Capital spending is on the rise for oil and natural gas producers, and their exploration and production (E&P) investment strategy appears to reflect a continuing sense of optimism in industry fundamentals, and in particular, a strong outlook for cash, Raymond James’ energy analysts said in a new report.

J. Marshall Adkins, Wayne Andrews and Pavel Molchonov forecast in the latest “Stat of the Week” to clients that spending “will sustain organic growth in production volumes. E&P profitability also continues to look very compelling, even with rising service costs.” They forecast a 20-25% rise in capital expenditures this year for the companies they cover, with the amount spent on drilling up 30-35%.

In Raymond James’ midyear 2005 E&P survey, the analysts noted that in April, “we made what must have seemed to be quite a bold prediction — capital spending for our 44-company E&P coverage universe would post a 30% year-over-year increase in 2005, for the third year in a row. Our forecast was especially bullish against the background of other spending surveys, suggesting that spending should show relatively meager growth. Well, the numbers are in — the first half actuals and the revised full-year budgets — and, as has recently been the case, conservative forecasts were again proven wrong.”

Exploration and development (E&D) spending for companies covered by Raymond James grew 46% year-over-year in the first six months of 2005. Total cash flow (before changes in working capital) was $20.2 billion, an increase of 31% over the year-ago period. Analysts estimate that 6% of the rise came from production growth. Total spending was $22.8 billion, an increase of 63%. Spending included $14.9 billion for E%D, or 65% of total spending; $5.3 billion for property acquisitions, or 23% of total spending; and $2.6 billion million for stock buyback, or 12% of total spending.

“The most important fact to emphasize is that E&D spending — by far the largest component of capital expenditures for our universe — posted 46% growth over the year-ago period,” said analysts. In addition, the companies they cover repaid more than $0.5 billion of debt year-to-date.

In 2005, Raymond James’ companies had initially budgeted $25.4 billion for E&D, up 11% over actual 2004 spending.

“Now the mid-year budget increases are in, and they are averaging a healthy 14%. To put this in context, initial budgets in early 2004 were $18.7 billion and updated mid-year budgets were $20.9 billion, an 11% increase. In total, the revised budgets for 2005 stand at $28.9 billion. However, as has historically been the case, we believe that companies will outspend even these higher budgets.”

Raymond James’ updated forecast for E&D is about $30.2 billion, implying growth of 32% over actual 2004 spending and 19% over the initial 2005 budgets. “Given our $42.0 billion cash flow forecast, this leaves plenty of room for debt repayment or stock buyback.”

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