted Demand (Thousand b/d) 8497 8292 8526 8368 8947 8760 8978 8992 9176 9086 9090 8988 8885 8867 8818 9097 9075 9136 9149 9524 9233 9252 9154 9067 9034 9062 9015 8964 8986 9146 9176 9473 9274 9297 9164 9120 9091 9188 9140 9292 9259 9331 Percent Change in Demand from Previous Month 0.2% -2.4% -0.8% -1.9% -2.0% -2.1% 1.8% 0.2% -2.6% -1.0% 0.0% -1.1% -1.1% -0.2% -0.6% 3.2% -0.2% 0.7% 0.1% 4.1% -3.1% 0.2% -1.1% -1.0% -0.4% 0.3% -0.5% -0.6% 0.2% 1.8% 0.3% 3.2% -2.1% 0.2% -1.4% -0.5% -0.3% 1.1% -0.5% 1.7% -0.4% 0.8%
Source: Global Insights; Platts; U.S. Energy Information Administration.
DISTILLATE DEMAND
U.S. distillate demand has risen by an average of 2% over the last 20 years. Changes in year-over-year demand have been more volatile than demand for gasoline, primarily due to swings in weather-driven consumption of heating oil. The yearover-year change in demand has ranged from a high of 4.9% in 1988 and 1996 to a low of negative 4.3% in 1990. Distillate demand, which represents consumption of heating oil and diesel fuel, is driven by weather and the strength of the economy particularly the manufacturing sector, which influences trucking activity (see Exhibit 47). While weather is unpredictable, trucking activity can be measured by manufacturers shipments measured by the U.S. Census Bureau, given that trucks haul approximately twothirds of tonnage carried by all modes of domestic freight transportation.
Exhibit 47. Manufacturers Shipments Versus Distillate and Implied Diesel Demand
7.5% 5.5%
Percentage Change
3.5% 1.5% -0.5% -2.5% -4.5%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Manufacturers' Shipments
Distillate Demand
Diesel
Source: Haver Analytics; U.S. Census Bureau.
On average, diesel fuel accounts for roughly two-thirds of annual distillate demand, and consumption does not vary by season. Heating oil is the more volatile, seasonal component of distillate. Typically, distillate demand peaks in January. The lowestdemand period for distillate is during the summer months (see Exhibit 48).
Exhibit 48. Distillate Demand by Month
Demand (000's bbls)
4,500 4,000 3,500 3,000 2,500

Ja n95 Ja n96 Ja n97 Ja n98 Ja n99 Ja n00 Ja n01 Ja n02 Ja n03 Ja n04 Ja n05 Ja n06
CRUDE AND PRODUCT PRICES VS. REFINING MARGINS
There is a misperception that refining margins move with oil prices. Crude feedstock costs often influence product prices directionally. However, the relationship between oil prices and refining margins is less stable. In the past five years, the R-squared for WTI spot crude oil prices and Gulf Coast refining margins is 0.49 (see Exhibit 49). The driving factors for prices and margins are supply, demand, and inventory movements for crude oil versus those for each refined product. Understanding what may move oil prices is only one step in projecting refining margins.
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Exhibit 49. Crude Oil Prices Versus Refining Margins

85 75 WTI Spot Price ($/bbl) 65 55 45 35 25 15
2000 2001 2002 2003 2004 2004 2005 WTI Spot Price
Source: Global Insights; Platts.
27 22 17 12 7 2
2006 Gulf Coast Refining Margins
FORECASTING LIGHT/HEAVY SPREADS
We find that the most important driver to changes in light/heavy spreads is OPEC production levels. The reason for this is that OPEC seeks to maximize the value of its unit production. As the swing producer, when OPEC cuts production, it typically reduces output of lower-value, poorer-quality crudes. Reduced supply of this oil raises its price relative to light, sweet crude, thereby narrowing the spread. When OPEC expands production, it puts the oil that it had taken off-line back onto the market, thereby increasing the supply of heavy oil and widening the light/heavy spread (see Exhibit 50).
Exhibit 50. Light/Heavy Spreads Versus OPEC Production
20 18 16 14 12 29,000 $/bbl 10 28,000 8 6 4 2 0 12/1/1998 12/1/1999 12/1/2000 12/1/2001 12/1/2002 12/1/2003 12/1/2004 12/1/2005 12/1/2006 3/1/1999 6/1/1999 9/1/1999 3/1/2000 6/1/2000 9/1/2000 3/1/2001 6/1/2001 9/1/2001 3/1/2002 6/1/2002 9/1/2002 3/1/2003 6/1/2003 9/1/2003 3/1/2004 6/1/2004 9/1/2004 3/1/2005 6/1/2005 9/1/2005 3/1/2006 6/1/2006 9/1/2006 27,000 26,000 25,000 24,000 OPEC Production WTI-Arab Heavy 33,000 32,000 31,000 30,000 b/d in thousands
Source: Global Insights; Platts.
Gulf Coast Refining Margin ($/bbl)
ENVIRONMENTAL REGULATIONS
In 2004-06, new regulations associated with the Clean Air Act required refiners to reduce sulfur content in gasoline to 30 parts per million (ppm), and in diesel fuel to 15 ppm (see Exhibit 51). We estimate the costs to refiners was approximately $1,000 per barrel of daily refining capacity. Small refineries, particularly in the Midwest and Rocky Mountain states, where average sulfur content is higher than the national average, were facing the highest unit costs for compliance. For this reason, many were granted waivers that allow them to defer full compliance until 2010. One challenge refiners have faced with ultra-low-sulfur diesel regulations (aside from sulfur removal) is to accommodate downstream contamination and volume loss due to reprocessing. According to the regulations, ultra-low-sulfur diesel can be no more than 15 ppm at the time it is sold at the pump. To get to the pump, various refined products travel through the same pipeline at different times. As a product runs through a pipeline, it can pick up sulfur from other refined products that have passed through the pipeline before it. As a result, the ultra-low-sulfur diesel that leaves the refinery gate must be lower than 15 ppm (mostly 7 ppm-10 ppm) to offset any stray sulfur that may be captured in the pipeline. Any amount of ultra-low-sulfur diesel that is contaminated above 15 ppm will be sent back to the refinery for additional processing.
Exhibit 51. Low Sulfur Requirements for Gasoline and Diesel by Year
600
Sulfur Content (PPM)
500 400 300 200 100 0 300
500
500
500
120
90
30 15 2006 Diesel
30 15 Beyond
2003
2004 Gasoline
2005
Source: U.S. Environmental Protection Agency.
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Investing in Refining Stocks

