North American Equity Research

Houston 8 September 2003

E&P 101: A Primer

Oil and Gas Exploration & Production

Exploration & Production Shannon Nome

(1-713) 216-1918 shannon.nome@jpmorgan.com

Phillips Johnston, CFA

(1-212) 622-6491 jphillips.johnston@jpmorgan.com

Wade Suki
(1-713) 216-1939 wade.suki@jpmorgan.com

Dave Wilson, CFA, CPA

(1-713) 216-5036 dave.t.wilson@jpmorgan.com

Everything You Wanted to Know About E&P, But Were Afraid to Ask:
Glossary of energy terms The oil & gas value chain Conversion factors Basic industry statistics and key facts E&P stocks as investments Interpretation of hypothetical E&P press releases
http://mm.jpmorgan.com See last two pages for analyst certification and important disclosures, including investment banking relationships. JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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Table of Contents
THE BASICS: TERMS AND DEFINITIONS........................................................ 3 Oil and Gas.................................................................................................................. 3 Prices........................................................................................................................... 4 Reserve Terms............................................................................................................. 5 Exploration Terms....................................................................................................... 6 Production Terms ........................................................................................................ 8 Oil & Gas Value Chain: Think of a River............................................................... 9 Upstream Segment ...................................................................................................... 9 Midstream Segment..................................................................................................... 9 Downstream Segment ............................................................................................... 10 CONVERSIONS AND STATISTICS.................................................................... 10 Exercise ..................................................................................................................... 10 Putting Statistics Into Perspective ......................................................................... 11 E&P STOCKS AS INVESTMENTS ..................................................................... 13 Types of E&P Companies ......................................................................................... 13 What Matters To Investors ........................................................................................ 14 Macro Data To Watch ............................................................................................... 18 VALUATION .......................................................................................................... 19 Why Earnings Are Less of a Concern to E&P Investors........................................... 22

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THE BASICS: TERMS AND DEFINITIONS

Oil and Gas
Hydrocarbons: a compound of carbon and hydrogen. Includes crude oil, natural gas, natural gas liquids (NGLs), coal, and others. Oil = Petroleum = Crude Oil: unrefined liquid mixture of hydrocarbons that can be refined to yield oil products such as gasoline, naphthas, jet fuel, diesel fuel, heating oil, fuel oil, asphalt, etc. Oil is also used as feedstocks (inputs) for chemical manufacturers in the production of commodity chemicals, plastics, etc. If crude is high in sulfur content, it is a sour crude; otherwise it is a sweet crude. Crude oil may also be referred to as heavy or light according to its API gravity, which is the American Petroleum Institute's measurement of the specific gravity of crude oil (ranging from 9 to 55), the lighter oils having the higher gravities (closer to 55).
Table 1: The Oil Barrel
Products Ethane, Propane Butane Naphthas Gasolines Uses Heating, cooking Chemical feedstocks, Motor gasoline blending Petrochemical feedstocks Reforming into gasoline, Automotive fuel

Liquefied Petroleum Gas (LPGs) 10% Light Ends

35% Middle Distillates Jet Kerosene Diesel Heating/Gasoil Vacuum Gasoil 35% Middle Distillates Cracked Fuel Oil Straight-Run Fuel Oil Asphalt Bitumens, Coke Sulfur Power generation, Ship fuel Lighter products, Fuel oil Road surfacing, Roofing Manufacturing of steel Chemical industry Aviation fuel Automotive fuel Domestic heating fuel Distilled to lighter product

20%

Source: Bloomberg. Note: Percentages are approximate and vary by crude and refinery type.

Natural Gas: a clean burning, odorless, colorless, highly compressible mixture of hydrocarbons occurring naturally in gaseous form. Primarily comprised of methane, but can also include ethane, propane, butane, and natural gasoline. If these later components (called NGLs) are high in content, the gas is considered wet, and the NGLs may be separated from the methane in a processing plant to be sold separately. Uses for natural gas include space heating, water heating, cooking, etc (residential and commercial); steam generation, melting, and use as feedstocks for chemical manufacturing (industrial) and use as fuel for electricity generation (electric utility and independent power producers).

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North American Equity Research Houston 8 September 2003

Table 2: The Natural Gas Mcf

Products Uses Methane (aka pipeline-quality gas) Space heating, water heating, cooking Steam generation, melting Petrochemical feedstocks Power generation 95% Wet gas (Natural Gas Liquids) 5%
Source: JPMorgan estimates. Note: Percentages vary by region and basin.

Dry gas

Ethane, propane, butane, iso-butane, and natural gasoline

Space heating, water heating, cooking Petrochemical feedstocks, Refining feedstocks, Motor gasoline blending

Natural Gas Liquids (NGLs): hydrocarbons that are originally in gaseous form underground, but turn into liquid form when either brought to the surface or processed in gas processing plants. NGLs include ethane, propane, butane, and natural gasoline. Many refer to crude oil and NGLs interchangeably (often as liquids), and most companies group NGL production and reserves together with oil production and reserves. NGLs should not to be confused with LNG (see below). Liquefied Natural Gas (LNG): natural gas that has been cooled to very low temperatures and turned into liquid form for transportation (usually by ship or vehicle). The LNG is turned back into gas form before it reaches the end-user. Liquefied Petroleum Gas (LPG): propane gas or butane gas that has been compressed into a liquid. LPG is used in rural areas for home heating and cooking and has industrial, agricultural, and commercial applications. Principal source is natural gas, from which the liquefied petroleum gases are separated by fractionation. Liquids: general term that refers to crude oil and/or natural gas liquids (NGLs). Deep Gas: natural gas located 15,000 feet or more below the earth's surface. Tight Gas: natural gas located in rock with low permeability (ability for fluids to flow through pore spaces of a reservoir). Enhanced recovery techniques like fractionation must be performed to efficiently produce tight gas reserves. Coal Bed Methane (CBM): natural gas located in coal deposits. CBM is formed during coalification, the natural process of turning organic matter into coal under high pressure and heat. It usually consists of methanethe purest, driest, and most environmentally friendly form of natural gas.

Prices
Henry Hub price: the benchmark natural gas price measured in $/MMbtu or $/Mcf (these two are essentially interchangeable). Natural gas futures contracts that trade on the NYMEX physically settle at Henry Hub, a vast intersection of natural gas pipelines located in Louisiana. Henry Hub prices can refer to spot or futures prices. WTI price: the benchmark crude oil price in the U.S. measured in $/barrel. WTI stands for West Texas Intermediate, which refers to a type of high quality, light in gravity crude oil. Ironically, WTI crude oil futures contracts that trade on the
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North American Equity Research Houston 8 September 2003

NYMEX physically settle at a storage facility in Cushing, Oklahoma, rather than in Texas. WTI prices have historically traded at a $1-2/barrel premium to Brent prices. Brent price: the benchmark crude oil price in Europe, as traded on the International Petroleum Exchange in London. Brent crude refers to a particular grade of crude found in the Brent field located in the North Sea. Brent crude is slightly heavier than WTI crude (lighter oil is generally more desirable than heavier oil because it is easier and less costly to refine). Strip price: the market's expectation of average prices over a certain amount of time in the future. The strip price is calculated by taking the average of all monthly futures prices for the specific time period. For instance, the 12-month strip price calculated in July 2003 is an average of 12 futures prices (beginning with the nearmonth contract that settles in August 2003 and ending with the contract that settles in July 2004). Just as the shape of the interest rate curve can offer insight to the economy and investors' expectations of the future, the shape of energy futures curves can offer insight to the state of the market and expectations for future changes in fundamentals.

