Rating agency Moody's said the credit quality for exploration and production companies will improve through 2019, but that companies that can reduce leverage through debt repayment rather than earnings growth will see credit metrics improve more quickly.
"Higher oil prices and very low production and development costs helped E&P companies make substantial progress in 2017 in improving their operating and financial performance and repairing their balance sheets from very weak levels. Still, most exploration and production companies today have significantly higher leverage, lower cash margins and weaker capital productivity metrics than before the downturn, reflecting relatively high credit risk," Moody's analysts said in a June 11 note.
Moody's said the most effective way to improve credit quality is through debt elimination and companies that can quickly eliminate debt will see a more immediate and substantive improvement in credit quality.
But the agency found that of the 35 top rated exploration and production companies only 17 had lower debt balance at the end of 2017 than 2014, and the quantum of debt reduction was relatively small for nine of those 17 companies at less than 15%. Further, 18 companies saw their debt level rise during the 2015-2017 period, especially those that made large acquisitions or had significant capital commitments entering into the downturn.
Moody's said the companies that achieved material debt reduction of more than 30% did so primarily through asset sales while sacrificing some cash flow. The analysts found 70% of the 35 companies were still generating negative free cash flow at the end of 2017 and will have no capacity to repay debt.
Unable to repay debt, these companies will likely de-lever through traditional means of gradual production and cash flow growth, barring oil prices averaged around the middle of Moody's expected $45/bbl to $65/bbl price range, the analysts said.
Moody's said this could prove challenging however, as emerging logistical and labor problems in the top producing U.S. basins could temporarily slow production volume growth, and a decision to move away from the self-imposed production restrictions by OPEC and Russia could discourage further investment in exploration and production.
Despite the challenges, the analysts still see revenue and margin recovery through 2018, although at a slower rate than in 2017 when revenue and margins improved to 2015 levels as companies held down operating costs and improved capital efficiency. Moody's attributed its 2018 outlook to cost creeps and likely step-out drilling from most productive areas as companies try to bump up volumes.
Moody's still expects exploration and production companies to generate significantly more free cash flow particularly if high oil prices persist.
In a June 11 note, Jefferies raised its 2018 Brent price forecast to $77/bbl from $64/bbl, and upped its 2019 and 2020 outlooks to $75/bbl and $70/bbl from $60/bbl and $65/bbl, respectively.
"Although companies will generate significantly more free cash flow if today's elevated oil prices persist over an extended period, what companies ultimately do with the excess cash will dictate how quickly ratings can increase," Moody's said.
