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More U.S. E&P Defaults Likely as Liquidity Pressures Intensify, Say Moody's, S&P

Oil and gas companies were kept afloat by accommodating capital markets during the first half of this year, but more defaults are expected and merger activity may increase as operators restructure and liquidity issues intensify, credit analysts said Friday.

The industry always has followed a boom and bust cycle, and during the most recent boom, which began in 2009, producers increased debt loads to fund heavy onshore spending to develop unconventional resources. It all went bust last year with collapsing oil prices. Standard & Poor's Ratings Services (S&P) and Moody's Investors Service separately weighed in on the likelihood of more defaults, which they said is high as liquidity becomes a bigger issue.

The sector now is grappling with the prospect that prices aren't going to strengthen for two years or more, said S&P's Christine Besset, primary credit analyst for the latest exploration and production (E&P) outlook.

Because of lower cash flow generation and asset valuations, "many companies will keep struggling to comply with debt covenants while trying to maintain adequate liquidity," she wrote. This downturn is unlike the bust of 2008-2009 during the financial crisis because a lot of capital has been available. Lenders in general have been "patient and flexible" during the latest downturn.

"Nevertheless, we believe more defaults are likely in 2015," Besset wrote. "Despite reined-in capital spending and falling service costs, we forecast debt leverage for exploration and production (E&P) companies to increase in 2015 and stay elevated in 2016 as production levels off and commodity prices remain weak...

"Raising new capital will likely become increasingly difficult for speculative-grade companies as commodity prices remain low for at least a while longer. In fact," she said, "market sentiment deteriorated in July amid slumping oil prices and choppy fixed-income markets."

S&P expects capital expenditures (capex) to be sharply lower this year. "Based on our internal forecast, we estimate that E&P capex will be, on average, 35% lower in 2015 over 2014 -- or a whopping $69 billion in absolute value."

At the end of June, S&P rated 15 issuers "CCC+" or below, only a few notches from default.

"Many industry bonds are trading at distressed levels, so the likelihood for more distressed debt exchanges (resulting in selective defaults) remains elevated," Besset said. "In addition, since commodity prices will likely remain low, we expect further, and potentially deeper, reductions in borrowing bases for E&P companies following borrowing base redeterminations slated for the fall, as hedges roll off and companies are adding less reserves."

Energy is likely to be the primary driver of defaults over the next year, said Moody's analysts John E. Puchalla and Tom Marshella. "We project the U.S. speculative-grade default rate will climb to 3.2% in February 2016 before slipping back to 2.9% by June the same year. The oil and gas sector accounts for a disproportionate share of companies with low ratings and weak liquidity, and is thus at greatest risk of default."

With an expectation that West Texas Intermediate prices now will average only $55/bbl this year and $60 in 2016, E&P earnings are "unlikely to improve materially," said Puchalla and Marshella.

"Another round of borrowing base redeterminations this fall, the roll-off of prior favorable hedges, and lenders being cautious with additional funding until oil prices recover, will further add to liquidity and default risk over the next 12 to 18 months."

Several U.S. onshore producers make Moody's "probability of default rating," or PDR, list. Those downgraded to PDR in the second quarter to "Caa2-PD" and below include some familiar names.

Aubrey McClendon-led American Energy-Woodford LLC is on the PDR list, along with Halcon Resources Corp., Magnum Hunter Resources Corp., Quicksilver Inc., Sabine Oil & Gas Corp. and Warren Resources Inc. Oilfield services provider Preferred Proppants LLC also saw its PDR cut to “Caa2PD.”

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