December 30, 2006 at 1:38 pm #4084
Monday December 11, 1:48 pm ET
CHICAGO–(BUSINESS WIRE)–Fitch Ratings’ overall view for the oil and gas industry remains positive even though commodity prices have retreated from record highs. Fitch currently maintains a Stable Outlook on each of the major industry segments (upstream, drilling and services, and refining) despite the robust market conditions as a result of most companies already being at their target capital structures. As a result of the relative strength in balance sheets across the industry, excess cash flows are expected to be directed toward shareholder-friendly activities (dividends and share repurchase programs), growth-oriented capital expenditures, and acquisitions.
Fitch anticipates that commodity prices will continue their downward slide in 2007, although this trend is likely to be marked by temporary spikes stemming from continued geo-political uncertainty and concerns of near-term spikes in weather-related demand. Fitch’s 2007 price deck for crude oil and natural gas is $50/bbl (NYMEX-WTI) and $5.50/Mcf (U.S. Henry Hub). Fitch’s price deck represents significant declines from current market prices; however, it is important to recall that oil prices averaged $41.51 per barrel in 2004 and $56.59 per barrel in 2005. In addition, natural gas prices averaged $5.47 per Mcf in 2003 and $5.89 per Mcf in 2004 before their record year in 2005 at $8.71 per Mcf, which was driven in large part by a record hurricane season. While Fitch’s price deck is used primarily for modeling and rating purposes (and is therefore intended to have a more conservative slant), it is also intended to represent our belief that prices will ultimately revert back to more historical (mean) levels driven by fundamental supply and demand forces in a well-functioning market.
While commodity prices in 2007 are expected to be softer than 2006, costs are expected to continue to rise stemming primarily from increased drilling and service costs and wage pressures. That said, cash flow generation is still expected to remain strong as prices remain well above breakeven levels for most upstream companies. With record levels of cash on balance sheets and pressure from investors to continue to show growth, merger and acquisition activity and shareholder-friendly activities which result in increased leverage are expected to remain the key concerns within the industry. Strength in the underlying industry has provided companies with substantial flexibility to handle these activities to date.
Fitch currently expects U.S. GDP growth to slow to approximately 2.5% in 2007, down from 3.2% in 2006. Most of the weakness in the U.S. economy stems from reduced activity in the housing industry. As such, continued low unemployment and robust industrial projections point to continued strength in demand for energy commodities, albeit at reduced growth rates which are more in line with historical levels. Reduced demand growth rates (not reduced demand) are expected to help ease the tight balance between supply/demand levels witnessed over the past few years and support Fitch’s expectation of moderating prices.
Debt maturities across Fitch’s U.S. Oil & Gas portfolio are expected to remain modest in 2007. With modest refinancing activity, debt issuances driven by M&A activity will likely be the primary driver of borrowings in 2007. Due to continued high levels of demand for energy paper by investors, companies are expected to benefit from relatively weak covenant structures and a modest interest rate environment.
High commodity prices are expected to keep credit metrics for the U.S. upstream energy sector near record levels in 2007, although some slight deterioration could be seen as compared to 2006 levels driven by higher cost structures, lower commodity prices, and increased debt levels for those companies which have pursued large acquisitions. Driving Fitch’s positive view of the sector is our estimate for the breakeven price at most upstream companies to be approximately $30 per barrel of oil equivalent (boe). While high relative to Fitch’s long-term price deck, the breakeven price would be expected to fall in a lower commodity price environment as drilling and service costs, transportation expenses and production taxes retreat.
Despite our positive view, we have maintained a Stable Outlook on the upstream sector and most individual company outlooks remain Stable as well. This is driven by the fact that most firms have opted for using their excess cash flows to pursue shareholder-friendly activities, mergers and acquisitions, or more aggressive capital expenditure programs as opposed to debt reductions. While increased capital expenditures are regarded favorably by Fitch, their ability to make sizable improvements in credit metrics (both through increased EBITDA and lower debt/boe) generally play out over a number of years. In addition, as companies have been more acquisitive, the higher acquisition prices, even when financed with 50% equity, have resulted in higher leverage as measured by debt/boe and have mitigated any gains witnessed from organic growth.
In the near to intermediate term, supply concerns for crude have mitigated as the U.S. experienced a minor hurricane season and many of the geo-political concerns around the world have quieted for the time being. Demand growth projections have also been revised to be more consistent with historical growth patterns. The IEA is estimating global demand growth of 1.7% for 2007, ahead of the 1.2% expected for 2006 but also well below the 2.3% experienced since the end of 2002. Reduced demand growth levels and the lack of supply shocks have resulted in crude oil stocks remaining at record levels for this time of year.
