The bloodbath in the exploration and production sector, over the last week, has been attributed mainly to lower oil and natural gas prices as the market discounts a possible second recession and the resulting negative impact on global economic growth.
Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

While it is obvious that earnings will decline with commodity prices, investors should also consider the collateral effects of a drop in cash flows for these companies. These collateral impacts include insufficiently funded capital programs for 2011 and beyond, along with possible reductions in production growth if these companies are forced to cut capital spending.

Capital Intensive
Exploration and production companies are constantly reinvesting cash flow back into the ground to keep production and reserves from declining. This capital intensity has caused many companies to have underfunded capital plans for 2011 and 2012, even using relatively optimistic price assumptions for oil and natural gas. This gap will only increase if commodity prices drop further and a lower forecast becomes the consensus. (For related reading on capital budgeting, see Which Is A Better Measure For Capital Budgeting, IRR Or NPV?)

Deutsche Bank reports that a number of exploration and production companies, under its coverage, will generate insufficient cash flow to fund announced capital budgets in 2011. This analysis assumes that oil prices average $90 per barrel in 2011.

Oasis Petroleum (NYSE:OAS) has a $380 million funding gap in 2011 using the above prices for oil. The company has enough cash and borrowing capacity to meet this shortfall but may need to look for financing in 2012. Brigham Exploration (NYSE:BEXP) will fall $530 million short of funding its 2011 capital budget, and can meet this shortfall with cash and borrowing. Whiting Petroleum (NYSE:WLL) will have to plug a $400 million funding hole in 2011 and will have to meet this mainly through increased borrowing.

Funding the Gap
Exploration and production companies have a variety of methods to pay for capital budgets if free cash flow is inadequate. The company can use cash, borrow funds on an existing credit line or issue debt in the market.

Asset Sales
Another common method is through the sale of oil and gas properties that the company may consider to be noncore. SandRidge Energy (NYSE:SD) recently announced the sale of natural gas properties in East Texas for $231 million. The company plans to direct these funds towards the development of oil and liquids properties in its portfolio.

Joint Ventures
Some companies use joint ventures to help finance capital programs. Chesapeake Energy (NYSE:CHK) is looking for a joint venture partner to help finance its Utica Shale development program.

Equity Anyone?
Issuing equity is another method to fund shortfalls in capital spending, but this type of financing is the most disturbing to the market, which has an aversion to any type of dilution. (Investors need to be aware of the existence of dilutive securities and how they can affect existing shareholders. For more, see The Dangers Of Share Dilution.)

Capital Spending Cuts
Operators also have the option of reducing capital budgets in a worst case scenario where these funding options are not available. However, a cut here will trigger reductions in production growth guidance for the company.

The Bottom Line
During the depths of the financial crisis when capital markets closed for many companies in the energy sector, the stocks started to trade on the strength of balance sheets. Investors should monitor these attributes as well as traditional ones in the sector before jumping in.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Markets

    The 5 Biggest Chinese Natural Gas Companies

    Read about the top five Chinese natural gas companies as measured by gas production volume and learn a little more about their business operations.
  2. Economics

    Who Wins With Low Energy Prices? 

    Low oil prices are here to stay for some time. Which economies will benefit or lose from the low oil price regime?
  3. Options & Futures

    Analyzing The 5 Most Liquid Commodity Futures

    Crude oil leads the pack as the most liquid commodity futures market, followed by corn and natural gas.
  4. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  5. Savings

    Do Natural Gas Prices Always Follow Oil Trends?

    Prices for oil and natural gas are highly correlated. But investors should be aware of different factors affecting the prices of these commodities.
  6. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  8. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. Benchmark Crude Oil

    Benchmark crude oil is crude oil that serves as a pricing reference, ...
  5. Unconventional Oil

    A type of petroleum that is produced or obtained through techniques ...
  6. Green collar

    A worker who is employed in an industry in the environmental ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!