Reducing CAPEX In Oil

By Eric Fox | February 19, 2009 AAA

Although Forest Oil (NYSE:FST) is suffering from high debt accumulated from times when oil and gas prices were robust, the company is taking the necessary steps to get through the energy bear market and emerge a stronger company on the other side. Forest Oil is cutting capital expenditures (CAPEX), focusing mostly on developing known lower cost properties that will produce fairly immediate cash flow, reducing other costs and extending the term structure of its debt.

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Forest Oil is an exploration and production company with onshore operations in the U.S. and Canada. The company ended 2008 with proved reserves totaling 2.7 Tcfe (trillion cubic feet equivalent) of reserves, 75% of which are natural gas. Forest Oil is active in five core areas in North America, primarily in the Southeastern U.S., the Southwestern U.S. and one in Canada.

CAPEX And Other Cuts
Forest Oil said in a recent filing that it is "significantly" reducing CAPEX and will keep it "within our cash flow from operations". The company will also focus much of this CAPEX toward its core areas. Given the current situation with oil and gas prices, as well as general problems in the economy, Forest Oil's actions appear to be appropriate.

In a further attempt to save costs, the company is also scaling back its use of third party drilling rigs. During the fourth quarter of 2008, Forest Oil leased 43 rigs to develop its properties. Currently, it now leases eight rigs and expects to lease only one in 2009. Furthermore, Forest Oil will utilize company-owned rigs from its Lantern Drilling subsidiary to work its properties. Although it is unusual for an exploration and production company to own rigs, several companies in this sector do, including Unit Corp. (NYSE:UNT), which currently operates 132 rigs in North America. Forest Oil also has a pipeline segment and substantial reserves of oil and gas.

The cutback in drilling rigs by the industry is not encouraging for land drillers like Patterson-UTI Energy (Nasdaq:PTEN). During its most recent conference call, the company reported indiscriminate cuts. Patterson-UTI CEO Douglas J. Wall said, "Virtually no segment of the market has remained unscathed. All [of] our regions, all sizes of rigs have been impacted, and in most cases, it appears that little consideration has been given to the performance and efficiencies of any particular rig."

Extending Term Structure
Forest Oil recently sold a private offering of bonds to institutional investors last week. The issue has a principal amount of $600 million with an 8.5% coupon due February 14, 2014. The bonds were priced below par; therefore, the yield to maturity is much higher at 9.75%. The proceeds will be used to pay down bank debt and reduce the rollover risk associated with its bank lenders pulling or reducing the company's credit line. (Learn more in our bond tutorial section: Advanced Bond Concepts: Yield and Bond Price.)

The Forest Oil story is not without risk, and that is reflected in the yield on the notes that recently were sold to investors. Bond investors usually express the yield on a bond as a spread to the risk-free yield on U.S. Treasuries. The five-year Treasury note had a yield of 1.88% when the notes were priced, producing a spread of nearly 800 basis points. This risk is reflected in the company's ratings of BB-/Ba3, which are considered junk, or non-investment, grade. One encouraging sign comes from the bond-offering amount originally being set at $350 million. Strong investor interest apparently pushed the size of the issue to its final amount of $600 million.

Forest Oil is not the only energy company to access the capital markets recently. Chesapeake Energy (NYSE:CHK) priced $425 million of notes last week at a yield of 10%, an offering that was increased from an original amount of $300 million.

The consequence of Forest Oil's reduction in capital expenditures is that the company essentially will have flat production growth in 2009. The company produced 190 Bcfe in 2008 and its expectations for 2009 are 185-195 Bcfe.

Bottom Line
Forest Oil is taking the correct actions to face the current bear environment in the energy sector in 2009. The company is cutting costs, focusing its drilling on core areas, raising cash to fund operations during the lean times and extending its debt term structure. (Find out how to take advantage of this market without having to open a futures account in A Guide To Investing In Oil Markets.)

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