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Raymond James Analyst Says E&P Companies to Remain Profitable

Claims that "runaway" oil service costs might finally be catching up to exploration and production (E&P) companies are unfounded, analysts at Raymond James & Associates said last week. While oil service costs have certainly ramped up significantly, with average increases of 15% in 2004 and 10% year-to-date, the surge in oil and gas prices has more than offset these cost pressures, they said.

"One view we often hear from energy investors is that oil service companies have taken a large bite out of E&P profitability -- so much so that E&P companies may be challenged to maintain their sizeable returns from drilling," said analyst Wayne Andrews in Raymond James' latest Energy Stat of the Week. "We believe these fears are overblown, and submit that E&P companies are as profitable as ever."

He said E&P profitability looks "compelling" through the end of the decade, even assuming consistently rising service costs. As evidence he pointed to consistently strong industry fundamentals with high commodity prices that have outpaced service costs, and inexpensive stock valuations that have persistently denied the sustainability of robust oil and gas prices.

Andrews added that the "tremendous returns" from drilling also should drive E&P capital expenditure spending higher, which will benefit oil service companies.

"On the revenue side, we project oil and gas prices consistent with our official 2006 forecasts of $52.00/Bbl and $8.00/Mcf, and escalate them by 2% annually thereafter," Andrews said. "On the cost side, we assume E&P companies face annual inflation of 15% for finding and development costs (which incorporate the cost of drilling and completion services), 10% for lease operating expenses, 5% for production taxes, and 5% for G&A expenses. Impressively, by the end of the decade, E&P companies still boast extremely strong operating profit margins of nearly $19/Bbl, or 36%."

Under this hypothetical scenario, Andrews admits that it might incorporate cost inflation assumptions that may well prove excessive.

"In addition, our 2006 (and therefore subsequent) commodity price forecasts are arguably conservative, given that the NYMEX futures for 2006 are currently 15% and 3% higher for oil and gas, respectively," he said in the note.

"Despite the impressive 35% run for the S&P 1500 E&P index last year and its 36% performance year-to-date, we believe that E&P stocks still offer investors significant upside potential. Given the greatly improved profitability, strong cash flow generation and robust commodity price outlook, we believe that E&P companies are well positioned to maintain substantial margins over the next three to five years and beyond, even in the face of oil service cost pressures."

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