Despite the U.S. independent E&P sector's current strong performance, its history of high volatility and cyclicality will continue-and eventually the industry will witness an uptick in default rates. So contends Standard & Poor's Ratings Services in New York. "Clearly, a significant and prolonged fall in commodity prices has the potential to create a new wave of defaults across the industry," says S&P's credit analyst David Lundberg, commenting on the lessons learned from the firm's recent analysis of 15 bankruptcies and several distressed exchanges in the E&P sector during the past 10 years. Given the upward trend in companies' cost structures, oil prices don't need to fall all the way to $10, as in 1999, to see this new wave occur, he insists. In its 1996-2005 study, the credit-rating agency found the more vulnerable upstream companies are those that are both small and undiversified. "At the time of default, 11 of the 15 companies had proved reserves of less than 50 million barrels of oil equivalent (BOE) while eight had reserves of less than 25 million," says the analyst. Also, smaller independents are often less geographically diverse than their larger E&P brethren, he notes. Indeed, several of the 15 operators in the study had a heavy concentration in the Gulf of Mexico, as well as higher cost structures and lower financial resources. "Financial leverage matters," says Lundberg. "Some of the [study's] companies had such high debt levels that their interest expense per unit of production ranged between $6 and $8 per BOE. When such companies already had unlevered cost structures in the range of $12 to $15 per BOE, another $6 to $8 per BOE of cash interest expense proved overbearing, particularly during a time when oil prices stayed below $20 for almost two years." For more on this, see the May issue of Oil and Gas Investor. For a subscription, call 713-260-6441.

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