In anticipation of poor 2009 financial results for companies in the oil and gas sector, Standard & Poor's Ratings Services has taken a significant number of negative rating actions over the past three months, despite the group's healthy performance during the 2008 fourth quarter. Moreover, we expect to take additional negative rating actions, especially on speculative-grade [those rated BB+ and lower] companies.

The decline in hydrocarbon prices has been rapid and steep, although it appears to be near or at a low point. While we still believe in the long-term fundamentals for hydrocarbon prices, we currently believe oil has a better supply-and-demand outlook than natural gas does. In our view, producers with a greater exposure to oil should benefit before natural gas producers do.

Exploration & production companies may find few bright spots

Credit quality for exploration-and-production [E&P] companies continues to be negative. We expect unhedged natural gas-focused producers to generate sharply lower operating cash flows in 2009. Benchmark natural gas prices have now fallen below $4 per million Btu [mmBTU] and geographic differentials -- especially midcontinent -- remain wide. As a result we anticipate that few U.S. natural gas drilling companies will generate adequate rates of return in the current environment. The majority of U.S. operators produce more natural gas than crude oil.

Liquidity is becoming more problematic for several speculative-grade issuers -- in addition to higher financial leverage and worsening debt service coverage ratios. Falling hydrocarbon prices are resulting in many reductions on companies' borrowing bases, particularly for issuers that lack price hedges and have shorter-lived hydrocarbon reserves. Energy Partners is the only rated company to date that had its borrowing base fall below the amount of debt it had already borrowed, but several companies in the B category have seen significant drops. Financial covenant compliance has also become a bigger issue. Many companies have needed or proactively sought covenant amendments or waivers due to deteriorating financial performance.

Are there any bright spots? We don't see many. We believe that 2009 will be a particularly poor year for the industry, but that profitability should improve somewhat thereafter. Operators are rapidly idling drilling rigs and hydrocarbon supply will begin to decline, probably in the second half of the year. The question is whether the supply drop will match the falling demand. At some point prices should improve or costs decline more rapidly; the industry won't remain unprofitable forever. In the meantime, conditions will be painful. We obviously expect investment-grade issuers to have the financial wherewithal to weather this storm.