In 1909, John Moody introduced a simple grading system for U.S. railroad bonds that summarized their credit quality. He expressed his investment conclusions using letter-rating symbols. With that act, he became the first to rate public market debt securities. Perhaps not since Nathaniel Hawthorne's 19th-century novel, The Scarlet Letter, had a character in the alphabet carried such significance, this time for investors. In 1913, Moody expanded his base of analyzed companies to include industrial firms and utilities. By that time, his ratings had become a factor in the bond market. Nearly a century later, they're a dominant factor. Currently, Moody's Investors Service rates more than 150,000 debt obligations issued by thousands of corporations and governments in some 100 countries. Roughly 3,000 of the world's largest institutional investors-buysiders who manage an estimated 80% of all the capital in the global fixed-income markets-rely on Moody's ratings for guidance. "Our ratings are designed to provide investors with a framework for comparing the relative credit quality of various public debt securities," says John C. Diaz, managing director of Moody's energy group in New York. "We analyze such factors as the financial strength, default probability and loss severity of fixed-income instruments in various sectors. "In so doing, we provide investors with reliable, objective risk assessment so they can make informed investment decisions-not only about the purchase and pricing of debt instruments, but also about whether a given issuer will repay its rated obligations on time and in full." Meanwhile, the public debt issuers also benefit from the credit-rating system. "It allows them to access the capital markets, thereby improving liquidity for their offerings. Hopefully-depending on the rating-it may also lower their cost of capital," he says. "Also, the intermediaries or bankers that put together debt transactions benefit from a rating system that allows them to sell bonds in an efficient manner." Without a doubt, debt ratings play a very important role in today's capital markets. How much so? Consider this: domestically and internationally, there are now more than $80 trillion worth of rated bonds and other fixed-income securities. To understand what goes into a Moody's debt rating for a publicly traded or private energy company is to understand the bottoms-up approach to the firm's analysis. "We start with the macroeconomic picture," says Diaz. "This takes into account the relative political and economic risks that may exist in a country where an oil company is operating. If a country is unstable, that becomes a negative for the operator's debt rating." The second step is sector risk analysis. Integrated oils with both upstream and downstream operations tend to have sizeable, stable cash flows and hence, would be candidates for Moody's highest ratings-Aaa or Aa. Independent E&P companies, because they're more exposed to fluctuations in commodity prices, have a higher risk profile. "Those with the least leverage and most diversification within this sector probably wouldn't get higher than a single-A rating," says Diaz. "On the other hand, oilfield service companies, which have become less risky in recent years because of consolidation, have the potential for a rating as high as Aa3, which is what the bonds of Halliburton have recently carried." Third, Moody's weighs regulatory environment risk, globally and domestically, as well as competitive trends in a given energy sector. Right now, the firm is looking closely at the megamergers like BP Amoco, "which are going to put a lot of pressure on the whole oil and gas industry-smaller integrateds and independents alike-to restructure over the next couple of years." Fourth, the rating agency studies a firm's market position. In the case of E&P companies, this means scrutinizing the size, location and composition of its reserves-developed versus undeveloped-and its ability to generate revenues and grow from that base over time. Anadarko Petroleum, for instance, which has a strong, long-life, gas-reserve position domestically in the Hugoton Field, has been able to take cash flow from production there and reinvest it profitably overseas. The next step: quantitative analysis. This involves screening a company's financial statements and evaluating its past and likely future performance. In the case of E&P operators, it means analyzing their cash flow-to-debt, cash flow per equivalent barrel of oil and finding costs. "If a producer is able to generate more than enough cash to service its debt and cover its ongoing capital spending, it's growing," says Diaz. "If its cash margin divided by finding costs is a ratio of less than one, it has a shortfall in its ability to grow-and that would be a negative for its debt rating." Last, but not least, is qualitative analysis. This is where Moody's zeroes in on a company's strategic direction, financial flexibility and management. Says Diaz, "We want to know what a management team's