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Lehman Forecasts E&P Cash Flow to Rise 10-30%

Exploration and production (E&P) companies may see 2005-2006 cash flow estimates 10-30% higher, with the average target upside about 10%, said Lehman Brothers Tuesday. The financial analyst raised the natural gas price forecast by $0.25-1.00, to range between $6.00 and $6.25/MMBtu, and put oil price estimates $5-8/boe higher to $40-45/bbl.

In a report on large-cap E&Ps, analysts Thomas Driscoll and Jeffrey Robertson said they "continue to favor those companies that can demonstrate the ability to grow assets faster than the balance sheet. Given the recent severe cost pressures, those companies that are willing to buy back shares, reduce debt and raise dividends may outperform those that are aggressive drillers."

Over the past four years, companies that have cut back on drilling and used free cash flow to repurchase stock, pay down debt, increase dividends or to make acquisitions have outperformed those companies that have aggressively drilled, the analysts said. "The market has rewarded those companies that have reduced capital spending to levels well below cash flow." The average large-cap E&P companies that Lehman covers have appreciated 25-30% this year and have more than doubled since the beginning of 2003.

Current oil and gas prices "are far higher than the price expectations reflected in E&P shares today," according to the report. The average E&P stock "reflects a mid-cycle oil and gas price forecast of about $39/bbl and $5.75-6/MMBtu of natural gas," which is $15/bbl below current oil prices and about $1/MMBtu below current natural gas prices.

"If the gap between expectations and current prices continues to be closed via an increase in mid-cycle oil and gas price expectations, E&P share prices will likely appreciate sharply." Driscoll and Robertson wrote that E&P companies are likely to continue to perform well in the intermediate term.

Also, both drilling costs and finding and development costs have risen sharply in the past few years and "cost escalation is taking a toll." The shift toward longer-lived assets, such as resource plays, has increased the time lag between capital expenditure costs and cash-in flows.

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