Exploration and production (E&P) spending in 2003 is likely to be at least 20% higher than it was in 2002 because natural gas prices will generate substantially larger amounts of free cash flow, according to the latest “Stat Of the Week” by Raymond James Energy analysts.

A survey of producers weeks ago indicated that E&Ps would be flat or spending would be lower, basing their answers on a sub $3.50/Mcf gas environment. However, Raymond James analysts, led by Marshall Adkins, believe all of the pre-New Year’s surveys are worthless for two reasons: “E&P companies have no reason to tell the truth to surveyors; and actual cash flows (not budgets) drive actual E&P capital spending.” Also, analysts noted that the 12-month gas futures strip now is approximately $4.60/Mcf, while Raymond James’ 2003 gas price forecast is a “conservative” $5/Mcf.

E&Ps typically adjust their spending over the year to match cash flows, analysts noted, and the only year capital expenditures didn’t exceed cash flow was in 2000 when commodity prices spiked at year’s end. “Companies couldn’t put rigs to work fast enough to spend the windfall.” Now, “it seems pretty safe to assume that cash flow is the driver for capital spending and the budgets only serve as a guideline if commodity prices meet management’s expectations for the year…[and] given this pattern of spending, we don’t see any reason to believe that E&P companies won’t try to spend their cash flow in 2003.”

Quantifying how much upside a typical E&P would generate based on $5/Mcf gas prices versus $3.50/Mcf prices for 2003 (and assuming the budgeted capital expenditures were set at $3.50/Mcf), analysts found that the increased gas price would generate 53%, or $92 million in increased cash flow and spending in the new year. “A relatively small change in the gas price assumption would generate significant additional amounts of free cash flow if the company didn’t increase its capital spending.”

So, how much could spending actually increase on a percentage basis in 2003? “We believe it will be difficult for companies to increase spending enough to spend all of their free cash flows in 2003,” said analysts. “This is because the industry simply does not have the readily drillable prospects, rigs or personnel to increase budgets enough to spend all of the [free cash flow] that we expect in 2003. In other words, the industry simply does not have the capacity to increase activity by more than 50% over the next 12 months.”

E&Ps should be able to use some of their unused cash flow to reduce debt and to make acquisitions, analysts believe. If, for example, they used 55% of free cash flow to increase spending and the other 45% to reduce debt, “2003 E&P capital spending would increase over 25% versus [2002] and E&P balance sheets would get a huge shot in the arm.”

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