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That period of stagnant investment in infrastructure was followed by the recent economic boom in America and Asia that fuelled demand for oil.

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Companies are only now investing in infrastructure. It will still take years until the supply situation improves, so as long as economic activity remains strong, the oil price will remain high.

This provides a structural backdrop that creates a favourable climate for oil exploration stocks, especially ones such as Tullow, which is highly profitable, cash-generative and dividend-paying.

With geopolitical risks dissipating over Iran and big oil supply builds in America (on the back of warm weather), the price of oil has dropped by 8% in the past two weeks. We would let that move play out before buying an oil price-sensitive stock such as Tullow.

Judgment: buy Tullow on dips

Stuart Draper, head of research, Dolmen Securities Tullow Oil’s recent year-end trading statement confirmed that its oil and gas production had increased by 44% in 2005 to 58,450 barrels of oil equivalent (Boe) per day. The company now expects this to rise to 68,000 this year.

Tullow is also increasing its investment in exploration and development to £280m (€410m), from £192m last year. The potential for important progress in this area over the next three months gives the share price further upside potential.

Over the next three months, eight more exploration wells will be drilled, including three in the UK and a high-impact well in Uganda. Tullow’s Gabon wells, focused on extending existing fields, are relatively low-risk. New discoveries there continue to support further modest upgrades in net asset value.

Its M’Puta prospect in Uganda could contain up to 500m Boe, which, even though higher risk, would result in a much greater valuation boost because Tullow owns a 50% interest.

Even in the absence of such exploration success, the company’s current share price of 300p is well supported by further strong production growth this year and next.

Allowing for the recent UK budget supplementary corporation tax rate increase from 10% to 20%, this production growth should still deliver 22% earnings per share growth this year to 22p and further 20% growth next year to 26.5p.

As a result, Tullow Oil was one of our top stock picks for 2005, included in our Dolmen Dozen research publication at a share price of 150p.

With the share price having doubled since then, it is tempting to recommend some profit-taking at current levels. However, given continued record high energy prices, particularly for UK gas, we recently upgraded Tullow’s core net asset value to 225p per share.

Considering the exploration progress and potential outlined above, we also upgraded the company’s risked exploration upside to 115p per share, generating our new 12-month share price target of 340p.

Our view is that there is also an above-average probability of Tullow receiving a takeover approach in the next 12 months, given its unique positioning within the energy sector and the increasingly huge cash balances of the majors.

Judgment: buy

THE FIRM AT A GLANCE

Share price: £2.99 (€4.39)
Market cap: £1.7 bn
Year end: December 2006
EPS forecast: 17.2p
Dividend forecast: 3p

Leading shareholders: Merrill Lynch Investment Managers 14.3%, IFG International Trust Co 7.2%, Columbia Wanger Asset Management4.2%, Drew Finance 3.3%, FMR Corp 2.9%

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