Upstream investment worldwide hit a world-class pace in 2006, but the return on reserves volumes was paltry. This year, investor enthusiasm has declined, but capital expenditures (capex) by exploration and production (E&P) companies -- at least in the United States -- show signs of support for organic growth in production volumes, two groups of energy analysts said in their reviews of the sector.

According to a review by researcher John S. Herold Inc. and upstream adviser Harrison Lovegrove & Co. Ltd., worldwide upstream investment for 228 oil and gas producers increased 45% to $401 billion in 2006, more than $1 billion per day, but the record capital spending generated a measly 2% increase in reserves volumes, The 2007 Global Upstream Performance Review said spending lifted reserve volumes to 263 billion boe/d while reserve replacement costs jumped 33% to $13.60/boe.

"Revenue growth more than offset higher operating expenses and increased taxes, allowing the industry to report $243 billion in net income, the fourth consecutive record," said Herold's Robert Gillon, co-director of equity research. However, he said "rising costs are pressuring investment returns, as net income as a percentage of the book value of oil and gas assets declined in 2006 following three years of gains."

Harrison Lovegrove CEO Martin Lovegrove said the "key challenge facing the petroleum industry continues to be replacing reserves and growing production" because of two things: maturing basins and reduced accessibility to new acreage. "With opportunities scarce, proved and unproved acquisition costs increased 85%, while the implied costs for the acquisition of proved reserves soared 55%, more than twice the increase in oil prices."

Returns to shareholders last year were robust: dividends reached a record $83 billion (up $7 billion), while share repurchases increased 37% to $88 billion. Combined, returns to shareholders accounted for 55% of net income. In the last two years, the industry spent more to repurchase shares than to acquire proved reserves, the review noted.

According to the study, the United States in 2006 was the only region in which profitability declined as finding and development costs nearly tripled and reserve replacement costs soared 83%. And while oil reserves and production in Canada continued to climb, natural gas languished as investment was directed at oilsands development.

The 40th annual study was based on data filed with the U.S. Securities and Exchange Commission and similar agencies worldwide. Among other things, the review found:

A review of the 55 domestic E&Ps in Raymond James & Associates Inc.'s coverage universe by energy analysts Wayne Andrews and John Freeman determined that the "biggest beneficiaries" of increased spending in the United States "will be companies with the most leverage to the drillbit: specifically, the U.S. land drillers, jackup drillers, tubular manufacturers and other gas-weighted service companies."

In their mid-May 2007 E&P capex forecast, the Raymond James analysts said they expected domestic E&P budgets would be flat to slightly higher this year. "In fact, our 1Q2007 spending survey showed that not only were preliminary 2007 budgets up an average of 7% over 2006 spending, but budgets for the full year increased further by 6% after the first quarter alone."

After compiling all of the 2Q2007 results and updated budgets by the E&Ps, the Raymond James review found spending among its 55 producers grew 35% year-over-year in the first six months of this year. Total cash flow (before changes in working capital) was $27.4 billion, about 2.5% higher over the year-ago period. This compares with an increase of 27% from the first six months of 2005 to the first six months of 2006.

"The relative weakness in cash flow growth followed lower commodity prices at the start of 2007," said the analysts. Overall, however, the survey indicated that E&P companies still generated strong cash flows in a relatively subdued commodity price environment.

Total spending by the producer group in the first half of this year was $37.1 billion, an increase of 12% over the first six months of 2006. The spending included:

"The most important fact to emphasize is that E&D spending -- by far the largest component of capital expenditures for our universe -- posted 35% growth over the year-ago period," said Andrews and company. "Despite the commodity price volatility over the past year, drilling budgets keep growing and growing."

Some producers need to borrow, but balance sheets among the domestic E&Ps are in "fine shape overall," the analysts noted. "Given our $54.3 billion 2007 operating cash flow forecast for our coverage universe, it is apparent that E&P companies do not plan to scale back activity -- and are set to modestly outspend their cash flow -- even in the face of potentially depressed gas prices over the next few months. Despite our bearish gas forecasts for the second half of 2007, we are projecting a similar picture as in the first half of 2007, with total operating cash flow of $26.9 billion from our coverage universe, only slightly below cash flow in the first half of 2007."

Raymond James is forecasting total second half 2007 E&D spending of $28.1 billion, which is, again, modestly higher than projected cash flow. For the year, Raymond James estimates total spending for its domestic E&P coverage universe will be 20% above projected cash flow.

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