Reserve Terms
Reservoir: a single continuous deposit of oil and/or gas in the pores of a rock layer. Most reservoirs contain gas, oil, and water. A reservoir has a single pressure system and does not mix with other reservoirs. Major reservoir characteristics include thickness, porosity (a measure of the reservoir rock's storage capacity for fluids), permeability (a measure of the ease in which fluid flows through the reservoir), and saturation (the volume percentage of different fluids like water, oil and gas in the pore spaces of the reservoir). Proved/proven reserves: quantities of oil or natural gas that are recoverable in future years from known reservoirs under existing economic and operating conditions. It usually takes a discovery well to book proved reserves. Note: proved reserves are the only type of reserves that a company can report in SEC filings. Proved developed reserves: proved reserves that are expected to be produced from existing wells. These can be classified into two categories: proved developed producing (PDP), or proved developed non-producing (PDNP). Proved undeveloped reserves (PUDs): proved reserves that are expected to be produced from new wells drilled or recompletions of old wells. Probable reserves: quantities of oil or natural gas whose existence is not proven by geological information, but its probably present due to the proximity of proven reserves and can be produced if located. Probable reserves are less accurate than proven reserves. Note: companies cannot report probable reserves in SEC filings. Possible reserves: quantities of oil or natural gas that is inferred to be present by speculative geological information and can be produced if located. Probable reserves are less accurate than proven reserves and probable reserves. Note: companies cannot report possible reserves in SEC filings. 2P reserves: Proved plus probable reserves.

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3P reserves: The sum of proved, probable and possible reserves. Reserve Life: reserve to production ratio (R/P ratio). The amount of time in years it would take to fully produce or deplete oil and gas reserves at current production rates. Reserve Impairment: A non-cash charge to earnings representing the difference between the book value of a company's reserves on the balance sheet and the estimated discounted future net cash flows of those reserves, based on currently prevailing commodity prices. Companies that utilize the full cost method of accounting must capitalize all costs related to their oil and gas properties (both productive and non-productive properties). These capitalized costs are amortized on an aggregate basis over the estimated lives of the properties using the units-of-production method. At the end of each quarter, full cost companies must conduct a "full cost ceiling test" which limits the book value of these capitalized costs to the present value of future net revenues attributable to these reserves discounted at 10% (using prevailing oil and gas process at that date), plus the lower of cost or market value of unproved properties. If the book value of the capitalized costs exceeds the ceiling test, the company must writedown its capitalized costs that are in excess of the present value calculation. Restoration of a quarterly writedown following an improvement in oil and gas prices is not allowed. Under the successful methods method of accounting, a ceiling test is not formally required, primarily because FASB did not expect capitalized costs to normally exceed the underlying value of the reserves since successful efforts companies can only capitalize costs related to discovered reserves. PV-10 Calculation = Standardized Measure of Discounted Future Net Cash Flows: A discounted cash flow calculation that the SEC requires every publiclytraded company with significant oil and gas producing activities to disclose in annual financial statements. The calculation measures the present value of estimated future cash flows (revenues less development costs, production costs, and taxes) from the companies proved reserves, discounted at 10%. The PV-10 calculation is somewhat subjective in that companies provide their own assumptions regarding future development costs, future production costs, how fast the production base is declining, etc. Furthermore, companies must take whatever the prevailing commodity prices were at the end of a reporting period and assume these prices are held constant throughout the life of the reserves. This leads to significant volatility in the PV-10 calculation from one year to another simply because of fluctuating commodity prices.

Exploration Terms
Exploration: all of the activities associated with finding new reserves of hydrocarbons (oil and gas). Includes acquiring acreage, shooting 2-D or 3-D seismic surveys, studying the geology and geophysics of a particular area, obtaining drilling rigs, and drilling exploration wells. Prospect = Exploration Prospect: a potential drilling location.

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Exploration Well = Wildcat Well: a well drilled to find a new reservoir, formation, or deposit of hydrocarbons. If successful, the well may be referred to as a discovery well. Appraisal Well = Step-Out Well = Delineation Well: a well drilled after a discovery well to gain more information about the reservoir. Most are drilled to help determine the size or extent of the reservoir or field. Sidetrack: to directionally drill around broken drill pipe, junk, or casing that has become permanently lodged at the bottom of an in-progress well.

Dry Hole: an unsuccessful exploration or development well. Well costs can range from tens of thousands of dollars all the way up to $100 million. Seismic: an exploration method used to map subsurface geological structures in order to locate potential hydrocarbon-bearing reservoirs (e.g., 2-D and 3-D seismic data). Acreage: land held under lease for the purposes of exploration and production of oil and gas. Can also be used to refer to a concession. Concession: a legal agreement between a government and an oil company whereby the company is granted a permit for the right to explore, drill and produce oil and gas in a certain area for a fixed period of time. If proved reserves are discovered, the permit is held through the productive life of the area. Today, most concession agreements are structured so that the government receives a bonus and royalty payments. The government does not usually participate in operations or marketing. Production Sharing Contract (PSC): an arrangement that is similar to a concession agreement, except the company is required to spend a specified amount of money each year for a specified time period. Furthermore, discovered reserves are owned by the government, rather than the company, with the company receiving a specified share of production, usually 15-20%. Royalty: the fractional share of the gross (free of costs, except taxes) production revenues from a well or lease that is retained by the owner of the mineral rights. In the U.S., the landowner receives the royalty on onshore leases, and the Federal government receives the royalty on offshore leases. In most foreign countries, royalties are paid only to the government. Note: mineral rights may be owned separately from the surface rights or together with the surface rights. Royalty Interest (RI): an economic interest retained by the mineral interest owner when that owner leases the property to another party. The RI receives a specified
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fractional share of the gross (free of costs, except taxes) production revenues from a well or lease. A royalty takes preference over all other payments from lease revenue. A typical royalty interest would be 12.5% of gross production revenues. The RI is a nonoperating or nonworking interest, meaning that it is passive. Working Interest (WI): the economic interest remaining after deducting all nonworking interests, including the royalty interest. The working interest must pay all of the costs of exploring for, developing and producing oil and gas. The working interest may be divided among several parties (for example Party 1 may have a 75% working interest and Party 2 may have the other 25% working interest). Net Revenue Interest (NRI): the share of production revenue after all royalties and other nonworking interests have been paid. For example, a company owning a 100% working interest on a lease will have a lower net revenue interest (87.5% would be typical) after royalty payments are paid to the owner of the royalty interest.

Production Terms
Development: the process of producing oil and/or gas from an area that contains proved reserves. This area may or may not be already under production. Exploitation: basically another word for development but also connotes activity in a more mature area and may not involve drilling new wells. May involve enhanced oil recovery techniques including secondary recovery and tertiary recovery. These include stimulating production levels through techniques like water flooding, steam injection, or fracturing the sands or rock in the reservoir in order to produce the reserves faster and/or more efficiently. Development Well: a well drilled in an area where proved reserves already exist in order to bring on new production. Horizontal Well: a well that is initially drilled vertically, then by directional drilling, it curves at an angle and is drilled horizontally, or at another non-vertical angle.

