MORGAN STANLEY DEAN WITTER

Equity Research North America

In-Depth

Page 1

Industry

Exploration & Production

Industry Overview

Lloyd Byrne (byrnel@ms.com) (212) 761-8343 Philip Kehl (kehlp@ms.com) (212) 761-3472

May 15, 2000

E&P Valuation Mosaic, An Industry Primer

E&P Valuation Mosaic covers the fundamental basics . . .
In the following pages, Lloyd Byrne and Philip Kehl walk through the basics of the exploration and production group, addressing primary valuation metrics, accounting vagaries, emerging trends and close with our current investment perspective.

Please refer to important disclosures at the end of this report.

MORGAN STANLEY DEAN WITTER

Page 2

E&P Valuation Mosaic, An Industry Primer

In the following pages, Lloyd Byrne and Philip Kehl walk through the basics of the exploration and production group, addressing primary valuation metrics, accounting vagaries, emerging trends and close with our current investment perspective.

Setting the Stage: The oil and gas industry is a data-friendly environment. As analysts, we have almost instant access to oil and gas prices worldwide. We can also ascertain any companys production levels with a reasonable degree of accuracy. With experience we know the characteristics of numerous fields and the production costs associated with each. The costs of third party products and services can also be determined fairly accurately. As we learn the operating style of management, we can estimate a companys cost of adding reserves by including in our calculations an appraisal of managements skill, while allowing for some degree of luck. Which of these metrics is the most important? How can we use them to determine value? These are some of the questions we will try to answer in this introduction to our compilation of E&P statistics. The most important factor to consider is that E&P stocks are both commodity surrogates and financial instruments. If we wish to view them only as commodity surrogates, then E&P companies are best analyzed with a finely tuned oil and gas price forecast. We also should study a reserve report and the companys cost structure. If we view E&P stocks only as financial instruments, then we should be most interested in returns on equity and returns on capital. We think it is best to look at many different valuation metrics in order to arrive at a range of value at which we would buy or sell a stock. That said, there is one metric that seems to tie the commodity and financial world together the finding cost or the cost of adding reserves. A company that consistently replaces production with low finding costs would most likely be successful regardless of commodity prices. That company also would exhibit a high degree of capital discipline and score well on measures in which we believe highly, like return on equity and return on capital. The Valuation Methods: One of the best commodity-based valuation metrics is net asset value. Similar metrics would

be liquidation value or net present value. Since the balance sheet shows only the original cost of leases or acquisitions, book value (assets minus liabilities) is of little use in assessing the value of an E&P company. The SEC, however, requires disclosure of reserve quantities (barrels of oil and cubic feet of gas). We can use this information to estimate the value of a company (or stock). A starting point is to have a view of oil and gas prices (a price deck) and an estimate of the companys production costs. We can then apply this information to annual production of the company (which we can derive from the reserve report and the reserve life) (see Exhibits 1 and 2). We can then apply a discount rate to the sum of this net future revenue to arrive at an approximation of value for the assets. In the case of Devon Energy the value is approximately $53/share. The SEC requires a calculation like this in the 10-K, but this calculation is based on year-end prices held constant forever. Year-end oil and gas prices can be much higher or much lower than an analysts estimate of future prices, so this SECmandated calculation can be misleading. Our calculated asset value can then be substituted for book assets in the balance sheet to arrive at an adjusted book value or net asset value. Another way to calculate net asset value is to examine the prices paid in the recent past for reserves in the fields in which the company operates. These transaction values can then be applied to the reserves in question to arrive at an asset valuation. Net asset value provides a nice reality check for stock prices since it approximates private market value or liquidation value. A stock trading well below net asset value should probably be bought, and one selling well above net asset value should raise a red flag. To then determine whether the stock is a sale candidate, the investor needs to assess the inherent exploration option.

Exploration & Production May 15, 2000

Please refer to important disclosures at the end of this report.