U.S. natural gas markets continue to face unfavorable supply and demand fundamentals; however, prices have remained robust driven primarily by relative strength in crude prices and uncertainty around winter weather. With storage at record levels, the direction of prices in 2007 will ultimately be driven by the severity of the upcoming winter weather. While an unusually cold winter could drive demand higher and result in a large storage draw, normal and warm winter weather will undoubtedly result in significant downward pressure on prices in 2007 as the storage overhang will persist into the next injection/withdrawal cycle.
With U.S. natural gas spot prices currently in the $7-$8 per Mcf range, demand for the commodity may continue to face pressure. As Fitch has noted for some time, demand for natural gas has been falling for all downstream market segments except for demand by electric generators. Since demand by electric generators is driven primarily by summer weather, natural gas markets are not expected to get any near-term relief from this segment. U.S. natural gas production levels continue to fall short of prior year levels; however, the reduced demand levels have more than compensated for this, resulting in some independent upstream companies to shut-in higher cost production for the current winter.
Fitch’s long-term price deck for crude and natural gas prices remain well below current market prices. Fitch’s long-term price for WTI is $30 per barrel and U.S. Henry Hub gas is $4.00 per Mcf during a mid-cycle environment. While these prices are not expected to be seen in 2007 or 2008, Fitch expects the large capital investments being made to eventually result in increased production levels while demand growth rates are expected to moderate. Natural gas markets are expected to continue to face demand weakness as prices remain well above historical levels. Supply increases are expected to come from increased imports of liquefied natural gas (LNG) later this decade as well as from the exploration success companies have had in the deepwater U.S. Gulf of Mexico. Fuel-switching concerns should abate as crude prices pull back, helping to drive natural gas prices lower.
Bondholders will continue to face risks from the upstream sector. These risks are expected to stem from higher service and drilling costs, increased M&A activity at much higher premiums, increased shareholder friendly transactions and higher finding and development (F&D) costs as well as higher overall cost structures. Current high prices have mitigated the near-term impacts of these concerns; however, a substantial pullback in prices would highlight each of these risks to bondholders. These risks are further highlighted by the fact that the recent low interest rate environment and robust sector performance have provided companies the opportunity to refinance or pay off much of their bond issuances and credit facilities which contained more restrictive covenant packages.
Drilling and Services:
With robust commodity pricing levels in 2006 and continued strength in the forward strip for both crude and natural gas, upstream capital budgets are expected to be equal to or slightly above 2006 levels. This is expected to support the sector as supply of offshore rigs is expected to rise in 2007 with the delivery of the first wave of newbuild jackups. Fitch continues to maintain a stable outlook for the drilling and service sector despite our belief that the universal strength in all subsectors of the market will give way to a bifurcated market in which some subsectors will see continued strength while others will begin to weaken.
Deepwater markets are expected to continue to remain robust driven by limited supply of these rigs. Further increased demand for deepwater rigs is expected due to continued announcements of deepwater exploration and development successes coming from upstream companies. While the U.S. Gulf of Mexico (GOM) is expected to remain the strongest of the deepwater markets due to its proximity to U.S. demand, other global deepwater markets from Brazil to West Africa and potentially even the Mexican GOM are expected to remain strong. The strength in the ultra-deepwater is expected to continue to lend support to the mid-water floating rig market as these lower quality rigs have historically been idled while operators preferred the higher quality assets. With nearly every ultra-deepwater rig under long-term contract for the next 3-4 years, operators are expected to continue to use these mid-water floating rigs.
Jackup markets are expected to see the delivery of approximately 20 newbuild rigs, although this figure could fall as delivery dates continue to get pushed back. These 20 rigs represent a 5% increase in the supply of jackup rigs and the expected delivery of an additional 26 jackups in 2008 will keep downward pressure on dayrates and utilization levels for jackups. The relative weakness of the jackup market is expected to be further split by global drilling basin. Middle East, Southeast Asia, and African markets are expected to remain the most robust, while the U.S. GOM is expected to continue to lag these markets. Weakness in the U.S. GOM appears to have hit a plateau for the time being; however, potential weakness in natural gas prices resulting from a less than robust winter heating season could place additional pressure on the domestic jackup market. Operators with high levels of exposure to the domestic jackup market and those drilling contractors with more commodity-style jackup rigs should be monitored more closely during 2007.
