Low prices, lower demand impact offshore economics

In the current economic environment, cash-rich companies, including majors and super independents, are generally faring better than mid-sized and smaller operators, particularly those that are over-leveraged.

Richard Nemec, OGFJ Correspondent, Los Angeles

Global financial shock waves the last half of 2008 left little of the industrial world untouched. As a result, the one certainty so far in 2009 for the oil and gas sector is that companies are reworking their financial strategies to fit a tumultuous, credit-constrained world with falling energy prices and decreasing market values.

Cash positions and balance sheet protection are the common drivers in financial plans talked about in the first quarter of the new year. Now that market values of all companies have plunged and the need to de-leverage has become more acute, the large and/or highly cash-rich companies are best positioned to keep their finances intact in the continuing choppy waters for the foreseeable future. But even they cannot ignore the fundamental shifts on a macro level.

In early March, BP announced it plans to slow production and keep capital spending at 2008 levels. While last year it was targeting production of oil and natural gas to reach a 4.3 million boe/d level in 2012, BP now is eyeing 4.1 million boe/d by 2012, according to CEO Tony Hayward speaking in March at a business conference in London.

Part of the increasingly bumpy economic ride is a thriving offshore sector spawning record profits at the same time many of its principal publicly held players are experiencing decreased market values. So for investors, this is a good time to buy into energy companies, and for many of the companies this is a good time for aggressive stock buy-back programs.

“This is certainly an era of financial turbulence unlike anything I have seen in my career,” said Paul Bulmahn, CEO/founder of ATP Oil & Gas Corp. “Since starting ATP in 1991, we have gone through a lot of cycles. We lived through $1 gas and $11/bbl oil, but I think this cycle has great problems attached to it. Nevertheless, it is still cyclical, and a company has got to be able to weather various cycles. Since 1991, ATP has been very effective in both the up and down cycles.”

Bulmahn says ATP retains the flexibility to adjust its capital spending, turning off the spigot when necessary. ATP is carefully adjusting its spending and development activities as the year progresses.

“We cut back on our capital expenditures for 2009 and rearranged our capital to be more focused on the projects that will deliver the highest return and are doing it within our own cash flow,” Bulmahn says.

Mid-sized oil and gas companies like ATP face a wrestling match with volatility that even the majors in the offshore space can’t ignore. When there are triple-digit changes (up and down) on Wall Street daily, the capital markets retract and liquidity dries up. Only those who have to be there are in the capital market these days.

Variables that matter to one degree or another continue to include:

• to what extent firms are equity or leverage based;
• where they operate geographically;
• what is their global oil price sensitivity; and,
• how they have managed the run-ups in costs for labor, materials, and equipment.

And a no-brainer is whether a company is sitting on relatively large pools of cash or operating under limited partnerships in which large amounts of capital need to continue flowing from investors. Strategic joint ventures and partnerships will be more important than ever for players of all sizes.

In a similar macro-economic sense, what happens post-financial crisis with the current climate change response and initiatives to move away from carbon-based energy, will drive the long-term plans of the entire energy sector – not just offshore. In mid-February, a Cambridge, Mass., research firm, Emerging Energy Research, released a report concluding there is a potential $30 billion to $70 billion annual industry waiting to emerge by 2030 in the carbon capture/storage sector. The report said many super majors already are pursuing CCS strategies as it speculated that they have the expertise and incentive to develop what EER called “key demonstration projects.”

After reporting fourth-quarter earnings ($4.90 billion) essentially the same as the same period in 2007 ($4.88 billion) and full-year 2008 profits up 28% to $23.93 billion, Chevron Corp. announced in February a $22.8 billion capital and exploration program for this year, closely mirroring its programs in 2008. Three-quarters of its spending was targeted for upstream, including several prospects in the deepwater Gulf of Mexico. A couple of days later, in early February, Chevron announced a new deepwater oil discovery at the Buckskin prospect located in the deepwater GoM.

“We believe we’ll get better economics by holding back,” said Chevron CEO Dave O’Reilly. “Our long-term view never changed. You could already tell when oil got to the $140 level that demand was falling.”

Saying barrels associated with deferred projects won’t be lost, but will be there “for when conditions change,” George Kirkland, Chevron executive vice president, told Wall Street analysts earlier this year that a significant portion of the company’s 2009 upstream investing will involve development projects tied to exploration successes in recent years. Those opportunities include deepwater GoM, offshore West Africa, and the Gulf of Thailand.

How does a worsening global economic picture complicate the plans of cash-rich offshore players? Although they may not be threatened, they may have fewer future options. For example, several E&P companies contacted for this article said it will be harder to replace reserves and find new areas that are worthwhile economically. Some smaller international offshore players operating in developing nations still have unused credit lines at the World Bank, and they are wondering where to apply this capital in 2009.