MORGAN STANLEY DEAN WITTER

Page 3

Exhibit 1

Devon Energy - Discounted Cash Flow Reserve Valuation (Reserves as of December 31, 1999)
Reserves Year (MMBbls.) 2000 353.7 2001 323.6 2002 291.7 2003 261.4 2004 232.7 2005 205.4 2006 179.4 2007 154.7 2008 131.3 2009 109.0 2010 87.9 2011 67.8 2012 48.7 2013 30.6 2014 13.4 Balance Total OIL Production (MMBbls.) 30.1 31.9 30.3 28.8 27.3 26.0 24.7 23.4 22.3 21.1 20.1 19.1 18.1 17.2 13.4 353.7 Pricing $ / Bbl 23.09 17.09 17.09 17.09 17.09 17.79 18.51 19.26 20.04 20.84 21.67 22.53 23.42 24.34 25.30 26.29 Reserves (Bcf) 1,896.5 1,608.2 1,296.8 1,000.9 719.9 452.9 199.2 NATURAL GAS Production (Bcf) 288.3 311.4 295.8 281.0 267.0 253.6 199.2 1,896.5 Pricing $ / Mcf $2.38 2.28 2.18 2.18 2.18 2.27 2.36 2.45 2.54 2.63 2.73 2.84 2.94 3.06 3.17 3.29 Oil Revenues ($MM) $695.77 544.6 517.3 491.5 466.9 461.7 456.5 451.3 446.0 440.7 435.3 430.0 424.6 419.3 338.5 Gas Revenues ($MM) $687.57 711.4 646.3 614.0 583.3 575.4 469.3 Total Revenues ($MM) $1,383.34 1,256.0 1,163.6 1,105.4 1,050.2 1,037.1 925.8 451.3 446.0 440.7 435.3 430.0 424.6 419.3 338.5 Total Production Costs ($MM) 300.1 321.5 305.4 290.2 275.6 261.9 222.1 89.9 85.4 81.1 77.1 73.2 69.6 66.1 51.4 2,570.6 Total Development Costs ($MM) 49.3 49.3 49.3 49.3 49.3 246.5 Total Pre-Tax Cash Flow ($MM) 1034.0 885.2 808.9 766.0 725.2 775.3 703.7 361.3 360.6 359.5 358.2 356.7 355.1 353.2 287.2 0.0 8490.1 NPV (9.8%) Total Future Pre-Tax CF ($MM) $941.77 $734.40 $611.25 $527.22 $454.65 $442.69 $366.01 $171.17 $155.57 $141.29 $128.23 $116.31 $105.44 $95.53 $70.75 0.0 5,062.3 $7.56 0.78 $520.92 $52.75

Pricing Parameters: OIL 2000 $26.00 2001 $20.00 2002 $20.00 2003 $20.00 2004 $20.00 Thereafter 3.5% Company Diff. Cost Parameters: Production Costs Production Decline: Oil Natural Gas Reserves: Oil Natural Gas Shares Outstanding (MM): ($2.91)

GAS $2.60 $2.50 $2.40 $2.40 $2.40 3.5% ($0.22)

Net Present Value / Equivalent Bbl Reserves Net Debt / Equivalent Barrel Reserves E&P Allocated Net Debt Liquidation Stock Price

$3.84

3% 3%

53% 47%

86.1

Source: Company financials and MSDW Equity Research Estimates

Exploration & Production May 15, 2000

Please refer to important disclosures at the end of this report.

MORGAN STANLEY DEAN WITTER

Page 4

Exhibit 2

Reserve Valuation - Input Page

Company Name Latest Year Oil (2000) Total Reserves (MMBbls) Undeveloped Reserves (MMBbls) Production (MMbbls) - 2000 Pricing ($/Bbl) - 2000 Production (MMBbls) (2001) Natural Gas (2000) Total Reserves (Bcf) Undeveloped Reserves (Bcf) Production (Bcf) - 2000 Pricing ($/Mcf) - 2000 Production (Bcf) (2001) Pricing Parameters: 2000 2001 2002 2003 2004 Thereafter Company Diff. Fixed Differential Discount Rate Tax Rate Devon Energy-Combined 1999 Cost Parameters: Production Costs ($/Bbl)

3.84

353.7 135.0 30.1 $23.09 31.9

Development Costs (% dev. each year) 2000 2001 2002 2003 2004 % of F&D for Dev.

