Talk to virtually any E&P or oil-service analyst these days and their message is essentially the same: look for 2006 to be another strong year, both for commodity prices and stock-price appreciation. Considering that 2005 marked the third consecutive year of market outperformance for the energy sector, that's saying a lot. Shannon Nome, E&P analyst for JPMorgan Securities in Houston, for instance, notes that upstream stocks under her coverage sported an average 58% gain last year, on the heels of a 45% rise in 2004 and a 29% increase in 2003. "The top 2005 performers were either take-outs or resource players, that is, producers offering sustainable, visible growth potential via long-lived assets and sizeable unconventional drilling inventories," she says. This year, with an average oil-price expectation of $56.25 and $8.81 for gas, Nome's top upstream picks are again producers with low cost structures, low or improving asset intensity (which measures maintenance capex as a percent of cash flow), visible drilling inventories and low financial leverage. She rates as Overweight the shares of Cheniere Energy, Denbury Resources, EOG Resources, McMoRan Exploration, Noble Energy, Range Resources, Southwestern Energy, Ultra Petroleum, Western Gas Resources and XTO Energy. Raymond James & Associates' energy team in Houston, meanwhile, is even more bullish in its 2006 commodity-price outlook, calling for an average $58 for oil and $10.50 for gas. What's more, the group is initiating an aggressive $62 oil-price forecast for 2007 versus consensus expectations of about $52. J. Marshall Adkins, head of the Raymond James energy research group, emphasizes that world oil markets have entered a new paradigm where chronically low excess crude productive capacity within OPEC-probably now less than 1.5 million barrels per day-will likely lead to increased price volatility, along with generally higher average crude prices. He notes that production from such OPEC members as Venezuela and Indonesia already appears to be in permanent decline. Meanwhile, non-OPEC supply continues to face an uphill battle, with most mature oil-producing regions in decline and Russia experiencing dramatically decreasing production growth during the past year. "The oil market finally appears to have worked off its supply 'bubble' to the point where oil prices have moved to a higher sustainable level for the long run," stresses Adkins. "In fact, the supply/demand equation has tightened to the point where there is no room for any significant supply disruptions." Against this backdrop of favorable industry fundamentals, Adkins' research team believes that E&P stocks will continue to appreciate, by as much as 25% in 2006-particularly producers that reinvest the bulk of their cash flows in organic expansion and accretive acquisitions while striving to maintain fiscal discipline. As of early December, the team's top large-cap E&P picks for 2006 were Anadarko Petroleum, Occidental Petroleum, Pioneer Natural Resources, Chesapeake Energy, XTO Energy, Ultra Petroleum, Apache Corp. and Noble Energy. Favorites in its small- to midcap universe were Bois d'Arc Energy, Brigham Exploration, Cimarex Energy, Comstock Resources, Forest Oil, Houston Exploration, InterOil Corp., Plains Exploration & Production, Remington Oil & Gas and Western Gas Resources. Adkins adds that as robust commodity prices prove sustainable, rising E&P cash flows should lead to continued growth in capital spending, particularly on drilling. "After an approximately 30% year-over-year increase in capital spending for our E&P universe in 2005, we're looking for another 20% to 25% increase in 2006," he says. "This should result in more pricing power, higher revenues and solid share-price appreciation for oil-service companies. This past December, the research team's top 2006 favorites among land drillers were Patterson-UTI Energy, Nabors Industries, Grey Wolf, Pioneer Drilling and Unit Corp. Within the offshore jackup-drilling universe, the group liked Todco, Ensco International and Rowan Cos.; among niche manufacturers, Grant Prideco, National Oilwell Varco and Lufkin Industries; among more diversified service providers, BJ Services.