SECTOR REVIEW
A Comprehensive Review of the E&Ps in 2008
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E&P stocks hard hit in 2008. E&P stocks declined 47% on average in 2008
(vs. a 38% drop in the S&P 500), a sharp contrast to the 26% gain in 2007
(vs. a 4% gain in the S&P 500). Amid generally weak equity markets, the
E&Ps were even harder hit, as WTI crude oil and NYMEX natural gas prices
both tumbled by over 50% from midyear peaks on weakening demand and
robust supply growth for gas. For the year, gas-focused producers
outperformed oil-focused producers (-43% yr/yr vs. -48%), as oil prices fell
further than gas (-54% yr/yr vs. -25%). Valuations on an EV-to-EBITDA
basis averaged 6.0x vs. 6.3x in 2007.
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A tale of two halves. In the first half of 2008, investors rewarded those
E&Ps possessing accelerating production growth profiles amid a host of new
emerging unconventional gas plays and rising commodity prices. Little
regard was given to balance sheet health and returns as companies
financed profligate drilling with borrowed money and frequent equity
issuances. Companies with large undeveloped acreage positions were given
advanced credit for unbooked reserve potential. However, the tide quickly
changed in H2’08 amid falling commodity prices and evaporating external
financing. Investor attention shifted away from high growth and toward
financial health (leverage and liquidity), and more disciplined capital
allocation (free cash flow). As we publish this note today, growthy E&Ps
have recovered, and investors are again rewarding unbooked potential.
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Debt concerns prevalent in H2'08. E&P leverage became a primary
concern in the back half of the year as a result of reduced cash flows, large
funding gaps, and highly levered balance sheets from prior periods of
overspending. With producers looking to sustain growth, some E&Ps
resorted to their bank lines for funding, with several producers drawing down
as much as 75% of available bank capacity. The increased reliance on bank
debt was particularly concerning given the fragile state of the banking sector
and the possibility of reduced borrowing bases. While the improving credit
markets have allowed numerous producers to repay bank debt through
corporate debt issuances, liquidity is still a concern and the potential for
reduced borrowing bases with October redeterminations remains evident.
The ‘Balance Sheet Trade’ ruled in H2’08. Illustrating the early-year preference for
volume growth at all costs, producers with aggressive spending plans were the early
winners. Specifically, E&Ps outspending internal cash flow to achieve rapid growth
rose 70% from Jan. 1, 2008, to a peak on July 1 but fell 71% through the year-end. In
contrast, free-cash-generating E&Ps rose a more modest 41% to the peak, but fell a
less dramatic 60% through the year-end. Likewise, companies with stronger balance
sheets outperformed high-leverage producers by ~13% from September 2 through the
year-end, as investors focused on financial strength and funding. (The 'balance sheet
trade' ran its course.)
■ 2008 onshore gas production surged. U.S. natural gas production surged in 2008,
with onshore production rising 11% compared with 6% in 2007 as producers ramped
up activity to exploit low-risk onshore unconventional gas plays. Overall production
rose 7% in 2008 despite hurricane activity in the Gulf of Mexico that shut in an
estimated 415 Bcf of cumulative gas production. The faster-growing public
independent producers that we track saw gas growth of some 13%. Shale plays
garnered significant investor attention, as producers frequently raised budgets to
levels well above internal cash flow to expand acreage purchases and drilling.
However, the surge in gas volumes amid weakening economic demand drove the
market to substantial oversupply in the second half. Although cash prices tumbled in
H2'08, forcing producers to drastically reduce activity, production has not fallen much
as of yet.
■ Rig count collapses after September’08 peak. During 2008, the total U.S. rig count
rose 6% on average to 1,879 rigs (from 1,768). The modest year-over-year average
rig increase masked dramatic volatility during the year, as the rig count climbed 14%
from YE'07 to recent historic levels (2,031 rigs) in September, and subsequently fell
rapidly by a sharp 15% in the final 3 months. With commodity prices plummeting and
capital markets difficult, E&Ps were forced to cut back on drilling activity dramatically.
