?Credit-rating and research firm Standard & Poor’s reports on the Top 10 trends in the oil and gas industry that will affect credit quality in 2008—both up and down.
No. 1 Not surprisingly, the first is strong oil prices. West Texas Intermediate prices have been volatile, but a drop in the price is expected due to economic fears and demand destruction. “Heightened fear of a recession has been one of the main causes, as growing inventories in the U.S. suggest that slowing economic activity is reducing demand,” says Thomas Watters, S&P managing director. “Also, high U.S. gasoline prices appear to have destroyed some demand.
“Nonetheless, a collapse in crude oil prices is unlikely, based on still-tight supply-and-demand fundamentals, which largely reflect the challenges of increasing global oil output, combined with resilient, though slowing, demand growth.”
S&P chief economist David Wyss sees oil prices falling to about $75 per barrel by this summer, but geopolitical risk around the world remains the wildcard that could swing prices significantly in either direction.
The firm’s view of short-term pricing bodes well for the credit quality of oil-weighted E&P companies in the B-rated category. E&Ps with relatively high cost structures and aggressive spending will need strong prices to support their financial measures.
No. 2 S&P reports that while gas weathered another mild winter, lower prices could pressure credit ratings. The outlook for North American firms leveraged to gas remains cautious, says Watters. Those in the low-speculative-grade rating category risk a downgrade if gas prices fall to less than $6 per thousand cubic feet.
Also, a cutback in drilling would hurt the oilfield-services providers and pressure ratings of E&Ps—particularly those with limited hedge protection, limited liquidity or high breakeven-cost structures. While liquefied natural gas (LNG) imports increased substantially in 2007, they are a relatively small source of supply and are unlikely to depress prices in the near term.
No. 3 After a default-free 2007, E&Ps are more vulnerable in 2008, says Watters. “We are not forecasting a rash of defaults, but several of our newly rated B- and CCC+ companies are vulnerable to even a moderate drop in commodity prices, particularly for gas. These companies’ credit measures are far worse than the averages in the B-rating category, and they often paid exorbitant coupons, around 13%, to launch their bond deals in what appears to have been the top of the credit cycle.”
No. 4 Upstream capital-spending growth will slow to a more modest pace, according to the report. Although many companies have not formally announced their 2008 spending plans, industry surveys suggest that upstream expenditures should grow a mere 10% from 2007 levels, compared with more than 20% for each of the past three years. Spending will strengthen offshore and outside of North America, says Watters. The supermajors will stay disciplined while North American independents will remain net users of capital.
No. 5 International political risk will follow global oil prices upward. However, although the threat of resource nationalism remains, “we expect to see a degree of stabilization in 2008 because most oil-producing countries have devised stricter fiscal rules and defined larger roles for their national oil companies,” says Watters. The near-term focus will be on Nigeria. More geopolitical risk is found in deals with Brazil, Russia and Kazakhstan. E&Ps may seek to develop projects in more-stable regions, even if they are less profitable.
No. 6 M&A will force more heavy lifting on credit quality. S&P expects M&A activity to keep straining credit quality in 2008. Also, according to energy-research firm John S. Herold Inc., while upstream transaction activity remained robust in 2007, exceeding $156 billion worldwide, it is unclear whether ongoing capital-markets turmoil will moderate the pace of deals in 2008.
“For the integrated firms and larger independents, healthy commodity prices and sturdy balance sheets could certainly provide the financial wherewithal to pursue further M&A in the year ahead,” says Watters. “Conversely, smaller market participants with aggressive spending programs may find it harder to tap capital markets over the near-to-intermediate term.”
No. 7 While the oilfield-services and drilling sector has solid performers, growth may be abating. Nonetheless, S&P’s credit outlook for this sector is stable to positive, due to generally low levels of debt leverage, ample liquidity, expectations of solid operating performance and ongoing international-growth prospects. Upgrades have continued to outpace downgrades in recent months.
“We expect credit quality for large, diversified service firms to remain sound, given their sturdy, organic cash flow, favorable international revenue exposure and modest debt levels.”
S&P is less positive on the near-term growth prospects for North American land drillers, small and regional onshore service providers, and shallow-water Gulf of Mexico drillers. “Their asset utilization is weaker, and some dayrates are under pressure.” Still, Watters says the low debt of most of the firms should buoy credit quality if near-term results grow.
No. 8 Lofty oil prices, coupled with softening demand for refined products, will end the uptick of the current refining cycle. “We expect margins in 2008 to be solid by historical standards but below the peak of 2006 to 2007,” says Watters. Several factors will determine refiners’ performance over the next year. Soft demand could spoil margins despite tight supply. Also, margins for diesel and other distillates might outpace those for gasoline.
No. 9 Refiners will have to upgrade some facilities to process the nearly 1 million additional barrels of Canadian oil-sands production expected by 2010. Canadian upstream companies that sat out of the deals last year appear to have had buying opportunities since two of the largest U.S. refiners, Valero Energy Corp. and Sunoco Inc., say they may sell assets.
Meanwhile, S&P expects credit quality among Canadian upstream producers to remain fairly stable. The larger Canadian companies are leveraging their diverse portfolios. The smaller, more regionally focused gas producers, whose resources had been constrained until 2007, are gaining greater access to drilling rigs and related services as larger producers lower their demand for them,” says Watters.
No. 10 E&P master limited partnerships will pause for tighter credit markets. “Assuming the capital markets don’t turn around dramatically, we expect few IPOs of MLPs in the sector in 2008. However, management teams will still be searching hard for creative ways to increase stock valuations, particularly since most believe that their stock prices don’t properly reflect the value of their low-growth, long-lived assets,” he says.
While most companies will wait for better markets to pursue MLP structures again, a few could choose to proceed despite the poor market conditions. Others may look for alternative structures. Volumetric production payments may become more fashionable in 2008.