Infill Drilling: drilling wells between producing wells to increase production and possibly the ultimate recovery from the reservoir. Completion: the process of bringing a new well onto production. Includes adding steel casing (pipe) to the well (often using cement), perforating the casing, adding flow control equipment, etc. Fracture Stimulation = Fracture Treating = Frac Job: a well-stimulation process in which fluids and proppants are pumped into the reservoir at high pressure to artificially fracture it and increase permeability and production.

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Finding Cost = Finding & Development (F&D) Cost: capital spent in order to add new reserves or to initiate new production from an area containing proved reserves either through exploration and development activities. These expenditures are capitalized on the balance sheet as plant, property and equipment (PP&E) and eventually flow through the income statement in the DD&A expense line item. All-in Finding Cost = Finding, Development and Acquisition (FD&A) Cost: same as above but includes capital spent on acquisitions of proved reserves from another party. Operating Costs = Lease Operating Costs (LOE) = Production Costs = Lifting Costs: the direct costs incurred to operate and maintain wells and related equipment and facilities. Included are labor costs; repairs and maintenance; materials, supplies and fuel consumed and services utilized in operating the wells and related equipment; property taxes and insurance premiums; and finally severance taxes (a.k.a. production taxes), which are state taxes on the volume or value of oil or gas produced and sold.

Oil & Gas Value Chain: Think of a River

Upstream Segment
Involves all operations associated with finding and extracting oil and gas from the earth. Exploration & Production Sector The first step of exploration often involves leasing land from a private owner or government and studying it (geology, geophysics, 2-D and/or 3-D seismic). This will help boost chances of exploration success. Next step is to drill an attractive prospect(s). Most E&P companies contract out the actual drilling activities to oilfield services companies. If the well is successful and new reserves are encountered, next step is to produce the reserves (a.k.a. develop the reserves) out of the ground and sell them to a third party. The timing of both the development process and achieving first oil or gas production following a successful discovery varies significantly and can take up to several years, depending on the complexity of the required engineering and the availability of infrastructure. E&P company fortunes are tied directly to oil and natural gas prices. As producers of commodities, E&P companies are price takers, unless the company has locked in prices via hedging contracts. Oilfield Services Sector Includes rig construction, rig leasing, drilling, seismic, well logging, cementing, stimulation, etc. Oilfield services company fortunes are tied directly to capital spending in the E&P sector.

Midstream Segment
Involves all operations associated with transporting oil and gas from the wellhead to refineries, processing plants, and/or end-users. Oil can be transported by pipelines, trucks, and oil tankers. Natural gas midstream operations include gas pipelines and storage facilities. Operators usually carry little commodity price risk, and instead

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charge a transportation fee or tariff. Midstream sector fortunes are tied to demand from end markets and supply from commodity source.

Downstream Segment
Includes refining crude oil into crude oil products (gasoline, jet fuel, heating oil, diesel, fuel oil, asphalt, etc), marketing the crude oil products (retail gasoline stations and convenience stores), and/or chemicals divisions. An example of a pure-play downstream company is independent refiner Valero Energy. Downstream natural gas operations mostly involve local distribution companies (LDCs), a.k.a. natural gas utilities (e.g., KeySpan). Fortunes of the downstream sector are tied to refining margins, chemicals businesses, and consumer demand.

CONVERSIONS AND STATISTICS

1 barrel (bbl) of oil = 42 gallons 1 Mcf of natural gas = 1,000 cubic feet 1 MMcf = 1 million cubic feet 1 Bcf = 1 billion cubic feet 1 Tcf = 1 trillion cubic feet 1 Btu (British Thermal Unit) refers to heating value, rather than volume, but as a rule of thumb, 1 MMBtu (1 million Btus) = 1 Mcf (1,000 cubic feet) of natural gas Oil and gas can be statistically converted into one another based on heating values, or Btus 1 barrel (bbl) of oil 1,000 bbls of oil 1 MMbbls of oil 1 billion bbls of oil = = = = 6 Mcf of natural gas 6 MMcf of natural gas 6 Bcf of natural gas 6 Tcf of natural gas

Converting all of a company's reserves or production into crude oil gives you barrel oil-equivalent (boe) units Converting all of a company's reserves or production into natural gas gives you thousand cubic feet-equivalent (Mcfe) units

Exercise
Company XYZ has 1,200 MMcf of natural gas reserves and 200,000 barrels of crude oil reserves. How many boe's does it have? How many Mcfe's does it have? Oil-equivalent answer: 1,200 MMcf = 1,200,000 Mcf 1,200,000 Mcf / 6 = 200,000 boe 200,000 boe + 200,000 bbls = 400,000 boe (can also be written as 400 Mboe) Natural gas-equivalent answer: 200,000 bbls x 6 = 1,200,000 Mcfe 1,200,000 Mcfe + 1,200,000 Mcf = 2,400,000 Mcfe 2,400,000 Mcfe = 2,400 MMcfe (can also be written as 2.4 Bcfe)
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Putting Statistics Into Perspective

Crude Oil Market: A Global Market
World produces and consumes roughly 76 MMbbl/d (million barrels per day). OPEC produces about 26 MMbbl/d (million barrels per day), or a third of world supply. United States produces about 8 MMbbl/d (million barrels per day), or only 11% of world supply. United States consumes over 19 MMbbl/d (million barrels per day), or 25% of world supply. All global oil transactions occur in US dollars.

Table 3: A Perspective Of World Oil Reserves

Proved oil reserves 1,047 billion bbls 40.6 years 819 billion bbls 82 years 78 billion bbls 23 years 72 billion bbls 10 years 73 billion bbls 262 billion bbls 86 years 113 billion bbls 98 billion bbls 97 billion bbls 90 billion bbls 78 billion bbls 60 billion bbls 30 billion bbls 11 years % of total world reserves 100% 78% 7% 7% 7% 25% 11% 9% 9% 9% 7% 6% 3% -

World oil reserves (YE2002) World oil reserve life (YE2002) By Producer Group OPEC oil reserves (YE2002) OPEC oil reserve life (YE2002) Former Soviet Union oil reserves (YE2002) FSU oil reserve life (YE2002) OCED oil reserves (YE2002) OCED oil reserve life (YE2002) Other world oil reserves (YE2002) By Country (examples) Saudi Arabia oil reserves (YE2002) Saudi Arabia oil reserve life (YE2002) Iraq oil reserves (YE2002) UAE oil reserves (YE2002) Kuwait oil reserves (YE2002) Iran oil reserves (YE2002) Venezuela oil reserves (YE2002) Russian Federation oil reserves (YE2002) US oil reserves (YE2002) US oil reserve life (YE2002)
Source: BP Statistical Review of World Energy. Note: Figures have been rounded.

Natural Gas Market: Primarily a Regional Market, but LNG Is Changing This United States produces about 54 Bcf/d of natural gas, or about 20 Tcf per year. North America produces about 67 Bcf/d of natural gas, or about 24.5 Tcf per year. Canada is a net exporter of natural gas to the U.S. as U.S. demand is close to 65 Bcf/d. Liquefied natural gas (LNG) has made major strides in recent years in bringing stranded natural gas to developed markets. We expect the gas market will move to a more global market as a result of advances in LNG.

