A sustained period of elevated oil prices, due in part to the US ban on Russian energy imports, will test the exploration and production (E&P) sector’s capital allocation and production discipline, says Fitch Ratings. FCF will increase significantly if oil prices remain near current levels and E&P companies only moderately increase capex. Increased FCF will allow issuers to continue debt pay-down and return cash to shareholders. While strategic M&A may also increase as cash flow and equity prices rise, E&P companies generally remain averse to credit-dilutive M&A.

Significantly higher energy prices and operating cash flow will likely lead to leverage metrics that are below 2.0x, and in some cases less than 1.0x for many issuers in 2022. However, Fitch rates companies on a midcycle basis to avoid ratings volatility. The effect on ratings will therefore depend on how much, if any, of the windfall companies use for additional capital structure improvements versus distributions.

Although Fitch expects capital discipline will largely hold across the industry, recent political calls to increase production might spur higher capex. President Biden announced an executive order to ban the import of Russian oil, liquefied natural gas and coal into the US. Oil prices have spiralled upward significantly since the beginning of the Russia/Ukraine conflict, in part due to global oil supply concerns.

Whether issuers increase production to cover the supply gap from Russia remains uncertain, given industry constrains and companies’ commitments to investors to prioritize FCF and profitable returns. Although the current situation is unprecedented and may lead issuers to break their pattern of capital discipline, there are also operational constraints that could limit producer responses in the short-term.

These operational constraints include tight labor markets for service providers, lower levels of drilled but uncompleted wells (which could be brought online faster) and limitations to lease drilling rigs under short term contracts. We believe companies will prudently weigh the risk of overdeveloping, particularly due to the energy transition and likely long-term shift away from fossil fuels.
Source: Fitch Ratings