Important points for investing in refining stocks: Refining is a highly cyclical and sometimes volatile business. In our view, refining is the most difficult sector in energy to forecast accurately. Refiners stock prices move with margins, and a good indicator of the direction in margins is inventory levels. There is no seasonality to refining stock prices. Refinery acquisitions are part of most refiners growth strategy. Historical valuation averages for the refiners: 5.5x-7.0x enterprise value to EBITDA; 8.0x-14.0x P/E; and 4.5x-7.5x price to cash flow. Multiples tend to compress at the top of a refining cycle and to expand at the trough. The company valuation analysis can be found in Section 3 of this report. At the end of this section, under the headline, Pointers and Rules of Thumb, we have provided tips on modeling and other helpful exercises.
INVESTING IN REFINERS
The earnings of independent refiners are highly sensitive to changes in refining margins. We calculate that each $1.00/bbl change in the refining margin affects earnings for the five independent refiners under our coverage (Frontier Oil, Sunoco Inc., Tesoro Petroleum Corp., Valero, and Western Refining) by $1.17, or 25% of our 2008 estimates (see Exhibit 25 on page 54). As a result of this high operating leverage, refining stocks generally outperform the market when margins move above mid-cycle levels, and underperform when they move below mid-cycle levels (see Exhibit 52). The exception to this would appear to be 2006, when average refining margins were above normal, but the performance of the BSC Refining Index was below that of the S&P 500. In 2006, refining margins were strongest in the first half of the year, and then came down sharply in the second half of the year, causing the stock prices to fall sharply as well. As of midyear 2006, the BSC Refining index was up 23.4%, compared to S&P 500 performance of 2%. In a volatile margin environment such as 2006, trading in refining stocks is shortterm-oriented.
Exhibit 52. Performance of the S&P 500, Bear Stearns Refining Index, and Refining Margins
130.0% 110.0% 90.0% Rate of Return 70.0% 50.0% 30.0% 10.0% -10.0% -30.0%
06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 98 19 97 19
12
SPX
Bear Stearns Refining Index
Nationwide Avg. Refining Margins
Source: Global Insights; Platts; Bloomberg; Bear, Stearns & Co. Inc. Refining Index.
Refining margins and refining stocks are cyclical and can be highly volatile. However, the length of cycles are difficult to predict. As we have written in the previous pages, a host of factors can influence the margin from supply and demand for crude oil to supply and demand for each refined product. How these market forces occur and interact makes forecasting refining margins difficult. While not always 100% accurate, significant inventory draws and builds are good indicators of a turn in the cycle (see Exhibit 53).
Exhibit 53. Gulf Coast Refining Margin and Nationwide Gasoline Inventories
230 225 Gasoline Inventories (million bbls) 220 215 210 205 200 195 190
19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06
11 10 9 8 7 6 5 4 3 2 Gulf Coast Refining Margin ($/bbl)
Source: Platts; Global Insights; Energy Information Administration.
Gulf Coast Refining Margins
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Margin ($ / bbl)
In the last two years, the industry has enjoyed a period of exceptionally high margins, due to strong demand (particularly for distillates), refinery downtime in 2005, and speculation about supply outages driven, in part, by stringent environmental regulations and high worldwide capacity utilization.
NO SEASONAL TRADE IN REFINING STOCKS
One common misconception is that refining stocks generally rise through the winter and fall in the summer. We have found no consistent performance related to seasonality. Exhibit 54 shows the quarterly performance of the Bear Stearns Refining Index relative to the S&P 500. The first and fourth quarters of every year, often thought of as the time to own refining stocks, are reflected with white bars, and the second and third quarters are reflected with black bars. If refining stocks outperformed the S&P every winter, then there should be a pattern of white bars being positive and black bars being negative or, at least, the white bars should consistently outperform the black bars. We do not find such a seasonal pattern. Instead, relative performance has been more consistent with the refining cycle, outperforming on the up-cycle and underperforming on the down-cycle.
Exhibit 54. Relative Performance of Bear Stearns Refining Index to the S&P 500
33.0%
Percentage Change
23.0%
13.0%
3.0%
-7.0%
-17.0%
Oct-06 Jun-06 Feb-06 Oct-05 Jun-05 Feb-05 Oct-04 Jun-04 Feb-04 Oct-03 Jun-03 Feb-03 Oct-02 Jun-02 Feb-02 Oct-01 Jun-01 Feb-01 Oct-00 Jun-00 Feb-00 Oct-99 Jun-99 Feb-99 Oct-98 Jun-98 Feb-98 Oct-97 Jun-97 Feb-97 Oct-96 Jun-96 Feb-96 Oct-95 Jun-95
Black bars: Second and third quarters. White bars: First and fourth quarters.
Source: Bloomberg; Bear, Stearns & Co. Inc. Refining Index.
That said, since the gasoline sulfur rules took effect in 2004, we have noted a sharp uptick in refining margins in the second quarter, which has been accompanied by outperformance by the refining stocks. The rigorous new specs make production of summer-grade gasoline challenging to produce so much so that it cannot be mixed with winter-grade blend. In preparation for production of summer-grade gasoline, refiners rid their storage tanks of winter-grade fuel to rebuild with the summer-grade blend. This causes inventories to decline to low levels in the spring, raising supply concerns. Gasoline prices have risen sharply in the spring to reflect those concerns.
REFINERY ACQUISITIONS ARE PART OF MOST REFINERS GROWTH STRATEGY
Refiners can grow in three ways: 1) build a new refinery, 2) acquire a new refinery, and 3) expand or add new units to existing refineries. The Garyville, Louisiana, refinery (255,000 b/d), built in 1976, was the last refinery built in the United States. New refinery construction has not been undertaken owing to years of poor margins and overcapacity, the high cost of building, long construction lead times, and the difficulties in obtaining permits. Refiners also have been reluctant to build new units because of concerns about obsolescence, given the rapid changes in product specifications and the unpredictability of these changes. A project to build a state-of-the-art, complex refinery in Arizona is under way. Plans are for this 150,000 b/d refinery to process 100% heavy crude oil, and costs are estimated at $2.6 billion ($17,300 per barrel of daily refining capacity). It is still in the permitting phase, and major financing has not been obtained. Completion of this refinery is scheduled for 2011. It remains to be seen whether this project will be successful. It has been cheaper to buy refineries than to build them. This was true even in 200406, when transaction prices rose sharply to reflect exceptionally high refining margins. Exhibit 55 shows refinery purchases over the last five years. Purchase price per barrel of daily refining capacity varies widely for each transaction for two reasons. First, purchase prices for refineries, in general, have risen with robust refining margins. Second, purchase prices reflect the sophistication of the plant. Refineries that produce more gasoline or have heavy crude oil processing capabilities are more valuable because they generate more profit. For example, West Coast refineries are more profitable because they are configured so that they produce a disproportionate amount of gasoline relative to refineries in the rest of the country.
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Exhibit 55. Recent Refinery Purchases