Land drilling markets are another subsector that should be carefully monitored in 2007. Domestic land rig markets have the largest exposure to natural gas prices, which continue to be extremely volatile and show a larger degree of weakness in the underlying fundamentals. In addition, U.S. land drilling continues to be dominated by independent E&P companies which tend to be cyclical in their capital spending plans. Land drillers also face a large influx of newbuild and refurbished rigs in 2007, which is expected to put pressure on rig rates and utilization levels of older, commodity-type rigs. Land drilling contractors with smaller, regionally focused fleets or fleets which lack diversity across rig types should be monitored most closely during 2007. While activity levels are expected to pull back from record high levels, Fitch currently expects conditions to favor a more moderate pullback as opposed to a precipitous and sustained fall.
In addition to risks of moderating market conditions for certain subsectors of the industry, additional risks include higher levels of capital expenditure to support newbuilds, rig reactivations, or rig upgrade projects; shareholder-friendly activities (share repurchase programs, dividend increases or leveraged acquisitions); and rising costs for labor, materials and insurance. The key area of risk for the sector continues to be transaction risk either from large, leveraged share repurchase programs or from M&A/LBO transactions. Investors should take note of the covenants in their bond indentures to evaluate the protections they have from these types of risks. Additional risks stemming from delays in newbuild projects should be monitored, but are expected to primarily result in higher capital expenditures as opposed to risks of cancellation of previously announced contracts with operators. Because of the tight market conditions, cancellations or renegotiations of contract terms currently are not viewed as a significant risk. Finally, based on the outcome of the U.S. Minerals Management Service (MMS) increased regulations in the U.S. GOM, both floating and jackup rigs operated domestically face the potential of increased capital expenditures and/or longer shipyard stays to make the necessary upgrades to rigs. This would be expected to occur prior to the start of the next hurricane season.
Fitch’s outlook on the refining sector is stable. While refining margins have shown significant volatility in 2006, on average benchmark crack spreads remain well above their historical levels, generating ample free cash flow to service debt. Most refiners continue to recognize the inherent volatility of the industry and have taken advantage of the strong margin environment to strengthen their balance sheets through debt reduction and refinancing high-coupon debt. With strong global demand, a tight supply-demand capacity balance, and favorable margin conditions, we expect the sector’s solid performance to continue. No major debt maturities are due across our universe of refiners over the near term.
The transition to EPA mandated Tier II ultra low sulfur diesel (less than 15 parts per million of sulfur) is now largely complete, and the Oct. 15 deadline for stocking this fuel at retail stations has for the most part passed uneventfully. With the 2006 Tier II spending requirement mostly behind them, mandatory spending commitments for domestic refiners have begun to tail off. Recent guidance from a number of companies tells the story. For example, Valero’s Tier II and other mandatory spending will drop off by more than half from 2006 to 2007, falling from $1.4 billion to $660 million. As a result, management is increasingly free to channel its strong cash flow toward discretionary activity, including expansion investments, additional debt pay down, and shareholder-friendly activities. However, it is worth noting that some refiners have adopted an interim compliance strategy which allows them to continue to produce non-specification diesel until 2010. For these firms, a concern going forward is any big increase in projected spending especially in today’s environment of fast rising construction costs.
Fast-rising construction costs- primarily skilled labor and steel – are not just an issue for Tier II projects. Project cost inflation has become an issue across the industry and could serve as a roadblock for announced industry expansion plans by making it harder to finish large projects on-time and under-budget. A number of refiners and integrated oil companies, including Tesoro, Sunoco, and Marathon, have recently announced sharp increases in refinery project costs. Earlier this summer, Tesoro responded to these cost pressures by shelving plans to build a 25,000-bpd coker at its Anacortes refinery. Such cost pressures could force other companies to scale back or abandon discretionary expansion plans, especially if the cycle begins to turn and refining margins soften. Yet it is worth noting that high costs are also bullish for the industry, because high costs limit the amount of new capacity that gets built, further supporting margins and possibly extending the length of the cycle.
With the winter heating season in full swing, weather-related distillate demand will continue to be a near-term driver of downstream profitability. To date, much of the U.S. has seen a slow start to the winter heating season, and the NOAA is predicting a winter that will be slightly warmer than its 30-year average. For analysis purpose, Fitch assumes normalized weather conditions, but it is worth noting that if the Northern Hemisphere were to experience a very mild winter, this could drag heating oil demand lower, which could significantly weaken crack spreads.