20% 20% 20% 20% 20% 75% $6.14

1,896.5 145.1 288.3 $2.38 311.4 OIL $26.00 $20.00 $20.00 $20.00 $20.00 3.5% -$2.91 -$2.99 9.8% 45% GAS $2.60 $2.50 $2.40 $2.40 $2.40 3.5% -$0.22

Historical F&D Costs Production Decline: Oil Natural Gas Reserves: Oil Natural Gas Shares Outstanding (MM): Net Debt Total Assets Total E&P Assets Oil / Gas Conversion: $

3% 3%

53% 47% 86.1 676.3

$ 4,569.3 $ 3,519.3 6.0

Source: Company data, Morgan Stanley Dean Witter Research

Other Metrics Are Needed As Well: Asset values alone can be too subjective, and since E&P stocks are also financial assets we can apply traditional financial analyses. Historically, financial reporting for oil and gas companies has been confusing since there are two different accounting methods used in the industry. In Full Cost accounting the entire cost of drilling a well or acquiring reserves is capitalized. Drilling costs are capitalized even if the well is unsuccessful. In Successful Efforts accounting, the cost of unsuccessful drilling is expensed in the period the well is abandoned. Certain costs incurred in the course of

exploration like seismic surveys are also expensed as they occur (Exhibit 3). It is easy to see that a small company using successful efforts accounting would be subject to wild fluctuations in earnings. That is why most small companies use full cost accounting. Interestingly, many large companies that once were small still use full cost accounting (e.g., Apache and Anadarko). Since E&P analysts didnt focus on earnings, company management didnt focus on earnings either, which may have contributed to the destruction of capital in the energy sector over the past ten years.

Exploration & Production May 15, 2000

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MORGAN STANLEY DEAN WITTER

Page 5

Exhibit 3

Full Cost vs. Successful Efforts

Exploration Success Successful Efforts Full Cost Only successful costs that Capitalized directly result in the finding of hydrocarbons are capitalized. Expensed Capitalized Capitalized Expensed Expensed Capitalized Capitalized Capitalized Capitalized Expensed

Exploration Dry Hole Acquisition Costs Development Costs G&G Costs Production Costs

amortization and exploration. This metric essentially compares the capital invested in the company to cash flow before interest and taxes. We find this an increasingly useful metric since many producers have a high degree of financial leverage. In the company specific section of the report, we have graphed significant historic trading metrics including EV/EBITDAX. In the end, however, it all comes back to earnings. As investors, we like to see a high return on equity. We also like to see a return on capital employed (ROCE) that exceeds the cost of capital. ROCE is a refinement of EV/EBITDAX. It compares income after tax but before interest to the sum of debt plus equity. It is the earnings thrown off by the capital employed in the business, and it should exceed the cost of that capital. Most E&P companies have not covered their cost of capital over the past ten years, which is the reason capital has stopped flowing into the segment (Exhibit 4).
Exhibit 4

Source: Company data, Morgan Stanley Dean Witter Research

We think that earnings do matter. Positive earnings show that a company is covering not only its cash costs, but also its non-cash costs (which are the costs of leases and reserves acquired in the past). A dollar spent on the business should be recovered through operations whether it is capitalized or expensed. A renewed emphasis on positive earnings is going a long way toward instilling capital discipline in the industry (see our piece To E&P or Not to Be, dated December 13, 1999) Historically, cash flow was the metric of choice for valuation. Cash flow can be calculated from the top down (revenue minus cash costs) or from the bottom up (net income plus deferred taxes plus depreciation, depletion and amortization plus exploration expense). Both cash and noncash (i.e., dry hole costs) exploration expense is added back in order to put full cost and successful efforts companies on the same basis. The problem with using cash flow as a valuation metric is that it tells you nothing about rate of return on investment. Are investors getting a return on capital, or only a return of capital? Comparisons between companies can also be difficult if they have different capital structures. Companies with a lot of debt generally sell at lower cash flow multiples, but they are not necessarily cheaper stocks. One way to neutralize the impact of debt on valuation comparisons is to compare enterprise value to EBITDAX. Enterprise value (EV) is the sum of equity market capitalization and debt. EBITDAX is earnings before interest, taxes, depreciation, depletion,

ROCE Has Lagged WACC

2.0% 0.0% Equal Weighted SEVA.

