A Comprehensive Review of the E&Ps in 2007
■  E&P stocks outperform in 2007. E&P stock prices gained 26% on average in
2007 (vs. an increase of 4% for the S&P 500), a sharp improvement from the 2%
average loss in 2006 (vs. an increase of 14% for the S&P 500). The strong share
performance was supported by margin expansion (higher commodity prices were
only partially offset by rising costs) and robust reserve and production growth.
Unit reserve valuations averaged $3.14 per Mcfe, down 2% compared with $3.21
per Mcfe in 2006. Meanwhile, on EV to EBITDA, valuations held flat in 2007 (vs.
2006) at 6.3 times. With the group up 30% year to date on rising commodity
prices, we estimate that the E&Ps currently trade at $3.98 per Mcfe on 2007
reserves and at 5.3 times 2008 EBITDA (on Strip prices).
■  Rig additions slow in 2007 given improved efficiency. During 2007, the total U.S.
rig count rose 7% on average (to 1,768 rigs), well below the 19% rig count
increase in 2006. Despite a slower pace of rig additions, U.S. gas production
growth was actually stronger in 2007 (up 3.7% year over year in 2007 vs. 3.0%
in 2006), as companies benefited from improved rig efficiency (e.g., fit-forpurpose
new build land rigs), which reduced drilling times in unconventional gas
plays by about one-third. Also, improved horizontal completion processes have
led to rising reserves and production per well (particularly in shale plays).
■  Drill  bit F&D costs (excluding revisions) rise 8% to  $3.05  per Mcfe. Worldwide
organic F&D costs (excluding revisions) for the E&Ps rose 8% year over year to
$3.05 per Mcfe, marking the ninth consecutive increase since 1999. However, it
appears F&D cost inflation is starting to ease, with drill-bit F&D cost inflation of
8% in 2007, below the year-over-year increases of 18% in 2006, 40% in 2005,
and 11% in 2004. When including reserve revisions, drill-bit F&D averaged $2.42
per Mcfe (down 16% year over year).
■  Organic reserve replacement soars in 2007. Given high reinvestment rates and
moderating F&D costs, median reserve replacement through the drill-bit rose to a
record high 226% in 2007 (vs. 175% in 2006). When excluding reserve revisions,
organic reserve replacement totaled 190% in 2007 (vs. 179% in 2006).
■  All-In F&D costs fall to $2.80 per Mcfe in  2007. On an all-in basis (including
acquisitions and revisions), worldwide F&D costs fell 9% year over year to $2.80
per Mcfe, marking the first year-over-year decline for this metric since 2002. In
North America, all-in F&D costs averaged $2.79 per Mcfe (down 12% year over
year). Positive reserve revisions have helped improve all-in F&D metrics, with
reserve revisions (both performance- and price-related) measuring 2% of total
reserves in 2007 vs. -2% in 2006, -1% in 2005, and -1% in 2004.

■ Drill-bit capex  budget rose 36% in 2007. Organic spending rose 36% year over year in
2007 as producers steadily accelerated drilling activity over the year amid pressure to
achieve stated growth targets. (Initial 2007 budgets were indicated up just 16%.) Budget
increases will likely be a recurring theme in 2008 given the significant uptick in oil and gas
prices and investors’ continued preference for growth. Initial 2008 capex budgets were up a
median 8% versus 2007 levels, but are now up 21% year over year (as of the first quarter
2008 earnings season) and we expect ultimate drill-bit spending will ultimately rise by
25%-plus year over year.
■ Producer reinvestment boom continues. The E&Ps spent a median 115% of cash flow in
2007 (versus 122% in 2006), as internal cash flow fell short of funding growth-seeking
capex budgets. Average E&P volume growth rates came in at about 10% of last year and
look on track to be up 12%-plus in 2008. Producers mainly relied on the external capital
markets to help finance the spending gap, while also pursuing asset sales and other asset
monetization strategies (MLP, VPP). At current 2008 budgets, the median reinvestment
rate measures approximately 112% (less than $90 oil/$8 gas price assumptions); however,
given the steady escalation in both oil and gas prices and an undiminished appetite for
growth, we think budgets will be raised in 2008 (similar to last year) leading to similar
reinvestment rates as in 2007. While the overall capital markets have tightened, access to
capital has not been a limitation for the E&Ps, with many producers having completed
equity/debt transactions year to date.
■ Even stronger growth possible for 2008. Following robust 3.7% year-over-year gas growth
in 2007 (an increase of 2.1 Bcf/d), we believe 2008 could post even stronger growth as
independent producers (which comprise more than two-thirds of the U.S. market) continue
to target big growth rates (10%-plus), which we believe could be increased (along with
higher budgets). The latest figures from EIA-914 survey data (February 2008) show gas
growth kicking off the year at an extremely rapid rate, with growth running a shocking 5.8
Bcf/d year over year (up 10.5% year over year). We expect these rates to fall some given
tougher year-over-year comps for this coming summer and considering January/February
2007 production was lower due to winter weather disruptions. Nonetheless, we still see
2008 growth comfortably surpassing 2007 levels and see an upward bias to our full-year
2008 forecast of a 2.9 Bcf/d year-over-year (up 5.0%) increase in U.S. gas volumes
(onshore +2.6 Bcf/d, offshore +0.3 Bcf/d).
■ Overall gas  market should loosen. While supply/demand balances tightened over the
2007-08 winter season, we believe accelerating supply growth will overwhelm year-over-year
declines in LNG/Canada imports and potential demand increases. Specifically, we see the
current U.S. gas market as 0.8 Bcf/d looser, which assumes the following year-over-year
increases/decreases: onshore supply +2.6 Bcf/d, offshore supply +0.3 Bcf/d, LNG imports -0.7
Bcf/d, Canada imports -0.9 Bcf/d, and demand +0.5 Bcf/d (given a tough summer demand
comparison and better nuke and hydro expectations). Likewise, storage inventories may be
low now, but will likely fill quickly with storage feasibly approaching 3.3-3.4 Tcf by Octoberend
(barring extreme summer weather), giving the market greater comfort.
■ Costs stabilize in 2007. Following steep cost increases in 2005 and 2006, 2007 witnessed
moderating cost inflation (for both F&D and operating costs), as drilling costs subsided
owing to excess rig and service capacity and producers benefited from improved
drilling/operating efficiencies. Specifically, the total cost structure for the E&P group rose
10% year over year (versus 16% and 21% increases in 2005 and 2006). Total cash costs
rose 6% year over year in 2007 (versus 17% increases in 2005 and 2006). Meanwhile drillbit
F&D costs (excluding revisions) rose 8% in 2007, below the year-over-year increases of
18% in 2006 and 40% in 2005. Costs have remained relatively stable into 2008, but could
rise later in the year on higher rig demand (given expected budget increases) and already
sharply rising steel prices (for tubulars). Nevertheless, we believe F&D costs will not
increase much in 2008 owing to continued improvements in drilling efficiency
(unconventional gas) and typical time lag for increased service costs to filter through.