Fitch: Stability Reigns for U.S. Oil & Gas Industry in 2006
Fitch Ratings’ overall view for the oil and gas industry remains positive but with a Stable Outlook on each major segment: upstream, drilling and services, and refining. Industry conditions exist for companies to have the opportunity to meaningfully improve their balance sheets and receive rating upgrades if permanent balance sheet improvement is a top priority. That said, most companies are already at their target capital structures and rating levels (with a few notable exceptions such as Kerr-McGee Corporation, among others); therefore, excess cash flows will likely continue to be targeted toward growth-oriented capital expenditures, dividends increases, stock repurchases, and acquisitions.
Upstream Sector
Extremely high commodity prices should continue to generate robust credit metrics for the U.S. upstream energy sector in 2006 compared with historical levels. With the breakeven price for most upstream companies still in a low to mid $20 per barrel of oil equivalent (boe) range, Fitch continues to view the industry positively. Many players in the sector have chosen to reward all investors through debt reduction, share buybacks, and increased dividends. Given Fitch’s longer term view of prices and that most companies are already at or better than their target capital structure, Fitch also continues to maintain a Stable Outlook on the sector.
Although public pressure continues to mount on the upstream sector, Fitch expects a market-driven response to push prices toward more historical levels. Fitch maintains a conservative posture on the sector, reflecting a gradual decline in prices in line with Fitch’s longer term view. As such, Fitch’s price deck for 2006 is $45.00 per barrel (bbl) for the spot price of West Texas Intermediate (WTI) crude and $7.00 per thousand cubic feet (mcf) for natural gas at the Henry Hub. Although the price deck reflects a significant drop from current levels, the spot price for WTI ended 2004 at $43.45/bbl.
In the near to intermediate term, the response to the recent supply shock and price spike following the hurricanes and the pace of economic growth in southeast Asia and the U.S. continue to drive views on demand. With cold weather arriving, Fitch anticipates prices will remain high throughout much of the winter. Supply concerns remain focused on the Gulf of Mexico and whether OPEC and other major global producers have the ability to meet the growing demand. Despite the industry’s ability to recover from the recent storms, the fragility of the U.S. energy sector has again been brought into focus, and lingering concerns will put upward pressure on prices for some time.
Fitch’s long-term assessment for WTI remains at $25.00/bbl, reflecting expectations for global demand growth to soften or flatten from the extraordinary growth rates seen in recent quarters. Fitch expects the supply side to come under pressure from the significant investments being made to add production and capitalize on the current price environment, ultimately resulting in rising global crude supplies. Fitch continues to forecast natural gas at the Henry Hub returning to $3.50/mcf later in the decade, primarily due to pressure on natural gas markets from declining crude prices and increasing imports of liquefied natural gas (LNG).
Despite the strong performance, bondholders will continue to face risks from the upstream sector: inflation in service costs, greater acquisition premiums, and major shareholder-friendly transactions. Finding and development (F&D) costs have increased across the sector as demand for rigs and other oilfield services have driven up dayrates and overall cost structures. Acquisitions are no longer the cheaper alternative to replace/grow reserves as purchase prices have eclipsed $20.00 per boe in recent transactions. Although still meeting the company’s debt to capitalization targets, major acquisitions can add significant leverage relative to the peer group. As noted in recent Fitch analyses, acquisitions funded with 50% debt in the current price environment are leveraging transactions due to the higher debt/boe incurred.
Contract Drilling and Oil Field Services Sectors
With expectations for increased capital budgets in the upstream sector in 2006, the contract drilling and oil field service sectors remain very strong going into 2006. During the third quarter of 2005, the Baker Hughes domestic rig count increased for the 11th consecutive quarter, continuing to put positive pressure on dayrates. Offshore drilling activity throughout the other major drilling basins around the world continues to show strength as well. Utilization rates are increasing and dayrates for jackups and floaters are being pushed higher as the competition to lock up rigs continues. This trend is expected to continue into 2006 as new contract prices continue to exceed the dayrates on the expiring contracts. While recognizing the strong fundamentals in the near term, Fitch also continues to maintain a Stable Outlook for the drilling and service sectors. The Outlook is supported by an anticipated pullback in commodity prices to historical means and the potentially weaker pricing environment for jackup rigs beginning in 2007 and beyond resulting from the large number of announced newbuilds.
