Exploration and production companies that are just above and below the boundary separating investment grade from speculative grade walk a fine line, S&P Global Ratings credit analysts said, with the key numbers to watch in 2018 being commodity pricing and ratios of funds from operations to debt.
Funds from operations in the E&P sector are heavily dependent on commodity prices, which S&P expects to stay low and stable, but a company's spending habits and reach can push its credit rating up or down, the analysts said.
"A pivotal barrier separates companies classified as investment ('BBB-' and higher) or speculative ('BB+' and lower) grade," S&P analysts David Lagasse and Paul Harvey said in a recent note. "Companies can move from one group to the other, and S&P Global Ratings has names for those with potential to move in either direction: 'fallen angels' and 'rising stars.' We define fallen angels as issuers we've recently downgraded to speculative grade from investment grade, and potential fallen angels are issuers rated 'BBB-', one notch above slipping to speculative grade. Rising stars, on the other hand, are companies on which we currently have speculative-grade ratings but have the potential to move up to investment grade."
Being large helps toward getting an investment grade, S&P said, insulating oil and gas firms from commodity market fluctuations. But becoming larger involves more capital spending, which could have negative impacts on credit ratings, S&P said in describing the credit tightrope.
"The E&P sector is capital-intensive, and higher-than-expected capital spending can directly damage core and supplemental ratios, potentially warranting a downgrade," S&P said. "However, companies have generally pulled back on capital spending in recent years when oil and gas prices fall to help control costs and salvage margins; nevertheless this is only a temporary solution."
Larger companies also have assets on hand to sell into the market to maintain payments on their debt, although S&P said there are fewer bullets in the asset gun after the oil price downturn of 2015 to 2016 prompted may firms to sell.
S&P identified five oil and gas companies on the "ratings cliff" that could get a downgrade that pushes them out of investment grade — Cimarex Energy Co., Concho Resources Inc., Hess Corp., Marathon Oil Corp. and Murphy Oil Corp. — and five speculative-grade E&Ps that could move up if warranted: Continental Resources Inc., Newfield Exploration Co., Hilcorp Energy I LP, QEP Resources Inc. and Range Resources Corp. In almost every case, key factors are how they handle their debt and the ratio of funds from operations to debt, S&P said.
Companies looking to jump the fence from speculative grade to investment grade need to get larger without doing too much harm to their leverage and coverage ratios, the analysts wrote. "We would consider upgrades for a number of companies if they were able to significantly increase their proved reserves, while not allowing debt metrics to deteriorate," S&P said. "Gaining scale in proved reserves can show promise for future operational flexibility, which we view as a positive credit factor for a company's business risk profile."
Financial ratios and careful planning only go so far, S&P said, because the primary drivers of E&P credit ratings are the prices of oil and gas. "The ability to generate positive cash flow depends on the value of crude oil and natural gas," S&P said. "If we were to lower our price deck assumptions [West Texas Intermediate $50 per barrel and Henry Hub $3/MMBtu for 2018], it's likely we would lower ratings on a plethora of investment-grade companies, including those we rate 'BBB-' because we believe many of the remedies used in 2015-2016, such as significant noncore asset sales, have been fully utilized," S&P said.
Likewise, a move up for the speculative-grade companies is linked to an unforeseen rise in commodity prices, S&P said. "Much of the favorable trajectory in credit metrics for 'BB+' issuers relies on commodity prices rising beyond our expectations."
S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.