While the pace of exploration and production (E&P) company mergers and acquisitions (M&A) is expected to remain brisk in 2006, the recent upward credit rating momentum in the sector has been dampened by uses of excess cash flow to buy back stock and pay premium prices for assets and by liberal use of debt leverage to fund M&A, Standard and Poor’s Ratings Service (S&P) said in a new “Industry Report Card: U.S. Oil and Gas.”

Using conservative price forecasts for 2006 of $40/bbl for crude oil and $5.50/Mcf for natural gas, S&P analyst John Thieroff warned E&P companies to demonstrate fiscal prudence on purchases and in financial management.

“High commodity prices are expected to continue to outweigh cost growth in the near term, indicating continued, although likely reduced, positive free cash flows (after sustaining capital expenditures),” Thieroff said in the report. “E&P companies seeking to invest excess cash in their business are challenged by high asset valuations and rising finding costs, but alternatives are not currently compelling.”

Thieroff said the S&P sector is facing a “wide gap between strong financial performance, buoyed by high commodity prices, and operating weakness.” The largest companies, which tend to have higher credit ratings, have had difficulty mentioning growth on their large production and reserve bases. Reluctance to reinvest at levels necessary to maintain growth has been due in part to higher operating costs.

“Many companies at the other end of the rating spectrum now require prices to remain near $30 for oil and $5 for natural gas merely to achieve an economic return on investment,” he said. “The lack of strong production response to an increase in prices is also to some degree a result of longer lead time projects in the deepwater Gulf and international areas.”

Thieroff noted that many of the majors have either sold their shallow-water Gulf and onshore reserves or allowed them to deplete in favor of so called high-impact projects overseas or in the deepwater Gulf. “This shift results in increased risk, as larger, more expensive projects in more challenging operating and political environments become more individually important to companies’ performance.”

He predicted that leverage among E&P companies would remain high given the premium cost of reserves. Companies have avoided being downgraded because of high commodity prices and hedging, but hedging is becoming less popular and operating costs are on the rise.

Companies have turned to M&A to offset accelerated depletion rates and maintain growth, and Thieroff predicted that pace of acquisition activity would remain accelerated in 2006. But bargains are becoming few and far between, he said. “Strong competition for assets, fueled by the belief that the industry lacks large numbers of attractive drilling opportunities, high drilling costs and the desirability of certain basins (e.g. Rocky Mountains, Appalachia and the Midcontinent) has caused the price per proved reserve to rise rapidly. As a result, our analysis of transactions will include careful assessment of assumptions related to reserve profiles, finding costs, and integration efforts required to make these purchases succeed, particularly at elevated prices.

“Companies that incur substantial debt through M&A are likely to be candidates for downgrades,” Thieroff said. “Acquisition targets are likely to be upgraded if they are purchased by a higher-rated company given strengthened balance sheets across the industry.”

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