Implied Value per Bbl of Refining Capacity Capacity (b/d) ($/bbl) 172,000 100,000 98,700 110,550 275,000 282,000 360,240 790,000 245,000 180,000 185,000 155,000 150,000 190,000 25,000 62,000 168,000 110,000 115,000 850,000 75,000 130,000 250,000 295,000 160,000 110,000 $8,140 $13,500 $14,184 $18,996 $4,364 $14,681 $10,404 $10,127 $2,510 $4,444 $2,865 $4,548 $1,640 $1,658 $1,000 $2,065 $6,000 $6,036 $2,557 $7,176 $1,333 $6,154 $2,640 $1,424 $5,594 $1,545 $18,996 $5,207 $4,364 $1,000
Date 2/1/2007 1/30/2007 8/28/2006 8/1/2006 11/25/2005 9/12/2005 4/28/2005 4/25/2005 2/4/2004 1/15/2004 6/27/2003 6/3/2003 4/30/2003 3/1/2003 6/3/2002 2/12/2002 2/5/2002 6/2/2001 6/1/2001 5/1/2001 7/31/2000 6/23/2000 6/22/2000 6/1/2000 5/1/2000 11/1/1999
Acquirer Petroplus Tesoro Western Refining Lyondell ConocoPhillips Royal Dutch Shell Marathon Oil Valero Valero Premcor Valero Valero Sunoco Premcor Holly Giant Tesoro Tesoro Valero Valero Tosco UDS Tosco Tosco Valero Frontier
Seller BP: Coryton, UK Royal Dutch Shell: Wilmington, CA Giant Industries Citgo Louis Dreyfus Energy: Wilhelmshaven, Germany Government of Turkey Ashland Premcor El Paso: Aruba refinery Motiva Enterprises: Delaware City, DE Orion refining corp: LA Norco: New Orleans, LA El Paso: Eagle Point, NJ William Cos: Memphis, TN BP: Wood Cross, Utah BP: Yorktown, VA Valero: Golden Eagle, CA BP: Mandan & Salt Lake El Paso: Corpus Christi, TX UDS Irish National Petroleum Avon Refinery Alliance - Belle Chasse Wood River, IL. Benecia, CA El Dorado High Mean Median Low
Transaction Value ($mm) $1,400 $1,900 $1,400 $2,100 $1,200 $4,140 $3,748 $8,000 $615 $800 $530 $705 $246 $315 $25 $128 $1,008 $664 $294 $6,100 $100 $800 $660 $420 $895 $170 $8,000 $1,444 $705 $25
Refiners also look to grow organically through adding new units within the refinery gate or by expanding existing facilities. They can increase overall throughput by expanding crude units; they can produce higher-valued products such as gasoline by adding hydrocrackers; or they can run lower-quality crudes by adding cokers or hydrotreaters. Sometimes capacity can be increased simply by improving efficiencies, such as replacing pipelines inside a refinery complex with largerdiameter pipes. The cost of expansion varies widely depending on the refinery configurations and what projects are undertaken. In general, capacity expansions, or heavy conversion projects, can cost $10,000-$20,000 per barrel of daily refining capacity.
POINTERS AND RULES OF THUMB
In Modeling the Earnings for Independent Refiners, How Do You Derive the Realized Margin Assumption from the Proxy Margin? Refiners actual realized margins relative to proxy margins will vary depending on the configuration and location of the refineries, changes in the product yield, changes in the light/heavy spreads, transportations costs, and other logistical considerations. In modeling a companys earnings, the first thing to do is select the appropriate proxy, which is determined by geographic location, product mix, and feedstock slate. Product prices and feedstock costs can vary by region, so build a proxy based on
prices in that refinerys geographic region. Next, configure the proxy so that it resembles the refinerys product mix. A widely used proxy is the 3-2-1 crack, which calculates a margin based on a refined product yield of two parts (67%) gasoline and one part (33%) distillate. A less-sophisticated refinery on the Gulf Coast may only produce one part (50% gasoline) and one part (50%) distillate. In this case, the appropriate proxy would be the Gulf Coast 2-1-1 crack. The most widely used proxy feedstock is WTI. By using WTI, you get a simple refining margin. If the refinery is sophisticated, you can alter your margin assumption based on the price spread between WTI and the refinerys feedstock slate. Few refineries process 100% of one low-quality crude a mix is brought in, either to optimize the plants hardware and/or based on availability. Based on the proxy margin, circumstances unique to the refinery can be taken into account. For instance, if the refinery is down for maintenance, or if a unit goes down, margin realizations will decline relative to the proxy. If the refinery is far from a crude hub, additional transportation costs will need to be added. The proxy is really just a starting point. An approximate shortcut to all of these adjustments is to select the appropriate proxy margin and calculate the change in the proxy. Oftentimes, the change in the proxy margin will correlate to changes in the refiners realized margins. For example, if the Gulf Coast 3-2-1 increases by 10%, then a refinerys realized margin that resembles a 3-2-1 product mix may increase roughly 10%. A Gulf Coast 3-2-1 is quoted on Bloomberg (see the Appendix for the ticker symbol). How to Model a Refinery Basically, modeling a refinery is volume, margin, and costs. Most independent refiners provide all the data. Below is a sample of a year of operations at Valero Corp. Using the 295,000 b/d Port Arthur refinery as an example, the key drivers of profitability are refining throughput (measured in thousands of barrels per day), gross refining margin (usually modeled in $/bbl), and operating expenses (cost of labor, natural gas used to fire the plant, etc.). Operating expenses can be modeled on either a per-barrel basis, or a gross basis. Both are provided for clarity in the example below.
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Assumptions: Average annual throughput: 295,000 b/d. Realized gross refining margin: $13.25/bbl (average for year) Operating expenses: $4.10/bbl Calculations: Annual Gross Margin: (295,000 b/d x $13.25/bbl x 365 days) = $1.4 billion Annual operating expenses: (295,000 x $4.10/bbl x 365 days) = $441.5 million Operating Income (pretax): ($1.430 billion - $441.5 million) = $988.5 million
Refining margins tend to vary by season, and, consequently, earnings are typically stronger during the summer months, when higher-valued gasoline is in the greatest demand. For a full year, the model might look like the example below, which shows actual refining margins realized by Valero in 2006, on the Gulf Coast.1 Note that operating costs include DD&A expense. Some refiners report cash operating costs and DD&A expense separately.
Exhibit 56. Sample Operating Model 1Q Throughput (000 b/d) Gross refining margin / bbl Operating expense ($ millions) Operating cost per bbl Operating income ($ millions)
2Q 295 $16.00 110.4 $4.11 $319.1
3Q 295 $14.00 110.4 $4.07 $269.6
4Q 295 $11.60 110.4 $4.07 $204.4
Full Year 295 $13.25 441.5 $4.10 $988.1
295 $11.50 110.4 $4.16 $195.0
What Refining Margin Is Reflected in an Individual Companys Consensus Earnings Estimate? We can approximate the refining margin reflected in consensus earnings using the companys sensitivity to a $1.00/bbl change in the refining margin, and our earnings per share estimate based on our margin assumptions. For example, what refining margin is reflected in Valeros stock price? We estimate that every $1.00/bbl change in the refining margin changes Valeros earnings by $1.36 per share (see methodology for this calculation on page 54). Our EPS estimate for 2007, based on our estimate for a consolidated refining margin for the company of $9.25/bbl, is $6.10 per share. Consensus is $7.17 per share. The difference is $1.07 per share, implying a difference of $0.79/bbl in the refining margin assumption
Some numbers have been rounded.
from our estimate of $9.25/bbl. Therefore, consensus estimates reflect a refining margin of approximately $10.04/bbl in 2007. This exercise does not take into account differences in other assumptions, such as retail margins. However, these differences tend to be small.
Valeros sensitivity to a $1.00/bbl change in refining margins = $1.36 per share Our earnings estimate: $6.10 per share; our refining margin assumption: $9.25/bbl Consensus earnings estimate: $7.17 per share Implied refined margin = [($7.17 - $6.10) / $1.36] + $9.25/bbl = $10.04/bbl
What Is a Stocks Upside/Downside if Actual Refining Margins Differ from Consensus? What is Valeros stock price upside if refining margins average $8.00/bbl next year? Following on from the previous example, the implied consensus refining margin assumption for Valero is $10.04/bbl next year. First, we would derive an earnings estimate at $8.00/bbl refining margins. The difference of $2.04/bbl in the refining margin assumption from consensus implies additional earnings downside of $2.77 per share from consensus. Subtracting this from consensus earnings of $7.17 implies earnings of $4.40 per share. At $59, Valero currently trades at 8.2x consensus earnings (or substitute a historical average P/E multiple, if appropriate, as P/E multiples generally do not remain constant if margins swing widely), which, using the same multiple on downside earnings, implies a stock price of $36. Keep in mind that valuation multiples are typically compressed in a high commodity price environment, and vice versa, so if margins average $8.00/bbl next year, the appropriate P/E multiple may be higher.
Valeros sensitivity to a $1.00/bbl change in oil price = $1.36 per share Projected change in refining margins from consensus: $10.04 - $8.00 = $2.04/bbl Estimated earnings impact of refining margin change = $1.36 x $2.04 = $2.77 per share New estimated consensus earnings estimate: $7.17 - $2.77 = $4.40 per share Forward P/E based on old consensus = $59 / $7.17 = 8.2x Implied stock price: 8.2 x $4.40 = $36.08 per share
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Section 3
Page 83
Valuation
Traditionally, investors value oil and independent refining stocks on mid-cycle prices and refining margins. This approach makes sense, given the high volatility in oil and gas prices and refining margins. In our opinion, there is no single valuation measure that is right for oil and independent refining stocks. We see values being determined by a series of factors, which take on increasing or decreasing importance at various times. In theory, the market discounts each companys expected cash flows (DCF). Generally, we find that all valuation parameters are related to DCF. For example, price to earnings (P/E) and price to cash flow (P/CF) are shortcuts to approximate DCF values. Enterprise-value-to-EBITDA (EV/EBITDA) multiples, which have become widely used in recent years, attempt to take into account balance sheet strength or weakness by including debt as part of the valuation. Appraised value estimates, another DCF exercise, attempts to mark assets and liabilities to market. This can be useful in identifying potential takeover situations. We believe history is a good guide for determining multiples that are applicable to individual stocks, although market conditions may influence valuation parameters at any given time. For instance, multiples are typically compressed in a high commodity price environment, and vice versa. However, average multiples over a ten-year period may be a good bellwether for mid-cycle. Alternatively, an investor may look at years in which macro conditions were consistent with current conditions for insight on valuation during periods of high or low commodity prices. Exhibit 57 below, which shows Exxon Mobils trading history, illustrates these points. Our 2007 and 2008 estimates are based on $60/bbl and $50/bbl for WTI, respectively. Note that our projected trading range reflects multiples that are below the 12-year average in 2007, but consistent with mid-cycle in 2008. In 2008, our price projections reflect multiples that are consistent with a declining price environment. Note the multiple expansion that occurred in 1998 and in 2001. Exxon Mobil fares well in a falling price environment, in part, because it is viewed as one of the quality companies, a good investment in a declining commodity price environment. We should note that historically, we have viewed mid-cycle as roughly $22/bbl for WTI. Given the changes that have occurred in the industry in the past two years, we believe that mid-cycle, at least for the intermediate term, is closer to $50/bbl. Hence, our stock price projections are consistent with historical mid-cycle. Our projections, however, are somewhat less certain as we do not have the history behind us.
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Exhibit 57. Exxon Mobil Trading Range

