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Blue Skies Forecast for North American E&P Earnings

Energy analysts are forecasting a double-digit earnings season for the energy sector in 1Q2008, with several standouts and positive surprises expected from North American unconventional natural gas players.

In a note to clients, UBS energy analyst William Featherston singled out several of the leading unconventional gas players as his top picks for the first three months of the year: Southwestern Energy Corp., Ultra Petroleum Corp. and XTO Energy Inc. Occidental Petroleum Corp., Anadarko Petroleum Corp. and Devon Energy Corp., he said, have the "potential to deliver upside surprises." Another gas player, Quicksilver Resources Inc., was the "lone potential downside surprise candidate" because of the company's recent announcement that revised upward its outlook on oil service costs.

Lifted by high oil and gas prices, 1Q2008 earnings per share "should increase by 56%" from the year-ago period, Featherston said. "With government data showing production growth of 7% in January and December, the sector is poised to deliver upside volume surprises, particularly companies with exposure to onshore resource plays."

UBS analyst Andrew Coleman added coverage of several other onshore players, including Cabot Oil & Gas Corp., Cimarex Energy Co., Denbury Resources Ltd. and Forest Oil Corp. Ratings were initiated on Petrohawk Energy Corp., PetroQuest Inc., Plains Exploration & Production Co. and Swift Energy Co. All of the companies drew "buy" recommendations with the exception of Plains and PetroQuest, which both received a rating of "neutral."

John Gerdes and Michael Dane, energy analysts with SunTrust Robinson Humphrey/the Gerdes Group (STRH), said in a note Friday that investors should continue to buy gas-weighted E&P shares. Their favorites are Anadarko Petroleum Corp., Chesapeake Energy Corp., Penn Virginia Corp., Unit Corp. and Cimarex.

"Since late '06, modest oilfield service price deflation has slowed the escalation in E&P capital intensity to less than 10% per annum," wrote the STRH duo. "Notably, the E&P sector is essentially free cash flow neutral in a $9.50 gas price environment." Assuming $88/bbl oil and $8.88/Mcf Henry Hub gas prices this year, "E&P cash margins should expand almost 20%."

North American gas-directed drilling is forecast to "steadily increase" over the next few quarters, wrote the STRH analysts. "In the U.S., the gas-rig count is projected to average 1,490 rigs in '08 (1,550 gas rig count in 4Q2008) assuming an $8.75-9.50 gas price environment, a 2% increase over '07."

"The time to remain more bullish than ever on natural gas prices is upon us," said a FirstEnergy research report to investors.

In Canada, soaring prices will lead to a surge for E&Ps, and some analysts predict some producers may begin adding to their spending budgets, which were cut from a year ago.

"The three key variables from a Canadian producer's perspective -- namely, oil price, natural gas price and heavy oil differentials -- all improved materially in the first quarter," Tristone Capital Inc. energy analyst Chris Feltin said in a note. "We're expecting pretty much every company to outperform what even they were expecting to do."

When they set 2008 budgets, EnCana Corp., Canadian Natural and Talisman Energy Inc. were among Canadian producers that slashed their capital budgets for 2008. They blamed not only soaring costs, but also the move by Alberta to hike royalties paid by the energy industry and -- at the time -- lower gas prices.

"It would be tough for Canadian producers not to look at their budgets, with an eye toward increasing capital spending, particularly in the last half of the year," Feltin said.

The increase in Canada's gas-directed drilling should parallel the United States, wrote Gerdes and Dane, "although from a lower base of activity, as Canadian gas producer cash margins remain structurally 30% weaker than their U.S. counterparts."

Standard & Poor's Ratings Services (S&P) said the U.S. economy may appear anemic, but the same can't be said for the U.S. oil and gas sector. S&P analysts expect the sector to continue to see positive momentum this year, defying what's expected to be a negative overall trend for industrial ratings. Oil and gas prices should remain "at or near current levels, which should support -- or possibly even improve -- the sector's credit quality." The "E&P and drilling services sectors have seen numerous positive rating actions and most continue to deliver strong financial performances."

S&P analysts noted that their outlook was more cautious for natural gas at the beginning of the year. "However, the relatively cold winter and expectations for fewer Canadian and liquefied natural gas imports have instead caused 12-month future strip pricing to increase significantly, approaching the range of $9.50-$10.00/MMBtu."

Most rated E&P companies reported satisfactory reserve replacement and finding and development (F&D) costs at the end of 2007, although there were a few notable exceptions, such as Chevron Corp., S&P noted.

"Median reserve replacement costs among the companies we rate improved to roughly $3/Mcfe in 2007 from $3.50/Mcfe in 2006, aided in part by price-related reserve revisions," said S&P analysts. "In 2008, we expect that most independent companies will keep their capital spending within internally generated cash flow. High commodity prices will enable them to spend relatively aggressively, and many are targeting production growth in the 6% to 9% range. Some speculative-grade companies, such as Chesapeake Energy Corp., will spend considerably more than their cash flow in an effort to boost production."

Overall credit trends for the E&P sector "should be stable to positive in the year ahead," said S&P analysts. So far this year, S&P has upgraded for E&Ps: Devon, St. Mary Land & Exploration Co., PetroQuest and Berry Petroleum Co. "We don't expect to see much debt reduction this year -- rather, some companies will increase their borrowings to finance property acquisitions. Nevertheless, growth in reserves and production could allow some companies to pay down their debt."

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