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Table 4: A Perspective Of World Natural Gas Reserves

Proved gas reserves 5,502 Tcfe 61 years 1,953 Tcfe 76 years 1,680 Tcfe 812 Tcfe 509 Tcfe 225 Tcfe 212 Tcfe 184 Tcfe 10 years 160 Tcfe 124 Tcfe 60 Tcfe 9 years % of total world reserves 100% 35% 31% 15% 9% 4% 4% 3% 3% 2% 1% -

World gas reserves (YE2002) World gas reserve life (YE2002) By Country or Producer Group (examples) Former Soviet Union gas reserves (YE2002) FSU gas reserve life (YE2002) Russian Federation gas reserves (YE2002) Iran gas reserves (YE2002) Qatar gas reserves (YE2002) Saudi Arabia gas reserves (YE2002) UAE gas reserves (YE2002) US gas reserves (YE2002) US gas reserve life (YE2002) Algeria gas reserves (YE2002) Nigeria gas reserves (YE2002) Canada gas reserves (YE2002) Canada gas reserve life (YE2002)
Source: BP Statistical Review of World Energy. Note: Figures have been rounded.

Table 5: A Perspective Of Reserves By Company, Field and Well

Comment By Company (Examples) Exxon Mobil - YE2002 Anadarko Petroleum - YE2002 Noble Energy - YE2002 Westport Resources - YE2002 Quicksilver Resources - YE2002 Spinnaker Exploration - YE2002 By Field or Well (Examples) Prudhoe Bay Thunder Horse Standalone successful Deepwater GOM field (range) Standalone successful Deepwater GOM field (average) Successful Deep Shelf GOM target (range) Successful Deep Shelf GOM target (average) Successful Conventional GOM Shelf well (range) US onshore conventional well (range) Coal Bed Methane well (range) Largest Supermajor Large-cap E&P Large-cap E&P Mid-cap E&P Small-cap E&P Small-cap E&P Largest oilfield in N. America Largest oilfield in GOM Proved reserves (oil-equivalent) 21,109 MMboe 2,328 MMboe 468 MMboe 263 MMboe 133 MMboe 54 MMboe 23 billion boe* 1-3 billion boe 75 MMboe - 3,000 MMboe 100-150 MMboe 3-33 MMboe 3 MMboe 0.5-7 MMboe 125 Mboe-17.0 MMboe 25 Mboe-3.3 MMboe Proved reserves (gas-equivalent) 126,654 Bcfe 13,968 Bcfe 2,808 Bcfe 1,578 Bcfe 798 Bcfe 324 Bcfe 138 Tcfe* 6-18 Tcfe 450 Bcfe - 18,000 Bcfe 600-900 Bcfe 20-200 Bcfe 20 Bcfe 3-40 Bcfe 750 MMcfe-100 Bcfe 150 MMcfe-20 Bcfe

Source: Company reports, MMS, Netherland, Sewell & Associates, and JPMorgan estimates. * Includes 10 Bboe produced to date and 13 Bboe of estimated recoverable reserves.

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Table 6: A Perspective Of Production By Company, Field and Well

Comment By Company (Examples) Exxon Mobil - 2002 Anadarko Petroleum - 2002 Noble Energy - 2002 Westport Resources - 2002 Spinnaker Exploration - 2002 Quicksilver Resources - 2002 By Field or Well (Examples) Deepwater GOM field (range) Deepwater GOM field (average) Deep Shelf GOM target (range) Deep Shelf GOM target (average) Conventional GOM Shelf well (average) US onshore conventional well (average) Coal Bed Methane well (range)
Source: Company reports, MMS, Netherland, Sewell & Associates, and JPMorgan estimates.

Production (oil-equivalent) 1,077 Mboe/d 540 Mboe/d 99 Mboe/d 59 Mboe/d 23 Mboe/d 18 Mboe/d Initial Production 25-250 Mboe/d 50 Mboe/d 3-58 Mboe/d 5-8 Mboe/d 2 Mboe/d 0.4 Mboe/d 8-833 boe/d

Production (gas-equivalent) 6,462 MMcfe/d 3,239 MMcfe/d 592 MMcfe/d 356 MMcfe/d 141 MMcfe/d 107 MMcfe/d Initial Production 150-1,500 MMcfe/d 300 MMcfe/d 20-350 MMcfe/d 28-45 MMcfe/d 13 MMcfe/d 2.5 MMcfe/d 50 Mcfe/d-5 MMcfe/d

Largest Supermajor Large-cap E&P Large-cap E&P Mid-cap E&P Small-cap E&P Small-cap E&P

E&P STOCKS AS INVESTMENTS

E&P stocks represent a "pure play" investment on oil and gas prices. Most investors prefer to invest in E&P stocks rather than oil and gas futures as many institutional investors are prohibited from futures trading, futures have margin requirements, and futures contract sizes are large. Exposure to oil versus natural gas varies widely among E&P companies. In general, the average E&P company is more exposed to gas than oil. As a result, most E&P investors focus more on natural gas prices and fundamentals than oil prices and OPEC, but the latter is obviously still quite important.

Types of E&P Companies

Pure Exploration Companies: Rely solely on the drillbit (i.e., drilling exploration wells) for growth in reserves and production. Requires highly skilled exploration technical staff. May command a premium because not beholden to M&A market for growth. Example: Spinnaker Exploration Acquire and Develop Companies (a.k.a. Acquire and Exploit Companies): For the most part, these companies take the "E" out of E&P, as exploration activity is either not very significant or non-existent. Instead, the strategies of these companies involve acquiring mature properties and reserves from other companies and developing or exploiting the reserves. In the past 10-20 years, the majors in general have been slowly shedding lower return, mature assets in the U.S. in search of higher returns abroad. Many E&Ps have found a niche in acquiring such properties (both from majors, integrateds, and even larger E&Ps), and paying closer attention to the properties in order to add value. This may involve enhanced oil recovery techniques including secondary recovery and tertiary recovery. These include stimulating production levels through techniques like water flooding, steam injection, or fracturing the sands or rock in the reservoir in order to produce the reserves faster and/or more efficiently. The major
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drawback for these types of companies is the fact that they are beholden to M&A market as a source of growth. The M&A market is highly competitive and can be quite efficient, so it is often hard to truly add value. Example: XTO Energy Combination of Both: Most E&P companies employ a combination of both strategies discussed above. This approach is a little more flexible. Companies often like to concentrate on exploration and development drilling when commodity prices are high and acquiring reserves when commodity prices (and therefore asset prices) are low. Example: Most E&P companies

What Matters to Investors

Cash Flow Growth: Although more emphasis is being placed these days on returns and profitability metrics like ROCE, the typical E&P investor is more focused with the rate companies grow their cash flow (a.k.a. discretionary cash flow or cash flow from operations before changes in working capital). Over the long run, companies cannot grow cash flow without growing production, so there is a huge emphasis on production growth. On that note, companies can't sustain production growth without finding or acquiring new reserves, so reserve growth is also highly important. Production Growth: Growing production is easier said than done, as natural decline rates can be difficult to offset (think of a filled water balloon with the tip pointed upwardas water flows out, pressure drops and the rate that the water flows out decreases). Most E&Ps will do well to show any growth at all, barring specific major development project(s) coming on-line, or a boost in drilling activity. Cost Control: Keeping costs in check is challenging in an environment where costs are creeping up across the industry (see Figure 1). Finding, development and acquisition costs (FD&A costs) include capital spent in order to add new reserves either through exploration and development activities, or through acquisitions of new properties or companies. These expenditures are capitalized on the balance sheet as plant, property, and equipment (PP&E) and eventually flow through the income statement in the DD&A expense line item. FD&A costs are especially important because they usually represent the greatest portion of a company's cost structure. Production costs (a.k.a. lifting costs, operating costs, lease operating expense, or LOE) are also important. We note that the characteristics of particular fields or basins (geology, infrastructure, oil field service costs, politics, etc) can vary significantly, which can meaningfully affect FD&A and operating costs. G&A and interest expenses are usually a smaller portion of the cost equation.

