Strong free cash flow, modest production growth and sustained higher prices could lead exploration and production (E&P) shares 20-25% higher in the next year, according to Lehman Brothers. Analysts raised their targets based on higher oil prices, but they also warned that natural gas prices are likely to remain weak until winter begins.

Thomas Driscoll and Jeffrey Robertson said in an industry update that sustained “relatively strong oil and natural gas prices are likely to lead investors to revalue E&P shares upward.” Along with price-related re-evaluations, they said “modest” production and reserve growth would drive enterprise values upward, while decreasing debt levels or dividends) would lead to even stronger overall equity returns.

The expected gain in share prices over the next 12 months was calculated by the analysts using a $2/boe upward move in long-term oil and gas price expectations, which they calculate at $28-30/boe and $4.50/MMBtu, which would add 10% to share prices, while per-share asset values, excluding the impact of changes in price expectations, would increase 10-15% a year in 2004-2005.

“We remain bullish on E&P stocks,” said Driscoll and Robertson, who gave their top nods to Burlington Resources, Devon Energy Corp., EOG Resources, Noble Energy Inc., Talisman Energy and XTO Energy. All of the recommended stocks have a strong North American presence.

For 2005, Lehman revised its crude oil forecasts upward by 17% to $35/bbl and raised the gas price forecast by 10% to $5.50/MMBtu. For 2006, it estimates $30/bbl and $5/Mcf. Through this year, gas price estimates were dropped by 25 cents to $5.75/MMBtu.

“Gas price weakness is a concern,” said the analysts. “Natural gas storage levels have been building more rapidly than we had expected since mid-June (gas prices peaked in early June). We remain cautious about gas prices over the next one-two months but anticipate that the beginning of the winter heating season will lead gas prices higher,” which they said “appears to be the consensus and perhaps this heightens the risk of disappointment.” The analysts estimate that Hurricane Ivan knocked out 20-40 Bcf of production, but “we still expect storage levels to be at or near record levels as we enter the winter heating season.”

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