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Raymond James Says Drilling Spending Up Despite Price Volatility

Not to put too fine a point on it, but "the bears were again proven wrong" when it comes to exploration and development (E&D) spending, says Raymond James & Associates in its weekly research note. In fact, say the firm's energy analysts, E&D spending for their selected universe of companies posted 41% growth over 2004.

Looking at 2006, Raymond James expects solid budgets in spite of gas price volatility. "For 2006, our universe has budgeted $40.1 billion for E&D, already up 20% over actual 2005 spending. To put this in context, initial budgets in early 2005 totaled $26 billion and updated mid-year budgets totaled $29 billion, a 13% increase. While upcoming mid-year budget increases are not likely to be nearly as high, even if budgets stay in line with their initial levels, that would imply a fourth consecutive year with a 20%+ spending increase. Given our cash flow forecast for $49 billion, this leaves plenty of room for acquisitions and/or stock buyback."

Raymond James finds that allocation of capex dollars continues to favor drillbit growth. Companies have a choice of E&D spending and acquisitions, as well as share buybacks and debt reduction. "In 2005, the companies in our universe clearly favored the first two options, as is typical for the industry. Notably, 77% of their aggregated operating cash flows were spent on E&D (up from 72% in 2004). For the third year in a row, this percentage was low relative to average levels of the past two decades, as rising spending could not keep pace with the massive increase in cash flow. We should also point out that acquisitions were largely funded internally, rather than via the capital markets."

The firm provided the caveat that its universe does not represent the entire industry, representing only about 20% to 25% of U.S. production. Companies in the Raymond James universe tend to have the most aggressive drilling programs in the industry. "Our conclusion that their E&D spending should rise 20%+ year-over-year should not, therefore, be extrapolated for the entire industry. In particular, U.S. drilling activity by the majors has grown much more slowly, and in 2006, the majors are unlikely to grow their E&D spending by more than 10%. At the same time, we believe that 2006 E&D spending by independents outside our coverage universe (both public and private) should post smaller but still solid growth of about 15%."

Raymond James said the environment is "highly favorable" for both E&P and service companies. Capex spending is on the rise across the board, and E&P investment strategy reflects continued optimism in industry fundamentals, in spite of the recent volatility in natural gas prices. "Management presentations at our recent Institutional Investors Conference (see NGI, March 20) also consistently made this point, noting that spending is unlikely to slow down materially unless gas prices drop below the $5 to $6/Mcf range," Raymond James said. "We have long argued that debt-adjusted growth in reserves and production per share is the surest way of enhancing shareholder value. Rising capex spending will sustain organic growth in production volumes, positioning our coverage universe for continuing success over the intermediate term."

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