Even with higher finding and development (F&D) costs, the exploration and production (E&P) sector’s strong cash flow and historically low trading levels make it an ideal time for additional wells to be drilled in North America, according to Raymond James’ latest “Stat of the Week.”

Raymond James’ large cap E&P coverage universe currently is trading at $1.30/Mcfe of proved reserves, “significantly below a fair value range of $1.50-$1.75/Mcfe, given that the 12-month natural gas strip is currently at $4.90/Mcf and cash flows for 2003 are estimated to be 55% higher than in 2002.”

Analysts Jeffrey L. Mobley and Wayne Andrews cast aside arguments that the investment rate of return (IRR) on drilling new wells is not high enough to justify new investments because the E&Ps would “destroy capital.” They noted that while higher F&D costs are certainly exerting some downward pressure, drilling returns are also a function of current and future price realizations. “In our view, the current high commodity price environment more than offsets these higher costs and results in very generous E&P returns.”

Costs should not be ignored, said the analysts, but “they tell only half the story…remember that commodity prices are at historically high levels, averaging nearly $5.50/Mcf so far this year. This more than compensates for the increase in F&D costs.” Even assuming rising costs, “a very conservative cost and gas price assumption of $4/Mcf produces expected IRR in the double digits.”

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