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Some Independents Could Face 'Survival Risks' This Fall

Independent producers have faced downturns before, but companies that are heavily leveraged -- such as those that borrowed to gain entry into the cash-intensive natural gas shales and tight sands -- face liquidity problems and "survival risks" without the full support of their lenders, Moody's Investors Service reported last week.

Even if an exploration and production (E&P) company is not stressed now, the loss of borrowing capacity could take its toll on production replacement as the recession continues, Moody's analysts wrote in "Surviving the Oil & Gas Cycle: Borrowing Bases & Other Issues -- Another Wild Roundtrip."

"While the current down-cycle challenges are not new to the sector, some new characteristics of this cycle dealing with the composition of reserve portfolios may intensify the stress for some E&Ps," said Moody's Senior Analyst Andrew Oram.

Scheduled borrowing base redeterminations seem "destined" for more significant reductions later this year given the weak gas price outlook, the widening of gas price discounts relative to oil and the roll-off of up-cycle hedging, Moody's reported.

"While issuers are concerned about reduced borrowing bases during this spring's redetermination season, there may be greater sector concern about results during the fall round, which are based on the price outlook at that time and mid-year reserve estimates," said Oram.

For example, this is the first time in which E&Ps built largely around "extremely" capital-intensive unconventional gas shale and tight gas sands resource plays will be tested by a serious down-cycle, he noted.

"These plays require heavy drilling and development spending to offset the very steep production declines in the first six months of each new well," said Oram. "It also takes large numbers of new wells to average out the widely varying results per well in such plays. On the plus side, several issuers have alternative sources of cash funding of a large scale not seen in prior down-cycles."

The sharp market decline in gas and oil prices negatively impacted most borrowing base values, as banks adjusted their price assumptions, the report noted. Going forward, lenders could call a default if an E&P failed to lower its bank borrowings below its new borrowing base within the agreed cure period, said analysts.

Last Thursday junior explorer Pinnacle Gas Resources used a portion of proceeds from the sale of some onshore natural gas assets to reduce the amount borrowed under its existing credit facility to $9 million to remain in compliance with its borrowing base on April 14 (see related story).

Separately Moody's reported that because of the steep decline in commodity prices, there's a dwindling amount of gas and oil reserves considered economic to produce, which in turn has reduced companies' reported reserves.

The Securities and Exchange Commission (SEC) revamped the oil and gas reserves rules, but the new rules won't take effect until Jan. 1, 2010. Those rules "promise a far less volatile valuation for oil and natural gas reserves over the years," said Moody's in a separate report, "E&P Reserves Revisions: Price Issue or Performance Problem."

"The new rules are likely to affect price-related revisions, but are unlikely to change the reporting of performance-related revisions," said Senior Analyst Francis Messina.

Factors that may reduce a company's reported reserves from one year to the next include reinterpretation of prior-year proved reserves, significant delays in development activities and downward price changes. And even though there was an "enormous" increase in commodity prices in the first six months of 2008, oil and gas prices actually fell from year-end 2007 to year-end 2008, noted Messina.

In the case of investment-grade companies, which accounted for 73% of total proved reserves, almost all revisions were price-related. A "modest" 4% of total reserves revisions in 2008 were performance-related, he noted.

"Because the SEC rules do not require E&P companies to separately disclose pricing and performance revisions, the balance between these two factors is often unknown," said Messina. In short, the drop in oil and gas prices over the last year may have given some producers an opportunity to mask true production problems -- as opposed to uneconomical conditions -- that may have contributed to negative revisions.

The North American E&P sector also suffered in 2008 in terms of reserves replacement, the credit ratings agency said.

In the Moody's 54-company North American E&P universe, total proved reserves of 33.2 billion boe were revised lower from earlier reported figures by 757.2 million boe. Around 61% of the downward revisions came from falling commodity prices; companies attributed nearly 40% of their 2008 revisions to performance.

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