Focusing on oil and natural gas liquids (NGL) has paid off for small exploration and production (E&P) companies, which are expected to gain from rapid production and reserve growth, according to Moody’s Investors Service.

The upstream focus on liquids-rich development has trickled down to the midstream sector, too, where players can look forward to at least a year’s worth of strong results, the ratings agency said last week.

“Because of recent technological advances, smaller E&P companies that have large positions in newly productive, unconventional resource plays are expected to show rapid reserve and production growth over the next few years,” said Moody’s Stuart Miller, a senior analyst. “In addition, companies that have a high percentage of their production comprised of oil or natural gas liquids are expected to benefit from increased cash flow and greater liquidity. We believe that smaller, speculative-grade companies are disproportionately, and positively, affected by these developments.”

Horizontal drilling and multi-stage hydraulic fracturing are again given the credit for the improving outlook in the energy patch. Companies that have been successful in applying these new drilling and completion techniques have lowered their finding and development costs, improved their risked return on investment, and enjoyed significant reserve and production growth, according to Moody’s. “Future drilling results and production levels can now be predicted with greater certainty over large acreage positions, due to the improved performance of wells drilled using this new technology,” said Moody’s.

Over the next few years, many small E&P companies with a high proportion of oil and NGLs in their production streams are expected by Moody’s to report improving operating cash flow levels, higher capital budgets, declining leverage metrics, and better liquidity. Conversely, companies with a high proportion of their production made up of dry natural gas are expected to be more at risk on a relative basis, Moody’s said.

Dry natural gas-focused companies may be forced to scale-back capital budgets and slow growth, the ratings agency warned. “In more extreme cases, natural gas E&P companies may be forced to sell or monetize assets to manage their leverage ratios.”

Moody’s identified a group of speculative-grade E&P companies that are poised to benefit the most from the technological advances, or from sustained high oil prices. The firm placed 23 speculative-grade companies on review for upgrade: Alta Mesa Holdings LP (B2), Antero Resources LLC (B2), Baytex Energy Corp. (B1), Berry Petroleum Co. (B1), Chaparral Energy Inc. (B3), Clayton Williams Energy Inc. (B3), Concho Resources Inc. (Ba3), Carrizo Oil & Gas Inc. (B2), Energy XXI Gulf Coast Inc. (B3), Harvest Operations Corp. (Ba2), Hilcorp Energy I LP (Ba3), Laredo Petroleum Inc. (B3) MEG Energy Corp. (B1), Oasis Petroleum Inc. (B3), PDC Energy (B2), RAAM Global Energy Co. (Caa1), Rosetta Resources Inc. (B2), SandRidge Energy Inc. (B2), Sheridan Production Partners (B2), Stone Energy Corp. (B3), Swift Energy Co. (B2), Unit Corp. (B1) and W&T Offshore Inc. (B3)

The companies placed on review for upgrade either have a more oily mix to their production streams or a large inventory of drilling locations in unconventional reservoirs, Moody’s said. “And while E&P companies of all sizes may benefit from the positive industry trends, the smaller and more weakly rated companies are expected to benefit the most, resulting in an improving risk profile.”

Producers’ migration to liquids-rich shale plays has been good for the midstream energy sector, too. It can look forward to increased capital spending and a robust environment through the middle of next year and possibly beyond, according to Moody’s.

Moody’s has a “positive” outlook on the midstream sector for the next 12-18 months. The ratings agency forecasts that earnings before interest, taxes, depreciation and amortization for the sector will grow by more than 20% in 2012. Growing production of oil, natural gas and NGL and higher margins are driving increased earnings and cash flow for midstream companies, Moody’s said.

“Rising North American production will give midstream energy companies both higher earnings and more demand for new infrastructure through mid-2013,” said Pete Speer, a Moody’s vice president. “We see midstream sector capital spending increasing by over 60% in 2012 as companies try to meet the strong demand for new infrastructure.”

Elevated oil and NGL prices have driven high drilling activity by North American exploration and production companies, which in turn has increased demand for new midstream infrastructure, said Moody’s. This is expected to offset the decline in natural gas-directed drilling caused by natural gas prices, which are at 10-year lows.

“High oil prices will continue to support drilling by exploration and production companies (E&P) in North America because they justify the cost of developing technically difficult plays,” the ratings agency said in its report. “Drilling activity continues to grow in oil-producing plays, including [the] Bakken in North Dakota and Montana and [the] Eagle Ford in southern Texas. E&Ps are also exploiting other unconventional reservoirs in established producing areas, including the prolific Permian Basin of West Texas, [the] DJ [Denver-Julesburg] Basin of northeastern Colorado and the Uinta Basin in Utah.”

Moody’s said NGL prices remain attractive for continued drilling and production in natural gas properties where there is high liquids content, such as in the wet gas sections of the Eagle Ford and Marcellus shales, as well as the Granite Wash. “At 2012 prices, NGLs offer producers an extra $1-3/MMBtu of natural gas that they produce,” the firm said. “This significantly boosts their returns on investments from this drilling, despite the very weak natural gas prices that we expect to persist into 2013.

“While midstream company margins for natural gas processing are likely to narrow in 2012…we expect natural gas processing margins to remain above five-year historical averages during 2012. NGL prices should also keep NGL volumes growing through 2013.”

The outlook is not without risks. For instance, “a complete collapse in natural gas prices — which could happen if storage capacity were to fill completely in the summer or fall, for example — would lead to bigger production shut-ins and would hurt midstream earnings in the second half of 2012,” Moody’s said. “Lower commodity prices would not only reduce earnings in such price-sensitive business lines as gas processing, but would also reduce production volumes as E&Ps pull back on drilling activity.”

Moody’s highlighted the largest and most diversified midstream players as the ones reaping the benefit from this demand, especially those with existing gathering and processing or pipeline infrastructure near booming shale plays. The report said Energy Transfer Partners, Enterprise Products Partners, Oneok Partners and Williams Partners are among those best positioned for organic growth.

In addition, Moody’s said low interest rates — and the sector’s lower commodity price sensitivity — have made the midstream sector very attractive to equity investors, while both high-yield and investment-grade midstream companies are able to tap the open capital markets for funding to fuel growth.

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