Usually at this time of year, E&P investors are stampeding back into the market in anticipation of rising stock valuations that typically occur during any first quarter.

But at the start of January 2007, analysts were urging caution. As they frantically churned out downward revisions to earlier commodity-price expectations for the year, they shouted almost in chorus that there could well be more downside ahead for the shares of independents amid persisting inventory overhangs.

"While we are still bullish about the long-term commodity environment, we expect an extremely volatile first-quarter 2007 for both natural gas and oil prices," says Irene Haas, upstream analyst for Canaccord Adams in Houston. "For the next two months, we would recommend sitting on the sidelines and waiting for tangible signs, such as capital-expenditure cuts, from U.S. producers that would lead to gas-production declines."

She adds that, during the next six months, as both the world oil market and North American gas markets begin to re-establish equilibrium, there will be plenty of opportunities for investors to bargain-hunt.

Similarly, Joseph Allman, E&P analyst for JPMorgan Securities in Houston, says commodity markets probably create above-average risk, despite the fact that producer stocks at the start of January were down 9.3% since early December-and were trading at a 23% discount to net asset value (NAV).

"The downside potential for (upstream) stocks matches the upside potential-around 15% to 30%," he contends. "Thus, the reward does not justify the risk until the commodity markets improve-and we think natural gas has not reached a bottom yet."

Allman suggests buying only defensive E&P stocks or stocks with clear catalysts for growth such as Apache Corp. or Anadarko Petroleum Corp. Apache, for instance, has a natural hedge with its 50/50 oil-gas production profile, he says.

"It is also among the cheapest stocks in our research universe, trading at a 29% discount to NAV, and the market is not giving it much credit for its unbooked-reserves potential." Operational catalysts include a ramp-up of production in Canada and Egypt and significant exploration drilling in the North Sea, Egypt and Australia.

Shannon Nome, E&P analyst for Deutsche Banc Securities in Houston, agrees that, if the bear view that "winter is over" proves out, "there's really no way around natural gas prices continuing to drop and taking E&P stocks down with them."

However, the analyst believes normal winter weather will prevail and maintains a more positive view of the upstream relative to recent bearish consensus. Her rationale?

"Assuming normal weather takes hold, storage should still work its way down to, or below, the year-ago 1.7-trillion-cubic-foot, winter-ending level. While this is clearly not a bullish backdrop, we note that even in 2006 the gas strip never broke below $7, despite the unprecedented overhang."

Nome also expects disappointment in domestic gas supplies this year. "The stagnation in the U.S. rig count, but more importantly the major drop in Canadian drilling, should bite hard by midyear, particularly given the challenges of offsetting the steep initial declines in unconventional gas plays," she says.

"Also, the high year-end 2006 finding costs expected to be announced by producers will underscore the great difficulty of adding to North American gas supply. We find it hard to imagine that gas can stay at $6 when it costs the average producer nearly half that just to find it, let alone to develop and operate it."

The analyst says she would use recent market weakness to add to or initiate positions in E&P names offering significant upside to NAV. Her top stock picks are Range Resources Corp., Southwestern Energy Co. and Chesapeake Energy Corp., with XTO Energy Inc. a defensive selection. She points out that Range, Southwestern and XTO are 55% to 70% hedged for 2007, while Chesapeake is 25% hedged.

Wayne Andrews, E&P analyst for Raymond James & Associates in Houston, also suggests that, short term, energy investors should look at well-hedged producers that provide the most insulation from commodity-price volatility. He notes that the average E&P company in his coverage universe has hedged about one-third of its 2007 gas production at $7 to $8.

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