TEXT - S&P cuts Connacher Oil & Gas to -B-'
Overview -- We are lowering our long-term corporate credit rating on Connacher Oil and Gas Ltd. to 'B-' from 'B'. -- The outlook remains negative. -- We are also lowering our senior secured debt rating on the company's second lien debt to 'B+' from 'BB-'. -- The '1' recovery rating on the second-lien debt is unchanged. -- Connacher has concluded its strategic review process without finding either a joint venture partner or purchaser, so we believe the company's prospective financial risk profile is no longer able to support the 'B' rating. Rating Action On Dec. 6, 2012, Standard & Poor's Rating Services lowered its long-term corporate credit rating on Calgary, Alta.-based oil and gas producer Connacher Oil and Gas Ltd. to 'B-' from 'B'. At the same time, Standard & Poor's lowered its issue-level debt ratings on Connacher's US$550 million and C$350 million second-lien debt to 'B+' from 'BB-'. The recovery ratings on the two debt issues are unchanged at '1', which indicates our expectation of very high (90%-100%) recovery under our default scenario. The outlook remains negative. Our decision in September 2012 to revise the outlook to negative reflected our assessment of the execution risk associated with the timely completion of the company's strategic review process. Connacher has concluded this process without finding either a joint venture partner or purchaser, so we believe the company's prospective financial risk profile, and specifically its cash flow protection metrics, are no longer able to support the 'B' rating. In addition, we believe that, beyond its current liquidity, Connacher's existing operations are not able to generate sufficient funds from operations (FFO) to internally fund its minimum required maintenance capital spending beyond 2013. Although we believe it will continue to seek other forms of external financing, the uncertainty associated with the timing and success of this process further weakens the company's overall credit profile. Rationale The ratings on Connacher reflect Standard & Poor's views of the company's high full-cycle cost structure, weak expected FFO generation, and highly leveraged balance sheet. In our view, these factors hamper Connacher's ability to fully realize the organic growth potential inherent in its large oil sands resource base. We believe that somewhat mitigating these weaknesses are the company's large oil sands resources, the good visibility to long-term drill-bit related production growth, and the potential for strong operating cash flows if it achieves better economies of scale, which we believe is possible with a larger production base. With the completion of its asset sales in fourth quarter of 2012, Connacher's business operations will focus solely on the development of its steam-assisted gravity drainage (SAGD) properties. The company's assets now consist of its wholly owned in-situ bitumen resources in northeast Alberta. Connacher's vulnerable business risk profile reflects our view of the company's prospective cost structure, and the resulting strained profitability. Although we believe Connacher's pro forma adjusted year-end 2011 410.7 million barrels reserves base, which includes its total net proven and probable SAGD bitumen reserves, would support a stronger rating, the company's limited financial resources will make it difficult to exploit the organic growth potential inherent in the SAGD reserves. Our assessment of Connacher's profitability incorporates the effect of the discounted realized prices for its heavy oil production, as well as its high cost structure. In our opinion, the company's unit production costs are high for its SAGD peer group. In addition, Connacher's cost structure reflects the recent increase in transportation costs, which we expect will persist throughout our forecast period. Transportation costs have increased because the company has supplemented its use of trucking with rail transport in an effort to access more distant markets with stronger pricing fundamentals. However, the heightened discounts to West Texas Intermediate (WTI) benchmark prices, which we believe will persist throughout 2013, have adversely affected Alberta netbacks. Based on Standard & Poor's calculated total cash operating costs (production, diluent, transportation interest,, and general and administrative costs) at Sept. 30, 2012, which we estimate at C$84.61 per barrel, we forecast Connacher's FFO will likely fund about half its required maintenance capital spending during our forecast period. Given its limited internal cash flow generation, we do not believe the company will be able to sustain its operations beyond 2013 without significant external funding. In our view, there is no flexibility in the capital structure to accommodate incremental debt; therefore, we believe Connacher will require substantial equity financing to continue developing its Great Divide project, without further weakening its financial risk profile and the ratings. Despite the inability to exploit the organic growth potential inherent in its oil sands resource base, we believe the company's business risk profile could strengthen in the medium and long