In a spring 2007 report, Raymond James & Associates in Houston predicted that E&P capital budgets for the 55 upstream companies it covers would be flat to slightly up this year versus last. This projection, however, turned out to be just a tad on the conservative side.

"Our mid-2007 capex survey now indicates that exploration and development (E&D) spending in our coverage universe actually grew 35% year over year during the first half of 2007," report E&P equity analysts Wayne Andrews and John Freeman.

That 35% growth in E&D spending translated into an outlay of $29.4 billion, or 79% of total capital expenditures of $37.1 billion for first-half 2007. This was followed by $6.4 billion for acquisitions (17% of total spending) and another $1.3 billion for stock buybacks (4% of total spending).

"With capex spending on the rise across the board, E&P investment strategy reflects a continuing sense of optimism about industry fundamentals," says Andrews. "Notwithstanding a near-term bearish gas-price environment, [upstream] companies apparently have expectations for strong returns in the long run.

"We emphasize that rising capex spending should support organic growth in production volumes among many E&P companies."

Most producers have stated they would not significantly cut back on gas drilling activity unless strip prices dip meaningfully below $7 per thousand cubic feet, he adds. "And even if natural gas prices remain permanently at $7, drilling an additional well would still generate an average internal rate of return of about 20%-assuming a $2.50 finding and development cost."

For all of 2007, Andrews now estimates that total E&D spending by the 55 producers in his coverage universe will be $57.4 billion, implying a growth rate in excess of 15% versus 2006 E&D spending and about 7% more than initial 2007 E&P budgets.

Their updated upstream spending survey also finds that, while many operators must borrow, most E&P balance sheets have improved during the past several years and are perfectly capable of taking on some incremental leverage.

Freeman says, "Our E&P coverage universe as a whole is maintaining financial discipline, with current debt-to-cap levels averaging around 35%, compared with a ratio of 43% in 2003."

Obviously, higher capex budgets bode well for oil-service companies, he adds. "As we have long argued, the biggest beneficiaries [in that sector] will be those with the most leverage to the drillbit, specifically, U.S. land drillers, jackup drillers, tubular manufacturers and other gas-weighted service companies."

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