Moody’s latest outlook for the global exploration and production business—which reflects its expectations for the fundamental business conditions in the industry over the next 12-18 months—is stable.
The stable outlook reflects a view that the industry will generate little to no earnings growth through 2020. Volatile oil prices and weak natural gas prices, restrained capital investments, shareholder pressures, a slowing global economy, and persistent supply growth all pose risks to earnings, although continued volume growth, narrower basis differentials in key North American producing basins, partial hedge protection, and restricted supply from several countries will lend some support.
Moody’s would change its outlook to negative if a 5% or greater drop in earnings through late 2020 is projected, or to positive if a 5% or greater increase is projected.
Commodity prices
Volatile oil prices and weak gas prices present primary risks to the industry.
Crude-price volatility has jumped sharply since late 2018 on concerns over rising supply, particularly from US shale producers, and potentially slower global demand growth. The world’s largest energy-consuming nations are grappling with decelerating economic activity and increasing trade barriers.
Additionally, lower breakeven costs, more industrial scale development, and increasing takeaway capacity in the prolific Permian basin will only encourage production growth in US, pressuring prices. Any easing of sanctions against Iran would also drag prices lower.
While voluntary curtailments by members of the Organization of Petroleum Exporting Countries, Russia, and Canada as well as stricter enforcement of sanctions against Iran and Venezuela will restrict crude supply, non-OPEC supply from the US, Brazil, Norway, and Guyana will keep rising.
It is also unclear whether the OPEC+ group will extend its 1.2 million-b/d voluntary production curb beyond first-quarter 2020 that was agreed upon in early July. On balance, Moody’s expects global crude supply growth will outpace demand through 2020, in line with OPEC, the US Energy Information Administration, and the International Energy Agency, which collectively forecast a 500,000-800,000 b/d build-up of inventory through 2020.
North American gas prices have also sunk to very low levels amid a persistent supply glut that will shave earnings, particularly for unhedged producers. Prices will remain under strain because of a number of ongoing industry conditions: recently added takeaway infrastructure and the narrowing of price differentials will support volume growth in the Marcellus and Utica shales of Appalachia; rapid growth in oil production will drive up associated gas production in the Permian and other oil-rich shale plays; and producers in the Haynesville shale formation in Louisiana and Arkansas will increasingly ramp up volumes to support US LNG exports.
Henry Hub gas prices averaged $2.74/MMbtu in this year’s first half. Futures indicate Henry Hub prices ranging $2.50-$2.75/MMbtu through 2020.
Volumes growth
The E&P industry’s volume growth will remain robust in 2019-20, despite volatile prices and reduced reinvestments, that will help producers partially offset lower year-on-year price realizations, Moody’s said.
However, growth has slowed from the record pace of 2018 and will slow further as approaching 2020. US drilling shrunk by 11% at midyear from its recent peak in November 2018, which will suppress growth with a lag in this year’s second half. Low prices also will prompt companies to avoid producing higher-cost marginal barrels.
Nevertheless, improved well productivity and capital efficiency enabling lower breakeven costs will facilitate low double-digit volume growth for both oil and gas.
US oil production will increase by about 1.4 million b/d in 2019 and by another 1.1 million b/d in 2020 from 11 million b/d in 2018, when production had soared by an unprecedented 1.6 million b/d, according to EIA data.
Permian producers will deliver most of the incremental volume growth as has been the case since 2016. Additionally, the US will likely capture more market share from other countries if prices remain near $60/bbl. The short cycle time, capital flexibility, low geological risks, and low breakeven costs help US shale producers deal with price volatility more effectively.
Gas production also will remain strong despite weak projected prices, increasing by 8 bcfd in 2019 after jumping by a record 10 bcfd in 2018, according to EIA. The growth will come primarily from the three regions that have driven the segment since 2016: the Marcellus and Utica shales, the Permian, and the Haynesville.
Capital discipline
The increased focus on capital discipline and free cash flow generation bodes well for the long-term health of the E&P industry. But aggressive share buybacks or dividend increases will likely hurt E&P companies’ credit quality if they do not sufficiently reinvest or debt fund shareholder distributions, according to Moody’s.
“We expect that aggregate capital spending for the E&P sector will fall by high single-digit percentages in 2019 (excluding investments from the integrated or national oil companies) and will not rebound much in 2020 without higher prices or greater price stabilization. The capital flight from long-cycle projects to short-cycle projects will remain very much alive as producers try to retain financial flexibility and maintain capital market access,” Moody’s said.
Yet whether the newfound capital discipline will last beyond the current uncertain price environment remains to be seen, according to Moody’s.
“Although production and reserves both grew in 2017-18, the long-term implications of reduced capital investments may not surface until several years have passed. Most companies that have slashed capital spending recently will eventually have to face declining production and cash flow. We believe the larger and less-leveraged companies will have more flexibility to sustain balanced capital-allocation strategies, maintain production, and meet shareholder expectations. E&P companies with lower asset quality, higher capital intensity, or higher leverage will struggle to live within operating cash flow as the snowballing effects of falling volumes and weak prices create untenable funding situations for them.”
Capital efficiency
Capital efficiency for the E&P industry is unlikely to get a further boost in 2019-20 after 2 years of visible improvements, according to Moody’s.
E&P companies drove down development costs dramatically during 2015-16 by squeezing the lowest possible prices from oversupplied oil field service providers, drilling their best locations, and focusing on short-cycle projects, while also adding reserves through favorable price revisions. These ongoing efforts led to a strong sequential improvement in capital productivity in 2017-18.
E&P companies will benefit from cheaper local sand and lower transportation and midstream costs in the Permian basin, and modestly lower drilling and completion costs in 2019 relative to 2018. The slowdown in drilling and completion demand from E&P companies since late 2018 has caused oversupplied markets for oil field services equipment in the US. This excess supply has allowed E&P companies to negotiate slightly lower prices from service providers in 2019 following a period of steady cost inflation in 2017-18.
However, selling, general, and administrative costs are still rising in a tight US labor market, with unemployment at six-decade lows as of mid-2019. The cost of oil country tubular goods also has risen with the 25% tariff that the US imposed on imported steel in April 2018. Also, recent merger and acquisition deal multiples suggest acreage costs are generally rising.
Leverage, M&A
According to Moody’s, deleveraging prospects appear slim through 2020, with flat cash flow growth and smaller inventories of sellable assets. Lower cash margins and cash flow and increased shareholder payouts will hinder debt reduction.
“Even if companies wind up with stronger cash flow than projected, we believe the excess cash will largely go to shareholders,” Moody’s said.
Higher oil prices plus unprecedented production growth helped boost the E&P sector’s earnings and cash flow in 2017-18, which helped companies improve leverage and financial flexibility. Several companies used asset sales very effectively to lower their debt loads in 2017-18. But this approach is less likely in today’s markets, since companies have fewer assets to sell, and valuations are generally unattractive for noncore, lower quality, and smaller asset packages. Moody’s believes that the improving trend in E&P leverage will reverse by late 2019 as earnings slide further.
Meanwhile, M&A activity among US shale-focused E&Ps will continue as organic growth slows down and companies deplete their core inventory. But consolidation will be primarily strategic through 2020 and involve mostly large public companies.
