D?espite best efforts, the credit-quality decline for many U.S. oil and gas producers is far from over. During the past three months, in anticipation of poor financial results throughout 2009, New York-based Standard & Poor’s Ratings Services has taken a significant number of negative rating actions in the sector.
According to S&P analyst Thomas Watters, the firm expects to assign more negative ratings in the months ahead, especially on speculative-grade companies—those rated BB+ or lower.
The forecasted downgrades will likely be driven by continued low oil and gas prices, borrowing-base resets under revolving credit facilities, and covenant concerns. “The decline in hydrocarbon prices has been rapid and steep,” he says, “although it appears to be near or at a trough.”
Also, when it comes to price recovery, oil and gas producers are not created equal. “In our view, producers with a greater exposure to oil should benefit before natural gas producers.”
S&P is predicting that unhedged gas-focused producers will generate sharply lower operating cash flows in 2009. At press time, Henry Hub-indexed gas prices had fallen below $4 per million Btu and geographic differentials, especially in the Midcontinent, remained wide.
“As a result, we anticipate that most gas- drilling companies will not generate adequate rates of return in the current environment,” says Watters.
Meanwhile, liquidity is becoming more problematic for several speculative-grade issuers due to higher financial leverage and worsening debt-service coverage ratios. Dropping prices and accompanying reduced bank price decks are forcing reductions on borrowing bases, particularly for E&Ps lacking price hedges or holding short-reserve-life assets.
Financial-covenant compliance has also become a bigger issue. Many companies are attempting to get in front of compliance issues by proactively seeking covenant amendments or waivers from their lenders, due to deteriorating financial performance, before being faced with default notification.
Are there any bright spots? “We don’t see many,” Watters says. “We believe that 2009 will be a particularly poor year for the industry, but that profitability should improve somewhat thereafter. Operators are rapidly laying down drilling rigs and hydrocarbon supply will begin to decline, probably in the second half of the year. The question is whether the supply drop will match the falling demand.”
At some point prices should improve or costs decline more rapidly, since the industry won’t remain unprofitable forever. In the meantime, “it will be painful,” says Watters. “We obviously expect investment-grade issuers to have the financial wherewithal to weather this storm.”
However, if conditions do not soon improve, many weaker companies could falter and industry may see the first significant rash of defaults since the 2002 downturn.
Not to be left out, oilfield services and drilling contractors have also been hard hit.
The S&P 2009 outlook for oilfield-service and contract-drilling providers has become increasingly. More negative ratings action is expected in the sector.
In particular, speculative-grade firms with high leverage, tight liquidity and limited headroom under their financial covenants could experience further credit deterioration.
“Following our oilfield-service sector review in February, we took negative rating actions on 14 firms. Despite largely good fourth-quarter results for the majority of oilfield-service firms, we expected that first-quarter earnings would be where the rubber hits the road,” says Watters.
According to its analysis, the ratings firm expects first-quarter results will illuminate the financial impact on service providers from weaker industry conditions during the past six months. The decline in financial performance for most oilfield-service companies tends to lag weakening commodity prices.
“We expect that the dramatic decline in commodity prices from 2008 highs, particularly for gas, and sharp drops in rig counts and reduced upstream capital spending will translate into weaker service demand and increased pricing pressure,” he says.
“In general, we expect prospects for larger and more internationally diversified firms to be relatively better,” says Watters. “Nonetheless, we expect all customer groups—independent, national and integrated oil companies—to push hard for further oilfield-service pricing reductions.”
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