Even Energy Companies Feel the Pinch

Rising oil and gas prices are weighing on the operations and financial health of several exploration, production, and refining outfits

by Michelle Dathorne and Ben Tsocanos From Standard & Poor's RatingsDirect

Consumers aren't the only ones sweating higher energy prices. The escalation is also weighing on the operations and finances of companies in the exploration and production (E&P) and refining categories. While it's likely oil prices will remain volatile, rising and falling on each day's headlines, Standard & Poor's Ratings Services believes they are cycling around a rising trend. That's because global demand for oil continues to climb, but its supply is rising only slowly.

As a result, even some E&P companies face a sometimes difficult balancing act. For example, companies that extract crude from Canada's oil sands are rapidly expanding development to take advantage of the higher oil prices, but they also face fast-rising capital spending requirements and increasing competition for equipment and skilled labor.

For refiners, dependence on oil as their primary feedstock has meant that the pricier oil gets, the thinner the margins on their refined products. Part of the margin problem results from a slowing U.S. economy that's keeping refiners from passing on their higher costs to consumers. Adding to the squeeze on refiners is the large amount of ethanol in the fuel supply and high natural gas prices.

Still, strategies exist in both camps to make the best of a tough situation. Suncor Energy (SU; S&P credit rating, A-) and others in the Canadian oil sands sector are trying to increase cash flow to cope with rampant development cost inflation. And Valero Energy (VLO; BBB) is one refiner that has fared better than many of its competitors because it has been able to more efficiently make end products from cheaper, lower-quality grades of crude and shift more output to higher-margin fuels such as diesel. It's also employing initiatives that reduce capacity, further improve operating efficiency, and conserve liquidity.

Exploration & Production

In Canada, rising crude oil prices have had several effects on companies' development plans and government regulation of the industry. Nowhere is this more evident than in the Athabasca oil sands region. The Alberta government's April 2008 estimate of oil sands projects either recently completed or in progress is now about C$163 billion—up from just under C$68 billion in 2005.

The accelerating development, both from longtime oil sands operators and new entrants, is directly linked to the runup in crude oil prices. These capital-intensive megaprojects still provide attractive returns, despite rising development costs. The Canadian oil and gas companies sponsoring these projects say they can satisfy their internal investment hurdles, despite rampant cost inflation and increasing labor productivity issues. Furthermore, even the Alberta government's 2007 decision to adjust its oil and gas royalty framework to more closely align royalties with current prices and the changing production mix have not slowed oil sands development plans.

Despite the strong credit attributes associated with the oil sands' massive resource base and steady long-term production profile, two factors, capital costs and labor productivity, are adversely affecting near-term credit quality. Increasing activity in Alberta's oil sands region is resulting in higher project development costs, which ultimately could put pressure on ratings. The breakeven crude oil price (including required investment returns) has risen to between US$60 and $80 a barrel today, up from about $35 a few years ago. As the fully levered breakeven price increases, the risk of credit profile deterioration during project construction also increases.