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.
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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.

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