?The larger companies generating free cash are better positioned to benefit from the current economic downturn. This is according to Tudor, Pickering, Holt & Co. Securities Inc. analysts Michael Jacobs and David Keikkinen, after a meeting with Steve Chazen, chief financial officer of Occidental Petroleum Corp.
Chazen offered a somber prediction for the credit markets for the next year, “suggesting ongoing financial market turmoil has resulted in a crippled ability to finance any sizeable deals and implying that there won’t be significant buyers of properties any time soon.?
“Alternatively, he believes many near-term deals may take the form of stock-for-stock over the next six months, as troubled companies look to merge with others.”
This bodes well for cash-rich companies like Occidental, which had $1.5 billion in cash on June 30 and is expected to generate another $3.5- to $4 billion in 2009 of free cash flow, Jacobs and Keikkinen report.
“Deals are coming...just not in the near future. In a market with limited access to capital, selling free-cash-flow-negative properties becomes extremely difficult, as those asset values are only maximized with rigs being put to work—and spending is scarce with tight capital dollars.”
Chazen suggested that there is little industry distinction between oil or gas deals, but that investors should focus on cash flow.
“There was a suggestion that some companies—perhaps in dire straits—may sell free-cash-flow-positive assets to fund recently acquired acreage,” the analysts report. The larger-cap companies with strong balance sheets “have seen the writing on the wall and recognize the strategic benefits of sitting on cash, in the event that financing difficulties persist.”
Companies with below-average cash-flow plowbacks in 2009 may continue to build cash during the next three to six months while cash-strapped companies rein in spending and do not benefit from accelerating development of their inventory.
“Although corporate deals could take some time to develop, at some point, buyers could come in and strike a middle ground. This middle ground would allow buyers to get assets on the cheap, while sellers could participate in the equity upside with accelerated drilling.”
Capex budgets are being slashed and rigs are being released.
“When looking at international, versus domestic, service costs, it appears that there remains significantly more pressure on the domestic side. Occidental believes natural gas drilling should fall off, causing rig rates to plummet. Relatively speaking, international service companies should fare better as those contracts tend to be a little stickier, as they require government approval. Oxy indicated that steel costs are already coming down significantly, as are tubular costs.”
The implications are that many of the companies in the E&P sector will need additional access to capital “to fully realize the benefit of their strong acreage positions. However, the near-term outlook for credit markets is bleak, and there aren’t too many buyers of free-cash-flow-negative properties.
“In fact, there unfortunately aren’t too many companies generating material free cash flow outside of the large-cap space, which suggests that large-cap E&Ps should continue to outperform for the next six to 12 months. While this may pose a problem for small- to midcap portfolio managers that want to own resource plays to have exposure to E&Ps, we still see some value out there that should not have any problems weathering the storm.”
The analysts report their favorite midcap companies are Southwestern Energy Co., Concho Resources Inc. and Plains Exploration & Production Co.

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