Energy Finance

“We believe that the tightening credit markets and lower commodity prices may temporarily delay some rig construction programs,” says Mark Urness, analyst with Calyon Ssecurities.

“These delays could result in deferment of bookings or possible cancellations for the rig equipment manufacturer, NOV, and some shipyards in Asia such as Hyundai, DSME and Samsung. In our view, these delays and possible cancellations have positive implications for leading deepwater drillers.”

According to ODS-Petrodata, there are currently 100 floaters under construction or on order, expected to be delivered by 2012. The tightening credit markets and declining commodity prices have resulted in temporary delays in some floater construction programs, he says. NOV, the world’s largest rig equipment manufacturer, secured three orders on the 12 deepwater rigs under LOIs issued by Petrobras in March.

“It is unclear when, and if, the other nine orders will be awarded, as some of the Brazilian contractors are having trouble obtaining financing. We believe that Petrobras is currently helping some of these contractors secure financing for the rigs,” he says.

The current construction program consists of 24 speculative newbuild floaters, being built by relatively less experienced contractors, that have not yet been awarded firm contracts by any E&P company and are expected to be delivered during 2010-2012. “We believe that these construction programs are at a greater risk of being deferred further until financing becomes more readily available,” says Urness.

The major rigbuilding yards in Asia include Hyundai Heavy Industries, Samsung Heavy Industries and Daewoo Shipbuilding. “We have identified 21 floater programs in these yards that could witness short- to medium-term delays due to financing issues. Samsung Heavy Industries is expected to carry out a majority (13 units) of these construction programs at its Geoje shipyard.”

E&P is a capital allocation game, and in a capital intensive industry, driven by a depleting asset base, the capital allocation process is perhaps the single largest driver of future equity value, says Morgan Stanley & Co. Inc research analyst Stephen Richardson.

“While lower (and falling) commodity price and tight credit continue to dominate the debate in the industry, the capital budgeting process for 2009 is underway. While capex cuts have been of focus to date, looking forward where capital is allocated (not the absolute level) is likely of more importance. Stock selection matters,” he says.

A key consideration for the 2009 capital program is likely to be drill it, acquire it, or buy it back, he says.

“As we have highlighted previously, much of the group is trading at reserve metrics back to proved reserve levels. With this in mind, and acknowledging that not all assets are equal and future development capital requirements differ across the industry, equity valuations are back to levels where acquiring reserves (either via M&A or repurchasing your own capital) may now be a better decision (on average) than organic drilling projects. We acknowledge that on a project level (versus a corporate level) incremental F&D and project economics are likely to attract additional capital, regardless of the availability of lower cost and or higher risk alternatives in the acquisition market. While operational concerns may dominate near-term decision-making, investing in the lowest cost barrels remains the best decision.”

A coming consolidation cycle? Not yet, says Richardson. Despite the sound financial logic of acquiring versus drilling, “we are unlikely to see material follow through on this strategy until credit market conditions stabilize. We expect capital preservation to remain the order of the day, particularly as commodity price volatility continues. It is the shrewdest capital allocators with funding capacity that are the likely beneficiaries.”

To reflect changing market conditions, Calyon Securities is adjusting its valuation methodology and now bases all target prices on a blend of 50% of net asset value and 2009 estimates of EV/EBITDAX ratio, which have been trimmed by 25% to 35%.

In coordination with Calyone’s head of oil and gas research, Hernan Ladeuix, it is lowering its oil and gas price forecasts for 2009 to $71.50 per oil barrel and $7.50 per million Btu, down from $96.50 and $8.00.

“We believe investors should focus on well-capitalized gas-levered names with strong balance sheets,” says Calyon’s Jeb Armstrong. “On average, we are lowering target prices by 49%.”

Due to liquidity concerns surrounding production deferred after Gustav and Ike, Calyon now bases valuation of ATP Oil & Gas exclusively on proved reserves. “We are lowering our ATPG target price from $56 to $16.”

“We are raising our ratings on two stocks based on valuation. We are upgrading WTI to ADD from NEUTRAL and ME to BUY from ADD. Both have a Gulf of Mexico focus and have seen their stocks get pummeled by the deterioration of the overall market and September’s hurricanes,” says Armstrong.

“In coordination with today’s note by Hernan Ladeuix, we are lowering our 2009 and long-term commodity price forecasts, which are incorporated into our new target prices. Worsening economic conditions, both in the U.S. and abroad, are the primary reasons. The U.S. is experiencing the worst demand decline in crude oil in more than 20 years,” he says.

Former federal reserve chairman Alan Greenspan said at a congressional hearing today that a flaw in his free-market ideology contributed to a “once-in-a-century credit tsunami,” according to Bloomberg News.