1993
-2.0% -4.0% -6.0% -8.0% -10.0% -12.0%

1994

1995

1996

1997

1998

Source: Stern Stewart, Morgan Stanley Equity Research SEVA = Stern Stewart ROIC - WACC

We believe most E&P companies have recognized this failure, and are attempting to become more disciplined in their capital investments. Many are forced to be more disciplined. Their capital budgets have recently been limited to cash flow since external financing has all but disappeared for the sector. Combining Metrics: The discussion of capital discipline leads us back to square one: a meeting of commodity-based metrics and financial metrics. In our opinion, one of the keys to financial success by an E&P company is a consistently low finding cost (Exhibit 5).

Exploration & Production May 15, 2000

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MORGAN STANLEY DEAN WITTER

Page 6

Exhibit 5

5-Year Finding & Developing A Data Point in Returns ($/BOE)

5 Year Average Finding and Development Costs

$12 $10 $8 $6 $4 $2 $0
PXD

SGY

AVG

RRC

SFS

BRR

SFY

COG

KMG

DVN

HSE

BR

EOG

THX

APA

Source: Company data, Morgan Stanley Dean Witter Equity Research. Note: Burlington Resources F&D 3-yr. average.

A company that can replace production without using all its cash flow will have more financial flexibility than a company requiring all of its cash flow to replace production. Excess cash flow gives a company the flexibility to re-invest in projects, reduce debt or buy back stock.

Moving one step forward, the combination of projected free cash generation and per share growth provides a compelling characteristic with which to begin the screening process. In the following exhibits we show this metric for both our U.S. and Canadian peer groups.

Exploration & Production May 15, 2000

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XTO

NEV

NBL

NFX

UCL

FST

POG

OEI

UPR

LD

APC

PPP

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Page 7

Exhibit 6

A Compelling Starting Point Free Cash Flow and Per Share Production Growth, 1998-2001E
20%

APC

15% NFX 10% EOG XT O APC/UPR* 5% BRR T HX SFS 0% $0.00 -5% FST -10% NBL LD SFY BR $1.00 $2.00 POG UPR OEI PXD VPI KMG $3.00 $4.00 $5.00 $6.00 APA HSE DVN

UCL

-$3.00

-$2.00 EEX

-$1.00

* Pro-forma for merger

-15%

RRC

Source: Company data, Morgan Stanley Dean Witter Research

The Acquisition: We are dealing with a cyclical industry. Companies with excess cash flow and/or under-leveraged balance sheets can take advantage of their less endowed peers when the cycle turns against them. In other words, the
Exhibit 7

financially strong can acquire cheaper reserves in times of weak commodity prices (Exhibit 7), or, more recently, weak stock prices.

BOE Transactions Track Commodity Price Buy Wisely!

$22.0
Peak I ($ 6 .17 /boe) 3 Trans actions Peak III ($ 5 .00 /boe) Peak IV 1 5 Trans actions ($ 6 .7 2 /boe) 1 8 Trans actions

$20.0
Peak II ($6 .1 1/boe) 5 Trans actions

$18.0

$16.0
Troug h III

$14.0 15 P eri od M o ving Avg . (WTI/NG 12 M onth Stri p)

$12.0

Troug h I ($ 4 .8 1 /boe) 1 1 Trans actions

Troug h II ($ 4 .94 /boe) 1 0 Trans actions

Troug h IV ($ 4 .6 1 /boe) 6 Trans actions

$10.0

Source: Morgan Stanley Equity Research, Herolds; * Per BOE numbers reflect average global private market transactions.

Exploration & Production May 15, 2000

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MORGAN STANLEY DEAN WITTER

Page 8

A $ BOE improvement in purchase price equates to between 100 and 150 basis points in returns, on average. Its All About Discipline: The key is the capital discipline to spend money on only the highest return projects when

prices are high, and to avoid high-cost acquisitions when times are good. Capital discipline feeds on itself, and creates a strong company able to thrive in both good times and bad.

