US Oil & Gas Sector's Credit Quality to Weaken as Commodity Fundamentals Remain Under Siege

The report, released today, says the drilling & services sector is suffering from an imbalance between supply and demand with weakened commodity prices having reduced demand just as supply of newbuild rigs continues to hit the market. Fitch expects the sector to continue to be under pressure from customers to reduce prices, driving margins lower in 2009 and 2010. Upstream companies continue to reduce capital expenditures in response to lower commodity prices, and falling 2010 strip prices would indicate little propensity for a significant increase in spending levels. While drilling and service companies are benefiting from previously signed contracts, Fitch expects credit profiles to decline from current levels.

For the downstream, the combination of soft product demand, low plant utilizations, and compressed crude oil spreads continues to pressure refining economics and suppress industry earnings despite the presence of decent crack spreads. Deep conversion refiners with significant coking capacity have been particularly affected by current market conditions, as crude oil differentials, which historically created feedstock advantages for this group, collapsed. Fitch notes that one rising threat that emerged over the first half of the year was fast-rising crude oil, which appears to have become somewhat decoupled from underlying product demand in North America.

For crude oil markets, falling demand levels continues to be the biggest driver of falling prices. The last time demand for oil declined due to a severe economic recession and demand destruction from high prices, it took 10 years for demand levels to reach their previous highs. Global oil supply concerns have also been mitigated due to the significant increase in spare capacity from OPEC producers. While fundamentals continue to indicate depressed pricing for oil, Fitch acknowledges that non-fundamental factors could again drive crude prices higher. Fears in the market of rampant inflation stemming from the quantitative easing actions by central banks around the world intended to stem the global economic recession could be a catalyst for higher crude oil prices.

While oil markets continue to struggle with falling demand levels, natural gas markets are plagued with rising supply and falling demand levels. Despite falling natural gas prices, supply of natural gas during the first four months of 2009 is up 2.6% over 2008 levels. Demand, led down by weak industrial demand and mild weather conditions, has only served to compound the problems facing natural gas prices. Because of the significant negative fundamentals facing natural gas markets, Fitch sees little opportunity of a rebound in prices in 2009. Falling 2010 forward prices could support reduced drilling by upstream companies and help bring the market into equilibrium during 2010. Fitch continues to expect natural gas prices during 2009 and perhaps 2010 to be closer to the Fitch stress case prices of $3.50/mcf (2009) and $3.75/mcf (2010).

To access 'Oil & Gas Insights,' Fitch's semiannual look at developments in the oil & gas industry, please visit Fitch's web site at www.fitchratings.com.