Record cash levels and historically low levels of debt should fuel strong exploration and production (E&P) earnings for the second quarter and perhaps encourage more mergers and acquisitions (M&A) within the energy sector through the rest of the year, but if natural gas prices remain low, producers weighted toward gas may see a slowdown in full-year earnings, according to energy analysts. E&P 2Q2006 earnings announcements will begin in earnest within the next few days.

Ever the optimists, Raymond James’ team of energy analysts, led by J. Marshall Adkins, also are looking for “solid, absolute and relative stock price performance from energy stocks over a 12-month time frame. On the E&P side, we believe stocks will continue to benefit from very favorable industry fundamentals, such as: (1) strong earnings and incremental returns that are benefiting from high oil and gas prices that have far outpaced increases in service costs and (2) attractive valuations that do not fully reflect the sustainability of the robust commodity price environment.”

Rising E&P cash flows also should lead to continued growth in capital spending, particularly drilling, according to Raymond James. “This increase should result in more pricing power, higher revenues, and solid share price appreciation for oilfield services companies. Likewise, our bullish oil and gas thesis translates into a bullish stance on coal. The stage appears to be set for higher average fossil fuel prices for years to come, which bodes well for the coal industry,” Adkins wrote.

“While energy stocks have outperformed the broader market during the past three years, we remain firmly supportive of the E&P space over the long run due to consistently strong industry fundamentals given high commodity prices and still relatively modest service costs, and inexpensive stock valuations that have persistently denied the full sustainability of robust oil and gas prices.”

Bank of America (BofA) energy analyst Robert Morris is not as optimistic. He lowered his full-year 2006 earnings per share (EPS) predictons for E&Ps by 6.4% and his cash flow per share (CFPS) estimates by 3.3% — mostly because of continued lower gas prices. BofA last week slashed its full-year 2006 spot gas price estimates to $6.50/MMBtu from $7.15, well below the current Street consensus of $7.80 (see Daily GPI, July 13).

“Our full-year ’06 EPS/CFPS estimates are now 1.2%/0.6% below Street consensus,” Morris said. However, he noted valuations for the E&P sector “remain attractive given our long-term outlook for crude oil and natural gas prices.” BofA’s “normalized [West Texas Intermediate] WTI spot oil and composite spot natural gas price projections remain $50/bbl and $7.50/MMBtu.”

BofA remains “overweight” in the E&P sector because “while it appears that 2006 consensus estimates for oil prices are likely to continue to rise at the same time that we believe consensus estimates for natural gas prices have to be reined in even further,…we are unable to predict the possible, and widely anticipated, intervention by Mother Nature. We have consistently noted in the past that the E&P sector has historically outperformed the broader markets for any extended period only when consensus estimates for crude oil and/or natural gas prices are rising. However, the group has rarely confronted such a divergence in direction on the consensus outlook for the two commodities. Thus, we believe the group will continue to exhibit sharp volatility in its relative performance near term.”

John Gerdes of SunTrust Robinson Humphrey/the Gerdes Group, whose coverage is weighted toward domestic gas producers, expects the companies his firm covers to have “solid” 2Q2006 earnings on higher oil prices, which also will help lift gas-weighted producers.

“Compared to a year ago, 2Q2006 EPS and CFPS should increase 25% due to 33% higher [New York Mercantile Exchange] Nymex oil prices, 1% higher Nymex natural gas prices and approximately 13% year-over-year production growth in the quarter.” But he cautioned that if gas prices remain lower through the rest of the year, E&P spending for the gas-weighted producers “should remain within budgeted plans.”

For those E&Ps with record cash, “large” M&A deals are expected to continue, according to PricewaterhouseCoopers (PwC) analysts. “2006 will be a record year for buyout size, while corporate acquirers are prepared to bid higher to get the assets they feel they need to maintain growth and support their stock prices.” PwC singled out five industries that are positioned to take advantage of M&A opportunities: energy, utilities, manufacturing, digital convergence and retail.

The energy sector — upstream, downstream and midstream — is a particularly hot area for M&A activity because of continued high commodity prices. Oil service companies also are expected to be part of the M&A consolidation. So far this year, some record energy mergers and buyouts already have been announced, including the $21.1 billion merger by Anadarko Petroleum Corp. with Kerr-McGee Corp. and Western Gas Resources (see Daily GPI, June 26), and Kinder Morgan Inc.’s $22 billion move to take its company private (see Daily GPI, May 31).

“After three years of unprecedented returns [in the energy industry] and the biggest stock buybacks in history, reinvestment levels as a percent of cash flow are moving up, and major companies — especially the big independents — are turning to M&A to increase their inventory of big projects,” said PwC analyst Bob Filek.

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