Even with a conservative Henry Hub gas price forecast of $5/MMBtu in 2004 and $3.50 over the long term and an oil price forecast of $30/bbl in 2004 and $21/bbl for beyond 2005, the credit rating picture and overall fundamentals for the exploration and production sector should continue to improve unless certain thorny issues, such as reserve revisions, get in the way of some companies, Standard and Poor’s (S&P) said in a new report.

“At this time, fundamentals for the energy market (notably little excess production capacity against a backdrop of growing demand) suggest that the pricing assumptions will prove conservative and that revisions to it are likely to be upward,” S&P said in its “Industry Report Card: U.S. Oil and Gas.”

S&P now believes that production will remain low for the near term (1-2% growth in 2004) with the most significant increases occurring from the middle to the end of this year. Slow production growth and limited liquefied natural gas (LNG) import capacity will prevent prices from falling sharply this year, unlike in 2003 when storage inventories were replenished at a record pace at a $5 gas price, the agency said.

“Weather may not be as mild [as in 2003] and industrial consumption appears to be increasing,” S&P said. Longer term, it sees only modest incremental supply growth from conventional and new sources until 2006 when additional LNG receiving terminals begin service.

“As a result of the outlook for…prices, 2004 should be another year of strong free cash flows…profitability and the opportunity to fortify balance sheets and address operational deficiencies for oil and gas producers,” S&P said in the report. “A trend of positive ratings actions outnumbering negative ratings actions should extend from 2003 to 2004 with the largest number of favorable actions likely occurring in the ‘BB’ category.”

The agency already has upgraded ratings for XTO Energy and Pioneer Natural Resources this year. For many high yield companies, low interest rates and a strong futures curve should provide opportunities to grow in a prolonged period of viability, S&P said.

“Nevertheless blemishes remain.” S&P questioned whether producers are investing enough to grow production materially. “The lack of a production response to a strong increase in drilling is largely a result of capital allocation to smaller onshore properties (the land rig has surged while the Gulf of Mexico jack-up rig count has sagged) and a preference to invest in long lead time deepwater projects versus the Outer Continental Shelf.

“In addition, major integrated companies, which appear to be reinvesting only 30% to 40% of their domestic cash flow in the United States have made strategic decisions to allow their shallow water and onshore natural gas production to deplete to redeploy capital to international (mainly oil) projects.”

However, if prices remain strong, S&P expects U.S. drilling budgets will continue to increase leading to “modest increases in aggregate production.”

The agency expressed concern about the possibility that corporate leverage will increase as E&P companies turn to more mergers and acquisitions to counter accelerating depletion rates and in response to pressure to continue to grow reserves and production per share. “An increase in M&A activity (kick-started by Kerr McGee and EnCana Corp.) could be accelerated by an easy fundraising environmental for companies of good credit quality and periods when the value of a company’s reserves implied by the futures strip are greater than the price recognized by the equity market,” S&P said. “Companies that incur substantial debt through M&A activity are likely to be candidates for downgrades.”

S&P also noted that the pressure by the equity market to show production and reserve growth per share with limited increases in unit finding and development costs “may be the culprit behind the E&P industry’s seemingly more aggressive assumptions for estimating proved reserves. For most of the industry, reserves estimates are unaudited by external engineers, subject to substantial management discretion, and have an embedded estimation error stemming merely from the limitations of the geosciences,” S&P said, adding that the potential for reserves exaggeration has always been considered in providing credit ratings.

Nevertheless, the very large negative reserve revisions of some companies (El Paso Corp., Forest Oil, Royal Dutch/Shell) have exceeded even S&P’s imagination and have been the source of negative ratings actions or CreditWatch listings.

“Activism by the SEC on reserve booking and disclosure practices, and the headline risk created by unearthed reserve booking irregularities are likely to prompt the remainder of the industry to conduct more thorough reviews that could yield additional negative revisions to reserves,” S&P warned, adding that such events could lead to negatives ratings actions. “In addition to a litany of corporate governance and litigation issues, these companies will have to expend unanticipated additional capital to prevent future production from declining relative to their indebtedness.”

But aside from the few small dark clouds on the horizon of some firms, the credit outlook is bright for the majority of companies. S&P already foresees a few potential ratings upgrades. “ConocoPhillips is a good example of a large integrated company whose ratings may rise as its financial position improves,” S&P said.

But the majors do face some challenges from their new strategy of repositioning their upstream operations to more long-lived projects mainly in emerging markets while using mature fields in North America and Europe as funding sources. “The strategic shift is simple,” S&P said. It’s where the oil and natural gas are. But the shift comes with a price in the form of increased political risk, longer lead times and higher up-front costs.

For more details from the S&P report, contact Bruce Schwartz at (212) 438-7809.

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