In anticipation of poor 2009 financial results for companies in the oil and gas sector, Standard & Poor's Ratings Services has taken a significant number of negative rating actions over the past three months, despite the group's healthy performance during the 2008 fourth quarter. Moreover, we expect to take additional negative rating actions, especially on speculative-grade (those rated BB+ and lower) companies.
The decline in hydrocarbon prices has been rapid and steep, although it appears to be near or at a low point. While we still believe in the long-term fundamentals for hydrocarbon prices, we currently believe oil has a better supply-and-demand outlook than natural gas does. In our view, producers with a greater exposure to oil should benefit before natural gas producers do.
Exploration & production companies may find few bright spots
Credit quality for exploration-and-production (E&P) companies continues to be negative. We expect unhedged natural gas-focused producers to generate sharply lower operating cash flows in 2009. Benchmark natural gas prices have now fallen below $4 per million Btu (mmBTU) and geographic differentials—especially midcontinent—remain wide. As a result we anticipate that few U.S. natural gas drilling companies will generate adequate rates of return in the current environment. The majority of U.S. operators produce more natural gas than crude oil.
Liquidity is becoming more problematic for several speculative-grade issuers—in addition to higher financial leverage and worsening debt service coverage ratios. Falling hydrocarbon prices are resulting in many reductions on companies' borrowing bases, particularly for issuers that lack price hedges and have shorter-lived hydrocarbon reserves. Energy Partners is the only rated company to date that had its borrowing base fall below the amount of debt it had already borrowed, but several companies in the B category have seen significant drops. Financial covenant compliance has also become a bigger issue. Many companies have needed or proactively sought covenant amendments or waivers due to deteriorating financial performance.
Are there any bright spots? We don't see many. We believe that 2009 will be a particularly poor year for the industry, but that profitability should improve somewhat thereafter. Operators are rapidly idling drilling rigs and hydrocarbon supply will begin to decline, probably in the second half of the year. The question is whether the supply drop will match the falling demand. At some point prices should improve or costs decline more rapidly; the industry won't remain unprofitable forever. In the meantime, conditions will be painful. We obviously expect investment-grade issuers to have the financial wherewithal to weather this storm. However, assuming conditions do not improve, many weaker credits could falter and we may see the first rash of defaults in the industry since the 2002 downturn.
Weak demand and overcapacity continue to plague refiners
This is shaping up to be another difficult year for the refining industry, if not the roller coaster that 2008 was. Still, the struggling U.S. and global economies and increasing worldwide refining capacity frame a bleak outlook.
Lower prices for refined products have failed to improve demand significantly, and once-mighty diesel prices have come back to earth. As a result, margins will remain volatile and could weaken significantly if the summer driving season is weak. The Energy Information Administration (EIA) is forecasting average summer gasoline prices of $2.23 per gallon, not far off current levels. The EIA's estimated summer diesel price of $2.27 per gallon is approximately $2 lower than year-ago levels, reflecting lower crude costs and a weakened market because international capacity has increased at the same time economies have swooned. Finally, the infusion of ethanol into the fuel supply continues to pressure gasoline margins. The EIA expects ethanol use in the U.S. to average around 670,000 barrels per day (bpd), which is about 7% of gasoline demand this summer.
As a result of the uncertain market, companies continue to position themselves for difficult operating conditions ahead. Building on 2008's initiatives, they are deferring capital projects, optimizing utilization levels, and managing working capital needs. Although last year saw a move to greater diesel production, 2009 may see a decline in production because increased international supplies have weakened margins and are now making the U.S. gasoline market more attractive. The biggest surprise in 2009 may be the continued strength of asphalt. Despite a drop in demand, lower asphalt production helped keep margins healthy in 2008, a trend that appears to be continuing in 2009. In addition the U.S. stimulus package should boost infrastructure spending and thus, asphalt demand, potentially supporting asphalt margins through 2009 and into 2010.
Given the struggling global economy, additions to refining capacity, and continued weak product demand in spite of lower gasoline and diesel prices, we expect refining performance to remain below average in 2009. Not all companies in the sector will suffer equally, however. Refiners that operate large, high-conversion facilities should continue to fare better than smaller players. These facilities have logistical advantages and can produce large proportions of clean fuels from discounted, low-quality crudes such as heavy or high-sulfur grades. Companies operating in niche markets also have an advantage over those in more competitive regions such as the Gulf Coast. As a result, higher complexity refining companies such as Flint Hills Resources, Frontier Oil (FTO), and Valero Energy (VLO) should continue to achieve better-than-average results for the industry. Smaller refining companies that have lower complexity and high debt leverage, such as Alon USA Energy (ALJ), United Refining, and Western Refining (WNR), will continue to struggle with weak margins because they lack the cost advantages of more complex refineries.
In addition, although lower crude oil prices have eased working capital needs, the decrease in the value of crude and refined products will limit the amount refiners can borrow and could limit availability for non-working capital needs. Nevertheless, the unexpected strength in asphalt could provide a cushion to low fuel margins over the summer months.
More downgrades are likely in North American oilfield services and contract drilling
Our 2009 outlook for the oilfield-service and contract-drilling sectors has become increasingly gloomy over the past six months. As a result, we are expecting more negative rating actions. In particular, North American-focused speculative-grade companies could see further credit deterioration—particularly those with high leverage, tight liquidity, and/or limited headroom under their financial covenants.
Following our oilfield-service sector review in February, we took negative rating actions on 14 companies. Despite largely good fourth-quarter results for the majority of oilfield-service companies, we expect that first-quarter earnings will be where the rubber hits the road. Because a decline in oilfield-service companies' financial performance tends to lag weakening commodity prices, we expect that first-quarter results will illuminate the financial effects of weaker industry conditions over the previous six months.
We expect that the dramatic decline in commodity prices from 2008 highs (particularly for North American natural gas), sharp drops in rig counts, and reduced upstream capital spending levels will translate into weaker service demand and increased pricing pressure. In the U.S., rig counts have declined roughly 50% from their September 2008 peak levels and most independent E&P firms operating in the region have substantially slashed their 2009 capital spending budgets. According to the American Petroleum Institute (API), first-quarter drilling activity in the U.S. has declined to 2004 levels.
In general, we expect prospects for larger and more internationally diversified companies to be relatively better. Rig-count declines outside of North America have been less severe thus far—down only 8% to 10% from 2008 peak levels. Nonetheless we expect all customer groups (independent, national, and integrated oil companies) to continue to push hard for further pricing reductions.
In a better position to weather the downturn in the short run are investment-grade offshore drillers—particularly those with long-term contracts for their deepwater units, such as Diamond Offshore Drilling Inc. (DO), Pride International (PDE), Noble (NE), and Transocean (RIG)—and oilfield equipment providers with substantial backlogs, such as Cameron International (CAM), FMC Technologies (FTI), and National Oilwell Varco (NOV). Still, we expect backlogs, new unit orders, and pricing for equipment providers to continue to erode over the next few quarters until industry conditions recover.
Watters is a credit analyst for Standard & Poor's Ratings Services .
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