Following a run-up in capital costs and volatile natural gas prices over the past year, energy analysts predicted that exploration and production (E&P) companies likely would flatten their drillbit and acquisition spending in 2007, especially after posting healthy returns for the past three years. However, with solid 1Q2007 reports in, some analysts now see U.S.-based independents bulking up their capital budgets, with their eyes on more exploration and possible acquisitions.

Raymond James & Associates analysts had predicted in early January that spending would be flat this year after their E&P universe coverage, which consists of 51 independents, increased their exploration and development (E&D) spending 39% in 2006 from the year before. Total cash flow last for their coverage universe was up 15%, and total spending increased almost 73%.

About 55% of last year's spending was directed toward E&D; 41% went to property acquisitions. Another 4% was directed toward stock buybacks.

"For 2007, our universe had preliminarily budgeted $53.1 billion for E&D, up 7% over actual 2006 spending, in contrast to our earlier expectation that budgets would flatten this year," said Raymond James analysts Wayne Andrews and John Freeman. "And some, if not most, companies will outspend their budgets. For context, initial budgets in early 2006 totaled $44 billion and updated mid-year budgets totaled $47 billion, a 7% increase."

Already, they noted, many E&Ps reported 1Q2007 earnings that were solid enough for them to increase capital spending for the full year. Currently, updated budgets are up 7% over preliminary budgets set earlier in the year.

For the full year, Raymond James analysts are predicting a "relative shift" toward more E&D spending. "In fact, given our assumption of fewer acquisitions, the percentage of total spending represented by E&D could easily rise above 70-80%, compared with 55% in 2006," they wrote. "This makes perfect sense if one considers the fact that of the $37 billion spending 2006 by our universe on acquisitions, nearly 60% was spent by one company alone, Anadarko Petroleum, in the concurrent acquisitions of Kerr-McGee and Western Gas."

In 2008 and beyond, the Raymond James analysts said they think the "growing trend" of E&P master limited partnership spin-offs will increase cash flow and drilling activity simultaneously.

Raymond James does not cover the entire U.S. E&P industry. Their analysts' spending review represents about 35% of total U.S. production, "and these companies unquestionably pursue among the most aggressive drilling programs in the industry -- not to mention the fact that they have some of the best drilling prospects." Besides not covering all of the independents, they also noted that U.S. drilling activity by the majors has grown more slowly. "At the same time, we believe that 2007 E&D spending by independents outside our coverage universe (both public and private) should post smaller, but still solid growth of about 5%."

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