The E&P sector has spent the last few quarters building its financial strength, lowering finding and development costs and keeping an eye on steady growth. Companies such as Burlington Resources and Occidental Petroleum have done so well at these measures that, if oil prices dropped back to $30 to $35, they would still be doing well, according to Standard & Poor's director and senior analyst John Thieroff. Yet despite the sector's amazing earnings growth, it's way too soon to start handing out credit-rating upgrades, he said at an S&P conference in Houston recently. "We expected to upgrade a lot more than we have," Thieroff said. "But understand that it's difficult to rate companies in an environment of $70, $60 or even $50 oil. We have to evaluate creditworthiness for the long term, so we don't get any comfort from near-term pricing. But it's a good sign when companies take excess cash flow and improve overall financial strength. In 2002, S&P made almost 60 energy-space credit-rating downgrades and approximately 22 upgrades. The ratio has slowly evened out over the years, and so far in 2005 it has made approximately 25 downgrades and 17 upgrades. Andrew Watt, an S&P director, said that while ratings actions for 2005 are becoming more balanced between upgrades and downgrades, a number of negative ratings on E&P companies have been due to financial-policy decisions such as share repurchases. He named Kerr-McGee's $4-billion stock-repurchase plan as one example of prompting a recent credit downgrade and Pioneer Natural Resources' $1-billion repurchase plan as the trigger for a CreditWatch flag. But gaining a stellar credit rating is about much more than posting solid revenues. "Management's financial-policy goals are very important," Watt said. "Its decisions regarding shareholder returns or debt reduction; use of windfall profits; trends in credit measures; desired capital structure; tolerance for debt leverage; and execution of a consistent financial policy are all imbedded in the ratings process. "But in terms of profits, it's great to be an E&P right now, as this is as good as it gets for the sector." The S&P global oil index is up more than 30%, and Watt says that while E&P may not be the top sector at the moment, it is certainly among the best performers. He expects that on a global basis, the oil and gas sector will reward its shareholders with more than $110 billion in share repurchases and dividends this year. "Credit measures are improved and financial performance across the sector is outstanding but debt levels remain largely unchanged," Watt said. The newfound liquidity is apparent in rising cash balances, greater credit-line availability and longer terms on credit facilities. IPOs in the sector number 12 so far this year, compared with 11 in all of 2004. To lock in predictable cash flow, more producers are hedging. "While predicting commodity prices these days is impossible, there are pros and cons to [hedging]," Watt said. "It's a costly restructuring, there are liquidity needs for margin-posting requirements and the short-lived nature of hedges provides limited support to a company's financial profile." On the other hand, hedging can finance expenditures such as acquisitions; and smaller and lower-rated issuers can benefit from the increased cash-flow protection. So what will it take for S&P to upgrade producers? Watt said, "Continued excellent financial performance, prudent stewardship and management discipline."