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Even with clean balance sheets, oil and gas drillers exposed to rate increases

US oil and gas producers have overhauled their spending habits in the past three years, with a focus on repaying debt rather than accruing it. Their efforts have insulated them from a liquidity crunch caused by rising interest rates, but they are not immune to the secondary effects of a slowing economy.

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Even with clean balance sheets, oil and gas drillers exposed to rate increases

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This newfound fiscal responsibility marked a dramatic shift for exploration and production companies (E&Ps). As new drilling techniques sparked a shale revolution over the past two decades, the E&Ps gained a reputation for borrowing billions to keep the rigs drilling and production growing. These days, shareholders punish E&Ps that use debt to finance more drilling or M&A deals that do not immediately add to the buyer's income.

"The impact of rising rates on the energy industry has been pretty muted by the fact that for the past couple of years — during the period when rates have actually been rising — the industry has been in a strong free cash flow generation phase," CreditSights senior analyst Charles Johnston said in an interview.

"Their reliance on new debt has declined dramatically, and they've also repaid a significant amount of existing debt over the past couple of years," Johnston said.

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In fact, most independent E&Ps that issued bonds have refinanced and now pay less than the double-digit interest rates they saw during the pandemic crisis of 2020, Johnston said. "That's just because the spreads have compressed significantly, as issuers repay debt and are benefited by improving ratings," he said.

Culture change in the oil and gas patch

The landscape has changed inside and outside the boardroom, said energy economist David Dismukes, who joined the Institute for Energy Research in May as a distinguished fellow and senior economist after decades as a professor at Louisiana State University's Center for Energy Studies.

"They're not the same companies from the '80s and the '90s, and even the early 2000s, when they were run by guys who started off as roughnecks or were petroleum engineers or geologists or something like that," Dismukes said.

"Most of these big companies now are run by people who are business people: lawyers, accountants, economists," Dismukes said. "The wildcatter mentality of the business is not there. They don't have a big appetite for going out and taking on any new debt because they have no big drilling agenda that's sitting out there in front of them."

Banking scare may reduce liquidity

E&Ps are not immune from interest rate pressures even if they have a pristine balance sheet, said Dennis Kissler, the senior vice president for the trading division at BOK Financial Corp., a financial holding company with interests in several regional banks in the oil patch. "The latest banking scares from some poorly managed regional banks could also very well shrink liquidity in the oil and gas industry into next year," Kissler said.

Almost all E&Ps have asset-backed lines of credit, often from a regional bank, which cover expenses during the gap between drilling a well and selling its output. "Rising interest rates equate to higher breakevens in oil and gas exploration, which reduce exploration projects and can make some existing fields non-profitable due to the added expense in well maintenance, et cetera," Kissler said.

Kissler said the impact of rising rates shows up first in the number of active oil and gas rigs, which is falling going into the summer. "As liquidity shrinks and borrowing costs increase, exploration activities slow down, reducing the overall growth potential of expected new production," Kissler said.

The sensitivity to rates goes beyond individual company credit habits, Kissler said. If Treasury bills are paying 6%, corporates must yield more than 6% to attract investors, he noted.

Rate increases could slow economy

Oil and gas producers are also sensitive to rising interest rates' effect on the broader economy. High interest rates can reduce energy demand as economic activity shrinks, forcing producers to lower oil and gas prices to balance commodity markets, Gaurav Sharma, the assistant director of strategy and research at financial consultancy Acuity Knowledge Partners (US) Inc., said in an email.

"Oil and gas companies are net debt negative now, they have the bargaining power for better interest rates for their future capex plans," Sharma said. "However, on the negative side, high interest rates lead to demand destruction which in turn impacts crude prices negatively."

"If this environment sustains for a longer period, it will eventually impact oil and gas companies' future cash flows (due to higher interest rate payout and lower income due to low demand and prices)," Sharma wrote.

S&P Global Commodity Insights produces content for distribution on S&P Capital IQ Pro.