Sensitivities
Sensitivities: We would also like to show how small changes in long-term sustainable (if there is such a thing) commodity prices can have a dramatic impact on incremental returns on capital invested. In Exhibit 8, we have modeled the average North American E&P company. In each of the examples we have held everything constant except long-term natural gas prices. The change in returns displayed at the top shows the economic sensitivity to the moves. And while this is not absolutely real life, as rig rates and personnel costs tend to rise with commodity prices, it goes a long way towards explaining leverage to the commodity. Example A includes the longer term average historic commodity prices of $19.50/bbl for crude oil and $1.90/Mcf for natural gas. Given the average cost structure of an E&P company, returns on investment have proven inadequate. In Example B, we increase the sustainable natural gas price by $0.10/Mcf. The impact is close to 3% to after tax returns. In Example C, we increase the natural gas price even further to $2.50/Mcf, Morgan Stanleys recently revised forecast. The economics speak for themselves.
Exhibit 8
E x a m p le I O i l P r i c e ( $ /B b l) N a tu r a l G a s P r i c e ( $ /M c f) F i n d in g C o s t p e r B O E R O I ( a fte r ta x ) E x h ib i t A $ 1 9 .5 0 $ 1 .9 0 $ 6 .7 6 2% E x h i b it B $ 1 9 .5 0 $ 2 .0 0 $ 6 .7 6 5% E x h ib i t C $ 1 9 .5 0 $ 2 .5 0 $ 6 .7 6 23%

E x a m p le I I O i l P r i c e ( $ /B b l) N a tu r a l G a s P r i c e ( $ /M c f) F i n d in g C o s t p e r B O E R O I ( a fte r ta x )

E x h ib i t A $ 1 9 .5 0 $ 1 .9 0 $ 6 .7 6 2%

E x h i b it B $ 1 9 .5 0 $ 1 .9 0 $ 6 .3 4 7%

E x h ib i t C $ 1 9 .5 0 $ 1 .9 0 $ 5 .6 3 17%

Source: Morgan Stanley Dean Witter Research

Exploration & Production May 15, 2000

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Page 9

Exhibit 9

Cost Optimization Model The Incremental Return Impact of Sustainable Rising Natural Gas Prices

Example A
Return on Investment (Pretax) Return on Investment (After Tax) Targeted Reserve Life Cost Per Producing Barrel Cost Per BOE of Proven Reserves Percent Gas Percent Oil Total Nat Gas Conversion Ratio Pricing Assumptions Natural Gas (US$ per MCF) Nat Gas Trans Cost (US$/MCF) Crude Oil (US$/Bbl) Crude Oil Quality Differential (US$/Bbl) Crude Oil Trans Cost (US$/Bbl) Exchange Rate (i.e. C$0.68 in Canada) $ 3% 2% 7.5 $18,500 $6.76 60% 40% 100% 6.0 $1.90 $0.35 $19.50 $2.30 $1.00 $1.00 $1.90 $0.35 $1.55 $19.50 $2.30 $1.00 $16.20 BOE Prices $11.40 $2.10 $9.30

Example B
$ 8% 5% 7.5 $18,500 $6.76 60% 40% 100% 6.0 $2.00 $0.35 $19.50 $2.30 $1.00 $1.00 $2.00 $0.35 $1.65 $19.50 $2.30 $1.00 $16.20 BOE Prices $12.00 $2.10 $9.90

Example C
$ 35% 23% 7.5 $18,500 $6.76 60% 40% 100% 6.0 $2.50 $0.35 $19.50 $2.30 $1.00 $1.00 $2.50 $0.35 $2.15 $19.50 $2.30 $1.00 $16.20 BOE Prices $15.00 $2.10 $12.90 Natural Gas Commodity Prices Adjusted to Show Sensitivity Return on Invest Changes with Commodity Prices

Realizations Natural Gas (C$ per MCF) Transportation Differential Nat. Gas Realization Crude Oil (C$/Bbl) Quality Differential Transportation Differential Crude Oil Realization Per BOE Analysis Revenue Royalties Net Revenue Op Cost Exploration Expense DD&A G&A Interest Total Cost Pretax Income Taxes After Tax Income

Blended BOE $12.06

Blended BOE $12.42

Blended BOE $14.22

$12.06 $0.00 $12.06 3.40 0.00 6.76 1.05 0.68 11.88 $0.18 $0.06 $0.12

0%

$12.42 $0.00 $12.42 3.40 0.00 6.76 1.05 0.68 11.88 $0.54 $0.18 $0.35

0%

$14.22 $0.00 $14.22 3.40 0.00 6.76 1.05 0.68 11.88 $2.34 $0.79 $1.54

0%

10%

10%

10%

34%

34%

34%

Source: Morgan Stanley Dean Witter Research

The other important variable we discussed previously is the expense necessary to replace reserves (i.e., Finding & Development costs). In Exhibit 10, weve run various finding cost scenarios to measure return sensitivities. We have held commodities flat

at historic levels, and changed the numbers of barrels found, impacting F&D on a per BOE basis. In Exhibit 9 Example A, returns on investment are 3%. As the per barrel cost is reduced returns rise to more compelling levels (Examples B & C).