appetite for risk is." In the case of E&P companies, does management intend to use future cash flows in riskier areas internationally or for exploration in the deepwater Gulf of Mexico? Will it take debt to the maximum to do an acquisition, or will it issue some equity to cover that move? Does it have contingency plans to deal with unexpected events, such as a collapse in commodity prices and the attendant unavailability of the equity markets? Does it have a track record of meeting its projections? The answers to these questions carry significant weight, in terms of how the agency rates a producer's bonds. Andrew Oram, vice president and senior analyst in Moody's energy group in New York, points to several E&P companies that pass the firm's quantitative and qualitative ratings tests with flying colors. "Seasoned producers like Apache, Newfield Exploration, Cross Timbers and Santa Fe Snyder have relatively efficient full-cycle cost structures. They're able to find or buy reserves cheaply relative to their margins, produce them cheaply, generate positive cash-on-cash returns from that production after interest expense, and plow money back into the ground to sustain growth internally-even during troughs. That makes them durable and their debt less risky for bondholders." These producers have also shown discipline during up cycles. "During those periods, they typically don't overpay, overbuy or overleverage when everything's more expensive; instead, they keep their powder dry until the bottom of a cycle, when producing properties and services are cheaper," says Oram. "In addition, the managements of these companies-people like Newfield's Joe B. Foster-are usually proactive in issuing equity for an acquisition, meaning they'll issue equity when the market's available, not when they absolutely need it and the market isn't there anymore because of an unforeseen price collapse." Alexandra S. Parker, vice president and senior credit officer in Moody's energy group, cites a producer that didn't follow that strategy. "Not long ago, Pioneer Natural Resources found itself between a rock and a hard place. After aggressively pursuing acquisitions that were financed primarily with debt-right before oil prices began falling in 1998-it was unable to issue equity because the market had gone away," she says. "As a result, the company, whose debt we downgraded from a Baa3 to a Ba2 with a negative outlook, had to restructure and sell assets. It's a classic example of the need for operators to plan not only for the upswings, but the downturns." Colleague Helen Calvelli, a vice president and senior analyst in Moody's energy group, notes that the same fate befell Eagle Geophysical. "This service company had made some large investments in good assets when the industry was really hot in 1997," she says. "Then, when oil prices fell and E&P companies cut back on their spending the following year, Eagle's liquidity was squeezed because it was carrying debt on assets that couldn't be employed at the levels they projected." Recently, Moody's downgraded Eagle's debt rating from Caa2 to Ca. Turning to the fine line that Moody's walks between helping investors and issuers alike, Oram cites two successive ratings on the debt of an offshore driller. They not only gave the agency credibility with investors, but also ultimately worked to the favor of the issuer. "Early in 1998, a newly merged offshore driller went to market with a major bond offering and the buyside bought the paper up like it was an easy crossover or investment-grade credit," he explains. However, unlike other agencies, Moody's didn't give the issue an investment-grade rating. Citing a wide range of major operating, liquidity and industry challenges that could derail the credit, the rating agency instead upgraded the company's bonds from Ba3 to Ba1-the top of the high-yield-rating range. Later in 1998, when those challenges surfaced, Moody's had a lot of credibility with the buyside-and so did its modest downgrade on the driller's debt, from Ba1 to Ba3, versus other agencies' more precipitous downgrades. Says Oram, "This helped the driller get a subsequent bond issue off that might otherwise have experienced difficult execution in the capital markets-at any price." The analyst's outlook for the E&P and service sectors? "For those troubled companies in the lowest end of the ratings spectrum, things aren't going to get much better. Some of them with better assets, however, may resurrect in the hands of different owners, or with a reorganized capital structure, and we'd look forward to helping them access the public debt markets," he says. "Higher up the ratings chain, there'll likely be some single-B credits that will graduate to Ba, and some Ba's that may migrate up to investment-grade status, which is Baa. These, again, will be companies that are good recyclers of capital. In particular, we see a lot of opportunity for E&P companies that are accessing equity now to reload for growth, in preparation for the spinoffs coming out of