“IFC, which is part of the World Bank, is a lender to [us],” said Russell Scheirman, president and COO of VAALCO Energy. “Given the bank’s stature, IFC’s partnership as a lender to our company has helped support our success in the regions in which we operate in West Africa.”

VAALCO CFO Greg Hullinger says the current challenging economic landscape does not impact all companies in the same way and that individual players within the industry will respond based on their own circumstances. Not a lot is likely to change at VAALCO, which he joined last fall, says Hullinger.

“The decline in oil prices has been factored into our economics, and all of our drilling opportunities remain viable,” he says. “For us, it comes down to an analysis of the options that exist in the portfolio and the returns we can achieve given expectations for the price of crude and the cost of drilling, for example. In other words, we apply prudent risk-taking.”

A company’s area of operations, economic models, and accessibility to affordable capital will dictate financing plans for the future and how resilient a company is likely to be in the face of the global economic downturn, Hullinger says.

Houston-based BPZ Energy is an energetic E&P holding exclusive license contracts for oil/gas exploration and production covering about 2.4 million acres in four properties in northwest Peru. While it has pulled back some in its capital expenditure planning, and a potential deal with Shell had to be abandoned late last year, BPZ has set aggressive goals for 2009, targeting a doubling of its production and reserves compared to last year.

“We are pulling back on some of our onshore development [in Peru], but actually accelerating some of our offshore development there,” says BPZ spokesperson Greg Smith, who noted since last fall the global economic mess has been effecting everyone – big and small alike.

In early February, BPZ raised $48 million as one of the first equity sales in the small-caps sector since last summer, and it had Smith and his colleagues pumped up. “This is a phenomenal deal in this market when nobody is raising money,” he says. Nevertheless, he concedes that financing in 2009 is a “huge” undertaking and the lack of global financing has widely affected the offshore sector.

At the onset of the financial crisis last fall, some of the leading independents expressed optimism they would not miss a beat despite the economic slowdown. Established firms like Anadarko Petroleum and Apache Corp. have thrived in spite of the chaos and are facing 2009 with confidence.

Apache CEO Steve Farris has reminded financial analysts that Apache has thrived in good and bad economic times. He spent the early part of this year explaining a one-time $3.6 billion reduction in the carrying value of its assets tied to lower commodity prices in the last quarter of 2008. He stresses that the write-down did not affect Apache’s cash position, which stood at nearly $4 billion at the outset of this year.

“The important news going forward is that Apache exited 2008 with a debt-to-capitalization ratio of 23%, more than $1.5 billion in available cash and short-term investments, and $2.3 billion in available credit facilities,” Farris said. “With a number of development projects coming on line in the first half of 2009, we are projecting production growth of 6% to 14% this year, depending on capital availability.”

Farris added that he intends to keep a tight lid on discretionary spending to match cash flows for the year in order to keep as much financial flexibility as possible.

Anadarko CEO Jim Hackett says his company is “mindful that a balance must be struck between capital spending and protecting our balance sheet,” while recognizing that the economic recovery could take longer to achieve than anticipated in the early months of 2009.

While many expect oil and gas prices to bottom out in 2009, Hackett says Anadarko is managing its 2009 capital program consistent with “a sustained lower-commodity-price environment.” His company ended 2008 with approximately $2.4 billion of cash on hand and retains the availability of its unused $1.3 billion committed credit agreement, along with access to credit markets.

“We expect this liquidity position to enable us to meet our 2009 operational objectives and capital commitments under current market conditions,” Hackett says.

Hackett’s insights came two months into 2009, but around the start of this year, financial news media were speculating that Anadarko and some other highly successful large independents operating in the deepwater offshore could be targeted for acquisition by one or more of the super majors – ExxonMobil, Shell, BP, Chevron, ConocoPhillips, and Total.

While CEOs like Hackett and ATP’s Bulmahn resist the idea of being targets, they openly acknowledge they are looking for prospects all the time – purchases, mergers, and joint ventures. Bulmahn thinks M&A activity will increase this year.

Several large development and exploration projects spread around among the GoM, offshore West Africa and Algeria are on Anadarko’s radar screen in 2009, says Hackett, noting the company may not “pursue every drill-ready prospect in our inventory,” but it has several mega-projects – the Jubilee field offshore Ghana, the Caesar/Tonga complex in deepwater GoM, and El Merk in Algeria.

“Approximately 20% of our 2009 capital program is geared toward global exploration,” Hackett says. “We expect to drill between four and six exploration/appraisal wells in deepwater GoM, building on the success of two recently announced discoveries at Heidelberg and Shenandoah prospects.”

The credit ratings agencies focus on supply-demand balances in the oil and gas sector, trying to gauge what will happen to capital spending in 2009-2010 and whether credit markets will still be there.