terms if it can continue exploiting its proven and probable bitumen reserves. Standard & Poor's rating methodology for upstream oil and gas companies with meaningful oil sands resources includes total net proven reserves and probable oil sands reserves in our analysis of the company's competitive position and overall business risk profile. Based on our adjusted reserves base of 410.7 million barrels, which includes 147.8 million barrels of net proven and 262.9 million barrels of probable bitumen reserves, we believe there is above-average visibility to organic production growth inherent in Connacher's upstream portfolio. Although we do not incorporate contingent and prospective oil sands resources into our corporate credit rating analysis, we factor them into our recovery rating analysis, and they contribute to our estimated enterprise value in our default scenario. In our opinion, the very long reserve life index and potential for production growth without the same geological risks associated with conventional oil and gas assets carry strong credit attributes, which should be unchanged in our business risk profile analysis in the medium and long terms. The company's highly leveraged financial risk profile reflects our view of its high debt levels, with fully adjusted debt-to-capital of 75.9% at Sept. 30, 2012, relative to its current and expected operating cash flow. The profile also reflects our analysis of the financial risks associated with the large capital requirements to develop oil sands projects. Based on our discounted crude oil price assumptions, which incorporate heavy oil price differentials of 22.5% for 2013, in conjunction with its high total cash operating costs, we expect Connacher's cash flow protection metrics, specifically its fully adjusted FFO-to-debt, will remain very weak throughout our forecast period, since we do not expect the company will be able to reduce its debt during 2012 and 2013. Connacher might improve its leverage position if it can secure external equity funding. In our view, this would alleviate some of the financial risk inherent in the continued development of the company's capital-intensive oil sands project. Liquidity In our opinion, because it has not been able to complete a joint venture or sale, Connacher's liquidity position will continue to deteriorate through 2013. Nevertheless, we believe the company's existing resources will remain sufficient to fully fund its financing and announced capital spending through year-end 2013, so liquidity should remain adequate during this timeframe. In isolation, its forecast EBITDA in 2012 and 2013 should exceed its financing requirements; however, our forecasts indicate FFO would not be sufficient to fund its minimum maintenance capital spending. Connacher was able to greatly enhance near-term liquidity with the proceeds of the sale of its conventional upstream properties and U.S. refinery. As a result, total current sources of liquidity will exceed expected uses. Pro forma the asset sales, our assessment of the company's liquidity and after repayment of its 2012 debt maturity, estimates net sources of liquidity will cover total expected uses about 2.5x. In our opinion, this provides sufficient resources to meet its expected 2013 spending requirements. Recovery analysis For the complete recovery analysis, see the recovery report published Sept. 24, 2012, on RatingsDirect on the Global Credit Portal. Outlook The negative outlook reflects our opinion that Connacher's internal cash flow generation is not sufficient to sustain its current operations. Without the liquidity enhancement from the sale of its conventional oil and gas assets and refinery (completed in fourth-quarter 2012), we do not believe the company would be able to fully fund its ongoing financing and maintenance capital spending requirements. Although we believe Connacher's cash resources, pro forma the asset sales, should allow it to fund its announced capital spending through year-end 2013, its liquidity position will begin to deteriorate within the next 12 months if it cannot secure external equity funding to sustain its current operations and continue expanding its multiphase SAGD project. We believe the liquidity position will deteriorate more rapidly in the second half of 2013. Standard & Poor's now believes there is significant uncertainty regarding the company's ability to secure external equity financing during our 12-month forecast period for Connacher; so we believe there is heightened risk of a further negative rating action. Based on the company's cash flow profile relative to its financing and maintenance capital spending requirements, there is no likelihood of a positive rating action without a transformative transaction. Related Criteria And Research Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012 Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 Canadian Oil Sands Projects: How We Rate Them, And Why, March 17, 2011 Ratings List Connacher Oil and Gas Ltd. Ratings Lowered/Recovery Rating Unchanged To From Corporate credit rating B-/Negative/-- B/Negative/-- Senior secured debt B+ BB- Recovery rating 1 1
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