Average WTI ($/bbl) 18.43 22.14 20.71 14.48 19.15 30.36 25.94 26.02 31.06 41.25 56.25 66.03 Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 STOCK PRICE Low High EPS 15 22 1.28 19 25 1.40 24 34 1.62 28 39 1.24 32 44 1.19 35 48 2.40 35 46 2.25 30 45 1.69 32 41 2.55 40 52 3.97 49 66 5.36 57 79 6.55 1995-2006 Average CFPS 2.79 2.86 3.07 2.38 2.16 3.25 3.55 3.06 4.31 5.35 7.03 8.30 DIV 0.75 0.78 0.82 0.82 0.84 0.88 0.91 0.92 0.98 1.06 1.14 1.28 EBITDA 3.27 3.56 3.81 3.01 2.96 5.30 4.71 3.92 5.59 8.00 10.74 13.26 P/E Range 11.8x 16.9x 13.9x 18.1x 14.9x 20.8x 22.8x 31.2x 27.0x 36.7x 14.6x 19.9x 15.6x 20.4x 17.6x 26.4x 12.4x 16.1x 10.1x 13.1x 9.2x 12.3x 8.6x 12.1x 13.8x 18.8x P/CF Range 5.4x 7.7x 6.8x 8.9x 7.9x 11.0x 11.9x 16.2x 14.9x 20.2x 10.8x 14.7x 9.9x 12.9x 9.7x 14.6x 7.3x 9.5x 7.5x 9.7x 7.0x 9.4x 6.8x 9.5x 8.3x 11.3x EV/EBITDA 5.2x 7.1x 5.8x 7.5x 6.7x 9.2x 9.9x 13.3x 11.6x 15.5x 6.7x 9.1x 7.5x 9.8x 7.6x 11.4x 5.6x 7.3x 4.7x 6.3x 4.3x 5.8x 4.0x 5.7x 6.2x 8.4x DIV YLD Range 3.5 5.0 3.1 4.0 2.4 3.4 2.1 2.9 1.9 2.6 1.8 2.5 2.0 2.6 2.1 3.1 2.4 3.1 2.0 2.7 1.7 2.3 1.6 2.3 2.3 % 3.1 %
60.00 50.00
Projected Trading Range 2007E $64 $85 $6.05 2008E $64 $85 $4.90
$8.00 $6.95
$1.37 $1.47
$13.04 $10.85
10.6 x 13.1 x
14.0 x 17.3 x
8.0 x 9.2 x
10.6 12.2
4.7 x 5.6 x
6.0 x 7.5 x
1.6 % 1.7 %
2.1 % 2.3 %
Another issue with our method is that it requires estimation. Ultimately, this means projecting oil and gas prices and refining margins, which has proved to be a difficult call for all analysts. Hence, earnings and cash flow estimates often are inaccurate. For the large integrated oils, we find that dividend yields often put a floor on where a stock will trade. Dividend yield analysis requires less speculation. However, dividends are visible, real, and usually relatively secure (integrated oils rarely cut dividends). Another driving force for valuation is return on capital employed (ROCE), which differentiates companies in terms of efficiency and investment discipline. If we can identify companies with improving ROCE, then we might make a case for upward revaluation of the share price through a higher P/E, P/CF, or EV/EBITDA multiple. This is helpful in setting price expectations, based on multiples we would expect to see. We calculate ROCE as follows:
ROCE = Net Income + After-Tax Interest Shareholders Equity + Total Debt
A good example of this is TOTAL. Since 1995, the companys return on average capital employed has grown consistently. TOTAL has gone from being not so competitive to a top-quartile performer. This was accomplished through valuecreating growth, both organic and through acquisitions. While the multiples have expanded and contracted with the cycles, note the relative multiples to its closest competitor, Chevron, shown in Exhibit 58. In the 1995-99 time period, Chevron generated average returns that were more than 400 basis points above TOTALs. In the last three years, returns for the two companies have been consistent, at approximately 25%. In 1995-99, TOTALs multiples reflected an average 7% discount to Chevrons. Over the past three years, TOTAL has traded at an average 8% premium to Chevron. TOTALs stock price rose 323% from December 1994 through December 2006. This compares to 154% for Chevron.
Exhibit 58. TOTAL and Chevron: ROCE and Trading Range TOTAL
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P/E Range 17.0x 22.7x 15.1x 20.2x 14.6x 22.3x 19.6x 28.2x 19.6x 28.5x 12.3x 16.3x 11.9x 16.0x 13.6x 18.7x 9.3x 14.3x 9.6x 12.0x 8.2x 10.9x 8.5x 10.7x 12.7x 17.5x P/CF Range 6.2x 8.2x 6.5x 8.7x 7.0x 10.7x 8.8x 12.6x 9.3x 13.6x 6.9x 9.2x 7.5x 10.0x 7.7x 10.6x 5.7x 8.7x 5.9x 7.4x 5.3x 7.0x 6.5x 8.1x 6.7x 9.2x EV/EBITDA 4.7x 6.3x 5.0x 6.7x 5.6x 8.5x 7.7x 10.8x 6.5x 9.3x 4.8x 6.4x 5.0x 6.6x 5.0x 6.8x 3.9x 5.9x 3.8x 4.7x 3.4x 4.5x 3.7x 4.6x 4.8x 6.5x ROACE 5.3 % 6.8 8.8 8.3 14.1 18.0 17.0 15.0 19.8 22.8 24.9 25.6 15.7 %
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P/E Range 14.3x 17.7x 12.6x 16.9x 12.8x 18.4x 22.9x 30.5x 21.4x 33.4x 8.6x 11.7x 12.3x 15.5x 15.7x 21.6x 8.7x 12.4x 7.5x 10.0x 7.7x 10.0x 6.9x 9.8x 11.8x 15.9x
Chevron
P/CF Range 7.0x 8.7x 6.3x 8.4x 7.9x 11.4x 9.8x 13.1x 12.5x 19.5x 5.8x 7.8x 7.8x 9.7x 7.4x 10.2x 5.4x 7.7x 6.2x 8.3x 5.4x 7.0x 4.9x 6.9x 6.7x 9.0x EV/EBITDA ROACE 6.1x 7.3x 11.9 % 5.2x 6.7x 14.6 5.6x 7.8x 15.9 9.6x 12.5x 10.3 7.6x 11.3x 11.2 4.0x 5.3x 22.8 5.0x 6.1x 15.9 6.2x 8.2x 10.5 3.9x 5.4x 16.0 3.6x 4.8x 23.0 3.5x 4.6x 21.8 2.9x 4.2x 30.6 5.1x 6.6x 17.6 %
The trick is to determine what valuation factor(s) is likely to affect each stock. It is essential to examine the rationale for why a stock trades at a certain level, which parameters will provide a downside cushion, and which may set a ceiling price. We like to project stock price ranges, based on historical multiples, price to appraised value (AV), and dividend yield, for all the companies that we cover. This leads to an examination of factors that might create a bottom and a top for the stock. We compare valuation statistics for each company against look-alikes, and make adjustments, if necessary. Also, we compare historical stock volatility with our projected ranges, and, if necessary, make further adjustments. Projecting stock price ranges allows us to estimate risk/reward ratios.
THE SIZE FACTOR: DOES IT MATTER?
The international integrated oils trade at premiums of 8%-86% versus the domestics, and 42%-86% versus the refiners, based on historical P/E and P/CF multiples. We believe the reasons for the higher valuations include operational efficiency, financial strength, reputation, diversification, and liquidity. As a group, the internationals have better reserve replacement and F&D cost records than the domestics. Importantly, ROCE is consistently higher for the internationals than the domestics and refiners. ROCE plays a major role in determining valuations, in our opinion.
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Exhibit 59. Multiple Ranges and ROCE