“I found a flaw,” Greenspan said. “That is precisely the reason I was shocked because I’d been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

Greenspan said he was partially wrong in his opposition to the regulation of derivatives. In May 2005, he said “private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.”

Committee Chairman Henry Waxman, a California Democrat, pointed the finger at Greenspan by saying he “had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis.”

“You were advised to do so by many others,” he told Greenspan. “And now our whole economy is paying the price.”

Greenspan now says that firms that bundle loans into securities for sale should be required to keep part of those securities, and should create rules for settlements and to discourage fraud.

Greenspan said that financial companies failed to execute sufficient surveillance’ on their trading counterparties, and the breakdown’ was where securities firms packaged home mortgages.

Greenspan said, “As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue,” giving the companies an incentive to ensure the assets are properly priced for risk.

Wal-Mart Stores Inc. will set new quality standards for its Chinese suppliers, following a series of scandals involving Chinese-made products, which account for a major portion of the company’s sales.

Meanwhile, the United Nations recommended China increase oversight of its food safety system and hold businesses accountable for their products, amid the latest scandal involving tainted milk products.

Melamine, used to make plastics and fertilizer, was recently found in Chinese-made baby formula. The product has been blamed for the deaths of four babies and sickening another 54,000 children. It was added to infant formula to artificially boost nitrogen levels and make it seem higher in protein when tested.

Dozens of countries have pulled Chinese-made goods with dairy ingredients off their shelves to test for melamine. Contamination has turned up in Chinese-made powered and liquid milk, yogurt and other products made with milk.

Confidence in Chinese products has been sagging after high levels of industrial toxins were found last year in exports ranging from toothpaste to toys.

In 2007, melamine was found in a Chinese-made pet food ingredient and blamed in the deaths of dozens of dogs and cats in North America.

Later that year, Mattel Inc. recalled more than 21 million Chinese-made toys worldwide because they contained lead paint or tiny, detachable magnets that might be swallowed.

Chinese-made cribs were part of a recall this week by New York-based Delta Enterprises. The cribs were recalled due to missing safety pegs.

BlackRock Inc., the largest publicly traded U.S. asset manager, said third-quarter earnings fell 15%. Investors, unnerved by the financial crisis, pulled money from its stock, bond and money-market funds.

BlackRock’s net income fell to $217.7 million, or $1.62 a share, down from $255.2 million, or $1.94, in 2007.

The bankruptcy last month of Lehman Brothers Holdings Inc. and losses at a money-market fund run by Reserve Management Corp. triggered $53.8 billion in withdrawals from BlackRock’s cash and securities-lending funds.

BlackRock’s assets fell 12% to $1.26 trillion from the prior quarter, driven by $69.1 billion of market depreciation in its stock funds.

Before today, the stock fell 34% this year, compared with the 43% decline in S&P’s index of 16 money managers and custody banks.

Investors contributed $60 billion into BlackRock’s funds in the first half of 2008, more than they invested with any other publicly traded money manager in the U.S.

Previously, BlackRock was picked by the Federal Reserve in March to oversee $30 billion of Bear Stearns Cos.’ investments when the fifth-largest U.S. securities firm agreed to be acquired by JPMorgan Chase & Co and was also called in by UBS AG to help manage a portfolio of mortgage assets.

Upstream capex cuts hold the potential to address near-term oversupply in North American natural gas and improve 2009 balances, says Stephen Richardson, analyst at Morgan Stanley & Co. Inc.

Lower rig counts are likely to take about three to four months before the supply impact is felt, but, using the cuts of 2001 as a roadmap, makes clear the potential for a material tightening of the supply and demand balances by the second half of 2009, he says.

The market remains exposed to near-term challenges of continued robust supply, winter weather, and weakening demand patterns. However, and perhaps more important for the equities, Richardson sees the potential for a change of sentiment towards North American gas as “evidence of producer discipline mounts.”

Compared to widely held near-term bearish sentiment towards crude, the gas market looks well positioned, as production is likely to adjust to lower prices (and tighter credit) to restore balances.

Also, with an increasingly challenged domestic economic outlook for next year, a key offset will be slowing gas demand (and in some cases, contraction) in key demand segments. His model suggests lower year-on-year weather-adjusted demand in both the industrial and electricity generation segments (based on the firm’s U.S economics 2009 GDP outlook of -0.2%). However, due to changes in the structure of demand centers since the last economic contraction, predicting demand impacts of an 2009 recession remains “more art than science.”

Despite improving clarity on 2009 balances, key near-term challenges remain. First, basis, particularly in the Midcontinent and the Rockies, remains an issue as key transport and storage outages have severely impacted regional prices. Second, frac margins have declined due to natural gas liquids oversupply and lower crude prices. Finally, additional liquids in the gas stream may increase near-term supply.

