Credit quality for the U.S. oil and gas sector is--and should remain--relatively stable for the remainder of 2011 and into 2012, in Standard & Poor's Ratings Services' view. The ongoing gradual improvement in GDP supports oil prices and could aid natural gas, which accounts for 30% of industrial energy demand, though excess supply will continue to set the direction of natural gas prices. Our 2011 and 2012 forecast for West Texas Intermediate (WTI) oil of $97.67 and $103.59 per barrel bodes well for exploration and production (E&P) companies with a focus on oil and oilfield services and drilling contract companies. Despite $100 oil, consumers have not cut back much on driving, which has benefited refineries' gasoline and diesel throughput and kept their utilization rates high.
We believe robust oil prices are sustainable throughout the remainder of the year and into 2012, which benefit any producer focused on oil and natural gas liquids. Healthy oil prices, favorable price hedges, and lease requirements that require drilling to hold acreage are helping oilfield and contract drilling companies achieve very strong ratios. We expect E&P companies to keep their capital expenditures high through 2012, thus helping oilfield service companies and drillers maintain healthy credit ratios and earnings.
Economic Outlook
Our latest base-case economic forecast still assumes a weak recovery in 2011 and 2012. Our base-case outlook for the oil and gas industry reflects that assumption and the following expectations:
- Real GDP remains moderately positive, with the economy growing 2.4% in 2011 and 2.6% in 2012. However, we can expect to shave off several basis points from our 2.4% estimate for 2011 after the disappointing economic news on July 29. U.S. GDP rose at an annualized rate of just 1.3% in the second quarter, after a downwardly revised 0.4% (originally 1.9%) in the first;
- Oil prices remain at about $100 per barrel, but below levels that would affect how much people drive and therefore, refinery throughput and margins;
- Oilfield services and drilling activity stays robust;
- Healthy capacity utilizations and margins continue for most refiners; and
- Capital market conditions and interest rates remain favorable.
At Standard & Poor's, we publish monthly our economists' scenario of where we think the U.S. economy could be heading. Beyond projecting GDP and inflation, we also include outlooks for other major economic categories. We call this forecast our "baseline scenario," and we use it in all areas of our credit analyses.
However, we realize that financial market participants also want to know how we think the economy could worsen--or improve--from our baseline scenario. Any point-in-time forecast of the economy will be wrong; it is simply a question of how far wrong. As a result, we now project two additional scenarios, one upside and one downside. These scenarios are set approximately at one standard deviation from the base line (roughly the 20th and 80th percentiles of the distribution of possible outcomes). We use the downside case to estimate the credit effect of an economic outlook that is weaker than our expected case.
Industry Credit Outlook
E&P producers reap the benefits of high oil prices
Several factors continue to support lofty crude prices: steady growth in the global economy, the loss of approximately 1.6 million barrels per day (1.8% of total daily consumption) of Libyan production, political turmoil in other North African countries and the Middle East, temporary North Sea production outages of approximately 400,000 barrels per day, and uncertainties surrounding Saudi Arabia's ability to ramp up additional capacity. Yet supply-demand fundamentals alone don't explain oil prices. The rise has mirrored the declining value of the U.S. dollar, which we expect to remain weak. High prices have benefited E&P producers' cash flows and, as a result, the companies have sought to acquire acreage in the oil and natural gas liquid rich fields, such as the Eagle Ford Shale and Granite Wash.
In sharp contrast, natural gas prices are still weak. Over the past couple of years, the number of natural gas rigs has largely exhibited inelastic behavior to declining prices, and a balancing of supply and demand remains elusive. Production economics and cash costs have taken a back seat to the ongoing need to drill to satisfy held by production (HBP) leases, joint venture agreements, and because of favorable producer hedges. Moreover, a significant backlog of drilled, but not yet completed, wells will continue to put downward pressure on gas prices.
We believe only a decline in supply could trigger an improvement in natural gas prices. Specifically, natural gas prices could increase when:
- Existing favorable price hedges roll off;
- Forward strip prices remain consistently below $5 per million cubic feet, which we believe to be an uneconomic threshold for a meaningful amount of production;
- Drilling declines meaningfully, possibly sometime in the latter half of 2012, due in part to a reduction in drilling to maintain lease acreage (HBP), particularly in the Haynesville shale; and
- A meaningful number of the drilled, but uncompleted, natural gas wells are completed.
Barring a recession, the confluence of these factors could reestablish the relationship between gas prices and rig count and ultimately lead to a reduction in natural gas inventories, thus increasing prices.
Demand for oilfield services and contract drilling is robust
Higher oil prices also benefit service providers that support oil drilling and production. Moreover, based on preliminary data, E&P capital budgets should be moderately up in 2012, continuing healthy demand for oilfield equipment and services. Land-based drillers, in particular, are benefiting as the drilling boom in liquids-rich shale plays offsets what we believe will be a slow but steady decline in natural gas drilling. With natural gas trading at record discounts relative to oil, we expect drillers to continue shifting to oil or liquids-based drilling (natural gas currently represents approximately 45% of the total rig count).
Offshore drillers face mixed prospects, with nascent signs of increasing demand offset by the specter of newbuild rig deliveries. Although the pace and prospects for tenders remains materially better than in 2010, the impact of scheduled additions to offshore fleets over the next several quarters is a risk in our view. Based on scheduled deliveries, we expect that global jackup and floating rig fleets will increase by approximately 7% and 13%, respectively, by the end of 2012. While we believe the recent trends of increasing dayrates and utilization for jackup rigs will continue over the next couple of years, given E&P companies' spending projections and the moderate nature of planned fleet additions, mid to deepwater floating rigs will likely face greater challenges because of the number of new deliveries coming on line. We expect to see further bifurcation between the segments with newer, higher-specification floating units achieving strong utilization levels and older, lower specification units facing lower utilization and potential declines in dayrates. Permitting activity in the Gulf of Mexico remains slow since the Macondo disaster, and will likely continue slow into 2012. The timing of a sustained recovery in drilling in the Gulf is still uncertain.
Refining and marketing margins should remain solid
After weathering very poor financial performance during 2009-2010, refineries will likely exhibit relatively stable credit quality this year. Margins for refining WTI oil have surged and gasoline and diesel production has increased along with the improvement in the economy.
Although earnings across the sector should remain healthy for the rest of 2011, a dichotomy has emerged between producers operating in the Mid-Continent and those operating on the West and East Coasts.
Mid-Continent producers, particularly those in the PADD II regions such as HollyFrontier Corp., Northern Tier Energy LLC, and Flint Hills Resources LLC, have access to and the capability to buy lower cost WTI and Canadian heavy crudes. The price for WTI and heavy and sour crude is lower than Brent and should remain so for the rest of 2011, resulting in healthy earnings for Mid-Continent producers in the second half.
West and East coast refineries, such as Tesoro Corp. and Sunoco Inc. respectively, will find doing as well as their Mid-Continent peers somewhat more difficult. Indeed, Tesoro, which relies mostly on Alaska North Slope crude, has witnessed the price differential relative to Brent tighten considerably, while Sunoco continues to source primarily higher cost Brent. Moreover, product margins in both regions have fallen far below what refiners in the Mid-Continent are realizing. In addition, refineries will likely face renewed challenges, as the global capacity projected to come on line over the next five years outstrips demand.
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