High Natural Gas Price to Test US E&P Production, Capital Discipline
High natural gas prices will test US exploration and production (E&P) issuers’ commitment to disciplined production and conservative financial policies, says Fitch Ratings. While some issuers, particularly smaller private producers looking to build scale, might increase production in response to higher prices, we expect most public companies to keep promises to investors by limiting capex and keeping reinvestment rates low. Fitch will incorporate changes in operational or financial policies that result in weaker credit protection measures into credit ratings.
In response to the prior two industry downturns (2015-2016 and the 2020 pandemic) and periodically constrained market access for highly speculative issuers, investors have demanded that E&Ps cut capex and prioritize FCF over production growth. These actions have resulted in increased operating efficiency and improved balance sheets, while also establishing a basis for limited supply response to higher gas prices.
Fitch has taken positive rating actions on several of the natural gas E&Ps in its portfolio over the past 12-15 months, due in large part to improved balance sheets and the positive effect of higher gas prices on EBITDA. EQT (BB+/Stable) was upgraded in May and Southwestern Energy’s (BB/Positive) Outlook was revised to Positive in August. CNX Resources’ (BB/Positive) and Comstock Resources’ (B/Positive) Outlooks were revised to Positive on the expectation of positive FCF generation and debt reduction during the summer of 2020.
Lower supply and a strong recovery in demand after economies reopened has caused natural gas prices around the world to increase significantly. Fitch increased its 2021 and 2022 natural gas price assumptions earlier this month, with Henry Hub assumed to average USD3.40/mcf, compared with our previous assumption of USD2.90/mcf in 2021 and USD2.75/mcf in 2022, compared with our USD2.45/mcf previous assumption.
Our assumptions consider the possibility of a warmer than normal winter and below-trend heating days, particularly given the increased frequency of extreme weather conditions due to the effects of climate change. However, colder than normal weather conditions would increase demand, leading to even higher prices if supply is not quickly replenished, given lower than normal natural gas storage levels. US stocks of working gas are already 16% below last year and 6.9% below the five-year average as of Sept. 17, at 3,082 billion cubic feet, per US Energy Information Administration data.
There is also high export demand for US liquefied natural gas (LNG) given gas deficits elsewhere, including in Europe. Record-high natural gas prices in Europe, which is competing with Asia for LNG, and a limited supply response from Gazprom, Europe’s largest supplier, is likely to also drive export demand.
Financial benefits to US E&Ps from a continued increase in natural gas prices, however, could be capped over the near term by hedging, as issuers increased hedging levels earlier due to the pandemic and resulting 2020 industry downturn. Many E&P companies have 80%-90% of their next 12 months of expected production hedged, with the exception of Comstock, which had approximately 70% of its remaining 2021 production hedged.