the majors." Parker is cautiously sanguine about the outlook for service companies over the long term. "Because of consolidation within that sector, we've ended up with investment-grade companies that carry an average Baa rating," she says. "These are companies that now have the diversification and size to withstand industry downturns. "This includes Halliburton, which has non-oilfield operations that have helped stabilize its earnings, Baker Hughes and Weatherford International. Among offshore drillers, we see consolidation continuing, as witnessed by Transocean's recent announcement that they're buying Sedco Forex. Again, the strategy is to be a sector leader, such that when there is a downturn, contracts with large oil companies would be least likely to be canceled." Two events also helping to shore up the debt ratings of offshore drillers like Transocean and Diamond Offshore are oil-company spending on deep water and far fewer speculative new builds in the rig fleet, says Parker. "That's something we expect to continue." Calvelli shares Parker's guarded optimism. "The demand for oil services is coming back. This doesn't mean that debt ratings will go up. But I think we've seen the worst. In 2000, there should be fewer downgrades, with more potential for upgrades." Thomas S. Coleman, senior vice president in Moody's energy group, says that the debt-rating outlook for the major integrated oils is stable to improving, with the average rating now about Aa3. "The big event in this sector, of course, has been the recent spate of megamergers-driven by the desire for more dominant market position, greater global reach, bigger reserve bases, cost synergies, superior access to low-cost capital and, in some cases, the ability to combine complementary parts of the business without asset overlap," he says. "There are probably more of these mergers to come, which will be positive for the credit-worthiness of the new, combined entities." The impetus for future mergers? "The fear of being left behind and being marginalized in an industry that requires huge amounts of capital and diversification to compete," says Coleman. "Right now, we're witnessing a triple tiering of the industry. At the top are BP Amoco, Exxon Mobil and Royal Dutch/Shell; in the middle, Chevron, Texaco, ENI, TotalFina, Elf Aquitaine, and Repsol-YPF; and at the bottom, Conoco, Phillips and Amerada Hess. Clearly, the companies in the middle and bottom tiers recognize they have to do something to keep up." Also needing to keep up with change and competition are the pipelines and utilities. Regulated local gas distribution companies carry an average A2 rating, and interstate gas pipelines, an average, lower Baa1, due to their diverse activities and higher business risk. "The big event we've seen during the past year is the convergence of the natural gas and electric utility industries through mergers," says Mihoko Manabe, a vice president and senior analyst in Moody's energy group. "From a credit perspective, these mergers have been on average slightly positive for the gas companies and slightly negative for the electric utilities, which are rated higher. Still, it's too early to tell if the new, combined entities will achieve improved credit quality." Says Manabe, "Some of the parent electric utilities that have acquired natural gas companies are so busy trying to grow through other acquisitions that improving the financial results of their gas affiliates is still low on their priority list. However, we expect to see those utilities focus more on synergies in 2000, to the benefit of their gas affiliates." Stephen G. Moore, vice president and senior analyst in Moody's energy group, rates the credit worthiness of global energy project financings. "In August 1998, the capital markets for emerging-markets project financing effectively shut down," he says. "A victim of that shutdown was the $4.6-billion Sincor Project to lift heavy crude from Venezuela's Orinoco Belt and export that product. However, looking out over the next six months, we believe the Sincor Project will go back to the bond market, which is beginning to come back. In fact, the Q-Chem project-aimed at downstream development in Qatar-has already approached the bank market and is now waiting to go to the bond market." Moore says there's no shortage of demand for crossborder project financing once the emerging-markets capital markets bounce back. "Developing nations require foreign capital and expertise. Also, most major energy developments are occurring outside North America, in places like the Caspian Sea region, the Middle East and offshore Latin America. Meanwhile, major oil companies are looking to fund projects in those areas in a way that mitigates their risk." Risk. It's what the oil and gas industry faces every day. And it's what Moody's tries to mitigate for investors every day, while at the same time helping issuers access the public debt markets-one hopes, at a low cost of capital.

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