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Figure 1: Cost Creep

Average all in costs, $/Mcfe
$3.00 $2.69 $2.50 $2.13 $2.00 $1.87 $1.96 $1.81 $2.42 $2.30 $2.64 $2.67

$1.50

$1.00

$0.50

$0.00 1997 1998 1999 2000 2001 2002 2003E 2004E 2005E

Source: Company reports and JPMorgan estimates. Note: We define all-in costs as LOE (including production/severance taxes and transportation costs), DD&A, net interest (including preferred dividends), and G&A expenses.

Return and Profitability Metrics: More emphasis is being placed on return and profitability metrics like return on capital employed (ROCE) and profit margins. Although commodity prices have generally been strong in the past few years, bolstering the top line, the phenomenon of "cost creep" has hampered returns on capital employed (see Figure 2).

Figure 2: Generating Mid-Cycle ROCEs Requires 30-35% Higher Prices Today

18% 16% 14% 12% 10% 8% 6% 4% 2% 0%

Estimated 2004 ROCE in line with L.T. average, despite assuming 33% higher av'g O&G prices
10-yr average: 8%

6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50

93

94

95

96
ROCE

97

98

99

00

01

02 03E 04E

Commodity Px Index ($/Mcfe)

Source: Company reports, JPMorgan estimates. Note: ROCE is defined as recurring earnings plus tax-effected interest (~NOPAT) divided by stockholders' equity plus debt. Commodity price index is a 50/50 oil/gas weighted index, stated in Mcf-equivalents converting at 6:1.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Catalysts: Investors often look for catalysts that can move a stock. Positive catalysts would include successful results of a key exploration well, first production from a key development project; an accretive acquisition at an attractive price, a boost in production guidance, a share repurchase program, or any macro factors that positively affect oil and gas prices. Negative catalysts would include a dry hole announcement at a key exploration well, delays at a key development project, disappointing reservoir performance or characteristics of a development field or project versus original expectations, a reduction of production guidance, an asset impairment charge (a.k.a. reserve writedown), or the announcement of an equity offering.

Hedging: Strategies among management teams vary, and investors have varying opinions as to whether or not companies should hedge. Some investors want full and complete exposure to commodity prices (remember the pure-play concept), while others prefer some degree of hedging, which can be used by management to protect its balance sheet, protect a capex program (thus helping ensure production growth), or lock-in the economics of a particular acquisition or a large development project coming online.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Figure 3: Summary E&P Hedge Positions, 2004E

As of August 21, 2003
800 *Average Hedge Position: 21% of Estimated 2004 Production 700
24% 44.63

$50.00

$45.00

40.85

600
35.78 23% 33.87 3% 33.07 16%

39.35

$40.00
Weighted Average Hedged Price ($-Boe)
35.30

Total 2004E Production (Mboe/d)

500

$35.00
3% 30.22 28.14 28.71 28.29 26.47 24.04 0% 31% 40% 10% 15% 16% 42% 9% 67% 59% 0% 0% 44% 15.75 23.88

400

27.69 26.04 26.60

$30.00
25.19 25.67

24.87 24.90

300
24.33 22.37 23.10

0%

$25.00
24.28

23.16

200

21.32

$20.00

100

$15.00

DVN APC UCL APA BR KMG EOG PXD XTO NBL NFX FST WRC TBI THX PXP SKE SFY KWK

$10.00

Hedged Volumes
Source: Company reports and JPMorgan estimates.

Unhedged Volumes

Avg. Floor and Ceiling Prices

Balance Sheet: Financial flexibility is crucial in the E&P sector, especially considering most E&P companies rely on acquisitions for meaningful growth. When commodity prices fall from peak to trough levels, stocks with higher financial leverage tend to underperform the group. Most independent E&P companies are below investment grade, with the exception of a select few including most of the larger cap names. The average net debt to capital ratio in our coverage universe stood at 41% at the end of Q1/03, with a range of -3% (SKE) to 66% (KWK). The average net debt to EBITDAX ratio in our coverage universe stood at 1.3 at the end of Q1/03.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Macro Data to Watch

Weekly Natural Gas Storage Levels (see Figure 4): Weekly storage reports are published every Thursday at 10:30 Eastern by the Energy Information Administration (EIA), a division of the US Department of Energy (DOE). Because a large proportion of natural gas demand is weather driven (used for heating), production in the spring, summer and fall exceeds demand, so there are net gas injections into storage facilities. Storage levels typically peak on or around October 31. From early November to late March, demand significantly exceeds production, so there are net gas withdrawals from storage. Storage levels typically trough on or around March 31st. Investors watch storage levels closely because natural gas prices are highly correlated with the tightness of storage levels. Prices tend to drop as storage levels move above average, and prices tend to rise when storage levels fall below average. Weekly Rig Counts: Baker Hughes publishes weekly rig counts every Friday. When rig counts rise, drilling activity is picking up. This is bearish for E&P stocks for two reasons. First, it signals that new supply (production) may increase. Second, it indicates that demand for rigs is increasing, which may boost E&P drilling costs. Weekly Crude Oil Reports: Weekly crude oil reports are published every Wednesday at 10:30 am ET by the EIA. The report details U.S. oil and oil product statistics including inventories, imports, demand, refining utilization, etc. E&P investors watch this report for much the same reason that they watch the weekly natural gas storage report. Crude oil prices are in part driven by the tightness of inventory levels. Prices tend to drop as inventories move above average, and prices tend to rise when inventories fall below average. Quarterly Gas Production Figures From North American Producers: The JPMorgan North American Natural Gas Supply Monitor is a bottom-up survey that attempts to estimate changes and trends in North American natural gas production by the industry, based on quarterly results from producers. Decline in supply is bullish for gas prices, and growth in supply is bearish for gas prices. Government Natural Gas Supply and Demand Data: Each month, the EIA releases gas supply and demand data, but these are of questionable value because the data lags significantly and is typically subject to later revisions. OPEC-Related News: OPEC represents roughly one third of worldwide oil supply, and thus has a major influence on prices.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Figure 4: Henry Hub Spot Natural Gas Prices and Working Gas Storage Levels
10 9 8 7 6 5 4 3 2 1 0
3700.0 3200.0 2700.0

$/MMBTU

bcf

2200.0 1700.0 1200.0 700.0 200.0 J F M A M J 2002 J A 2003 S O N D 5 Yr Range 5-Yr Avg

Source: Natural Gas Week, EIA, Bloomberg.

