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S&P likes newly disciplined drillers but wants cash flow to be used on debt

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S&P likes newly disciplined drillers but wants cash flow to be used on debt

The credit analysts at S&P Global Ratings like the new trend among oil and gas producers to keep spending in line with income, but they are not thrilled that extra cash is going to shareholders.

"We view the practice of capital discipline favorably," S&P credit analysts David Lagasse, Paul Harvey and Michael DeJohn said in a June 6 note. "Less spending generally results in improved cash flows as long as commodity prices are favorable and production is supported."

The analysts said increased equity shareholder programs can be a negative in that they tend to reduce cash balances and liquidity and can increase debt. "However, we don't believe companies will execute shareholder programs that will cause substantial liquidity deterioration or hurt credit metrics," the note said.

S&P said it understands investor impatience. The S&P 500 Oil and Gas Exploration and Production index has underperformed the larger S&P 500 by 41% over the past three years and "whopping" 81% over the last five years. Oil and gas drillers, who depend heavily on capital investment, need to assuage an investor base that is ready to head for the door.

"Underperformance has irked many market participants, and drove them to other industries, leaving sector participants questioning whether the long-term value investor has left the sector," S&P said. "A fickle long-term investor base is specifically troubling for the [exploration and production] sector because it has historically relied on the capital markets to fund operations and significant refinancing needs."

Exploration and production companies and their investors need to be aware that oil and gas has many barriers to recent success that will not be solved by the corporate equivalent of eating vegetables; the primary drivers of sector performance are oil and gas prices, the research note said.

"Although we expect some companies to incrementally improve cash flow by staying within cash flows, they must overcome other hurdles, like volatile hydrocarbon prices, and service-cost and material-cost inflation before they can fully satisfy investor goals because fluctuating prices influence capital spending," S&P said.

S&P Global Ratings expects the price for West Texas Intermediate crude oil to average $60 per barrel in 2018, with natural gas prices at the benchmark Henry Hub averaging $3/MMBtu.

S&P expects oil and gas drillers will outspend cash flows by a small margin in 2018, draw even in 2019 and have positive cash flows in 2020. "We also expect most North American [exploration and production] companies to strive to operate within leveraged free cash flows, in line with investor preferences," S&P said. "We believe the initiatives have some staying power because management teams need to re-attract long-term investors and demonstrate that the sector is a valuable investment."

S&P expects capital spending to grow 15% to 20% in 2018, S&P said, driven primarily by cost inflation for oilfield services and modest production growth targets.

A winner in 2018 will be the oilfield services sector as companies work through their inventory of wells already drilled but need hydraulic fracturing to be completed, S&P said. Fracking and completing shale oil and gas drills can be up three times as expensive as drilling the well itself.

"Specifically, we believe those providing pressure-pumping services will continue realizing strong demand, translating into the ability to increase margins," S&P said. "Although a significant amount of [pressure pumping] horsepower is under construction, we expect a significant portion will replace equipment currently in use but has suffered wear and tear from very high utilization," S&P said.

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S&P Global Ratings and S&P Global Market Intelligence are both owned by S&P Global, Inc. Descriptions in this news article were not prepared by S&P Global Ratings. The original S&P Global Ratings documents referred to in this news article can be found here.