What's the credit worthiness of E&P companies? For the non-investment-grade upstream sector, it has been slightly upbeat this year, but nonetheless that sector remains challenged, according to Moody's Investors Service, a leading New York-based credit-rating agency.

In 2006, the overall downgrades the agency made in the investment-grade and non-investment-grade E&P sector were 13 versus three upstream upgrades-including one for non-investment-grade-rated Petrohawk Energy as the result of its merger with KCS Energy.

Seven of the non-investment-grade E&P downgrades were mostly the result of poor margin performance, rising finding and development costs, growth not keeping up with spending, and increased leverage.

Comparatively, through the fall of 2007, Moody's made six credit downgrades in the upstream, including four for non-investment-grade-rated names: Plains Exploration & Production, Chaparral Energy, Energy Partners Ltd. and Harvest Energy. Of the three 2007 E&P credit upgrades it made, only one involved a non-investment-grade name-Range Resources.

"Most of the downgrades in the non-investment-grade sector were the result of M&A activity where considerable leverage was used," says Ken Austin, vice president and senior analyst for Moody's.

"This sector as a whole is experiencing several challenges, the primary one being meeting shareholder expectations for volume growth, and being able to do it within a competitive cost structure," he says.

The analyst notes the cost structure for the sector has been ramping up considerably and has put considerable pressure on margins-despite very strong commodity prices-due to oilfield-service costs.

In 2006, service companies were able to raise margins and dayrates, with rig-utilization basically maxed out, says Austin. But this year, there has been a pull-back for land drillers.

It started in Canada, where activity dropped off considerably due to falling gas prices late last year. That trickled down to other parts of the North American market. "So there has been some price softness-partly the result of added capacity, but also producers not accepting any more price increases. As for deepwater offshore drillers, they're still going gangbusters."

The 2008 credit-worthiness outlook for non-investment-grade E&P names?

"The outlook for the sector is stable," says Austin. "However, E&P companies face challenges. The primary reason is that the E&P business is very capital-intensive. Thus, producers have to contain costs and maintain margins and returns-otherwise, they'll face more shareholder pressure."

What about large-cap E&P companies? "That sector faces many of the same challenges, although it tends to be a bit more stable because large-cap producers generally have greater diversification, have been around longer and have weathered the ups and downs of the industry before," says Steve Wood, vice president and senior credit officer for Moody's.

Wood notes that 2005 was the peak of the credit cycle for energy companies because as commodity prices rose, most of that increase accrued to producers. But then service companies began to increase dayrates and services costs.

"And as we got into 2006, although E&P costs were rising, producers began to get comfortable with a higher commodity-price environment and higher levels of leverage. So they took on more debt and large-leveraging acquisitions."

Thus, in 2006, Moody's had only two upstream upgrades-EOG Resources and XTO Energy-driven by fundamental performance improvements. This year, Moody's upgraded Devon Energy-which has shown consistent improvement in its operating performance and lower financial leverage-and Hess Corp., says Wood.

The 2008 credit-worthiness outlook for large-cap E&Ps: again, pretty stable, says Wood. "Absent event risk like a leveraging acquisition, we don't expect a lot of rating changes in 2008. There are, however, positive outlooks for at least two producers: EnCana and Hess are showing improved performance in terms of production and reserve growth within a competitive cost structure as well as improvements in financial leverage."