Analysis: Fitch Sees Stable Outlook for Latin America O&G Industry in 2011

Fitch Ratings expects the credit outlook for the Latin America oil and gas industry to remain stable in 2011, supported by solid global demand for oil and moderate improvement in operating margins, according to a new report released by Fitch Ratings.

Overall, the Latin American oil and gas sector's revenues and earnings improved in 2010 due to rising oil prices and the recovery of domestic demand. As a result, the companies have registered solid credit metrics and reported a strong liquidity.

Many Latin American national oil companies (NOCs), including Petrobras, PEMEX, Ecopetrol and PDVSA, have raised their investment programs to support the growth in global energy demand, and have set aggressive oil and gas production volume targets. Capital expenditures (CAPEX) by the region's five NOCs are projected to be US $440 billion over the next five years in aggregate, Fitch noted.

In addition, the extensive production growth programs include operating in non-traditional challenging areas that will require the use of higher cost technology, and operating in higher cost deep water areas, which will put upward pressure on CAPEX.

"Most sector companies will require funding from external sources to implement their investment programs,' said Ana Paula Ares, senior director of Fitch Ratings. Fitch estimates that approximately US$150 billion of financing will be required to fund CAPEX and other uses of cash for the NOCs, and only 66 percent of internal cash generation will meet internal funding needs. "We anticipate strong financial support from the local financial community and the capital markets for the regional oil companies."

Fitch notes that most companies have the capacity for additional debt, enjoy strong support from the domestic and international financial markets and benefit from solid liquidity, with regional governments providing liquidity to the NOCs through state-owned banks, including the Brazilian Development Bank (BNDES). Additionally, China has signed loan and lines of credit for oil agreements with Petrobras and PDVSA.

"The ratings of the NOCs are supported by their close ties with Latin American governments," Fitch said, noting that the stream of funds the NOCs provide to the governments will continue to be an important source of funding for many of the countries, particularly Venezuela and Mexico. However, the combination of high payouts to the governments in the form of taxes and royalties in addition to high investment levels may in some cases lead to negative cash flow.

Despite the possibility of negative free cash flow, Fitch does not expect any significant changes in the legal, operational, and strategic ties with the governments in 2011 that would result in a material change in the linkage between the sovereign and NOCs' ratings.

The sector could move to a negative outlook if global oil and natural gas demand declines sharply or for a long period, or if debt funded CAPEX is significantly above Fitch's current expectations. Fitch believes a move to a positive outlook is unlikely given issuer focus on capital investments.

"Improvements in operating cash flow generation are unlikely to lead to any sustained deleveraging as funds will mainly be used to support the increase in production and reserve base and/or will be transferred to the governments, resulting in a decrease to negative free cash flows for most NOCs," Fitch said. Petrobras and Ecopetrol have announced aggressive production targets of 3.9 million BOE/d and 1.0 million BOE/d by 2015, respectively, while PEMEX is investing to stabilize production volumes at 3.7 million BOE/d.

Both privately owned YPF and PEMEX are investing to arrest declining annual production rates, and have adopted several measures, including the application of secondary and tertiary recovery techniques to the existing fields. During 2010, PEMEX gradually stabilized production volumes due to the more intensive use of technology in the Cantarell field and increased drilling activities in Chicotepec, although Fitch notes that it is too early to decisively discount the possibility of future declines in oil production.

Companies also may face increased regulatory and environmental controls and compliance costs following the Macondo oil spill in the Gulf of Mexico, which could add further upward pressures on cost, particularly for offshore companies such as Petrobras and PEMEX and change the outlook for 2011.

Fitch noted that the continued U.S. economic recovery, combined with continued robust economic and energy demand growth from China and India, are key drivers to current market prices. Additionally, a concern regarding U.S. monetary policies and the resulting expectations of inflation is a key non-fundamental factor resulting in oil prices continuing to exceed Fitch's long-term price expectations.

"Should the U.S. experience a "double-dip" recession of should economic growth slow in China or India, some of the premium currently embedded in oil prices could disappear," Fitch said.


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