Following our sector review of the U.S. oil and gas sector, we now rate nine companies 'BBB-' (see table 1), and eight of these companies have a negative outlook. We examine what kind of risks they face and how close they are to being a fallen angel.

Table 1

Our Crude Oil Price Assumptions Rise In 2021, But Remain Subject To Uncertain Market Forces

The ability of OPEC+ to lower crude oil production and the strength of a global economic recovery in the second half of 2020 will be key to improving crude oil prices and maintaining ratings. OPEC+ production cuts and declining U.S. production should help address the current excess oil supply, while the easing of coronavirus social distancing restrictions should support a recovery in global economies, spurring industrial and vehicular use of crude oil-based products. That in turn should lead to stronger crude oil demand and prices.

Table 2

They Entered Into 2020 With Generally Strong Financial Performance

One of the benefits of the industry's newfound capital restraint and focus on free cash flow is that the 'BBB-' rated companies started 2020 with improved balance sheets and cash flows relative the prior downturn (table 2). This set them apart from the fallen angels that had weaker financial measures due to acquisitions, heavy capital spending, or weak markets (table 3). Additionally, liquidity is solid for the 'BBB-' companies with no material near-term maturities for most providing a good support to ride out volatile markets over the next 12 to 18 months (see table 1). We expect these companies to continue to adhere to conservative financial policies and take actions to adapt quickly to changes in crude oil prices and expected cash flows to maintain solid liquidity and financial performance.

Table 3

Credits Are Bifurcated

As seen in the downgrade triggers, about half are 30% funds from operations (FFO) to debt and half 20% FFO to debt, we have made a distinction between credits, largely based on our assessment of the strength of their asset base, especially diversification. We continue to view asset diversity and scale as an advantage over single basin reserves in many cases. This is seen in the downgrade triggers which generally allow greater cushion to those with operations in multiple basins combined with good scale of operations. Reflecting this, companies with material positions in multiple basins, such as Noble Energy, generally have greater cushion to a downgrade, specifically 20% FFO to debt versus 30% FFO to debt for those whose ratings depend more on strong financial performance, such as Cimarex Energy. We believe asset diversity provides more options to react to often volatile swings in regional pricing, operating conditions, and regulations. This takes on greater significance given the industry's already weakened cash flows.

Table 4

We Plan To Review Our Price Assumptions In The Third Quarter

To avoid a whipsawing of ratings over the near term, our price assumptions (table 4) include the expectation for potentially high levels of price volatility in the second quarter, such as the April 20 negative pricing on the May WTI contract, as the full effect of excess crude oil production and COVID-19 demand destruction affect global markets. We plan to reevaluate our price assumptions in the third quarter when we expect more clarity on the trajectory of crude oil prices. Our current assumptions include the expected positive impact of reduced global crude oil supplies stemming from OPEC+'s 9.7 million barrel production cuts that should begin to take effect this month, as well as the negative impact to U.S. production levels due to significantly reduced drilling and completion activity that should help further reduce domestic crude supplies. On the demand side, the easing of social distancing restrictions used to combat COVID-19 should help increase demand for crude oil as domestic and global GDP begin to recover.

Risks Remain For Crude Oil Prices And Ratings

This holds true for both the WTI and Brent crude oil price assumptions and the 'BBB-' credits as a result. Both our crude oil price assumptions and ability of companies to meet base-case expectations face challenges. Since ratings assume a material recovery in crude oil prices in 2021 will drive improving financial measures, we assume $45 per barrel WTI and $50 per barrel Brent, a meaningful reduction in our price assumptions could trigger downgrades for many. Poor compliance with OPEC+'s 9.7 million barrel production cuts or expectations for a more prolonged demand destruction due to COVID-19 could erase the support for higher crude oil prices and cause us to reassess our price assumptions for 2021 and beyond. On top of low crude oil prices, a second year of reduced spending in 2021, assuming capital spending is cut to manage cash flow, would likely lead to production levels falling below current expectations, putting further pressure on financial performance. Other factors for consideration would include the ability of companies to generate breakeven or positive free cash flow, the production impact from reduced capital spending, as well as liquidity in the face of upcoming debt maturities.