The U.S. exploration and production (E&P) industry this year shows few signs of pulling out of its drilling decline, but the rapid and steep drop in natural gas and oil prices appears to be “near or at a trough,” Standard & Poor’s (S&P) said last week.

“While we still believe in the long-term fundamentals for hydrocarbon prices, we currently believe oil has a better supply and demand outlook than natural gas,” wrote S&P’s Thomas Watters. “In our view, producers with a greater exposure to oil should benefit before natural gas producers.”

S&P already undertook several negative rating actions in the oil and gas sector since the beginning of 2009 and it expects to take more in the months ahead, especially on speculative grade (“BB+” and lower) companies, Watters noted. “Oil and gas entities face continued low hydrocarbon prices, borrowing base resets under revolving credit facilities and covenant concerns,” he said.

The credit quality for E&P companies “continues to be negative,” said Watters. “We expect unhedged natural gas-focused producers to generate sharply lower operating cash flows in 2009. Henry Hub-indexed natural gas prices have now fallen below $4/MMBtu and geographic differentials, especially in the Midcontinent, remain wide. As a result, we anticipate that most U.S. natural gas drilling companies will not generate adequate rates of return in the current environment.”

Liquidity also is becoming more problematic for several speculative-grade issuers in addition to higher financial leverage and worsening debt service coverage ratios, said the analyst. “Falling hydrocarbon prices are resulting in many reductions on companies’ borrowing bases, particularly for issuers lacking price hedges and with short reserve lives.”

Are there any bright spots for 2009?

“We don’t see many,” said Watters. “We believe that 2009 will be a particularly poor year for the industry but that profitability should improve somewhat thereafter. Operators are rapidly laying down drilling rigs and hydrocarbon supply will begin to decline, probably in the second half of the year. The question is whether the supply drop will match the falling demand. At some point prices should improve or costs decline more rapidly, since the industry won’t remain unprofitable forever. In the meantime, it will be painful.

“We obviously expect investment-grade issuers to have the financial wherewithal to weather this storm. However, assuming conditions do not improve, many weaker credits could falter and we may see the first rash of defaults in the industry since the 2002 downturn.”

Energy analysts with Ernst & Young LLP said they will be closely watching the U.S. and global economies for signs of stabilization, along with U.S. government responses to looming geopolitical issues.

“There are some signs of global stabilization, but capital markets are showing little signs of opening up,” said Marcela Donadio, Americas Oil & Gas Leader at Ernst & Young. “In the medium to long term, spending cutbacks in the industry will cause us to face challenges of sufficient oil supply, retaining trained staff and aging equipment.”

According to Ernst & Young’s energy team, the low rig count could bottom out in May or June (see related story). However, offsetting low rig counts is an increase in costly horizontal drilling for gas shale plays. “U.S. gas producers will need to have cash to keep production flat. An effective hedging strategy is vital,” Donadio said.

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