Ja n93 Ja n94 Ja n95 Ja n96 Ja n97 Ja n98 Ja n99 Ja n00 Ja n01 Ja n02 Ja n03

VALUATION
Six Most Important E&P Valuation Metrics: Price/Cash Flow (P/CF): Stock price divided by discretionary cash flow (cash flow from operations before changes in working capital). In times of low commodity prices, multiples expand and in times of strong commodity prices, multiples contract. Enterprise Value/EBITDAX: A better metric than P/CF in our opinion because it adjusts for financial leverage (i.e., a highly-leveraged company may look cheap on a P/CF basis but more average or even rich on a EV/EBITDAX basis). The "X" in EBITDAX stands for the exploration expense for successful efforts companies (see discussion on page 22 entitled Why Earnings Are Less of a Concern to E&P Investors). In times of low commodity prices, multiples expand and in times of strong commodity prices, multiples contract. The E&P sector has traded at 6.0 times forward EBITDAX on average during the past five years, with a high of 11.0 and a low of 3.1. Enterprise Value/normalized EBITDAX: Same calculation as EV/EBITDAX, but the EBITDAX is based on a theoretical normalized value that is estimated assuming mid-cycle commodity prices of $3.50/MMbtu Henry Hub gas and $21/bbl WTI oil. Unlike the plain vanilla EV/EBITDAX multiple, this multiple contracts in times of low commodity prices and expands and in times of strong commodity prices. The E&P sector has traded at 5.5 times forward normalized EBITDAX on average during the past five years, with a high of 8.5 and a low of 3.3.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Enterprise Value/normalized Asset Value: A discounted cash flow analysis that assumes mid-cycle commodity prices of $3.50/MMbtu Henry Hub gas and $21/bbl WTI oil. The analysis mimics the SEC present value calculation (PV-10) that is required to be disclosed in the reserve section of companies' 10-Ks. The SEC calculation requires the assumption of whatever the prevailing commodity prices were at the end of a reporting period. This leads to significant volatility in the PV-10 calculation from one year to another, simply because of fluctuating commodity prices. Unlike the SEC calculation, our calculation assumes that normalized midcycle prices are held flat forever. Stocks can trade at discounts or premiums to their normalized asset values, depending on the commodity price cycle. The E&P sector has traded at 94% of normalized asset value on average during the past five years, with a high of 147% and a low of 55%. Enterprise Value/Reserves: A simplistic valuation tool that requires no estimates or assumptions. In general, this metric should not be used as a primary valuation multiple, as not all reserves were created equal, but it can serve as a useful point of reference. This metric is often used to evaluate the valuation of property acquisitions, when little is known about the specific cash flow generating potential of the acquired reserves. Companies also sometimes prefer to repurchase stock if the shares are trading below the EV/ Reserve multiples of potential corporate or property acquisitions. In general, the longer the reserve life of a company or property, the lower the EV/Reserve multiple, all other things being equal. This is because reserves with a longer reserve life (reserves/production ratio, or R/P ratio) take longer to produce and are therefore worth less on a time-value-of-money basis. The proportion of proved undeveloped reserves (PUDs) in the reserve base also affects this multiple. In general, the greater the proportion of proven undeveloped reserves, the lower the EV/Reserve multiple, all other things being equal. Asset Intensity: We believe a producer's finding efficiency and asset characteristics can be combined into a single metric that strongly indicates the potential for future growth. This metric is called asset intensity and is simply defined as the proportion of discretionary cash flow required in order to maintain flat production in a given period. We reason that those companies having more cash flow available after base declines are offset should be able to deliver higher and more sustainable growth.
Figure 5: Definition of Asset Intensity
Lower is Better

Maintenance Capex* Asset Intensity = Discretionary Cash Flow

* Note: Maintenance capex is defined as [ (Production Volumes * 3-yr Avg. FD&A) + non-E&P segment maintenance capex ] Source: JPMorgan.

As Figure 5 suggests, there are two components to our asset intensity metric: maintenance capital spending, or that investment required to keep production flat on an annual basis; and projected discretionary cash flow.
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North American Equity Research Houston 8 September 2003

To estimate maintenance capex, we employ a model that incorporates individual company decline curve profiles and indicative future finding costs. As a rough approximation of maintenance capex, however, an investor could simply multiply projected production volumes by the projected unit cost to find and develop, which is based on each company's three-year average (all-in) finding, development and acquisition (FD&A) costs per Mcfe. Also, for those companies needing to devote a certain amount of capital toward maintaining non-E&P businesses (such as chemicals or R&M), one would want to add in estimated maintenance capex for those businesses as well. Once we have a good approximation of maintenance capex, we divide that amount by estimated discretionary cash flow for that year. Our asset intensity calculation accounts for the tradeoffs inherent in unusually short or long reserve lives. Companies that generate a lot of cash flow due to a short reserve life also have a significant amount of production to replace each year, so the difference between favorable (low) asset intensity and high asset intensity can come down to finding and operating cost efficiency. Conversely, a longer lived producer will not have as great a maintenance burden since near-year production is a smaller portion of the total asset base, but the cash flow being generated from that asset base is also more limited. Again, finding efficiency and operating cost structure can make all the difference.

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North American Equity Research Houston 8 September 2003

Figure 6: Lower Asset Intensity Indicates Greater Growth Potential

XTO KWK APA PXD MUR BR NBL DVN CHK EOG NFX PXP OXY THX WRC FST SFY APC KMG SKE TBI UCL
47% 50%

Median = 63%
55% 56% 57% 58% 59% 60% 60% 61% 63% 64% 64% 66% 70% 70% 70% 70% 71% 72% 73% 74%

Less Attractive

More Attractive

0%

10%

20%

30%

40%

50%

60%

70%

80%

Source: Company reports and JPMorgan estimates. Note: Maintenance capex is defined as estimated capital spending required to keep production flat (see text for details). Our 2004 discretionary cash flow estimates are based on $4/MMbtu Henry Hub gas and $25.80/barrel WTI oil. For KMG, we include $80MM in assumed maintenance capex relating to its TiO2 business. For OXY, we include $100MM relating to its chemicals business. For MUR, we include $35MM relating to its R&M operations. Note: Anadarko Petroleum(APC/$44.10/Neutral) Apache(APA/$68.62/Overweight) Burlington Resources(BR/$48.40/Neutral) Devon Energy(DVN/$51.43/Neutral) EOG Resources, Inc.(EOG/$42.45/Neutral) Forest Oil Corporation(FST/$22.99/Underweight) Houston Exploration(THX/$34.41/Neutral) Kerr-McGee(KMG/$43.30/Underweight) Murphy Oil(MUR/$57.10/Overweight) Newfield Exploration Company(NFX/$38.42/Neutral) Noble Energy(NBL/$39.70/Underweight) Occidental Petroleum(OXY/$34.99/Overweight) Pioneer Natural Resources(PXD/$25.00/Overweight) Plains Exploration & Production(PXP/$12.40/Neutral) Quicksilver Resources Inc(KWK/$24.70/Overweight) Spinnaker Exploration Company(SKE/$22.17/Neutral) Swift Energy Company(SFY/$13.79/Underweight) Tom Brown, Inc(TBI/$26.70/Neutral) Unocal(UCL/$30.97/Overweight) Westport Resources(WRC/$23.96/Neutral) XTO Energy(XTO/$20.64/Overweight)

