When it comes to making forecasts about the industry, it's nice once in a while to err on the side of being a tad conservative. That way, if you're wrong, it's usually because things have gone better than expected.

Such is the case with Raymond James & Associates, which six months ago offered up a cautious 2007 capital-spending outlook for the E&P sector. This was against a consensus view at the time that U.S. drilling activity this year would slow down meaningfully in the face of commodity-price volatility.

"We made the prediction that drilling spending for our E&P coverage universe would flatten in 2007, after posting increases of 30% to 40% each year from 2004 through 2006," says Wayne Andrews, Houston-based E&P analyst for the investment-banking firm.

"However, looking at data since then, it appears that even our forecast for spending was conservative, once again."

Indeed, despite concerns about the recent volatility in natural gas prices, the firm's coverage universe of 51 E&P companies-not including upstream master limited partnerships (MLPs)-is boasting better-than-expected drilling budgets this year.

"For 2007, this universe had preliminarily budgeted $53.1 billion for exploration and development, up 7% versus actual 2006 spending-and some companies, if not most, will outspend their 2007 budgets," the analyst says.

Many E&P companies that have reported first-quarter 2007 results have already increased their upstream budgets for the full year, he adds. "Currently, their updated budgets are up 6% versus preliminary budgets set earlier in the year."

For context, the initial 2006 upstream budgets of the 51 E&P companies under Raymond James & Associates' coverage totaled $44 billion, their updated midyear 2006 budgets totaled $47 billion, and their actual E&P spending by year-end totaled $49.5 billion, or 55% of the group's total 2006 capital outlays of $90.1 billion.

Concurrently, acquisitions totaled $36.7 billion, or 41% of the group's total 2006 capital spending, while stock buybacks totaled $3.9 billion, or 4% of total outlays.

"The most important fact to emphasize is that E&P spending-by far the largest component of capital spending for our coverage universe-grew 39% in 2006 versus the prior year," says Andrews. Meanwhile, he observes that the coverage group maintained financial discipline, with the mean debt-to-cap ratio decreasing from 36% to 34%.

For full-year 2007, the analyst predicts a relative shift towards more E&P spending by the group. "In fact, given our assumption of fewer acquisitions, the percentage of total spending represented by exploration and development could easily rise above 70% to 80%, compared with 55% last year."

What does all this mean? Because of the stepped-up focus on exploration and development, drilling expenditures this year should be up 8% to 15% for the coverage group versus 2006, Andrews contends.

He believes this increased level of spending should not only sustain organic growth in production volumes, but will also benefit oil-service companies leveraged to the drillbit-specifically U.S. land drillers, offshore drillers, tubular manufacturers and other natural gas-weighted service companies.

Looking outward to 2008 and beyond, the analyst forecasts that the growing trend of upstream MLP spin-outs will simultaneously increase both cash flow and drilling activity and, hence, E&P spending budgets

"E&P companies can drop down low-decline, stable, producing assets into MLPs, which create a meaningful source of cash flow," he explains. "These companies can then accelerate their returns on investment by redeploying that cash flow into other presumably higher-return, growth assets. The benefits of this strategy include a revaluation of assets, an improved growth outlook for the remaining assets in the parent company and significant capital infusions."

Concludes Andrews, "With capex spending on the rise, E&P investment strategy reflects a continuing sense of optimism about industry fundamentals despite prospective volatility in natural gas prices." And, upstream spending is unlikely to slow down unless the natural gas strip drops meaningfully below $6 per thousand cubic feet.