However, the heating season is not the only driver of the distillate complex. Diesel is increasingly important as a transport fuel in the U.S., and any increase in its use by automakers will help support refining margins. Because distillates are already a dominant auto fuel in Europe, a number of refiners have voiced the belief that North America will increasingly compete with Europe for distillates, something which could lend support to crack spreads going forward. Although the transition to ultra low sulfur diesel has gone off smoothly in the U.S., it remains the case that ultra low sulfur diesel is more difficult to make and can more easily be contaminated than higher sulfur diesel, so future production hiccups bear watching. To date, domestic inventories of ultra low sulfur diesel have ramped up smartly, with stocks rising from just 1.5 million barrels at the beginning of 2006 to over 50 million barrels by October of this year.
In general, refined product demand has also held up well in the face of high prices, and there has not been strong evidence of demand conservation or other dramatic changes in consumer habits. Year to date, average gasoline demand stood at just under 10 million b/d and distillate demand averaged approximately 4.3 million b/d. Over the next 12 months, Fitch expects product demand to continue to be robust, and the recent drop in refined product prices (average U.S. gasoline and distillate prices are off some 21% and 14% from levels seen in Q3) could provide some tailwind for consumers, helping to increase demand.
Despite the potential for some weather-related softness this winter, the outlook for the industry remains solid over the near- to medium-term, and Fitch believes that a number of structural features should continue to support refining margins, including strong product demand, high barriers to entry for new green field refinery projects in the U.S., and stricter environmental regulations.
Fitch, however, continues to take a cautious approach to ratings in the refining sector, as the industry has a history of significant downturns and acquisitions financed principally with debt. Furthermore, capacity and throughput in this sector has invariably kept up with demand, sometimes with disastrous results for industry players. Additional risks to our outlook include a U.S. or global economic downturn and aggressive capacity expansions abroad. The high margin environment of 2004-2006 is now fostering additional growth capital for the downstream sector, and a number of refiners have announced global expansion projects to capitalize on this environment. With heavy discounts remaining well above normal (the Maya-WTI discount has averaged over $15/bbl so far for 2006 versus a 10-year average of less than $9/bbl) and limited light sweet crude reserves, many of industry’s global investments will likely be aimed at heavy oil conversion. On the acquisition front, prices continue to climb, with CITGO’s sale of its 41.25% interest in the 268,000-bbl Houston refinery to joint venture partner Lyondell coming in at $1.774 billion this past summer, or an implied price of over $16,000/bbl of capacity. Despite the high prices, Fitch expects to continue to see negotiated transactions as players seek to increase scale through consolidation.
The following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. Oil & Gas sector.Upstream – Integrated: — Chevron Corporation (‘AA’; Outlook Stable);— ConocoPhillips (‘A-‘; Outlook Positive);— ExxonMobil Corporation (‘AAA’; Outlook Stable);— Marathon Oil Corporation (‘BBB+’; Outlook Stable). Upstream – Independents: — Amerada Hess Corporation (‘BBB-‘; Outlook Stable);— Anadarko Petroleum Corp. (‘BBB’; Outlook Negative);— Apache Corporation (‘A’; Outlook Stable).— Chesapeake Energy Corp. (‘BB’; Outlook Stable);— Devon Energy Corporation (‘BBB’; Outlook Positive);— Husky Energy Inc. (‘BBB+’; Outlook Stable);— Newfield Exploration Company (‘BB+’; Outlook Stable);— Occidental Petroleum Corp. (‘A-‘; Outlook Stable);— Pioneer Natural Resources USA, Inc. (‘BB+’; Outlook Stable). Oil Field Services: — Halliburton Company (‘BBB+’; Outlook Stable);— Nabors Industries, Inc. (‘A-‘; Outlook Stable);— Noble Corporation (‘A-‘; Outlook Stable);— Pride International Inc. (‘BB’; Outlook Stable);— Smith International, Inc. (‘BBB+’; Outlook Stable);— Transocean Inc. (‘A-‘; Outlook Stable). Refining and Marketing: — CITGO Petroleum Corp. (‘BB-‘; Outlook Stable);— Frontier Oil Corp. (‘BB-‘; Outlook Stable);— Sunoco, Inc. (‘BBB’; Outlook Stable);— Tesoro Petroleum Corporation (‘BB’; Outlook Stable);— Valero Energy Corporation (‘BBB’; Outlook Stable).
Contact:Fitch RatingsChicago:Adam M. Miller, +1-312-368-3113orMark Sadeghian, +1-312-368-2090orSean T. Sexton, CFA, +1-312-368-3130orMedia Relations:New York:Brian Bertsch, +1-212-908-0549
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