Part 2: What Will '07 Bring for Key Sectors?

(page 2 of 3)

From Standard & Poor's RatingsDirect

On a related note, the music industry may suffer a continuing decline of CD sales—and without signs that paid digital downloads, despite their rapid growth, will fully compensate for this drop.

Metals & Mining: Still Enjoying High Prices

As metal prices continue their remarkable run, credit ratings on metals and mining companies around the world have improved, albeit at a slowing rate. Overall ratings are benefiting from the combination of stronger operating cash flow sectorwide and issuer-specific measures to reduce debt. Ratings in the sector, however, are becoming increasingly constrained by individual companies' business risk profiles, which reflect the highly competitive, volatile markets and other risks of these industries. In addition, the sector as a whole will be increasingly susceptible to operating cost inflation stemming from higher energy costs, higher currencies relative to the U.S. dollar, and a scarcity of materials and labor in 2007.

Although fundamentals remain sound for most metals heading into 2007, some significant risks exist. "China has represented the bulk of marginal demand in recent years, and any unexpected drop in industrial production there would likely adversely impact metals prices," says S&P Director Thomas Watters. "Compounding this potential volatility is the presence of speculative investment funds, which have taken large positions in most London Metals Exchange–traded metals." Watters notes that rapid investments flowing in and out of metals could seriously exacerbate short-term price declines.

The strength of base metals is expected to persist for at least the next several quarters, as demand remains solid and supplies continue to decline to critical levels. Nevertheless, further positive rating actions on companies in base metals will be tempered by higher spending aimed at replenishing reserves, increasing production, enhancing efficiency, and rewarding shareholders. Also, the event risks associated with large-scale M&A activity add complexity that will likely constrain further upgrades.

Oil & Gas: Search for New Reserves Is Key

The price of crude oil, which peaked at close to $80 per barrel in the summer, now hovers at $60, thanks to fewer perceived political and production risks in some oil-producing countries, as well as normal seasonal variation in the U.S. as the summer driving season ends. In 2007, S&P is maintaining stable outlooks for the vast majority of companies in the five groups of energy companies it rates: exploration and production companies, contract drillers, oilfield service outfits, refiners and marketers, and the big integrated oil companies. In general, lower-rated issuers are the weakest E&P, oilfield service, and refining and marketing companies, which are rated B or lower.

For the industry as a whole, finding new reserves at reasonable costs will continue to be a key concern in 2007. Since there are only two ways to replenish reserves—finding new sources or buying them from someone else—we see mergers and acquisitions as a continuing factor. Although companies will continue to explore, the thirst for more oil explains such megamergers as Anadarko Petroleum's (APC) $23 billion purchase of Western Gas Resources and Kerr-McGee in 2006.

In 2007, there is also the potential for more M&A activity in the refining sector, driven by the same scarcity of assets and record profitability. In some recent deals, buyers have paid as much as 40% more than it would cost to construct similar facilities. Although paying this premium will avoid the construction risk of building new refineries, S&P believes that the recent acquisitions will only make sense if strong market conditions persist. "The near-term outlook for the refining sector is favorable, but the industry remains fundamentally volatile and recent huge margins are not likely sustainable," said S&P Director Ben Tsocanos.