Why Earnings Are Less of a Concern to E&P Investors

Successful Efforts Versus Full Cost Accounting: Companies are given a choice between two methods to account for dry holes (unsuccessful exploration wells). Companies that employ the successful efforts method of accounting must expense the cost of the well immediately through the income statement. By contrast, companies that use the full cost method of accounting must capitalize the cost of the dry hole onto the balance sheet, and eventually amortize it through DD&A expense. Therefore, earnings from successful efforts companies can be very erratic, compared to those of full cost companies. The two accounting methods produce apples and oranges when looking at relative P/E ratios within the sector. Negative Earnings Are Common in Years of Low Commodity Prices: The fortunes of E&P companies are largely tied to oil and gas prices, which are cyclical. In times of weak prices, many E&P companies have negative earnings, making P/E ratios not meaningful. The integrated oil companies and majors have other businesses that usually do well when oil and gas prices are weak (like refining, marketing, and chemicals businesses).

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Appendix I: Hypothetical E&P Press Releases

Exploration Discoveries
Example 1: Deepwater Gulf of Mexico Discovery Press Release: Orange Resources reported today that an exploratory well testing the Humphrey Bogart Prospect on Garden Banks Block 782 in the Gulf of Mexico encountered over 360 net feet of pay in four intervals. The Garden Banks Block 782 #1 exploratory well, located in 4,642 feet of water, was drilled to a true vertical depth of 15,717 feet. Each pay zone was encountered at the predicted depth and generally met or exceeded the anticipated thickness. The rig Ocean Victory will stay on location to conduct subsequent appraisal drilling at Humphrey Bogart that will target several additional shallow and deep objectives that could not be penetrated from the initial wellbore location. Orange owns a 20 percent working interest in the Humphrey Bogart Prospect on Garden Banks Block 782 as well as in adjacent blocks 826 and 827 and nearby block 785. Purple Exploration holds an 80 percent working interest in these same blocks and serves as operator. Interpretation: Unless unrisked (total potential) pre-drill reserve estimates were disclosed prior to drilling this well, it is difficult to estimate the size and value of this discovery. However, one can deduce a few takeaways: First, Orange believes there is a chance the deepwater discovery is commercial, otherwise, it would not conduct appraisal drilling, and the well would likely be plugged and abandoned. Second, it is unlikely that there is any nearby infrastructure with spare capacity that could be utilized to more efficiently and more cheaply develop the discovery, otherwise, the press release would have likely mentioned this. This means that in their ultimate evaluation of the potential economics of the discovery, Purple and Orange will likely need to assume that a new production facility will need to be built in order to develop the reserves. Finally, because the well was drilled in very deep water (in the Gulf of Mexico, any depth greater than roughly 655 feet of water is considered deepwater) in an area with no nearby available infrastructure capacity, one can safely deduce that the target size of the reservoir was likely above 75 million boe. As a rule of thumb, undeveloped deepwater Gulf of Mexico discoveries have around $3-4/boe worth of net present value. Therefore, if this discovery is ultimately declared commercial, we would peg its NPV to be between $225-300 million on a gross basis, or $45-60 million net to Orange. Example 2: Deepwater Gulf of Mexico Discovery Press Release: Green and Yellow Petroleum Corporation announced a successful discovery at its Cary Grant prospect, located in 6,000 feet water depth in the Boarshead basin, 125 miles south-east of New Orleans, Louisiana. With estimated recoverable oil of at least one billion barrels of oil equivalent (boe), it is the biggest discovery ever in the Gulf deepwater. Green and Yellow is operator and holds a 75 percent interest. Partner Blue and Orange Oil holds 25 percent equity.
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North American Equity Research Houston 8 September 2003

Interpretation: This is obviously a huge discovery. Most deepwater exploration wells target a minimum of 75 million boe of gross reserves in areas with no nearby available infrastructure capacity. This press release states with confidence that the field holds at least one billion boe. As a rule of thumb, undeveloped deepwater Gulf of Mexico discoveries have around $3-4/boe worth of net present value. Therefore, we would peg its NPV to be at least $3-4 billion on a gross basis, or at least $2.25-3.00 billion net to Green and Yellow Petroleum. Example 3: Deepwater Gulf of Mexico Discovery Press Release: Violet Energy today announced a natural gas discovery at its James Cagney prospect in the Eastern Gulf of Mexico. The discovery well is located in Atwater Valley 349, and was spudded in 8,800 feet of water, about 200 miles southeast of New Orleans. It encountered a total of 83 feet of net pay and was drilled to the target depth of 18,310 feet using the Deepwater Millennium drillship. Estimated field size is 40 million to 50 million barrels of oil equivalent. Violet holds a 100 percent interest in the James Cagney discovery and adjacent blocks. The company believes James Cagney could be commercially produced when hub facilities are established in the area. Toward that goal, Violet will soon begin drilling its high-potential Spencer Tracy prospect located at Lloyd Ridge Block 360 in 9,100 feet of water. Interpretation: This is technically a discovery, but we would not necessarily call it a successful discovery, given its size (40-50 MMboe), water depth, and the lack of available infrastructure capacity. As a rule of thumb, companies drilling in deepwater in an area with no nearby available infrastructure capacity are targeting at least 75 million boe of gross reserves to justify a standalone commercial development project. These results therefore likely came in below the company's expectations. Furthermore, the company admits that the find is not commercial, unless other discoveries are found in the area that will augment economics. Until that occurs, the market will likely ascribe little-to-no value to James Cagney. Example 4: Deep-Shelf Gulf of Mexico Discovery Press Release: Pink Exploration today announced its first shallow-water, deep-shelf gas discovery at its Jimmy Stewart prospect at High Island 115 in 44 feet of water. The #1 well was drilled to 19,800 feet and tested 20 million cubic feet of gas per day. The company anticipates first production in seven to eight months, pending construction of facilities. Pink Exploration has a 50 percent working interest in the project. The well is operated by Beige Oil and Gas as a part of the previously announced jointventure agreement between both companies. Interpretation: Unless unrisked (total potential) pre-drill reserve estimates were disclosed prior to drilling this well, it is difficult to estimate the size and value of this discovery. However, one can use the production test rate data to back into an approximate gross reserve size. One could assume that, as a rule of thumb, a deep-shelf well will likely produce roughly half of its reserves in the first year, given the steep hyperbolic decline rates of shelf wells, and the other half over the next three or four years. Therefore, a well that initially produces 20 MMcf/d will likely produce around 7 Bcf of gas in year 1, implying total gross reserves of about 14 Bcf. Assuming these undeveloped gas reserves have a NPV of $0.80-0.90/Mcfe (worth more than deepwater undeveloped reserves because they can be brought onto production at much faster rates, sometimes through existing infrastructure), we would peg the NVP
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North American Equity Research Houston 8 September 2003

of the discovery between $11-12.5 million on a gross basis, or $5.5-6.3 million net to Pink.

