A Slippery Slope for Oil Outfits

S&P Ratings says factors such as demand swings, reserve replacement, and geopolitical risks could hurt the sector's credit quality

From Standard & Poor's RatingsDirect

U.S. oil and gas credit trends are likely to be more daunting in 2007 than in the past few years, as weakening fundamentals, particularly for natural gas, result in a softening of prices. In 2006, upgrades outpaced downgrades by more than two to one, in part due to robust industry conditions deriving from record hydrocarbon prices. For 2007, Standard & Poor's Ratings Services expects factors that influence crude oil and natural gas prices to have a significant impact on ratings activity and trends.

These factors include: weather patterns that affect demand, particularly with near-record levels of natural gas storage; good prospects for global economic growth; and resource nationalism and geopolitical developments that are generally the catalysts for heightened price volatility. Other concerns for ratings include: mergers and acquisitions activity, rising capital spending in a weaker price environment, and reserve replacement.

Softer natural-gas and crude-oil prices could challenge credit quality in the exploration (E&P) sector as we enter 2007. As of mid-January, the near-month crude oil contracts had fallen to less than $52 per barrel, from $63 at the end of third-quarter 2006. Meanwhile, natural-gas prices remain relatively tepid, even in the middle of the winter heating season, at less than $7 per thousand cubic feet. Mild weather, large storage volumes, questions on whether OPEC quotas will be enforced, and financial flows have all contributed to the low prices.

Awaiting Reserve Reports

Assuming prices stay at these levels or soften further, E&P companies' profit margins will be squeezed heading into 2007 and credit measures will deteriorate, particularly for those companies that are largely unhedged. A key question will be how willing companies are to scale back capital expenditures to be in line with internally generated cash flow.

Poor organic reserve replacement and high finding and development costs could also pressure credit quality in the sector. While companies haven't yet published their yearend 2006 reserve reports, a few large companies have pointed toward disappointing figures, which could prove representative of a wider trend. So far, ConocoPhillips COP and Anadarko Petroleum (APC) have preannounced reserve additions that were well below expectations.

Refining margins contracted substantially in the fourth quarter of 2006, reflecting a dissipation of disruptions such as lingering 2005 hurricane effects and a methyl tertiary-butyl ether (MTBE) phaseout that had constrained supply. Also, warmer than usual weather in much of the U.S. reduced demand for heating oil. Despite the decline, margins are still high by historical standards, and the outlook for the industry is favorable in the near term as long as the U.S. economy stays healthy.

Cost of Construction

Demand for refined products generally depends more on economic activity than on weather. A lack of major new projects in the past few years continues to limit refining capacity growth. While a number of large projects are under way in the U.S. and abroad, meaningful throughput additions won't come on stream until the end of the decade. The prospect of strong margins in the intermediate term is attracting investment into the sector, both for the limited number of acquisition targets and for expansion projects.

Increased competition for acquisitions and for engineering, labor, materials, and components in the case of construction, is leading to a steep escalation in costs. Much of the current investment depends on an extended period of high refining margins to meet expectations.

Following record financial performance and positive credit momentum in 2006 for oil field services providers, recent commodity price volatility raises some concern that product service pricing and additional cash flow growth could slow from its brisk pace. Despite some market readjustment in crude and natural-gas prices over the past several months, rig counts remain at healthy levels relative to historical counts. Domestic rig counts are up 16% year over year, and international rig counts roughly 10%.

Bigger Dividends

E&P capital spending worldwide—while expected to increase year over year (at roughly 5% to 10%)—also appears to be slowing from the substantial percentage increases of the past two years. Nevertheless, healthy current product and service pricing, high levels of equipment utilization, strong operating margins, and favorable supply-and-demand dynamics for services providers should continue to support solid performance in the near term.

We expect this to be the case particularly for larger and more geographically diversified operators such as Schlumberger (SLB), Halliburton (HAL), and Baker Hughes (BHI).

From a financial-policy perspective, an extremely favorable operating environment over the past two years has led to increasing rewards to shareholders, largely in the form of increased dividends and high levels of share repurchases. Additionally, low leverage and somewhat underperforming equity values (in light of favorable underlying financial performance) has intensified rumors of leveraging transactions (e.g., leveraged buyouts and additional debt-financed share repurchases), particularly in the marine offshore drilling sector. As a result, these types of transactions could have an adverse effect on credit quality in the upcoming months.

Standard & Poor's credit analysts Andrew Watt, CFA, and Ben Tsocanos contributed to this article