Clayton Williams Rating Downgraded

We are downgrading Clayton Williams Energy, Inc. (CWEI) to Hold on valuation grounds. The shift in strategy earlier this year away from wildcat exploration and greater focus on developmental drilling in the oil-prone Permian basin and Austin Chalk regions, helped in no small part by the earlier oil surge, pushed the stock price to new levels.

While the stock has pulled back some in recent weeks, it remains fairly close to our new net asset value (NAV)-based target price; hence the downgrade. We have, however, raised our earnings estimates to reflect a higher commodity-price deck and other model changes. Our new 2008 and 2009 EPS estimates are $11.39 and $9.83, up from $7.48 and 9.46, respectively. We are decreasing our price objective from $96 to $93 for Clayton Williams’ shares.

Clayton Williams reported better than expected second-quarter 2008 adjusted EPS of $4.29, compared to $0.77 in Q2 07 and $0.62 in the previous quarter. In its financial guidance for the rest of 2008, it was stated that natural gas production will decrease by approximately 10 MMcf/d for the remainder of 2008 due to the South Louisiana asset sale in Q1. However, due to the commitment to low-risk developmental drilling in its two oil heavy regions, CWEI is forecasting an increase in oil production of around 31 MM barrels, a 34% increase over 2007 levels.

The company is subject to significant exploration risks. Substantial debt leaves it open to liquidity risks. Oil and gas prices are extremely volatile. Although a good portion of CWEI production is hedged in 2008/2009, adverse prices could lower the company’s reserves and make it more difficult to obtain financing and strain its operating results.

Neil Malkin contributed to the report.

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