“It is still difficult to go out and do bonds,” says Jeffrey Morrison, a senior analyst with Standard & Poor’s Ratings Services. “Although we’ve seen some high-yield companies do this right now; it’s still a bit choppy out there. However, some companies have been able to access the bond market. The rates for high-yield companies have gone up significantly, though, since mid-2008.”

Morrison added, “The banks obviously are in a retrenched mode and are not that anxious to loan. So the bank market is not as robust now for the high-yield companies. In general, we expect capital spending to hold up better in the deepwater offshore than the shallow water plays.”

Both S&P and Moody’s Investors Service see a lot of activity continuing in deepwater offshore plays dominated by the majors and large independents, but say capital and credit will be problematic for companies operating in, say, the shallow waters of the GoM shelf, which is mainly the province of small- and mid-sized operators.

“A lot of these companies tend to be heavily leveraged, and it’s all about liquidity and cash flow, and they don’t have them,” says Kenneth Austin, vice president and senior analyst with Moody’s. “They will see a bit of a slowdown.”

After doubling its year-over-year third-quarter profits, Marathon Oil Corp. reported a $41 million loss due to a non-cash $1.4 billion impairment charge in the fourth quarter, along with reduced results for all of 2008, compared to 2007 overall. Earlier, CEO Clarence Cazalot, Jr., said he expected the company’s capital spending to pull back by about 15% in 2009, calling it a “prudent approach to the current business environment.” At the same time, Marathon approved going ahead with two major Gulf of Mexico deepwater development projects – Droshky and Ozona – for which the company might book a total of 29 million boe of natural gas and oil proved reserves.

What once were operating blips now could be formidable challenges in a world in which the credit markets and banking have been shaken to their core. Those challenges involve infrastructure, global competition for labor and materials, and heightened environmental rules and costs with the advent of climate change mitigation pressures.

Generally, infrastructure is only a major issue in the deepwater plays, but it can be a bigger impediment in the new world of finance because if a company doesn’t have the infrastructure it needs to get the oil or gas to market, it has to get those assets built and that means accessing the capital to get it done.

Houston-based ATP is finding some success for its deepwater efforts through its “floating production systems” that include drilling capabilities as well. These highly reusable rig systems are floated from one project area to another.

“It is a brand new concept for production anywhere in the world,” says Al Reese, ATP’s CFO. “Drilling has always had that capability, but now we have it in production, too. Most production facilities historically have only been dedicated to the reserves they initially produced, but this floating production unit will have the ability to access different reservoirs literally around the world.”

Infrastructure is usually not a problem in mature areas such as the GoM or the North Sea, but it is in Brazil, Africa, and Southeast Asia, says Alan Madian, a director with Washington, DC-based LECG Consultants, who a decade earlier was closely involved in the planning of the offshore infrastructure in Thailand.

The ironies this year run deeper than the offshore sector’s newest big finds as evidenced by firms such as drilling contractor Pride International Inc. which reported its highest-ever annual and very solid fourth quarter profits earlier this year while its CEO, Louis Raspino, nevertheless had to acknowledge that 2009 has begun with an unprecedented amount of economic uncertainty.

“Offshore drilling activity is noticeably lower in many regions around the world,” Raspino told a year-end earnings conference call. “Decreased customer demand is most evident in the jack-up rig sector, resulting in an increasing number of idle rigs while new, uncontracted capacity is being delivered.

“Overall, a more challenging near- to intermediate-term day-rate environment is likely, especially for the jack-up and mid-water fleets, while the industry’s deepwater fleet is expected to display more resilience due to longer term contract durations and strong geologic success during the past several years,” he adds.

Costs of construction materials and services have also been volatile. For example, steel has gone from super-high prices and long lead times to lower prices and greater availability in the span of one year.

Analysts say the cost of essential goods and materials should come down and their availability improve in the current downturn, but that doesn’t mean all the infrastructure that is needed will get built. Some of it will because the cash-rich majors and independents clearly need it to follow-up through deeper water plays.

S&P’s Morrison says from the rating agencies’ perspective there are still a lot of concerns with what is going on onshore North America – the very low natural gas prices and the really steep decline in the US rig count. Onshore has been the most negative story since the credit crisis and lower gas prices. Offshore, again, continues to be a more favorable story, he adds.

Offshore companies consider their operations environmentally responsible because they have been dealing with intense rules and regulation for a long time. The added rules anticipated from the current push on climate change are not expected to be onerous for future offshore operations. Companies have won praise in some environmental and business sectors for work in the North Sea and offshore Brazil in mitigating against the impact of their E&P operations.

“Certainly there is greater awareness about environmental footprints around the world, including in West Africa, and the rules reflect that,” says VAALCO’s Scheirman. “The environmental ministry typically has its own view on projects. For our industry, this generally means longer lead times to ensure proper planning rather than a change in the project’s financial proposition.”