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Moodys: E&P Sector Stable, but Cost Pressures Risky

Fueled by record oil and natural gas prices, investment-grade exploration and production (E&P) companies in North America have accumulated record cash, which in turn has enabled both organic and acquisitive business growth, according to Moody's Investors Service. The E&P sector overall remains stable, but companies are being forced to spend more as costs have risen and commodity prices have softened, increasing risks going forward.

An annual review led by Moody's senior credit officer Steven Wood examined the earnings of 15 publicly traded investment-grade U.S.- and Canadian-based E&Ps. The "Outlook for the Investment Grade North American Independent E&P Industry" determined that despite their stability, producers could be pressured by several issues in the near-term, including prices, shareholder expectations, capital discipline, and both event and political risks.

Using Henry Hub as the benchmark, Moody's expects over the near-to-medium term, North American natural gas will average around $4-6/MMBtu. Its stress test case for gas prices is $3/MMBtu. Using West Texas Intermediate as the benchmark, Moody's expects 2007 oil prices to average $45-50/bbl. Over the medium term (a three-year view), it is forecasting oil prices to average in the $35-40 range. Its stress test case sets oil prices in the mid-$20s.

Moody's reviewed some of the largest North American producers to compile its outlook: Anadarko Petroleum Corp., Apache Corp., Canadian Natural Resources, Devon Energy Corp., EnCana Corp., EOG Resources Inc., Hess Corp., Husky Energy Inc., Murphy Oil Corp., Nexen Inc., Noble Energy Corp., Occidental Petroleum Corp., Petro-Canada, Talisman Energy Inc. and XTO Energy Corp.

"The investment-grade E&P companies have experienced growing operating cash flows; however, these companies have spent much of this increased cash flow on capex [capital expenditures] both because of increased cost pressures and a desire to grow their businesses," said Wood. "They have also responded to shareholder pressure by returning a substantial portion of their higher cash flows in the form of stock buybacks and increased dividend payments."

Analysts were concerned that service costs "may continue to accelerate, which brings into question the sustainability of this excess free cash...Another concern is that cost structures are fundamentally higher in what appears to be a softening commodity price environment, which implies companies are at risk of margin compression. All-in costs per boe (cash costs, capital costs and dividends) averaged $25.40 in 2005, a 21% increase over 2004. For the period ended June 30, all-in costs averaged $28.04 (assumes 15% capital cost inflation, although costs could be higher).

"To put this in perspective, at recent gas prices of $5/Mcf, revenue per boe would be $30 (using a 6 Mcf to 1 barrel conversion ratio). With average all-in costs of $28, many companies could be operating at close to break-even."

Moody's used price assumptions for 2007 to set "stress test" case scenarios for its review. Its price assumptions are used to help project a company's earnings, cash flow and base level capital spending over the medium term. E&Ps provide Moody's their plans using base-case assumptions.

In evaluating sources and uses of cash, the Moody's review found that in spite of record commodity prices and cash flows, the E&Ps have been net borrowers between 2004 and mid-2006. "The big winner during this period has been shareholders in terms of both substantial share buybacks and increased dividend payments."

On average, there was only a small change in reserves and production characteristics between 2004 and 2005, the review found. "Broadly, these companies grew production, proved developed (PD) reserves and total proved reserves, although the percentage of proved undeveloped reserves increased. However, asset sales created noise in some individual companies' results, which makes analysis of underlying organic trends more difficult. Average PD reserve life increased as did total reserve life, which generally improves portfolio durability. For all of 2006, we expect continued modest growth in production and reserves over 2005 levels."

As a group, the E&Ps replaced 221% of their production from all sources in 2005, up from 187% in 2004. The increase resulted from improved organic reserves replacement (extensions and discoveries plus revisions), which increased from 134% in 2004 to 179% in 2005. Reserves replacement from acquisitions dropped to 43% in 2005 from 54% in 2004.

"Looking behind the averages, all companies replaced at least 100% of their production from all sources in 2005 except Murphy and Nexen," the report noted. "Acquisition activity in 2005 was relatively quiet with most companies reporting very low reserves replacement from acquisitions...Other than Hess and Noble, each company replaced more production organically than through acquisitions. The average replacement from revisions was a positive 28% in 2005, with 11 of the 15 having net positive revisions and four (Anadarko, Apache, Oxy, and Talisman) having net negative revisions, the largest being Anadarko with negative 15%."

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