North American energy markets remain negative, reflecting the lingering challenges in the exploration and oilfield services sectors, according to Fitch Ratings.
The exploration and production (E&P) market remains split. For the investment-grade (IG) E&Ps, a key theme has been "compression," with most rating actions limited by a combination of a single-notch downgrade and/or a "negative" outlook.
"Many IG names mitigated rating actions this year by strong self-help measures to preserve credit quality in the face of lower prices, including severe capital expenditure (capex) and dividend cuts, equity raises, asset sales and deleveraging," analysts said. Multi-notch downgrades generally were associated with event risk or acquisitions.
At the same time, the high-yield E&P defaults have skyrocketed. As of October, the the high-yield sector defaults stood at about 30%, but they may be near their peak.
"Many supports for the lowest rated high-yield credits -- hedges, monetizable assets, borrowing base availability -- have fallen away," analysts noted. "With stricter regulatory trends in energy lending, Fitch believes banks have made their decisions about which credits they are inclined to support, or not. Fitch believes high-yield E&P defaults are close to peaking at the current level."
Cost improvements by U.S. unconventional operators has been the key story of the current downturn, Fitch noted. Efficiency gains and service cost deflation reduced costs faster in the United States than anywhere else in the world, setting the stage for a rebound in the domestic shale patch at lower price levels.
"A key question in 2017 is how many of these gains the sector can hold onto in a rising price environment?" analysts asked. Fitch's team is expecting some giveback to be inevitable, but "many producers will continue to benefit from the shift toward pad drilling, longer laterals, enhanced completions and other structural efficiencies. These should improve full-cycle economics and cash generation per barrel, all else being equal."
Meanwhile, a pick-up in activity and pricing power in the offshore business should continue to lag in North America. The offshore is pressured by a huge oversupply in the rig market and limited moves to rationalize capacity. The offshore sector also is faced by E&Ps moving their near-term capex allocations to short-cycle shale and from longer-term projects, like the offshore.
"The overall sector outlook for North American energy is stable, as a trend of gradually improving fundamentals led to a better pricing environment after lows seen in the first quarter," Fitch analysts said. "While oil inventories remain high and global demand is still subdued, a significant supply response in the U.S. (1.0 million b/d decline versus the June 2015 peak) emerged.
"Two years of sharply lower global E&P capex should set the stage for further production declines and stabilization in pricing."
High inventories and the potential for U.S. unconventional production to respond quickly to any market tightening mean oil prices may flatline in 2017 before gradually moving higher over the next few years, analysts said. Supply and demand should be "broadly balanced" in the first half of 2017, moving to a more pronounced deficit in the back half of the year.
"But the still-high commercial inventories may delay any significant price response," analysts said. "We have therefore maintained our base-case assumption, used when rating energy-sector corporates, that both Brent and West Texas Intermediate (WTI) will average $45/bbl in 2017. We have also maintained our $55/bbl assumption for 2018 and introduced a 2019 price expectation of $60, reflecting our belief that it may take longer to fully return to our long-term equilibrium price of $65/bbl."
For natural gas, Fitch is assuming a 2016 Henry Hub price of $2.35/Mcf, moving to $2.75 in 2017 and $3.00 in 2018 and 2019. The long-term gas price assumption is $3.25/Mcf. Fitch also lowered assumptions for UK National Balancing Point gas prices, a proxy for international spot gas, and now expects prices to remain subdued for longer because of a medium-term oversupply of liquefied natural gas.
In its stress case for prices, Fitch assumes Brent/WTI prices will average $35/bbl in 2017 and $40 longer term. For Henry Hub, Fitch's stress case assumption for 2017 is $2.00/Mcf, with $2.25 in 2018, $2.35 in 2019 and $2.50 longer term.
There is, however, "significant uncertainty" about the future path of oil prices.
Unprecedented reductions in capital spending by exploration and production companies "could translate into a far sharper fall in output than the consensus expectation, while there is also potential for demand growth to slow if economic growth disappoints or for supply to be higher than expected if U.S. shale comes back strongly as prices rise," analysts noted.
The price assumptions don't factor in any impacts from a potential production cut by the Organization of the Petroleum Exporting Countries as the cartel meets this week to discuss a pullback.
"This is because even if a deal is agreed, its ability to have a lasting impact on prices is unclear and will depend on the size of the cuts and the willingness of members to stick to them.”