Analysts: Look For Faster Pace of Oil & Gas Asset Sales, M&A as Industry Right-Sizes

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Written by John Egan for Industrial Info Resources (Sugar Land, Texas)--As crude oil prices settle into a new normal of about $50 per barrel, Oil & Gas companies increasingly will look to grow their reserves and production by acquisition rather than drilling, analysts predict. Asset purchases and corporate acquisitions, sometimes called "drilling for oil on Wall Street," is one of the industry's traditional responses to crude-oil price volatility.

In a recent analysis, credit ratings firm Standard & Poor's (S&P) predicted U.S. exploration and production (E&P) companies will cut their full-year 2015 capital budgets by about $72 billion, or roughly 30%, compared to 2014 outlays. E&P firms will invest about $167 billion in U.S. activities this year, down from $239 billion in 2014, predicted Thomas Watters, an S&P managing director, in a mid-year assessment of the E&P industry. S&P is a subsidiary of McGraw Hill Financial Incorporated (NYSE:MHFI) (New York).

Despite reduced capital outlays, overall production of oil and gas is expected to rise this year compared to 2014, Watters predicted. Production will increase 4% this year, to about 6.9 billion barrels of oil equivalent (boe), from 6.6 billion boe in 2014. But he and other analysts foresee a decline in production next year, absent increased prices.

"Despite the decline in oil and natural gas prices, companies drilled numerous wells at the end of last year, and rig counts were at record highs before prices collapsed," Watters said. "Many of those wells began producing in the first quarter of this year. We expect production to fall in the second half of the year, given the steep declines in [capital expenditures] and the steep decline curves that are characteristics of shale."

Companies with lower credit ratings will have the largest increases in production, both on an absolute and percentage basis, he continued. Those lower-rated firms will increase production by about 16%, or approximately 81 million barrels of oil, compared to 2014, Watters predicted.

These lower-rated E&P firms, rated "BB" and below, also will cut back capital outlays more sharply than their better-rated peers, continued the S&P analysis. Cuts of 40% to 45% are expected for less-creditworthy drillers.

"It's not surprising that the companies in the lower rating categories recorded the largest reductions in [capital-expenditure] budgets," Watters wrote.

"Lower-rated E&P companies tend to be less diverse and have more limited liquidity, so they're generally the ones to take more severe actions during industry downturns," he wrote. Some of these lower-rated firms will face a "liquidity death spiral" if oil and gas prices don't increase meaningfully in the second half of the year, Watters predicted at an oil and gas conference earlier this year. "Those (lower-rated companies) are the ones that tend to go down pretty quickly when the markets get distressed. If markets don't recover, we could see a wave of defaults by the end of this year."

Almost all the E&P companies rated by S&P have concentrated their operations in domestic shale formations, where costs are higher than in conventional plays. Shale-focused companies feel a bigger impact when prices drop compared to companies drilling elsewhere or one with more diverse asset portfolios, Watters noted.

Another credit-rating firm, Moody's Investors Service, a unit of Moody's Corporation (NYSE:MCO) (New York), said U.S. E&P firms issued $21 billion in new equity and $73 billion in new debt during the first half of the year, despite low commodity prices. That fresh capital has allowed financially stressed producers to restructure their financial obligations rather that put properties, or themselves, on the selling block.

But an over-supplied market for oil and gas likely will hold down prices for both commodities, Moody's predicted. The firm forecast West Texas Intermediate (WTI) crude oil will sell for an average of about $55 per barrel this year--very close to current prices--and $60 next year. So operators should not expect to be rescued by high oil or gas prices.

E&P companies have spent most of the last 12 months cutting their capital budgets and tightening operations, which has reaped significant operational imrovements. For more on that issue, see July 16, 2015, article - Efficiency Gains Keep Oil & Gas Production Rising in the Face of Lower Prices. But firms' new debt and equity will increase their already-high financing costs, which may increase pressures for asset sales or outright mergers.

The Bloomberg news service recently reported interest payments ate up more than 10% of revenue for 27 of the 62 drillers in its North America Independent E&P Index. A year ago, only 12 firms had that high a debt-service level. E&P companies carried a total of $235 billion in debt through the end of the first quarter, a sum that surely rose during the second quarter. Year over year, drillers' debt increased 16% while revenue fell, Bloomberg reported.

"The question is, how long can they get away with this?" S&P analyst Watters asked rhetorically in an interview with Bloomberg. E&P firms with the lowest credit ratings "are in survival mode," he said. "There's a liquidity issue, and you start looking at the cash burn."

Even when WTI crude prices exceeded $100 per barrel, many producers were spending money faster than they were taking it in, betting that sustained high prices would eventually offset high finding and production costs, analysts note. Credit analysts at S&P and Moody's have closely watched drillers' costs and business expectations, rendering their judgment in the companies' bond ratings. Bonds issued by roughly 75% of the drillers in the Bloomberg E&P index carry "speculative," or junk, ratings.

Bloomberg noted almost $20 billion in bonds issued by the 62 E&P companies in its index trade at distressed levels, with yields more than 10 percentage points above U.S. Treasuries. Investors demand such high rates because they believe companies issuing the bonds may not repay their obligations in full.

"Credit markets have played a big role in keeping the entire sector alive," Amrita Sen, chief oil analyst at Energy Aspects Limited (London, England), told Bloomberg. "We haven't seen the worst," she added. So far this year, S&P has cut the debt ratings or lowered the outlook for about half of the E&P firms it follows.

All of this suggests that some E&P firms have been living on borrowed time, and the clock may start to run out in the second half of the year absent dramatic price gains for oil and gas.

At least that's the way consultants Ernst & Young (EY) (London, England) sees it. "Over the last six to 12 months, as oil prices tumbled, major oil players have been carefully managing costs and reviewing their growth strategy, and they are now ready to transact as the new normal for oil prices settles in," said Vance Scott, an EY oil expert, in a recent report. Private-equity firms may join established oil and gas companies in buying select assets or entire companies in the coming months.

"Between 2010 and 2014, U.S. E&P firms invested heavily to acquire acreage, develop it, drill it and produce from it," said Jesus Davis, Industrial Info's vice president of research for Oil & Gas Production, Pipelines and Terminals. "Now, even with sizable efficiency gains, lower commodity prices may push the industry into a period of right-sizing through asset sales, property swaps and mergers. A dramatic increase in the price of crude oil or natural gas could postpone this day of reckoning, but there are no signs of that happening anytime soon."

Industrial Info Resources (IIR), with global headquarters in Sugar Land, Texas, five offices in North America and 10 international offices, is the leading provider of global market intelligence specializing in the industrial process, heavy manufacturing and energy markets. Industrial Info's quality-assurance philosophy, the Living Forward Reporting Principle™, provides up-to-the-minute intelligence on what's happening now, while constantly keeping track of future opportunities.