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Big-Spending Little Guys Heading For Trouble, BMO Says

Small-cap producers are, for the most part, still spending too much relative to cash flow, leading to leverage that will be unsustainable. Prospects for future production growth are imperiled as "something more may have to give," BMO Capital Markets analysts said in a note Monday.

BMO's Dan McSpirit and A.J. Donnell have been reading the 2015 guidance coming from U.S. exploration and production small caps ($2 billion or less market value) and apparently shaking their heads.

"...[T]he producers [are] managing more for the stock price (short term) and less [for] the company (long term)," they said. "The economic reality is that many of the smaller-cap producers really need to solve for leverage and not growth -- at least that's how we've approached it in our own modeling."

Wall Street is similarly deluded about small-cap producer growth projects going forward, McSpirit and Donnell said. "...[T]he Street's assumptions on what these producers can deliver for growth in 2015 and periods beyond are not yet fully rooted in the current economic reality," they said, "not unlike the mindsets of many producers we find."

With West Texas Intermediate (WTI) prices around $60/bbl, "the economic limits of many assets within the portfolios of most producers are well above where the commodity trades, maybe permanently so," BMO said.

So, the small players with big debt will further have to right-size their capital spending plans and high-grade spending even further to only the most lucrative plays. Their already leveraged balance sheets can't withstand much more debt, BMO said. "That means less growth, if any. That means less attractively price shares, potentially."

BMO is modeling 2015 and 2016 capital spending by smaller-cap players at about 19% and 23%, respectively, below mean consensus estimates. This is based on the firm's revised WTI outlook of $63/bbl next year, $80 in 2016 and $85 in 2017 and beyond. "The result is much lower drilling activity, and, thus, much less capital spending than our original estimates showed and what we see the Street currently modeling."

The firm's cash flow estimates for the group are below consensus for 2015 and 2016, too, about 30% below. In part this is due to BMO's more pessimistic view on WTI, the analysts said. Additionally, the Street might be expecting more right-sizing of oilfield services costs than what BMO assumes.

"We believe the Street's assumptions on what these producers can deliver for growth in 2015 and 2016 are not fully rooted in current economic reality," McSpirit and Donnell said. "That tells us estimates are likely going lower, absent the return of much higher oil prices and/or a commensurate decrease in oilfield service costs."

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