Ten-Year P/E and P/CF Ranges
Ten - Year Ranges (1) P/E P/CF EV/EBITDA Low High Low High Low High International Integrated BP (BP) Chevron (CVX) Exxon Mobil (XOM) Royal Dutch Shell (RDS.A) TOTAL S.A. (TOT) Average Domestic Integrated ConocoPhillips (COP) Hess Corporation (HES) Marathon Oil (MRO) Murphy Oil (MUR) Occidental Petroleum (OXY) Average 14.9x 13.5 15.4 15.0 14.2 14.6x 11.8x 11.2 11.6 22.6 9.9 13.4x 20.8x 18.1 21.2 21.4 19.8 20.3x 16.5x 15.6 17.2 32.7 14.7 19.3x 8.5x 7.2 8.7 8.5 7.0 8.0x 4.5x 4.4 3.3 4.5 4.6 4.3x 11.8x 9.6 11.9 12.1 9.8 11.0x 6.4x 6.1 5.0 6.9 7.1 6.3x 6.4x 5.7 6.9 5.5 5.2 5.9x 4.9x 5.0 4.2 5.1 4.9 4.8x 8.7x 7.4 9.3 7.7 7.3 8.1x 6.2x 6.3 5.6 7.4 6.4 6.4x
ROCE
Ten-Year Average ROCE International Integrated Oils Domestic Integrated Oils Independent Refiners 16.8% 13.7% 13.7%
We note, however, that size does not equate to good performance or returns. Take super-major Royal Dutch/Shell, for instance, the third-largest company in our coverage universe, whose F&D costs have recently ranked among the highest among the major oils, and whose returns lag the groups. Size did not help other companies such as Texaco, Amoco, Gulf Oil, and Getty Oil, all of which where acquired by competitors, due in part to substandard operations and returns.
VALUATION FOR INDEPENDENT REFINERS
Independent refiners are valued similarly to the integrated oils. The only difference that we have observed is that, due to the high sensitivity of refiners earnings to changes in margins, there is a close correlation between changes in refining margins and refiners stock prices. Given the cyclicality of the refining industry, we believe that the best approach for investors is to use a trading strategy.
Exhibit 60. Correlation Between Refining Stock Prices and Refining Margins
14 Refining Margin $/bbl 12 10 8 6 4 2 0 4 3 2.5 2 1.5 1 0.5 0 Relative Performance 3.5
19 95
19 97
19 99
20 03
20 04
20 05
19 96
19 98
20 00
20 01
20 02
20 06
Nationwide Refining Margins BSC Refining Index Relative Performance to the S&P
20 07
In valuing independent refiners, we prefer EV/EBITDA multiples over P/E or P/CF multiples because EV/EBITDA takes into account balance sheet strength or weakness by including debt as part of the valuation. Given that refineries are so capital-intensive, independent refiners debt loads can vary and should be taken into consideration. In addition, due to volatile and sometimes negative earnings and cash flows from year to year for independent refiners, P/E and P/CF multiples are erratic, and, as a result, it is difficult to rely on historical ranges. Exhibit 61 below shows Valeros trading history. Our 2008 earnings estimates are based on approximately mid-cycle refining margins. As discussed earlier, generally, in periods where refining margins are above mid-cycle, the multiples contract, and, consequently, in periods where the margins are below mid-cycle, the multiples expand. Note that in 2001 and in 2004-06, periods of robust refining margins, multiples were below the ten-year average. In contrast, the very weak margins seen in 1998 and 2002 caused multiples to expand to very high levels. Our 2007 projected price ranges reflect multiples that are consistent with a declining refining margin environment, and 2008 multiples look to be more consistent with the historical midcycle, as our 2008 margin assumptions are approximately mid-cycle.
Exhibit 61. Historical Multiples for Valero Energy
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 PRICE Low High EPS 8 10 0.45 10 15 (0.30) 13 22 1.02 9 18 0.56 8 13 0.07 9 19 2.80 16 26 4.37 12 25 0.42 17 23 2.57 23 48 6.66 50 69 6.68 48 69 8.31 1995-2006 Average: $45 $38 $70 $65 $6.10 $4.50 CFPS 1.75 1.27 2.08 1.88 1.23 4.30 8.33 2.18 5.43 9.99 6.00 11.00 DIV 0.26 0.26 0.21 0.16 0.16 0.16 0.16 0.20 0.20 0.27 0.10 0.10 EBITDA 3.55 1.86 2.82 2.18 2.04 6.51 9.59 4.02 7.25 13.20 11.56 15.05 P/E Range 17.9 22.6 NM NM 13.3 21.2 15.7 32.6 8.6 17.7 3.4 6.9 3.7 5.9 28.8 59.6 6.4 9.1 3.5 7.2 7.4 10.3 5.8 8.3 8.1 x 14.2 x 7.4 x 8.4 x 11.5 x 14.4 x P/CF Range 4.6 5.8 8.0 11.9 6.5 10.4 4.7 9.7 6.8 10.3 2.2 4.5 2.0 3.1 5.5 11.3 3.1 4.3 2.3 4.8 8.3 11.5 4.4 6.3 4.9 x 7.8 x 5.1 x 5.1 x 8.0 x 8.7 x EV/EBITDA ROCE 5.3 6.0 4.8 10.0 12.6 1.4 5.5 8.4 6.6 7.0 9.3 4.8 7.0 9.1 2.7 2.7 4.2 17.0 4.7 5.7 10.8 7.3 10.5 4.6 4.5 5.4 8.2 2.6 4.4 18.2 4.9 6.6 25.5 3.6 5.0 25.2 5.0 x 6.9 x 10.8 % 4.7 x 4.8 x 6.4 x 7.4 x 16.1 % 11.1 % DIV YLD Range 2.6 3.2 1.7 2.6 1.0 1.6 0.9 1.8 1.3 1.9 0.8 1.7 0.6 1.0 0.8 1.7 0.9 1.2 0.6 1.2 0.1 0.2 0.1 0.2 0.9 % 1.5 % 0.2 % 0.3 % 0.2 % 0.3 %
2007E 2008E
$8.80 $7.50
$0.12 $0.12
$11.55 $9.52
For the past ten years, valuation multiples for the independent refining companies that we cover have been 8.0x-14.2x P/E, 4.4x-7.6x P/CF, and 5.3x-7.2x EV/EBITDA (see Exhibit 62).
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Exhibit 62. Historical Multiples by Company

