The U.S. pipeline sector is trending toward a negative outlook because of liquidity, increasing regulations and changing party counter risks, a Fitch Ratings Oil & Gas group analyst said Tuesday. “First and foremost,” said analyst Hugh Welton, the energy merchant-owned domestic pipelines are weighed down by the “negative overhang of liquidity issues at the parent company level.”

Fitch analysts held a teleconference Tuesday to review the North American and Latin American oil and gas sector, offering their views both short term and through 2003 on the pipeline, refining and marketing, and drilling and service sectors. Overall, the analysts affirmed that the North American energy sector is stable, but the flat and declining domestic market has been boosted by the global opportunities available in West Africa, Southeast Asia and the Middle East. For U.S. pipelines, however, international business cannot discount the pressure that has come to bear on the sector in the past 12 months, said Welton.

Most of the credit ratings pressures on U.S. pipes followed the demise of the energy merchant sector because many of them are subsidiaries of former merchant heavyweights — many which have been downgraded to below or nearly below investment-grade status. Welton listed increased regulatory risks at the Federal Energy Regulatory Commission and changing counterparty risks as two other credit pressures on the sector.

“In the past 12 months the ratings actions have been linked to the merchant companies’ severe credit crunch and ongoing investigations,” said Welton. Fitch’s ratings policy, he said, is keyed to the parent company, in general, and Fitch’s notching policy permits one-notch separation between a subsidiary and a parent. “FERC regulation allows very little insulation from the parent company.” However, “as the parent company moves deeper…this notching could be relaxed somewhat…there could be a wider gap.”

Welton said that “other than Enron, we have not seen yet the overleveraging at the subsidiary level” of energy merchants. He said the decision by FERC Chief Administrative Judge Curtis J. Wagner putting the blame on El Paso Corp.’s pipeline group for some of the 2000-2001 problems in California “took us a bit by surprise.” Shifting of the blame to regulated natural gas pipelines was “more shocking,” and “brings into question the legitimacy of pipeline decisions on safety issues,” he said. However, Welton said he was certain that “ultimately, this will be taken up by the full Commission [FERC].”

Regarding the counterparty credit shift at pipelines, Welton said “in today’s new environment, many ex-energy merchants are relinquishing their pipe capacity. Since the natural. gas and user dynamics are not likely to change, overall, this is a positive, and will return pipeline capacity back to the primary pipe customer.”

In the near-term, U.S. natural gas prices will be about $3.10/Mcf, and into 2003, gas prices will be about $3.00/Mcf, according to Fitch analyst Sean Sexton. Sexton, who directed his comments on the upstream and downstream prices, noted that global demand is only expected to grow “modestly” next year, after 2002’s flat growth. And, the “Iraqi situation” is expected to be “relatively short-lived,” having little effect on oil prices. However, if oil prices go higher, so will natural gas. “We remain bullish on the upstream in 2003, and there are several reasons for being bullish,” said Sexton, including the following:

“Lower crude prices may bring down natural gas prices a little,” he said, but added that the industrial demand in the United States will “result in higher gas prices” eventually. A cold winter also will push up gas prices, Sexton said. “It really should come as no surprise that Fitch’s view of the upstream is stable in the near- and intermediate-term. Most [of the companies covered] are at or near their capital structure.” A few companies, however, Ocean Energy Inc., Occidental Petroleum and Pioneer Natural Resources, garnered positive outlooks by Fitch because of “impressive” debt reduction or expected increased production.

In the North American drilling and service sector, analyst Patrick McGeever said companies are overall stable, with “weakness onshore in North America and in the shallow offshore,” offset by better opportunities in West Africa, the Middle East and Asia. McGeever said U.S. drilling is off 18% over a year ago, and Canada is down 3% year-over-year. More notable, though, is that the Gulf of Mexico is “generating 40% less than in 2001.”

Consolidation, the continued devaluation of prospects and reluctance by operators to expand their drilling budget all are contributing to the lower North American outlook, said McGeever. “They want to reduce debt instead of expanding their budgets.” He also cited tax increases in the United Kingdom, but the weak markets are offset by global opportunities.

Domestically, McGeever noted that “niche” companies are not faring as well as companies with a broader focus, and added that “service companies that need exploration money are struggling” because of the consolidated customer base. “There is little need for new seismic data in the near- to intermediate-term,” an abundance of offshore vessels are available, and finally, he said that technology research and development costs have been cut back.

“It’s the same onshore, domestically,” said McGeever. However, the analyst added that drilling services will remain “relatively stable” into 2003 because of “strong commodity prices.”

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