Constrained production capacity, combined with continued strong demand growth, signal a continuation of oil and natural gas prices “well above” historical norms, according to a report by Standard & Poor’s (S&P).

In the latest “Industry Report Card: U.S. Oil and Gas,” credit analyst John Thieroff said U.S. producers should benefit this year on the higher prices, with strong cash flow that affords them the opportunity to repay debt and bolster operations. He cautioned that only buying back shares instead of using some cash to replenish maturing assets or acquire new reserves could be a problem if prices fall.

“Many upstream and integrated firms have tamped down industrywide concerns over reserve reporting by engaging third-party engineers to review internal reserve reporting,” said Thieroff, and “surprisingly, few oil and gas companies have been required to file the noncompliance for material weakness under Sarbanes-Oxley 404.

“Still, Standard & Poor’s is cautious about the quality of reserves being booked and the potential for reserve revisions in coming quarters. Furthermore, many producers are either not spending enough capital or finding too few productive wells to offset the rapid declines from their existing reserve base. If this trend is not arrested, certain business profiles may be lowered which dampens the credit enthusiasm caused by sustained pricing above historical norms.”

S&P expects oil and natural gas prices to remain elevated for the medium term because of several factors, he said. Strong global demand for oil, driven in part by the large developing Asian economies, coupled with little excess production capacity, is likely to result in a tight market for the intermediate term.”

Thieroff said that along with strong oil prices, natural gas, “which tends to be both consumed and produced in the same market, have experienced less of a run-up, in part due to the lack of a risk premium. Although high oil and gas prices have compensated for increased costs, many companies will struggle to deliver adequate returns on investment if pricing retreats.”

He noted that given smaller prospects and accelerating depletion, cost containment “may be highly dependent on technological innovation, which can be slow to occur,” and he added that S&P has not found any current technologies “that will enable a step-change in cost reduction in the next few years.”

The most vulnerable companies, he said, “are those with short reserve lives, as their high asset turnover causes them to import inflation trends more rapidly than companies with longer-lived reserves.”

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