Historical Ranges (1) P/E P/CF EV/EBITDA Low High Low High Low High Frontier Oil Corp (FTO) Sunoco (SUN) Tesoro Corp. (TSO) Valero Energy Corp. (VLO) Average 8.3x 8.7x 6.7x 8.4x 8.0x 15.4x 13.6x 13.4x 14.2x 14.2x 5.2x 5.1x 2.5x 4.9x 4.4x 9.5x 8.3x 4.6x 7.8x 7.6x 5.2x 6.8x 4.0x 5.0x 5.3x 6.9x 9.3x 5.6x 6.9x 7.2x
(1) Range represents averages of low multiples and high multiples in each year based on high and low stock price.
Source: Company reports; Bear, Stearns & Co. Inc. calculations.
As discussed earlier, ROCE analysis is a way to differentiate companies in terms of efficiency and investment discipline. Because refineries are so capital-intensive, return on capital employed has historically been relatively low. However, during the past four years, abnormally high refining margins have allowed refiners to use substantial cash flows to pay down debt, thereby increasing their ROCEs. Exhibit 63 shows historical ROCEs for the independent refiners.
Exhibit 63. Return on Capital Employed
2000 2001 2002 2003 2004 2005 2006 FTO 16.6% 44.7% -0.4% 12.0% 21.3% 49.7% 50.6% SUN 19.1% 16.3% 1.7% 13.9% 23.2% 31.6% 28.1% TSO 9.2% 8.6% -0.2% 8.5% 17.2% 24.4% 26.2% VLO 17.0% 10.8% 4.6% 8.2% 18.2% 25.5% 25.2% WNR NA NA 35.0% 23.9% 24.5% 45.5% 35.8% Average 15.5% 20.1% 8.1% 13.3% 20.9% 35.3% 33.2%
Source: Company reports; Bear, Stearns & Co. Inc. calculations.
Section 4
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Industry Resources
PUBLICATIONS
Platts Oilgram News (daily) Telephone: 212-904-4100 Platts Oilgram Price (daily) Telephone: 212-904-4100 Oil Daily (daily) Telephone: 202-662-0700 Petroleum Intelligence Weekly (weekly) Telephone: 202-662-0700 Natural Gas Week (weekly) Telephone: 202-662-0700 Middle East Economics Survey (weekly) Telephone: 357 2 266 54 31 Monthly Statistical Report API (monthly) Telephone: 202-682-8000 Monthly Energy Review DOE (monthly) Telephone: 202-586-8800 Oil & Gas Journal (monthly) Telephone: 713-621-9720 Oil & Gas Investor (monthly) Telephone: 713-993-9325 Oil Market Report (IEA monthly) Telephone: 33 (0) 1 40-576557
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BOOKS
The Prize, by Daniel Yergin, Simon & Schuster, 1991 Our Industry, by British Petroleum Company, 1977 Fundamentals of Oil and Gas Accounting, by Rebecca Gallun, Charlotte Wright, Linda Nichols, John Stevenson, PennWell, 2001 Hubberts Peak, by Kenneth Deffeyes, Princeton University Press, 2001 The Hydrogen Economy, by Jeremy Rifkin, Tarcher/Penguin, 2002 International Petroleum Encyclopedia, by Bob Rippee, PennWell, 2004
WEB SITES
The following Web sites provide industry data: www.eia.doe.gov Department of Energys statistical site. www.api.org American Petroleum Institutes site. statistics for industry data. www.iea.org International Energy Agencys site. www.opec.org OPEC Web site. www.mms.gov Minerals Management Service (U.S. Dept. of Interior). The following Web sites provide information relating to issues relevant to the U.S. refining industry: www.epa.gov Environmental Protection Agency; Clean Air Act. www.npra.org National Petrochemicals and Refiners Association. Click on industry
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BLOOMBERG TICKER SYMBOLS
We use pricing data from Platts to calculate proxy reefing margins. Bloomberg also provides margins by region. Below are ticker symbols for some of the most widely followed refining margins: PADD 1 (East Coast): CRKS321Y (Index) PADD 2 (Midwest): CRCK321M (Index) PADD 3 (Gulf Coast): CRKS321W (Index) PADD 5 (West Coast): CRKS431A (Index) Asia-Dubai Crack Spread: CRKS321U (Index) Northwest Europe-Dated Brent: CRKS211B (Index) Crude Oil: WTI spot: USCRWTIC (Commodity) Dated Brent: EUCRBRDT (Commodity) Bloomberg Energy Page: NRG (Go)
REUTERS NEWS SYMBOLS
N/PET Petroleum News I/OPEC OPEC News I/MEAST Middle East News R/IR Iran News R/IZ Iraq News R/KU Kuwait News R/SA Saudi Arabia News R/TC United Arab Emirates News R/VE Venezuela News
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Consensus oil and gas prices estimates are listed on First Call: CONSENSUS OIL AND GAS PRICE ESTIMATES Oil (WTI spot): OIL.CP ON FIRST CALL Gas (Composite Spot Wellhead): NG.CP
SURVEYS
Oil & Gas Journal Worldwide Construction Update (Annual) Oil & Gas Journal Worldwide Refining Survey (Annual)
Glossary of Terms
The following are terms contained in the Department of Energys glossary: Alkylation: A refining process for chemically combining isobutane with olefin hydrocarbons (e.g., propylene, butylene) through the control of temperature and pressure in the presence of an acid catalyst, usually sulfuric acid or hydrofluoric acid. The product, alkylate, an isoparaffin, has high-octane value and is blended with motor and aviation gasoline to improve the antiknock value of the fuel. API gravity: American Petroleum Institute measure of specific gravity of crude oil or condensate in degrees. An arbitrary scale expressing the gravity or density of liquid petroleum products. The measuring scale is calibrated in terms of degrees API; it is calculated as follows: Degrees API = (141.5 / sp.gr.60 deg.F/60 deg.F) - 131.5 Barrel: A unit of volume equal to 42 U.S. gallons. Bitumen: A naturally occurring viscous mixture, mainly of hydrocarbons heavier than pentane, that may contain sulfur compounds and that, in its naturally occurring viscous state, is not recoverable at a commercial rate through a well. BOE: The abbreviation for barrels of oil equivalent (used internationally). Butane: A normally gaseous straight-chain or branch-chain hydrocarbon extracted from natural gas or refinery gas streams. Christmas Tree: The valves and fittings installed at the top of a gas or oil well to control and direct the flow of well fluids. Coking: Thermal refining processes used to produce fuel gas, gasoline blendstocks, distillates, and petroleum coke from the heavier products of atmospheric and vacuum distillation. Cubic Foot (cf), Natural Gas: The amount of natural gas contained at standard temperature and pressure (60 degrees Fahrenheit and 14.73 pounds standard per square inch) in a cube whose edges are one foot long. Dealer Tank Wagon (DTW) Sales: Wholesale sales of gasoline priced on a delivered basis to a retail outlet. Desulfurization: The removal of sulfur, as from molten metals, petroleum oil, or flue gases. Development Costs: Costs incurred to obtain access to proved reserves and to provide facilities for extracting, treating, gathering, and storing the oil and gas. Development Drilling: Drilling done to determine more precisely the size, grade, and configuration of an ore deposit subsequent to when the determination is made that the deposit can be commercially developed. Development Well: A well drilled within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive.
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Diesel Fuel: A fuel composed of distillates obtained in petroleum refining operation or blends of such distillates with residual oil used in motor vehicles. The boiling point and specific gravity are higher for diesel fuels than for gasoline. Distillate Fuel Oil: A general classification for one of the petroleum fractions produced in conventional distillation operations. It includes diesel fuels and fuel oils. Products known as No. 1, No. 2, and No. 4 diesel fuel are used in on-highway diesel engines, such as those in trucks and automobiles, as well as off-highway engines, such as those in railroad locomotives and agricultural machinery. Products known as No. 1, No. 2, and No. 4 fuel oils are used primarily for space heating and electric power generation. Distillation Unit (Atmospheric): The primary distillation unit that processes crude oil (including mixtures of other hydrocarbons) at approximately atmospheric conditions. It includes a pipe still for vaporizing the crude oil and a fractionation tower for separating the vaporized hydrocarbon components in the crude oil into fractions with different boiling ranges. This is done by continuously vaporizing and condensing the components to separate higher boiling point material. The selected boiling ranges are set by the processing scheme, the properties of the crude oil, and the product specifications. DOE: Department of Energy. Dry Hole: An exploratory or development well found to be incapable of producing either oil or gas in sufficient quantities to justify completion as an oil or gas well. EIA: The Energy Information Administration. An independent agency within the U.S. Department of Energy that develops surveys, collects energy data, and analyzes and models energy issues. The Agency must meet the requests of Congress, other elements within the Department of Energy, Federal Energy Regulatory Commission, the Executive Branch, its own independent needs, and assist the general public, or other interest groups, without taking a policy position. Fluid Catalytic Cracking: The refining process of breaking down the larger, heavier, and more complex hydrocarbon molecules into simpler and lighter molecules. Catalytic cracking is accomplished by the use of a catalytic agent and is an effective process for increasing the yield of gasoline from crude oil. Catalytic cracking processes fresh feeds and recycled feeds. Field: An area consisting of a single reservoir or multiple reservoirs all grouped on, or related to, the same individual geological structural feature and/or stratigraphic condition. There may be two or more reservoirs in a field that are separated vertically by intervening impervious strata or laterally by local geologic barriers, or by both. Gasoline: A complex mixture of relatively volatile hydrocarbons with or without small quantities of additives, blended to form a fuel suitable for use in spark-ignition engines. Motor gasoline, as defined in ASTM Specification D 4814 or Federal Specification VV-G-1690C, is characterized as having a boiling range of 122-158 degrees Fahrenheit at the 10% recovery point to 365-374 degrees Fahrenheit at the 90% recovery point. Motor gasoline includes conventional gasoline, all types of oxygenated gasoline, including gasohol, and reformulated gasoline, but excludes aviation gasoline. Geological and Geophysical (G&G) Costs: Costs incurred in making geological and geophysical studies, including, but not limited to, costs incurred for salaries, equipment, obtaining rights of access, and supplies for scouts, geologists, and geophysical crews.
Government-Owned Stocks: Oil stocks owned by the national government and held for national security. In the U.S., these stocks are known as the Strategic Petroleum Reserve. Jet Fuel: A refined petroleum product used in jet aircraft engines. It includes kerosene-type jet fuel and naphtha-type jet fuel. Heating Oil: A distillate fuel oil that has distillation temperatures of 400 degrees Fahrenheit at the 10% recovery point and 640 degrees Fahrenheit at the 90% recovery point. It is used in atomizing-type burners for domestic heating, or for moderate capacity commercial/industrial burner units. Hydrocracking: A refining process that uses hydrogen and catalysts with relatively low temperatures and high pressures for converting middle boiling or residual material to high-octane gasoline, reformer charge stock, jet fuel, and/or high-grade fuel oil. The process uses one or more catalysts, depending on product output, and can handle high-sulfur feedstocks without prior desulfurization. Hydrotreating: A refining process for treating petroleum fractions from atmospheric or vacuum distillation units (e.g., naphthas, middle distillates, reformer feeds, residual fuel oil, and heavy gas oil) and other petroleum (e.g., cat-cracked naphtha, coker naphtha, gas oil, etc.) in the presence of catalysts and substantial quantities of hydrogen. Hydrotreating includes desulfurization, removal of substances (e.g., nitrogen compounds) that deactivate catalysts, conversion of olefins to paraffins to reduce gum formation in gasoline, and other processes to upgrade the quality of the fractions. Isomerization: A refining process that alters the fundamental arrangement of atoms in the molecule without adding or removing anything from the original material. Used to convert normal butane into isobutane (C4), an alkylation process feedstock, and normal pentane and hexane into isopentane (C5) and isohexane (C6), high-octane gasoline components. MTBE (Methyl Tertiary Butyl Ether): An ether intended for gasoline blending in oxygenated gasoline. Naphthas: Refined or partly refined light distillates with an approximate boiling point range of 27-221 degrees centigrade. Blended further or mixed with other materials, they make high-grade motor gasoline or jet fuel. Also used as solvents, petrochemical feedstocks, or as raw materials for the production of town gas. Octane: A flammable liquid hydrocarbon found in petroleum. Used as a standard to measure of the antiknock properties of motor fuel. Offshore: That geographic area that lies seaward of the coastline. In general, the coastline is the line of ordinary low water along with that portion of the coast that is in direct contact with the open sea or the line marking the seaward limit of inland water. Oil: A mixture of hydrocarbons usually existing in the liquid state in natural underground pools or reservoirs. Gas is often found in association with oil. Oil Reservoir: An underground pool of liquid consisting of hydrocarbons, sulfur, oxygen, and nitrogen trapped within a geological formation and protected from evaporation by the overlying mineral strata. Oil Well: A well completed for the production of crude oil from at least one oil zone or reservoir.
