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From Standard & Poor's RatingsDirect
The recent run-up in oil prices, about $8 per barrel over the past three weeks, is due to escalating violence in the Middle East, ongoing concerns about Iran's nuclear program (and the possibility of sanctions), and explosions at a Nigerian pipeline.
Although Standard & Poor's Ratings Services is not forecasting $100 oil, the continued steady rise in oil prices over the past three years and the fear of potential supply disruptions, real or imagined, has created an environment where a triple-digit oil price in the near term is not unimaginable.
With global spare production capacity stretched incredibly thin—about one million barrels per day, maybe less—and continued healthy demand growth, the reality is that any number of significant events (a major hurricane in the Gulf of Mexico, a catastrophic act of terrorism against a major oil production or loading facility, or political or military actions that severely reduce or shut down production from a large producing nation) could cause such a spike. Those possibilities have prompted us to examine the broad implications of triple-digit oil prices for the credit quality of selected industries.
How would $100 oil affect ratings for oil and gas companies? How oil gets to that price level would likely determine the rating response. Our chief concern when revising our oil and gas pricing assumptions, particularly upward, is the sustainability of the current trend and our confidence level that the revised prices remain conservative. If oil prices were to rise quickly to $100 because of a real or feared temporary supply disruption but were likely to retreat after a short period, the credit effect would likely not be material.
That would be much like what happened in September, 2005, following Hurricanes Katrina and Rita. Oil prices briefly hit $70 per barrel but fell again to the mid-$50s per barrel by early November. A demand-driven run-up to $100 oil would probably be a stronger indicator of sustainability of a higher price environment than a supply constraint.
However, if there were a longer-term dislocation (say, the disabling of Saudi Arabia's Ras Tanura oil loading facility or war in Iran that severely curtailed production for an extended period) that was supported by a strong futures market providing companies the opportunity to hedge at or around $100 per barrel, there would likely be a material upward ratings response for those producers that chose to lock in significant volumes at those prices.
Recent history has shown, however, that companies have been reluctant to hedge in the rising price environment except to support high-priced, leveraged acquisitions.
Would $100 oil presage a drilling boom? Probably not, at least not in the near term. In the U.S., drilling is heavily weighted toward natural gas with less than 20% of working rigs currently drilling for oil. In addition, rig availability is an issue because few idle rigs are available. Most of the future growth in rig count will come from new rigs currently being built and expected to come online over the next two years.
Outside the U.S., particularly in offshore provinces, activity tends to occur on a much larger scale and requires long lead times and large capital investment. Decisions to pursue these types of developments usually are not influenced by fluctuations in near-term commodity prices.
Longer term, as companies become confident that higher prices are sustainable for a multiyear period, we would expect them to pursue projects previously deemed to be not economically viable, but capable of generating attractive returns in a higher commodity price environment. Again, rig availability is a significant factor in how much drilling activity can realistically increase.
Is there a potential credit downside to $100 oil for oil and gas companies? Strange as it may sound, yes. One of the factors driving the extremely active oil and gas M&A market is the disconnect between the value of oil in the futures market compared with the implied price of oil in the stock valuations of producers.
An additional $20-per-barrel jump in oil prices would likely widen that gap and, in theory, could spur an even bigger wave of acquisitions. Increased acquisition activity would depend on the strength of the futures market and the ability to lock in prices at these levels.
Although we would certainly view hedging a large portion of future production at around $100 per barrel as favorable to credit quality, we would expect a corresponding increase in asset prices. If the gap between implied oil prices in equity valuations and oil prices on the futures market continues to widen, increased debt funding of acquisitions would be likely.
The quality of the assets being acquired would be an important determinant of whether hedging at these extremely high prices would be enough to offset the potentially massive amounts of debt that producers would incur.
RISK OF BUYBACKS. Another area of concern is share buybacks and dividend increases. Shareholders of oil and gas companies have become accustomed to regular dividend increases and large, ongoing share repurchases in recent years as high commodity prices have allowed producers to generate robust free cash flow.
While we believe the highest-rated companies will exercise discretion during periods of commodity price moderation with regard to buybacks, we are concerned that among the more aggressive low-investment-grade and speculative-grade companies, the desire to appease shareholders could outweigh the need to conserve cash.
This could be particularly true if a drop in oil and gas prices were believed to be temporary. In addition, further cash accumulation at companies that lack a solid inventory of reinvestment opportunities could bring unwanted attention from activist shareholders.
Which investment-grade U.S. oil and gas producers are best positioned for an upgrade in a world with $100 oil? Obviously companies with a greater proportion of oil production will benefit more from higher oil prices than companies with a higher percentage of natural gas output. Whether or not rating improvement would be driven specifically by higher oil prices would depend on the magnitude and sustainability of the price increase. Investment-grade companies that are rated A or lower and have at least 60% of their production in oil include the following:
Going from producers to a key consumer, what effect would $100 oil have on the airline industry?A further significant increase in oil prices would hit U.S. airlines hard, probably aborting the current earnings recovery and conceivably endangering the survival of one or both bankrupt airlines, Delta Air Lines and Northwest Airlines. U.S. airlines have already seen fuel prices rise dramatically over the past several years.
Jet fuel averaged about 80 cents per gallon during 2000 to 2003, but rose to $1.50 per gallon in 2005 and $1.95 per gallon during the first five months of this year. Most airlines have limited fuel hedges in place because the high and volatile oil and jet fuel prices make such strategies expensive. Moreover their poor credit profiles often necessitate posting cash collateral to enter into swaps or other derivative transactions.
Airlines have been able to raise airfares over the past year, largely offsetting the higher fuel prices. This has been made possible by strong demand—reflecting the healthy economy—and reduced supply (significant reductions in flights, mostly in the domestic market, by bankrupt airlines).
However, a move to $100-per-barrel oil would drive fuel costs beyond what could be recovered in higher airfares (as happened in the fourth quarter of 2005, when hurricanes shut down refining capacity in the Gulf region, causing jet fuel prices to spike sharply). Furthermore, high oil prices could well slow the U.S. economy, eroding pricing power for airlines.
Which airlines are well positioned and which are vulnerable? Most U.S. airlines, while weak, have built up cash cushions and cut labor and other costs, providing some capacity to weather high oil prices, provided they do not stay at elevated levels for an extended period. The airlines at greatest risk are bankrupt Delta and Northwest.
Delta has more cash on hand, but has incurred heavier losses, while Northwest has reported better operating results but has more limited cash reserves. If either airline were to shut down or scale back operations significantly, competitors would benefit from reduced overall seat capacity in the market, improving prospects for raising fares to at least partly offset high fuel prices.
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