Many upstream companies have shown a great deal of confidence in the current cycle as evidenced by their willingness to sign contracts on rigs for the next several years and pay increasingly higher premiums in acquisitions (based partially on growth opportunities for their targets). Given this confidence and the pressure on upstream companies to show solid organic reserve replacement, the sector should benefit in 2006 from the ensuing high level of drilling activity. Furthermore, many service companies have succeeded in pushing substantial price increases through in 2005. The full impact of these price increases will continue to benefit the sector in 2006. While the increased hurricane activity is expected to temper the 2005 results somewhat, most drilling and service companies will start 2006 on the heels of a very strong year.
Although the offshore drillers were hit very hard by the hurricanes, the end result of the storms was a further strengthening of dayrates. The final tally from the two storms was 10 rigs completely destroyed and another 26 rigs damaged. Domestic dayrates for both jackups and floaters responded accordingly, showing significant quarter-over-quarter improvements.
As a result of the storms and the resulting damage, Fitch anticipates cost pressure on the drilling segment from two fronts. First, insurance rates are expected to rise and, while companies with U.S. exposure should be hardest hit, increases are expected to affect international fleets as well. Second, with the high number of semi-submersibles that broke free from their moorings, Fitch expects increased regulation by the U.S. Minerals Management Service (MMS), resulting in increased capital expenditures on these rigs. Noble Corporation has already announced plans to upgrade the mooring systems on the company’s GOM semi-submersible fleet, and other Gulf operators will likely find it increasingly difficult to avoid making the upgrades as well.
While Fitch currently believes the strong market conditions for the drilling cycle will last into 2006, 2007 could see some pricing erosion in the jackup market due to the aggressive newbuild program. A similar increase has been seen in the number of new deepwater semi-submersibles announced. Current research indicates that more than 80% of the announced jackups and semi-submersibles are being built on a speculative basis. However, due to the strength in the current deepwater market, Fitch expects many of the deepwater semi-submersibles to be under contract as their completion becomes more certain. Fitch, however, will continue to monitor this statistic closely.
Downstream Sector
With major unplanned refining outages becoming more frequent in recent years, the vulnerability of the U.S. refining sector and the lack of new domestic refining capacity have again been highlighted as well. Recognizing seasonal volatility, Fitch expects refining margins to remain well above historical norms through 2006. Fitch continues to view the sector positively as several factors suggest that the strong margin environment is sustainable: strong U.S. and global demand across refined products, heightened concern over global crude supplies, the lack of new U.S. and global refining capacity, heightened concern over unplanned refining shutdowns, and the substantially stricter sulfur levels on U.S. gasoline and diesel in 2006, among others. Offsetting concerns include the potential for a negative demand response from the high prices, additional pressure from imports, the risks of further acquisitions and the increase in shareholder-friendly activities. Given the above, Fitch continues to maintain a Stable Outlook for the sector.
For many refiners, the significant investments into low sulfur fuels are reaching an end, suggesting that the industry should continue to generate positive free cash flow even in a much weaker margin environment. Several major expansion projects have been announced in recent weeks as well. Any one of these projects, however, will also take several years to complete.
Going into 2006, stocks of all refined products (including heating oil for the Northeast region) are within normal ranges. While Fitch does not see any immediate risks, concerns over adequate supply and high profile refining outages will continue to support higher refining margins in coming quarters. Fitch expects gasoline consumption to continue its steady growth in 2006, averaging 2.0% growth over 2005. Distillate demand is highly dependent on weather and economic factors and remains uncertain.
As with crude oil, imports will continue to represent a greater percentage of refined product supply to U.S. consumers. Significant concerns have been raised over foreign producers’ ability to meet U.S. specifications. The ability to meet the tighter U.S. regulations, however, remains a matter of choice rather than ability given the robust cash flows of many of these companies in recent years.
Although the number of ‘dance partners’ continues to decline, acquisition risks remain a key concern with the sector. There are no cheap refining assets on the market with valuations nearing replacement costs. The refining sector has a history of using a significant level of cash and debt to finance transactions, and Fitch does not expect this to stop. Additional risks lie in pursuing international opportunities where regulations and market conditions may limit the upside potentials typically built into U.S. transactions.
The significant free cash flow generation has prompted several shareholder-friendly actions in recent months. While the recent windfall earnings provide arguments to support these activities, these transactions remain risky to bondholders, particularly given the volatility of the industry and the risks of a declining margin environment.
Fitch’s rating definitions and the terms of use of such ratings are available on the agency’s public site, ‘www.fitchratings.com’. Published ratings, criteria and methodologies are available from this site, at all times. Fitch’s code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the ‘Code of Conduct’ section of this site.