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OPEC (Organization of Petroleum Exporting Countries): The acronym for the Organization of Petroleum Exporting Countries that have organized for the purpose of negotiating with oil companies on matters of oil production, prices, and future concession rights. Current members (as of the date of this publication) are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Permeability: The ease with which fluid flows through a porous medium. Petrochemicals: Organic and inorganic compounds and mixtures that include but are not limited to organic chemicals, cyclic intermediates, plastics and resins, synthetic fibers, elastomers, organic dyes, organic pigments, detergents, surface active agents, carbon black, and ammonia. Petroleum: A broadly defined class of liquid hydrocarbon mixtures. Included are crude oil, lease condensate, unfinished oils, refined products obtained from the processing of crude oil, and natural gas plant liquids. Note that volumes of finished petroleum products include non-hydrocarbon compounds, such as additives and detergents, after they have been blended into the products. Petroleum Administration for Defense District (PADD): A geographic aggregation of the 50 states and the District of Columbia into five Districts, with PADD I further split into three sub-districts. Production Costs: Costs incurred to operate and maintain wells and related equipment and facilities, including depreciation and applicable operating costs of support equipment and facilities and other costs of operating and maintaining those wells and related equipment and facilities. Propane: A normally gaseous straight-chain hydrocarbon. It is a colorless paraffinic gas that boils at a temperature of -43.67 degrees Fahrenheit. It is extracted from natural gas or refinery gas streams. Refined Petroleum Products: Refined petroleum products include but are not limited to gasolines, kerosene, distillates (including No. 2 fuel oil), liquefied petroleum gas, asphalt, lubricating oils, diesel fuels, and residual fuels. Refiner: A firm or the part of a firm that refines products or blends and substantially changes products, or refines liquid hydrocarbons from oil and gas field gases, or recovers liquefied petroleum gases incident to petroleum refining, and sells those products to resellers, retailers, reseller/retailers, or ultimate consumers. Refiner includes any owner of products that contracts to have those products refined and then sells the refined products to resellers, retailers, or ultimate consumers. Refinery: An installation that manufactures finished petroleum products from crude oil, unfinished oils, natural gas liquids, other hydrocarbons, and oxygenates. Refinery Capacity Utilization: Ratio of the total amount of crude oil, unfinished oils, and natural gas plant liquids run through crude oil distillation units to the operable capacity of these units. Reserve Additions: The estimated original, recoverable, salable, and new proved reserves credited to new fields, new reservoirs, new gas purchase contracts, amendments to old gas purchase contracts, or purchase of reserves in-place that occurred during the year and had not been previously reported.
Reserve Revisions: Changes to prior year-end proved reserves estimates, either positive or negative, resulting from new information other than an increase in proved acreage (extension). Revisions include increases of proved reserves associated with the installation of improved recovery techniques or equipment. They also include correction of prior-year arithmetical or clerical errors and adjustments to prior year-end production volumes to the extent that these alter reserves estimates. Residual Fuel Oil: A general classification for the heavier oils, known as No. 5 and No. 6 fuel oils, that remain after the distillate fuel oils and lighter hydrocarbons are distilled away in refinery operations. It is used in steam-powered vessels in government service and inshore power plants. No. 6 fuel oil includes Bunker C fuel oil and is used for the production of electric power, space heating, vessel bunkering, and various industrial purposes. Royalty: A contractual arrangement providing a mineral interest that gives the owner a right to a fractional share of production, or proceeds therefrom, that does not contain rights and obligations of operating a mineral property, and that is normally free and clear of exploration, developmental, and operating costs, except production taxes. Salt Dome: A domical arch (anticline) of sedimentary rock beneath the earths surface in which the layers bend downward in opposite directions from the crest and that has a mass of rock salt as its core. Spot Price: The price for a onetime open market transaction for immediate delivery of a specific quantity of product at a specific location where the commodity is purchased on the spot at current market rates. Strategic Petroleum Reserve (SPR): Petroleum stocks maintained by the federal government for use during periods of major supply interruption. Sulfur: A yellowish nonmetallic element, sometimes known as brimstone. It is present at various levels of concentration in many fossil fuels whose combustion releases sulfur compounds that are considered harmful to the environment. Some of the most commonly used fossil fuels are categorized according to their sulfur content, with lower-sulfur fuels usually selling at a higher price. Note: No. 2 distillate fuel is currently reported as having either a 0.05% or lower sulfur level for on-highway vehicle use or a greater than 0.05% sulfur level for off-highway use, home heating oil, and commercial and industrial uses. Residual fuel, regardless of use, is classified as having either no more than 1% sulfur or greater than 1% sulfur. Coal is also classified as being low-sulfur at concentrations of 1% or less or high-sulfur at concentrations greater than 1%. Wax: A solid or semisolid material derived from petroleum distillates or residues by such treatments as chilling, precipitating with a solvent, or de-oiling. It is a light-colored, more-or-less translucent crystalline mass, slightly greasy to the touch, consisting of a mixture of solid hydrocarbons in which the paraffin series predominates. Includes all marketable wax, whether crude scale or fully refined. The three grades included are microcrystalline, crystalline-fully refined, and crystalline-other. The conversion factor is 280 pounds per 42 U.S. gallons per barrel. Well: A hole drilled in the earth for the purpose of 1) finding or producing crude oil or natural gas; or 2) producing services related to the production of crude oil or natural gas. Wellhead: The point at which the crude (and/or natural gas) exits the ground. Following historical precedent, the volume and price for crude oil production are labeled as wellhead, even though the cost and volume are now generally measured at the lease boundary. In the context of domestic crude price data, the term wellhead is the generic term used to reference the production site or lease property. Working Interest: An interest in a mineral property that entitles the owner of that interest to all or a share of the mineral production from the property, usually subject to a royalty.
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Companies mentioned under coverage: BP Plc (BP.LN-521p, BP-$62; Peer Perform) Chevron Corp. (CVX-$71; Peer Perform) ConocoPhillips (COP-$67; Peer Perform) Exxon Mobil Corp. (XOM-$75; Outperform) Frontier Oil Corporation (FTO-$30; Peer Perform) Hess Corp. (HES-$55; Outperform) Marathon Oil Corp. (MRO-$92; Peer Perform) Murphy Oil Corporation (MUR-$52; Outperform) Occidental Petroleum (OXY-$48; Peer Perform) Royal Dutch Shell PLC (RDSA.LN-1683p, RDSA-$67; Underperform) Sunoco, Inc. (SUN-$65; Outperform) Tesoro Corp. (TSO-$89; Outperform) Total S.A. (TOTF.PA-52, TOT-$69; Outperform) Valero Energy Corp. (VLO-$59; Outperform) Western Refining Inc (WNR-$28; Peer Perform)
Sector ratings Integrated Oil: Market Weight Independent Refiners: Market Weight
Addendum
Important Disclosures
For important disclosure information regarding the companies in this report, please contact your registered representative at 1-888-473-3819, or write to Sandra Pallante, Equity Research Compliance, Bear, Stearns & Co. Inc., 383 Madison Avenue, New York, NY 10179. Ratings for Stocks (vs. analyst coverage) Outperform (O) Stock is projected to outperform analysts industry coverage universe over the next 12 months. Peer Perform (P) Stock is projected to perform approximately in line with analysts industry coverage universe over the next 12 months. Underperform (U) Stock is projected to underperform analysts industry coverage universe over the next 12 months. Ratings for Sectors (vs. regional broader market index) Market Overweight (MO) Expect the industry to perform better than the primary market index for the region (S&P 500 in the U.S.) over the next 12 months. Market Weight (MW) Expect the industry to perform approximately in line with the primary market index for the region (S&P 500 in the U.S.) over the next 12 months. Market Underweight (MU) Expect the industry to underperform the primary market index for the region (S&P 500 in the U.S.) over the next 12 months. Bear, Stearns & Co. ratings distribution as of December 31, 2006 (% rated companies/% banking client in the last 12 months): Outperform (Buy): 41.0%/8.3% Peer Perform (Neutral): 49.5%/8.0% Underperform (Sell): 9.5%/0.0% For individual coverage industry data, please contact your account executive or visit www.bearstearns.com.
Addendum
Important Disclosures
Analyst Certification The Research Analyst(s) who prepared the research report hereby certify that the views expressed in this research report accurately reflect the analyst(s) personal views about the subject companies and their securities. The Research Analyst(s) also certify that the Analyst(s) have not been, are not, and will not be receiving direct or indirect compensation for expressing the specific recommendation(s) or view(s) in this report. Nicole L. Decker The costs and expenses of Equity Research, including the compensation of the analyst(s) that prepared this report, are paid out of the Firms total revenues, a portion of which is generated through investment banking activities. This report has been prepared in accordance with the Firms conflict management policies. Bear Stearns is unconditionally committed to the integrity, objectivity, and independence of its research. Bear Stearns research analysts and personnel report to the Director of Research and are not subject to the direct or indirect supervision or control of any other Firm department (or members of such department). This publication and any recommendation contained herein speak only as of the date hereof and are subject to change without notice. Bear Stearns and its affiliated companies and employees shall have no obligation to update or amend any information or opinion contained herein, and the frequency of subsequent publications, if any, remain in the discretion of the author and the Firm.
Other Disclaimers
This report has been prepared by Bear, Stearns & Co. Inc., Bear, Stearns International Limited or Bear Stearns Asia Limited (together with their affiliates, Bear Stearns), as indicated on the cover page hereof. This report has been adopted and approved for distribution in the United States by Bear, Stearns & Co. Inc. for its and its affiliates customers. If you are a recipient of this publication in the United States, orders in any securities referred to herein should be placed with Bear, Stearns & Co. Inc. This report has been approved for publication in the United Kingdom by Bear, Stearns International Limited, which is authorized and regulated by the United Kingdom Financial Services Authority. Private Customers in the U.K. should contact their Bear, Stearns International Limited representatives about the investments concerned. This report is distributed in Hong Kong by Bear Stearns Asia Limited, which is regulated by the Securities and Futures Commission of Hong Kong. Additional information is available upon request. Bear Stearns and its employees, officers, and directors deal as principal in transactions involving the securities referred to herein (or options or other instruments related thereto), including in transactions which may be contrary to any recommendations contained herein. Bear Stearns and its employees may also have engaged in transactions with issuers identified herein. Bear Stearns is affiliated with a specialist that may make a market in the securities of the issuers referred to in this document, and such specialist may have a position (long or short) and may be on the opposite side of public orders in such securities. This publication does not constitute an offer or solicitation of any transaction in any securities referred to herein. Any recommendation contained herein may not be suitable for all investors. Although the information contained in the subject report (not including disclosures contained herein) has been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. This publication and any recommendation contained herein speak only as of the date hereof and are subject to change without notice. Bear Stearns and its affiliated companies and employees shall have no obligation to update or amend any information or opinion contained herein. This publication is being furnished to you for informational purposes only and on the condition that it will not form the sole basis for any investment decision. Each investor must make their own determination of the appropriateness of an investment in any securities referred to herein based on the tax, or other considerations applicable to such investor and its own investment strategy. By virtue of this publication, neither Bear Stearns nor any of its employees nor any data provider or any of its employees shall be responsible for any investment decision. This report may not be reproduced, distributed, or published without the prior consent of Bear Stearns. 2007. All rights reserved by Bear Stearns. Bear Stearns and its logo are registered trademarks of The Bear Stearns Companies Inc. This report may discuss numerous securities, some of which may not be qualified for sale in certain states and may therefore not be offered to investors in such states. This document should not be construed as providing investment services. Investing in non-U.S. securities including ADRs involves significant risks such as fluctuation of exchange rates that may have adverse effects on the value or price of income derived from the security. Securities of some foreign companies may be less liquid and prices more volatile than securities of U.S. companies. Securities of nonU.S. issuers may not be registered with or subject to Securities and Exchange Commission reporting requirements; therefore, information regarding such issuers may be limited. NOTE TO ACCOUNT EXECUTIVES: For securities that are not listed on the NYSE, AMEX, or Nasdaq National Market System, check the Compliance page of the Bear Stearns Intranet site for State Blue Sky data prior to soliciting or accepting orders from clients. CIR 230 Disclaimer Bear Stearns does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. In order for Bear Stearns to comply with Internal Revenue Service Circular 230 (if applicable), you are notified that any discussion of U.S. federal tax issues contained or referred to herein is not intended or written to be used, and cannot be used, for the purpose of: (A) avoiding penalties that may be imposed under the Internal Revenue Code; nor (B) promoting, marketing or recommending to another party any transaction or matter discussed herein.

