Producers must resist the temptation to spend too freely, in this time of flush cash flows, according to Moody's Investors Service. In past commodity-price up-cycles, some companies have increased their leverage rather than strengthen their balance sheets, leaving them vulnerable when the cycle reverses. A reemerging risk is inflated oilfield-service costs and asset prices. "[Debt] issuers that can take strategic advantage of the recovery will be best positioned for sustainable long-term value-adding growth," Andy Oram, a Moody's vice president and senior credit officer, says in "High-Yield Oil & Gas Outlook & Opportunity: Healthy Realism; Favorable Fundamentals; Selective Ratings Upside." "This may entail not overspending the largesse during a period of rising costs and asset prices and tapping equity and long-term debt when reasonably available to the issuer." Moody's is broadly optimistic about producer and oilfield service companies' financial fundamentals. In E&P, most debt issuers are set for positive early up-cycle leveraged cash-on-cash returns. Prices are strong, operating and reserve replacement costs are moderate, production trends are favorable, and cash flows are strong. However, high oil and gas prices are leading to rising reserve acquisition and oilfield service costs, and sustained competitive unit reserve replacement costs in the mature North American petroleum basins remains the principal challenge for the independent E&P sector, Oram says. "Overall, our E&P perspective is that while commodity prices will rise and they will fall, the process of building independent E&Ps continues, and that market cycles can be the friend of disciplined issuers able to maintain spending programs during sector weakness," Oram says. "Lastly, we may see more mergers by high-yield E&Ps as they drive for scale for the traditional E&P purposes, but also to augment trading liquidity in their equities and to launch the larger debt-issue sizes preferred by a now far larger buyside." The drilling, vessels and other-services companies should see sequential quarterly firming in 2000, possibly accelerating later in the year, followed by strength in 2001 and probably in 2002, he adds. A major challenge for this segment is a shortage of experienced skilled personnel. "The service sector benefited during the trough from a stronger industry structure and this also should benefit it in the up-cycle," the report stated. "We envision further mergers to strengthen niches and accelerate deleveraging of bloated debt levels of key names." Overall, high-yield issuers in each energy sector would benefit from spending and debt discipline until equity markets are prepared to support expansion and acquisition plans. Markets will support disciplined companies with good transactions, good use-of-proceeds stories, and good track records in reinvesting capital, Oram concludes. -Jodi Wetuski
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