Despite Downturn, Producers In 'Remarkably Better' Shape Than '98

Even though the oil and gas industry is preparing for the "backside of the cycle" as natural gas prices fall, companies are in a better position today than in 1998, when financially constrained producers were forced to limit capital spending and drilling activity to service their debt, according to Raymond James Energy's Stat of the Week. Analyst Wayne Andrews said, "this time around, producers have worked to maintain financial flexibility through the peak and appear to be in a much better position to handle the potential weakness in commodity prices."

With improved debt coverage, a significant increase in the amount of cash on the balance sheet and a more conservative capital structure, Andrews said both the integrated and independent producers have ""much more financial flexibility" than three years ago. "Consequently, producers should be able to maintain reasonable capital budgets, which should support relatively strong activity levels through a downturn. Additionally, the large amount of cash on the balance sheet should foster an acceleration of merger and acquisition transactions that could provide some support for exploration and production (E&P) share prices in the face of potentially weak natural gas prices."

Before the last cyclical downturn in 1998, Andrews noted that many producers had been aggressively trying to increase production by spending "well in excess of operational cash flow" and also increasing their financial leverage. In 1998, the independent producers had a net debt/earnings before interest and taxes (EBIT) ratio of 1.8, "which was particularly high coming off of a peak period in commodity prices." Then, when prices began to fall, producers were forced to scale back their activity to conserve cash and to service their large debt levels.

Today, however, in the "face of another potential downturn in commodity prices, many producers have apparently learned their lesson," he said. "Debt coverage, especially for the independents, is remarkably better. At the end of the second quarter of 2001, the composite net debt/EBIT ratio for the group of 22 independents was approximately 1.0. With significantly improved financial flexibility, producers will have more discretion with regard to their activity levels, and many will be able to maintain strong capital spending programs through a downturn in commodity prices, relative to the 1998 trough."

What's helped producers this go round are several factors, including improved financial flexibility to support capital budgets, conservative capital structures and a "substantial amount of cash on the balance sheet, especially for the integrated producers," which should "fuel an acceleration of mergers and acquisitions (M&A) activity and provide some support for E&P share prices." Usually, when commodity prices decline, Andrews noted that share prices of producing companies also decline, creating an opportunity to acquire assets and increase production "at an attractive price."

Since 1998's downturn, integrated producers have increased the amount of cash on their balance sheets by more than two and a half times, to approximately $26 billion, said the analyst. "While the independent producers have not historically carried much cash at all on their balance sheets, the group has also seen a substantial 2.3 times increase since 1997." The capital structures of most independents also has improved, with debt/capitalization ratios falling from an average of 47% to 40% since the end of 1997.

"Based on the long-term bullish outlooks for both crude oil and natural gas, we believe that the integrated and large independent producers will use these cash and debt reserves to take advantage of declining E&P share prices and further consolidate the industry," said Andrews. As evidence, he pointed to the cash transactions proposed over the past six months, including Shell's unsuccessful takeover bid of Barrett Resources and Williams' success (see NGI, May 14), BP's successful acquisition of Triton Oil, and Devon Energy's announced merger with Anderson Exploration Ltd. (see NGI, Sept. 10).

Said Andrews, "we believe that, if the end of the cycle is indeed here, the trough for activity levels and ultimately oilfield service stocks will not be as severe as during the last downturn. Furthermore, accelerating M&A activity should provide support for E&P share prices even if commodity prices continue to deteriorate."

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