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Raymond James: E&Ps to Further Strengthen on Sustained High Prices

Exploration and production (E&P) companies, already riding a wave of record earnings, should expect to see their share prices further strengthen this year on continued high natural gas and oil prices, according to a new report by Raymond James.

E&P stocks continue to benefit from "very favorable industry fundamentals," said analysts, because of strong earnings and incremental returns that are benefiting from continued high oil and natural gas prices. The prices have "far outpaced increases in service costs." Also, as stock valuations prove sustainable in a robust commodity price environment, rising cash flows should lead to growth in capital expenditures, particularly drilling.

"We continue to emphasize that the underlying, nonweather-driven fundamentals for natural gas remain extremely bullish," according to the analysts. "We believe that the sentiment in the gas market will improve over the coming months, as year-over-year weather comparisons become more favorable and surplus gas currently available shrinks as a result of continuing declines in supply."

On a near-term basis, the report noted that because weather remains a major driver of gas prices, analysts lowered their 2005 gas forecast to reflect the fact that "weather has simply not cooperated this winter season."

Given the larger-than-expected gas storage volumes because of the mild winter and mild 2004 summer, and assuming BTU parity of crude oil to gas prices at 6:1, "fair value for gas in 2005 should be between $7.50 and $8." However, taking the weather into account, Raymond James took a more conservative approach and assumed a 7:1 ratio to hold for the second quarter, falling to a 6:1 parity through the rest of the year.

Raymond James is now calling for full-year 2005 gas prices of $6.80, with oil at $46.50.

Even though the gas price forecast is 70 cents or about 12% above the Wall Street consensus, "it is actually below current futures pricing. We also believe that over the longer term, our 6.25:1 parity assumption will prove to be conservative, as the natural gas price to crude oil price ratio should be closer to 5.5:1," reflecting higher heating oil equivalents.

"While we look for the entire [E&P] group to move up with the strength in commodity prices, we find the shares of Anadarko Petroleum and Pioneer Natural Resources to be particularly attractive from a valuation standpoint, given that they are trading below $1.60/Mcfe," according to the Raymond James report.

"We believe that the shares of Chesapeake Energy will perform well in light of our robust natural gas price outlook and the company's high natural gas focus, strong margins, high organic production growth rates and deep drilling inventory. Furthermore, we continue to be bullish on Apache Corp. for its solid growth profile, balanced reserve mix and savvy management."

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