Exploration & Production May 15, 2000

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Page 10

Exhibit 10

Other than Commodity Prices, F&D Remains Key Component of Incremental Investment

Example A
Return on Investment (Pretax) Return on Investment (After Tax) Targeted Reserve Life Cost Per Producing Barrel Cost Per BOE of Proven Reserves Percent Gas Percent Oil Total Nat Gas Conversion Ratio Pricing Assumptions Natural Gas (US$ per MCF) Nat Gas Trans Cost (US$/MCF) Crude Oil (US$/Bbl) Crude Oil Quality Differential (US$/Bbl) Crude Oil Trans Cost (US$/Bbl) Exchange Rate (i.e. C$0.68 in Canada) $ 3% 2% 7.5 $18,500 $6.76 60% 40% 100% 6.0 $1.90 $0.35 $19.50 $2.30 $1.00 $1.00 $1.90 $0.35 $1.55 $19.50 $2.30 $1.00 $16.20 BOE Prices $11.40 $2.10 $9.30

Example B
$ 10% 7% 8.0 $18,500 $6.34 60% 40% 100% 6.0 $1.90 $0.35 $19.50 $2.30 $1.00 $1.00 $1.90 $0.35 $1.55 $19.50 $2.30 $1.00 $16.20 BOE Prices $11.40 $2.10 $9.30

Example C
$ 25% 17% 9.0 $18,500 $5.63 60% 40% 100% 6.0 $1.90 $0.35 $19.50 $2.30 $1.00 $1.00 $1.90 $0.35 $1.55 $19.50 $2.30 $1.00 $16.20 BOE Prices $11.40 $2.10 $9.30 Commodity Prices Held Flat Return on Invest Changes with the Replacement Cost per BOE

Realizations Natural Gas (C$ per MCF) Transportation Differential Nat. Gas Realization Crude Oil (C$/Bbl) Quality Differential Transportation Differential Crude Oil Realization Per BOE Analysis Revenue Royalties Net Revenue Op Cost Exploration Expense DD&A G&A Interest Total Cost Pretax Income Taxes After Tax Income

Blended BOE $12.06

Blended BOE $12.06

Blended BOE $12.06

$12.06 $0.00 $12.06 3.40 0.00 6.76 1.05 0.68 11.88 $0.18 $0.06 $0.12

0%

$12.06 $0.00 $12.06 3.40 0.00 6.34 1.05 0.63 11.42 $0.64 $0.22 $0.42

0%

$12.06 $0.00 $12.06 3.40 0.00 5.63 1.05 0.56 10.64 $1.42 $0.48 $0.93

0%

10%

10%

10%

34%

34%

34%

Source: Morgan Stanley Dean Witter Research

Exploration & Production May 15, 2000

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MORGAN STANLEY DEAN WITTER

Page 11

Todays Investment Perspective

In summary, investors have often viewed E&P stocks as trading vehicles. We agree with this assessment, and still see upside in the current cycle. In the following exhibit, we have graphed Price to Forward Cash Flow for the group, relative to a commodity index (60%
Exhibit 11

natural gas, 40% crude oil). Using our MSDW normalized commodity forecasts of $20/bbl oil and $2.50/Mcf natural gas we still see upside approaching 20% today.

