With 2Q2010 earnings results now in the rearview mirror, energy analysts covering the domestic exploration and production (E&P) sector paused to review what they saw in the earnings reports and what they heard in the conference calls. What they concluded isn't necessarily a pretty picture for the second half of this year.
Morningstar Research Inc.'s Eric Chenoweth said E&Ps appear to be "caught in a vise," sandwiched between rising costs and low gas prices. When Morningstar issued its 2010 E&P outlook in January, it predicted a worst-case scenario for E&P earnings power that was setting up if gas prices remained low but service costs began to rise from their low 2009 levels.
"It became clear in second quarter earnings calls that we're living that scenario today -- with operators reporting 20%-50% higher completion costs (compared to late 2009) depending on the play," said Chenoweth.
There's been "unrelenting drilling to hold leases," funded largely by joint venture (JV) partners and "well-timed hedges made in 2008," and with both "turning the crank on this vise, one wonders how long this negative environment can persist," he said. "Some companies have sought comfort in the arms of oil, where stronger selling prices are thus far making up for rising costs, but most North American E&P companies are gas-focused."
Some of the "legs" supporting the negative environment appear to be "more stubborn," such as the large financially endowed JV partnerships providing funds to cash-poor E&Ps, but "we think the pace of these deals will eventually subside," he said.
Meanwhile, "great hedges are already much harder to find, and as we push into 2011-12, hedges will likely reset down to $5-$6/Mcf," said Chenoweth. "The scramble to hold leases signed in 2008 should also cool down by 2011-12. Eventually we think the industry will need to see lower activity levels unless the gas price is right, and tough times like we're experiencing now often act to break unhealthy industry behavior."
The second half of this year appears "dark" for E&P earnings power, but "we think the present high-cost, low-selling-price environment is unsustainable, and is far worse than what we expect looking out a few years," said the Morningstar analyst. "Should equity prices start to extrapolate the current negative environment, we might see more bargains emerge later this year." There are, he said, "limited pockets of value in the E&P space."
The SunTrust Robinson/Gerdes Group (STRH) team reviewed producer earnings for its coverage universe as well. Overall, producers reported stronger production that melded nicely with slightly lower expenses and price realizations, wrote John Gerdes, Cameron Horwitz and Ryan Oatman.
"Notably, coverage companies plan to increase capital spending 30% this year," said the trio. "E&P cash operating margin was unchanged as lower price realizations offset lower expenses."
However, "the relationship between capital spending and '10 production implies E&P capital intensity is slightly above '09. Capital intensity is likely to increase 10% over the next year given the intensity of oilfield activity in certain resource plays and the corresponding upward pressure on oilfield service prices, particularly pumping services," they said.
The unleveraged development cost intensity of STRH's E&P coverage portfolio is $5.80/Mcfe. Including exploration outlays, which comprise 5-10% of capital spending, the all-in cost intensity is elevated to $6.25/Mcfe, said Gerdes and his colleagues. The increase in capital spending is "suggesting an onset of oil service inflation."
According to STRH review, median U.S. E&P development capital intensity in the latest quarter was $3.90/Mcfe, which is 20% lower than the 4Q2008 peak and 5% higher than at the same time last year. Grossing up development capital intensity to account for exploration spending, which generally comprises 5-10% of E&P capital outlays, equates to an all-in E&P capital intensity of $4.25/Mcfe.
Meanwhile, unleveraged cash expenses this year for the STRH universe are $2.00/Mcfe, which is 1% above 2009 "largely due to modestly higher oil/gas prices and the corresponding impact on electric rates, fuel prices and production taxes." Including debt, depreciation and amortization, unleveraged expenses this year are $4.60/Mcfe, which is also 1% higher than 2009.
"Assuming $4.75 gas/$77.50 oil prices this year, E&P cash margins should increase 1%, while gross profit margins increase 4%," said the STRH team. "In '10, given $4.75 gas/$77.50 oil prices and 30% higher capex [capital expenditures] E&Ps are 30% free cash flow negative."
After adjusting for hedges, STRH's E&Ps are receiving a New York Mercantile Exchange-equivalent $5.75 gas price this year. "In 2011, assuming $5.50 gas/$77.50 oil prices, the E&P industry would need to reduce drilling activity 20% to approach free cash flow neutrality."
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