Canadian banks will enter 2009 on a much stronger footing than U.S. and European banks, according to Standard & Poor’s Ratings Services.

“Recessionary conditions in the U.S., a weakening global economy, and a comparatively stronger-but-weakening Canadian economy, along with the expectation that these trends will persist through at least the second half of 2009″ means Canada’s domestic retail and commercial banking businesses represent “a solid underpinning of stable revenues and earnings growth in the long term,” it reports.

“There is no doubt that the Canadian banks are facing a more challenging business cycle,” says Standard & Poor’s credit analyst Lidia Parfeniuk. Challenges include the slowing Canadian economy in tandem with rising credit costs, costly funding, fewer loan originations, and sharply lower capital markets-related revenues to pressure profitability growth. “Nevertheless, with what we view as substantially more robust balance sheets and capital positions and lower risk profiles, the banks’ foundation appears stronger than that of U.S. and European peers,” she says.

Canadian banks generally benefit from substantially stronger and more conservative balance sheets, especially compared with U.S. banks, by practicing on-balance-sheet financing and making less use of securitization, including generally more prudent risk practices that have helped them to maintain far superior credit quality metrics with the help of a strong Canadian economy.

They also retain relatively robust capital positions compared with universal banks.

S&P reports that liquidity “remains respectable for the Canadian banks and is improving with incentives to reduce reliance on short-term funding by terming out short-term obligations, increasing the size and enhancing the makeup of their excess liquidity pools, and relying less on unencumbered assets in favor of cash and closer equivalents.”

Further mark-to-market write-downs on structured products could affect the results of Canadian Imperial Bank of Commerce, Bank of Montreal and Royal Bank of Canada in particular, although those events are not expected to be ratings issues.

News from London:
Lending rates between banks in the U.S. and Europe fell on Thursday, giving evidence that some credit markets are thawing. Central banks pumped more liquidity into financial systems and some relaxed rules for banks to obtain credit.

The interbank lending rate for the three-month Euro Interbank Offered Rate, or Euribor, fell 0.08 percentage points to 5.09% today. The equivalent U.S. rate also dropped,by 0.05 points to 4.50%.

Also, the European Central Bank (ECB) and the Bank of England l(BoE) loosened requirements for banks to take out loans with them. The ECB will accept certificates of deposit and lower-rated credit assets. The BoE Thursday will have new borrowing facilities tailored for distressed lenders. Meanwhile, emergency BoE loan penalties will be significantly cut.

Interbank rates are still above the benchmark rates of 3.75% in the euro zone and 1.50% in the U.S.

Although the market is discounting doom and gloom for the oil service and drilling companies, the growth story is not yet over, says Mark Urness, analyst at Calyon Securities.

“We expect oilfield service and drilling companies to show 7% sequential earnings growth in 3Q08, in line with the two-year average. We estimate growth in the U.S. land drilling market and the seasonal pick-up in Canada to result in strong sequential earnings growth, offset by losses due to the hurricanes.

“However, due to the current financial crisis, we now anticipate reduced E&P spending and a rig count decline in 2009, particularly in North America. As a result, we recently lowered our 2009 EPS estimates by an average of 9%.

“We expect SLB to miss the consensus EPS estimates by $0.02 despite strong sequential earnings growth of 6%. We believe that BHI and NOV have the potential to exceed consensus earnings estimates. We estimate the large-cap service sector will show 9% sequential earnings growth in 3Q08. Among the mid-cap service companies, we see subsea equipment manufacturers such as CAM and FTI as most likely to exceed consensus expectations. BJS, partly impacted by hurricanes, expects 3Q08 EPS to be in the $0.55-$0.57 range.

“Due to continued strength in U.S. land drilling activity, rising day rates and higher utilization, we believe the land drillers will report higher margins in the core U.S. onshore drilling business. We expect the land drillers such as HP and BRNC to exceed consensus EPS estimates by $0.03 and $0.01 respectively while UNT may report a miss due to lower natural gas prices.

“We believe that the deepwater drilling companies such as DO and RIG have the potential to exceed the Street’s estimates. The GOM jackup drillers are well positioned in this group with solid day rate improvements and rollovers at higher-than-expected day rates seen in 3Q08 despite hurricanes impacting manufacturing at RDC’s LeTourneau facility and HERO’s liftboat and barge businesses. HERO expects 3Q08 EPS to be in the $0.36-$0.38 range.

“Considering the recent sell-off, we estimate the OSX has substantial remaining upside, despite the slowing growth. We reiterate our Overweight rating on the sector with a 12-month OSX target of 246,” he says.