Commodity and Index Valuations

$22 7.5 $20 6.5 $18 $16 $14 4.5 $12 3.5
MSDW 2000E Commodity Strip ($20/bbl Crude Oil / $2.50/mcf Natural Gas) Forward Cash Flow trailing peak cycle valuation by 40% 2001E implied valuation by 17%

5.5

$10 $8

2.5
7/ 08 10 /94 /2 1/ 9 2/ 4 03 /9 5/ 5 19 /9 9/ 5 01 12 /95 /1 5/ 9 3/ 5 29 /9 7/ 6 12 10 /96 /2 5/ 9 2/ 6 07 /9 5/ 7 23 / 9/ 97 05 12 /97 /1 9/ 9 4/ 7 03 / 7/ 98 17 10 /98 /3 0/ 9 2/ 8 12 / 5/ 99 28 /9 9/ 9 10 12 /99 /2 3/ 9 4/ 9 07 /0 20 0 00 E

Source: MSDW Equity Research; E = MSDW Research Estimates (data measured through 12/03/99). Note: We have used the large cap index, where the balance sheet is less of a factor. A better proxy for the mid-cap stocks is EV / EBITDA.

However, many company specific names are beginning to stretch historic valuation parameters, which is risky in cyclical groups, and we are recommending that investors move around in the names, be opportunistic and high grade into strength. Until returns are a real industry focus and can be generated across the cycle, the longer term E&P investment will remain under pressure. And since the Energy weighting has declined to only 8% of the S&P today (Exhibit 12), the market will only invest in E&P stocks if they can provide compelling company-specific reasons.

Exhibit 12

Energy Component of S&P Index Keeps Falling

Percent of S&P 500
% 25

20

15

10

1980 Energy Sector

1985 1990 Integrated Oils

1995

60/40 Gas/Oil 12 Month Strip.

1999

Forward P/CF Multiple.

Source: Morgan Stanley Dean Witter Research

Exploration & Production May 15, 2000

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MORGAN STANLEY DEAN WITTER

The Americas
1585 Broadway New York, NY 10036-8293 Tel: (1) 212 761-4000 BCE Place, 181 Bay Street, Suite 3700 Toronto, Ontario M5J 2T3, Canada Tel: (1) 416 943-8400

Europe
25 Cabot Square, Canary Wharf London E14 4QA, England Tel: (44 171) 425 8000 AB Asesores Plaza de la Lealtad, 3 Madrid 28014, Spain Tel: (34 91) 580 11 00

Japan
20-3, Ebisu 4-chome Shibuya-ku, Tokyo 150-6008, Japan Tel: (81) 3 5424 5000

Asia/Pacific
Three Exchange Square Hong Kong Tel: (852) 2848 5200 23 Church Street #16-01 Capital Square Singapore 049481 Tel: (65) 834 6888 4th Floor Forbes Building Charanjit Rai Marg Fort Mumbai 400 001, India Tel: (91 22) 209 6600 The Chifley Tower, Level 33 2 Chifley Square Sydney NSW 2000, Australia Tel: (61 2) 9770 1111

____________________________________________________ The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated (Morgan Stanley Dean Witter). Morgan Stanley Dean Witter does not undertake to advise you of changes in its opinion or information. Morgan Stanley Dean Witter and others associated with it may make markets or specialize in, have positions in and effect transactions in securities of companies mentioned and may also perform or seek to perform investment banking services for those companies. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Within the last three years, Morgan Stanley & Co. Incorporated, Dean Witter Reynolds Inc. and/or their affiliates managed or co-managed a public offering of the securities of . Amoco, Atlantic Richfield, BHP, Camco, Coflexip Stena, Devon, Diamond Shamrock, Dresser, Elf Aquitaine, ENI, Enron Oil & Gas, Enserch Exploration, Forest Oil, Halliburton, Lomak, Louis Dreyfus, Mobil, Monterey Resources, Noble Affiliates, Norsk Hydro, Petronas Dagangan, Phillips, Smedvig asa, Sun Company, Talisman Energy, Texaco, TransCanada Pipeline, Tosco, Ultramar, Union Pacific, Unocal, and Vastar, Zhenhai Refining. Morgan Stanley & Co. Incorporated, Dean Witter Reynolds Inc. and/or their affiliates make a market in the securities of Apache, British Petroleum, BHP, Chevron, Burlington Resources, Enterprise, Pogo Producing, Reading & Bates, Royal Dutch, Saga Petroleum, Shell Transport, Talisman Energy and Unocal Morgan Stanley & Co. Incorporated, Dean Witter Reynolds Inc. and/or their affiliates or their employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of issuers mentioned herein. 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Copyright 2000 Morgan Stanley Dean Witter & Co.

2000 Morgan Stanley Dean Witter