Successful Appraisal Well

Example 1: Successful Deepwater Appraisal Well Press Release: Grey Land & Exploration and its partners today announced another successful deepwater subsalt appraisal well on their Clark Gable discovery, located in the Gulf of Mexico on Green Canyon Block 562, about 180 miles south of New Orleans. "We're pleased to discover the potential field size of Clark Gable could be larger than Grey's previous estimates," said Grey's Chairman, President and CEO John Q Smith. "The Clark Gable No. 3 appraisal well was intended to confirm the northwestern edge of the field, but the field extends even deeper and farther beyond what we had predicted. In fact, the outermost limits of Clark Gable are still unknown." The Clark Gable No. 3 well was spudded by Black Gold Petroleum Co. in February 2003 in about 3,900 feet of water. The well reached a total depth of more than 27,000 feet and encountered a total of 208 feet of oil pay in two sands with no oil-water contact. The findings confirm the prior estimated gross reserves of about 100 million barrels of oil equivalent, and the lack of an oil-water contact suggests additional reserve potential. The well extended the limit of the proven oil column down dip an additional 800 feet on the Clark Gable structure. Grey holds a 52.5 percent working interest in the project; other partners include Black Gold (operator - 18.2 percent), Aqua Energy (16.8 percent) and Indigo Hydrocarbons (12.5 percent). The Clark Gable partner companies expect to make a decision on development plans as early as this summer. They are considering options including a separate structure or a tieback to the nearby Gregory Peck facility, which will be installed late this year and operated by Grey. First production from Clark Gable could be late 2004 or early 2005. Interpretation: From previous press releases, we know that Clark Gable was originally discovered in 1999, and an appraisal well was drilled in September 2002. The latest No. 3 well thus represents the second successful appraisal well drilled in the area. While the success of this well is obviously good news, the impact on Grey's stock price will be limited by the fact that the partners had already provided a 100 million boe estimate for the size of Clarke Gable. Most of the NPV of Clarke Gable was likely already discounted into the stock prior to the drilling of the No. 3 well. However, there may be a modest to moderate amount of upside in the stock, given the CEO's comments that Clarke Gable may be larger than previously estimated due to the lack of an oilwater contact.

Unsuccessful Appraisal Well

Example 1: Unsuccessful Deepwater Appraisal Well Press Release: Ewing Bank Block 994 (Marlon Brando Discovery)The initial exploratory well drilled at this location encountered 185 feet of pay. A delineation well failed to encounter hydrocarbons of sufficient commercial quantities to justify further development of this discovery. Brown Exploration & Production has a 40% working interest. The companys proved reserves as of December 31, 2001, included 7.2 million barrels of oil and 13 billion cubic feet of natural gas attributable to Marlon Brando.

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Shannon Nome (1-713) 216-1918 shannon.nome@jpmorgan.com

North American Equity Research Houston 8 September 2003

Interpretation: While this field was relatively small to begin with given the amount of reserves the company has booked, this is not good news and it will likely negatively impact Brown's stock, considering Brown is a small-cap E&P company. Brown had already booked reserves at Marlon Brando, so this will result in negative reserve revisions in the company's year-end financial statements. Furthermore, Brown's stock price likely accorded some value to the Marlon Brando reserves. Assuming the market valued these undeveloped reserves at $3-4/boe, between $28-37 million of NPV could be wiped out of the company's market capitalization. The downside could be even lower considering the negative effects on production growth estimates and financial leverage.

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North American Equity Research Houston 8 September 2003

Analyst Certification The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple analysts are primarily responsible for this research, the analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research.
JPMorgan Equity Research Ratings Distribution Overweight Neutral Underweight JPM Global Equity Research Coverage 34% 41% 25% IB clients* 26% 24% 22% Energy - N. America & Latin 24% 55% 22% IB clients* 67% 63% 42% *Percentage of investment banking clients in each rating category. For purposes of NASD/NYSE ratings distribution disclosure rules, our Overweight rating most closely corresponds to a buy rating; our Neutral rating most closely corresponds to a hold rating; and our Underweight rating most closely corresponds to a sell rating.

Legal Disclosures: Lead or Co-manager: JPMSI and/or its affiliates acted as lead or comanager in a public offering of equity and/or debt securities for Burlington Resources, Inc., Forest Oil Corporation, Murphy Oil, Newfield Exploration Company, Occidental Petroleum, Plains Exploration & Production, Westport Resources and XTO Energy Inc. within the past 12 months. Investment Banking (past 12 months): JPMSI and/or its affiliates received in the past 12 months compensation for investment banking services from Anadarko Petroleum Corp, Apache Corporation, Burlington Resources, Inc., Devon Energy Corporation, Forest Oil Corporation, Houston Exploration Co., Newfield Exploration Company, Noble Energy, Inc., Occidental Petroleum, Plains Exploration & Production, Unocal and XTO Energy Inc.. Investment Banking (next 3 months): JPMSI and/or its affiliates expect to receive, or intend to seek compensation for investment banking in the next three months from Anadarko Petroleum Corp, Apache Corporation, Burlington Resources, Inc., Devon Energy Corporation, EOG Resources, Inc., Forest Oil Corporation, Houston Exploration Co., Murphy Oil, Newfield Exploration Company, Noble Energy, Inc., Occidental Petroleum, Pioneer Natural Resources Co., Plains Exploration & Production, Tom Brown, Inc, Unocal, Westport Resources and XTO Energy Inc..

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North American Equity Research Houston 8 September 2003

Copyright 2003 J.P. Morgan Chase & Co.All rights reserved. Additional information available upon request. All research labeled North American Equity Research or Latin American Equity Research is a product of J.P. Morgan Securities Inc. (JPMSI). Legal Entities: JPMorgan is the marketing name used on global equity research issued by JPMSI and/or its affiliates worldwide. JPMSI is a member of NYSE, NASD and SIPC. The analysts who write global equity research are employees of JPMSI or its affiliated companies worldwide, including the following companies. J.P. Morgan Securities Ltd. (JPMSL), J.P. Morgan plc (JPM) and J.P. Morgan Europe Limited are authorised by the FSA. JPMSL is a member of the LSE. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities Asia Private Limited is regulated by the Monetary Authority of Singapore (MAS) and the Japan Financial Services Agency (FSA). J.P. 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Explanation of Ratings: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will under-perform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Prior to September 25, 2002, our rating system was: Buy--we expect the stock to outperform the market by a minimum of 5% within an investment horizon of one year. Long-Term Buy--we believe the stock will outperform the market over the long run, but we lack the visibility of a catalyst for outperformance within a one- year investment horizon; Market Performer --the stock is expected to perform in line with the market; Market Underperformer--we expect the stock to underperform the market by a minimum of 5% within an investment horizon of one year. U.K. and European Economic Area: Issued and approved for distribution in the U.K. and the European Economic Area (EEA) by JPMSL, JPM and JPMEL. All research issued to private clients in the U.K. is subject to the following: the investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Investors may get back less than they invested. Changes in rates of exchange may have an adverse effect on the value of investments. Revised August 22, 2003

This material is distributed in Japan by J.P. Morgan Securities Asia Pte Limited This material is issued and distributed in Singapore by J.P. Morgan Securities Singapore Private Limited [MITA (P) No. 213/05/2003] This material is issued and distributed in Malaysia by J.P. Morgan Malaysia Sdn. Bhd. (18146-X)