With sustained strength in oil and natural gas prices, Lehman Brothers on Tuesday raised its 2005 Henry Hub gas forecast by 75 cents to $7/MMBtu and the 2006 forecast by 50 cents to $6.50/MMBtu. The oil forecast also was increased by $5 for 2005 and 2006, to $50/bbl.

Lehman analysts Thomas Driscoll and Jeffrey Robertson also raised their 2005/2006 cash flow/share estimates for producers by an average of 11% in both years and raised price targets by an average of 15%. They said the average potential upside is close to 30%.

“We continue to recommend companies that we believe are demonstrating the ability to grow assets faster than the balance sheet,” they said. “Given the rapid increase in cost structures, we prefer those companies that favor earning high returns over delivering rapid production growth. The companies that are willing to restrain drilling capital in favor of share buybacks, debt pay-downs and dividend increases are likely to outperform those with aggressive drilling programs.”

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 companies that have aggressively drilled, they said. Part of the reason is that both drilling costs and finding and development costs have risen “sharply” during the same time period.

According to the analysts, the average large-cap exploration and production (E&P) stock this year already has appreciated roughly 25% and has more than doubled since the beginning of 2003.

There are potential downsides, however.

“While it is difficult to foresee what the catalyst for the next downward move in oil/gas prices could be, history has taught us that commodity prices go down as well as up — and we need to be wary of new supply growth and/or economic slowdowns or price-induced conservation,” said the analysts.

“We recognize that the risk that E&P shares could fall sharply has increased as a result of the strong appreciation that E&P shares have enjoyed over the past two years. Heightening the risk is the fact that we believe that nearly all of this appreciation is due to a revaluation of oil and gas assets — with only 15-20% of the appreciation coming from reinvestment returns. Despite the increased risk in E&P share prices, we think that the likelihood is that E&P shares continue to perform well in the intermediate term.”

Current oil and gas prices, they noted, “are far higher than the price expectations reflected in E&P shares today. We believe that the average E&P stock reflects a midcycle oil and gas price forecast of about $39/bbl of oil and $5.75-6.00/MMBtu of natural gas — close to $15/bbl below current oil prices and roughly $1.25-1.50/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.”

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