Electricity provider and gas magnate Origin Energy Ltd (ASX: ORG) finds itself in an uncomfortable situation after credit rating providers Standard & Poors indicated the company was running out of wriggle room.
Standard & Poors and Moodys both cut Origin Energy’s rating to the lowest possible level – just above junk status – back in April, and S&P recently indicated that, as a result of its latest oil price forecasts, Origin had experienced a significant reduction in its buffer before being downgraded.
Credit ratings are quite important for oil and gas producers at the moment as they determine the ability of companies to borrow money and interest rates they must pay in order to compensate lenders for the risk.
For companies like Origin and Santos Ltd (ASX: STO), which are struggling under low revenues and enormous debt, credit ratings can be make or break.
A company without an ability to source suitable finance and with repayment dates looming might be forced to issue corporate bonds at unconscionable rates, much like Fortescue Metals Group Limited (ASX: FMG) earlier this year.
Fortescue now pays interest rates of almost 10% on its bonds, and so investors are understandably worried that Santos and Origin might face a similar fate. However, there is one bright spot to the situation and that is the fact that rating agency forecasts for commodity prices are often questionable.
Standard & Poors will adjust its forecasts to reflect prices on offer in oil futures markets, which to my mind defeats the purpose of making a forecast since they effectively borrow the market view rather than providing independent commentary.
I covered the topic in more depth in my article back in January, but there are also instances where forecasts have absolutely no correlation to reality. In mid-June last year, S&P released forecasts for iron ore which suggested the commodity would trade at around US$95 for 2014, 2015, and 2016. Iron ore prices at the time were in the high US$80s, and there was ample evidence of massive oversupply coming.
Iron ore prices now trade at US$56/tonne. Price targets from rating agencies and analysts are inherently fallible, and I would suggest that all is not lost for shareholders in Origin Energy and Santos Ltd.
With that said, any investment in Origin or Santos right now is a highly leveraged bet on where oil prices are headed next.
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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.