Drilling Down at XTO

The natural gas producer could be set for a big quarter.
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One of the hottest energy companies of recent years,

XTO Energy

(XTO)

, is expected to report another blowout quarter Tuesday, driven by high commodity prices and expanded production.

The Fort Worth, Texas-based natural gas producer, whose market cap has swollen to $12 billion from $2 billion in five years, has already told Wall Street that second-quarter production will rise by 25% from a year ago, reflecting the addition of 775 billion cubic feet to its reserve base through $1.3 billion worth of acquisitions. In 2004, it acquired 1.3 trillion cubic feet of reserves for nearly $2 billion.

The stock, which is up 35% in 2005, closed Friday at $35.75, about 14.5 times its expected 2005 earnings of $2.46 a share.

Though analysts are confident that XTO will make its production target, opinions differ slightly about the bottom line.

"Of the

exploration and production companies under my coverage, XTO is the one I have the most confidence in," says Kim Pacanovsky, oil analyst at KeyBanc Captal Markets, citing management's reputation for conservative guidance. (Pacanovsky's firm has had an investment banking relationship with XTO in the past.)

XTO's method has been to acquire vast amounts of natural gas-rich properties where long-lived reserves with a predictable yield are known to exist. The company applies advanced technology to hard-to-extract rock such as shale and tends to drill as many wells as possible at each property, even if each yields only a couple million cubic feet of gas.

The strategy has resulted in impressive production growth at a time when natural gas prices have been surging. They're up 22% in 2005 alone to a recent $7.60 per thousand cubic feet. The average gas price between 2000 and 2002 was as little as $3.30 per thousand cubic feet.

Still, Pacanovsky expects the company to earn 56 cents a share in the second quarter, about 4 cents below the Thomson First Call consensus. The company earned 41 cents a share a year ago.

XTO previously said second-quarter average daily production should come to 1 billion cubic feet of natural gas, up 25% from the same time a year ago.

XTO Energy purchases properties mostly from supermajor oil companies such

Exxon Mobil

(XOM) - Get Report

that have decided that the extracting effort in certain areas is uneconomical relative to their size. In its expansion strategy, the company became the second-biggest driller both in the U.S. and the Barnett Shale of central Texas, a coveted area known for its natural-gas abundance.

Jason Gammel, oil analyst at Prudential Equity Group, estimates XTO will beat the consensus second-quarter earnings estimate by 5 cents a share. (Prudential has no investment banking relationships with XTO.)

Companies such as XTO apply their expertise and technology not just to extract more gas and oil from existing wells, but to increase the wells' reserves. This alchemy-like result, which can sometimes double the amount of gas available in a well, is achieved by special injection and fracturing techniques, according to Gary Simpson, XTO's senior vice president of investor relations.

Jeffries & Co.'s analyst David Tameron said in a note Friday that "through an acquire-and-exploit strategy, the company has built an inventory of low risk, long-lived assets. ... Given the opportunity, we would get more aggressive on XTO shares." (Jeffries has had an investment banking relationship with XTO.)

KeyBanc's Pacanovsky says the same market conditions and niche advantages enjoyed by XTO also apply to peers like

Chesapeake Energy

(CHK) - Get Report

and

EOG Resources

(EOG) - Get Report

. "Most of these companies are attractive to investors primarily because the predictability of their production curves," Pacanovsky says.

Chesapeake's second-quarter earnings are expected to increase by 36% compared with the same time a year ago, to 45 cents a share, according to Thomson Financial. The company gave production guidance of about 1 billion cubic feet of gas a day, about 30% more than last year.

The No. 3 independent natural gas producer operates mainly in the mid-continent, with an aggressive acquisition strategy that has added about 500 billion cubic feet to its existing reserves this year.

Jeffries' Tameron expects Chesapeake to beat Wall Street's expectation by 9 cents a share. Prudential's Gammel has them beating by 5 cents a share.

"What makes companies engaged in unconventional gas plays attractive to investors is their emphasis on development wells -- exploitation rather than exploration," Gammel says. "Development wells have a very low geological risk since the prospects have already been drilled."

As for EOG Resources, the largest independent natural gas producer, earnings are estimated to rise by 65% over the same time last year to 86 cents a share, driven by "strong drillbit production growth in the U.S. and Canada, incremental sales contracts in Trinidad and the start-up of production in the North Sea," Gammel said in a recent note.

The company, which says it has more than 5 trillion cubic feet of proven reserves, reportedly grew its production by about 18% to an estimated range of 1.12 billion to 1.19 billion cubic feet a day. Oil production also increased from last year to an estimated range of 24.6 thousand to 30.8 thousand barrels a day.

Despite having a lot of cash flow to fund the acquisitions of natural gas fields, the major concern is whether these companies can maintain profitability as they become natural gas behemoths.

In XTO's case, many analysts wonder if it might struggle to digest its recent run of acquisitions. Others are questioning when these companies will run out of new resources to buy as the contest to win America's last gas resources gains speed.

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