On the most recent data, the U.S. rig count has now fallen to 955, some 53% of the
peak. On the gas side, the rig count is at 742 and 54% off the peak. We expect the
sharp drop in drilling activity to lead soon to sharp declines in supply in the coming
quarters and see peak-to-trough production declines of ~7 Bcf/d.
■ Capex rose 47% yr/yr. Overall capex (organic plus unproved property acquisitions)
rose 47% yr/yr in 2008 amid surging drilling activity and aggressive land purchases
(acreage ‘grab’). Frequent budget increases were the norm. However, with cash flow
down substantially on lower prices and with capital market conditions difficult,
producers began to cut budgets late in the year. Drilling budgets look to be down
~31% this year, and it remains difficult to justify much activity at all with spot prices in
the high-$2s to low $3s in most basins. When including unproved acquisitions
(acreage), budgets are down 49% yr/yr. Still, we think capex is likely to fall even
further, as current budgets remain well over internal cash flows on the ’09 strip.
■ Reserve revisions hurt all-in F&D costs in 2008. 2008 worldwide all-in F&D costs
(including revisions) increased 56% to $4.45 per Mcfe from $2.85 per Mcfe a year ago.
Rising F&D was driven by (1) higher oil field costs, (2) dramatic increases in acreage
purchases (which adds little initially to reserves), and (3) lost reserves at lower yearend
pricing (which made ‘tail’ reserves and marginal PUDs uneconomic). Price-related
revisions alone had a very significant impact, reducing reserves by 7.2% on average
compared with a 0.7% positive impact in 2007. Excluding the effect of all revisions
(price and performance), all-in F&D costs rose a more modest 10% yr/yr to $3.50 per
Mcfe.
■ Drill-bit F&D (ex revisions) fell 3% yr/yr to $3.03 per Mcfe. Organic F&D costs
excluding revisions came in at $3.03 per Mcfe, down 3% from a year ago. Despite
cyclically higher service costs and price related reserve losses, drill-bit F&D appears to
have fallen on improving per well recoveries in unconventional gas plays, which have
seen great benefits from improving completion methods (i.e., longer laterals, increased
number of frac stages).
■ Organic reserve replacement declines in 2008. Drill-bit reserve replacement
(worldwide, including revisions) fell to 165% in 2008, down from 225% as lower
commodity prices shaved reserves from the books at year-end. All-in reserve
replacement came in at 203% compared with 268% in 2007. Meanwhile, when
excluding revisions, producers added significant reserves through the drill-bit
(excluding price and performance revisions) with 215% reserve replacement on a
worldwide basis (up from 193% in 2007).
■ LNG imports fairly light in 2008, but have picked up. LNG imports fell to just 1.0
Bcf/d in 2008 from 2.1 Bcf/d in 2007, a decline of 54% as strong demand globally
drove cargoes away from the U.S. Imports by Japan (the largest importer of LNG) rose
5% on an outage at the Kashiwazaki-Kariwa nuclear power plant while Spain imports
rose ~20% on depressed hydro levels. South Korea also saw imports rise 12% yr/yr.
Along with the strong demand abroad, liquefaction capacity issues also limited imports
into the U.S. The startup of Qatargas II Train 4 was pushed back into 2009 while there
were operational issues at key Atlantic Basin facilities, including Snohvit (Norway),
Algeria, and Nigeria (late in the year).
■ Market substantially loose today, but should tighten through the year. Despite
current gas market looseness (3-4 Bcf/d net imbalance), we expect tightness to ensue
later in the year as reduced drilling activity and bottoming demand lead to an
improving balance by Q4’09. Meanwhile, the roll-off of high-priced hedges and
leveraged balance sheets will make it difficult for producers to start spending again
quickly if prices improve in 2010.