Higher O&G Prices Could Reduce AROs for Upstream Companies

Fitch Ratings reports that higher year-over-year crude and natural gas prices in 2010 may reduce the size of reported Asset Retirement Obligations (AROs) for upstream U.S. oil & gas producers, by extending existing field lives and thereby delaying the remediation costs and associated present value (PV) of related retirement obligations.

However, other longer term factors remain in play in the sector which likely will continue to add pressure to the growth of future AROs, including inflation in key input costs such as rigs, boats, skilled labor costs, cement and other site remediation costs, a push by the industry into the offshore, and increased offshore regulations, especially in the Gulf of Mexico (GoM) following the Deepwater Horizon spill.

Output under production-sharing contracts also are an exception to the positive reverse revisions and lower PV of retirement obligations for existing fields from higher oil and gas prices, since output under production sharing contracts moves inversely to prices.

Growth in AROs is likely to continue to vary widely by company and upstream portfolio mix, with integrated and larger independents, the group whose growth prospects are most clearly tied to offshore and deepwater prospects, likely to see the largest growth in AROs relative to debt, while purely domestic onshore names, including companies primarily involved in shale gas and shale liquids plays, are expected to show more modest growth in AROs relative to debt.

As a result, AROs are a relatively small component of total liabilities for North American onshore producers relative to debt obligations. The low growth in AROs relative to debt for this group is due not only to the lower cost of remediation for onshore wells relative to offshore, but also to a greater preference among smaller producers to fund reserve and production growth with debt.

In contrast, integrated and large independent companies had cumulative growth in AROs slightly higher than 128 percent from 2005 to 2009, but was matched against a more conservative debt profile, with debt growing only a cumulative total of 75 percent between 2005 and year-end 2009. Cumulative reserve growth was nine percent for this group and reflects the ongoing difficulty among larger entities, particularly supermajors, to move the needle in terms of reserve growth.

The greatest increase in ARO among offshore independents was seen at Anadarko Petroleum Corp. with a 472 percent increase, which was driven by an aggressive drilling program and the build-out of key deepwater positions in the GoM, West Africa and Brazil. Anadarko’s growth in debt was also significant at 247 percent, fueled by the all-debt-financed acquisition of Kerr-McGee Corporation and Western Gas Resources Inc; however, reserve growth was down by six percent over this period, as asset sales were subsequently used to pay down acquisition debt.

Among larger integrated companies, Chevron's ARO grew 136 percent while its balance sheet gross debt fell 18 percent over the same time frame. Chevron is one of largest deepwater players in the GoM, with stakes in Tahiti, Jack/St. Malo, Perdido, and Big Foot discoveries. Chevron also has extensive deepwater exposure in West Africa, Brazil and Asia.

Noble Energy Inc. experienced a 32 percent reduction in ARO from 2005 to 2009 when it was impacted by Hurricanes Katrina and Rita, which resulted in extensive platform damage for assets in the GoM and accelerated the company's plugging and abandonment (P&A) activity in the GoM.

A third group of companies, which have either transitioned from the offshore to the onshore or are transitioning, have seen or are likely to see reductions in AROs as offshore fields with higher liabilities are sold. This group includes Devon Energy, which exited all offshore plays with 2010 asset sales as it refocuses on North American onshore plays, Forest Oil, which spun off its GoM subsidiary in March 2006 to Mariner, and Newfield Exploration, which divested its shallow water properties in mid-2007 to McMoRan Exploration Co. The sale included the transfer of all associated asset retirement obligations.

Oversight of drilling activity, including (P&A) activity, has increased following the Macondo spill in the GoM, and heightened scrutiny of offshore operations is expected to persist for years. Regulations issued by the Bureau of Ocean Energy Management, Regulations and Enforcement that requires that platforms deemed no longer useful for operations must be removed as soon as possible but no later than Oct. 15, 2015, and that wells on expired leases must be plugged permanently on a lease within one year after the lease terminates, either by relinquishment, expiration, cancellation or forfeiture. Additional tightening of P&A requirements affect P&A expense by either increasing expense associated with well plugging or accelerating the timing of P&A.

AROs are a key liability for exploration & production balance sheets which can have a wide-range of potential credit impacts. In terms of liquidity, lower-rated or smaller producers may be required to provide assurance to regulators or other parties that they are financially able to meet future remediation costs through Letters of Credit (LOCs), surety bonds, or other assurances, all of which can lower liquidity. AROs are also a factor in the consideration received for a property in a sale.

However, it is important to note that AROs also have characteristics of 'soft obligations'--unlike straight debt for example, an ARO can be effectively deferred through a successful drilling program which extends the life of an existing field and therefore delays the ultimate date of site remediation.


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