The recent oil price recovery, combined with the cost-cutting measures undertaken during 2016-2017, has given fresh vitality to high-yield exploration and production (E&P), Fitch Ratings says. Even highly leveraged companies with relatively high production costs are now healthier and should be able to reduce leverage over the next two years thanks to positive free cash flow (FCF). As prices could retreat in the long term, healthy liquidity, low costs, moderate leverage, and hedging discipline are significant differentiating credit factors in the sector.
Liquidity is a key rating factor for high-yield E&P players. The main lesson learned from the last downturn is that a lack of liquidity buffers can be fatal as a fall in oil prices and operational issues are difficult to predict. Over the past three years two small oil companies rated by Fitch in EMEA have defaulted – Afren plc and Seven Energy. Most small companies will see a significant improvement in their liquidity this year as oil prices have recovered. However, preserving adequate liquidity positions through the cycle with access to various sources of funding will continue to be a distinct feature of higher-quality issuers.
Most companies in the sector managed to significantly reduce their production costs in 2017 compared with 2014 as a result of improved spending discipline and efficiency gains, continued industry deflation and depreciation of currencies in oil-producing countries. However, the operating breakeven oil prices vary significantly across the sector. Lundin and Aker BP were the lowest-cost producers in Fitch’s peer group in 2017 with Fitch-assessed operating breakeven prices of around USD6/bbl and USD11/bbl, respectively. Faroe, EnQuest, Premier Oil and Ithaca had the highest cost bases and therefore the highest breakeven prices, which make them more vulnerable in the volatile oil price environment.
Most small players saw a significant improvement in leverage and coverage in 2017, and this positive trend will continue in 2018-19 on the back of positive FCF, and in the case of some companies the ramping up of production. Tullow Oil’s is the most impressive record as it cut net leverage from 5.2x in 2016 to 2.5x in 2017 through positive FCF and its rights issue.
Better-hedged companies are stronger credits, other things kept constant. Unlike large producers which fully expose themselves to hydrocarbon prices, some smaller O&G players widely use commodity hedges to improve cash-flow predictability. This is because smaller producers are usually characterised by higher capital intensity as they target reserves and production growth. Based on the estimated value of the companies’ hedging arrangements using a hypothetical stress case price, Ithaca and Faroe have leading hedging positions, followed by Kosmos, EnQuest and Premier Oil.