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Equity Research

Research Analysts Nicole L. Decker (212) 272-3962

Eric Richards, CFA (212) 272-8946

Raymond Sulentic (212) 272-6813

BEAR, STEARNS & CO. INC.

BEAR, STEARNS & CO. INC.

BEAR, STEARNS & CO. INC.

The Integrated Oil Company

Source: Industry sources.

BEAR, STEARNS & CO. INC.

WTI ($/bbl) GC Refining Margins ($/bbl)

Source: Company reports.

Exploration and Production Basics

BEAR, STEARNS & CO. INC.

... . .. . . . ... ... .

Source: Industry sources.

BEAR, STEARNS & CO. INC.

APPRAISAL AND DEVELOPMENT

BEAR, STEARNS & CO. INC.

Source: Industry sources.

Drivers of Integrated Oils Upstream Performance

OIL AND GAS PRICES

BEAR, STEARNS & CO. INC.

1.9 1.7 1.5 1.3 1.1

0.9 0.7 0.5

WTI Price (left)

Integrated Oils Relative Performance to S&P (right)

Source: Platts; Standard & Poors.

CRUDE OIL CHARACTERISTICS

BEAR, STEARNS & CO. INC.

Exhibit 6. Crude Oil Grades

Mexico Ecuador Canada

22o 25o 25.7

3.30% 1.30% 2.10%

Sour Sour Sour

31.2o 32.5o 32.5 33o 34o 34

34.5o 36o 38.5 40o

U.K. North Sea Australia

OPERATING COSTS AND FIELD RELIABILITY

Exhibit 7. Cash Production Costs

Source: Company reports.

BEAR, STEARNS & CO. INC.

Tracking Industry Fundamentals

FUNDAMENTAL DATA SOURCES

WORLDWIDE CRUDE OIL INVENTORY LEVELS

BEAR, STEARNS & CO. INC.

WTI Spot Oil Prices

Crude Oil Inventories

Source: Energy Information Administration; Platts.

SUPPLY: NON-OPEC PRODUCTION

Crude Oil Inventories (000s bbls)

Exhibit 9. Non-OPEC Production

BEAR, STEARNS & CO. INC.

55% 50% 45% 40%

30% 25% 20%

OPEC Crude Production

Source: International Energy Agency.

BEAR, STEARNS & CO. INC.

26000 25000 24000 23000 22000 21000 20000

BEAR, STEARNS & CO. INC.

U.S. SPR Stocks

WORLDWIDE OIL DEMAND

BEAR, STEARNS & CO. INC.