Despite a general decline in investor enthusiasm, capital expenditures (capex) by exploration and production (E&P) companies should support organic growth in production volumes despite the near-term bearish natural gas prices, energy analysts said in a review of the sector.
A review of the 55 E&Ps in Raymond James & Associates Inc.’s coverage universe was completed by energy analysts Wayne Andrews and John Freeman. They wrote, “As we have long argued, we believe that the biggest beneficiaries 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 analysts said they expected capital 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.”
Gas storage is trending toward record levels, and the Raymond James energy team is still bearish on near-term gas prices.
“Normally, we believe that bearish gas fundamentals (and resultant constraints on cash flow) would be a leading indicator of a slowdown in spending,” the analysts wrote. “Looking to last year, when gas storage peaked at over 3.4 Tcf and prices plunged to $4/Mcf at the end of September, we believed that capex spending for 2007 would be flat to only slightly up. The reality turned out to be quite different…”
Some producers need to borrow, but balance sheets 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.
“Our spending survey indicates that, while cash flow generation is still strong, many producers (particularly small and mid-cap companies) will require incremental borrowing to fund their full budgets. A number of these companies would have to borrow even under a $10/Mcf gas environment, which highlights E&P companies’ willingness to spend over and beyond internally generated cash flow to capitalize on individual growth opportunities.””
For the entire year, Raymond James is now estimating that total spending will be 20% above projected cash flow. However, even with aggressive capex spending and acquisitions, its E&P coverage universe as a whole is maintaining financial discipline, with current debt-to-cap levels averaging in the range of 35% (which compares with about 43% in 2003). In fact, said the analysts, E&P balance sheets have consistently improved during the past four years.
While acquisition spending remains strong, capex allocation continues to favor drillbit growth, the analysts said.
“Generally, most producers have stated that they would not significantly cut back on activity unless strip prices dip meaningfully below $6.50-7.00/Mcf. Even if gas remains permanently at $7.00/Mcf, we estimate that drilling an additional well would still generate an average internal rate of return of about 20%, assuming a $2.50/Mcfe finding and development cost. Therefore, if gas prices do fall temporarily to levels similar with last year’s bottom, we believe any resultant declines in activity would be entirely short-term in nature — and indeed, this is already evidenced by the continued increases in budgets from most companies in our survey.”
The stage is set for continued spending growth in 2008 and beyond, said the analysts. However, they noted that their survey is not representative of the entire industry.
“We readily acknowledge that our survey covers only 55 companies, representing about 30% of U.S. gas production,” wrote the analysts. “We also highlight the fact that the companies we cover pursue some of the most aggressive drilling programs in the country — not to mention that they have some of the best drilling prospects as well.”
The 15-18% increase in capex spending “should not be extrapolated for the entire industry,” they wrote. “In particular, U.S. drilling activity by the majors has grown much more slowly. We believe that 2007 E&D spending by independents outside our coverage universe (both public and private producers) should post smaller growth.”
Andrews and company also noted that in the past year, they have seen a “noticeable trend” toward more completion spending rather than drilling spending. As a result, “there is likely to be a disconnect between 2007 growth in spending versus the rig count, and this will probably hold true in the future as well.”
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