oil and gas sector exploration and production rating methodology

Corporates

www.fitchratings.com 6 April 2010

Energy (Oil & Gas) Global SectorSpecific Rating Criteria

Rating Oil and Gas Exploration and Production Companies Sector Credit Factors

Summary Consistent with the master “Corporate Rating Methodology”, dated 24 November 2009, the rating of oil and gas producers reflects both qualitative and quantitative factors encompassing the business and financial risks of companies and their debt. However, oil and gas companies are differentiated from other corporate sectors in that they are significantly exposed to crude oil and natural gas commodity prices and the resulting volatility in cash flows associated with them. In addition, upstream companies have depleting asset bases which require substantial reinvestment to replace reserves.

Because of these over‐arching issues, credit profiles are typically distinguished by lower levels of financial leverage in the sector than for an ‘average corporate’ across all rating categories. Additional financial metrics, including debt/barrel of oil equivalent (boe) of proven reserves and other cash flow‐based sector metrics, assist in the analysis of the overall financial leverage of companies in this sector. Operating metrics for the sector reflect reinvestment requirements to maintain the asset base, and the ability of the assets to generate positive free cash flows (FCF) to service debt.

Key drivers evaluated for upstream companies include the level of debt relative to the asset base, and the cash flow generation ability of the company across a range of business and operating market conditions. In addition, Fitch Ratings examines an entity’s reserve size, location, diversity across fuel types, reserve life, and ability to replace reserves economically over time. Fitch examines the firm’s production profile, including size of production, production costs, and realisations (which are impacted by location, fuel mix, and taxation issues). Because of the commodity nature of the business, adequate cost control is an over‐riding concern. Full cycle costs, and the ability to generate sufficient cash flows to reinvest in the company’s asset base and sustain it over time, remain a primary focus of the analysis.

This report defines and groups the ratings of companies operating in the sector into natural rating territories, based on Fitch’s view of the inherent risk profile of the industry or sector as a whole. For example, pure exploration and production companies would tend to have their ratings limited to, at best, the ‘A’ rating category, due to the sector‐specific risk profile in which these companies operate. By contrast, large and diversified integrated oil and gas companies could achieve more robust profiles and be rated up to the ‘AAA’ rating category.

Sector Risk Profile Oil and gas exploration companies, including both independents, pure upstream‐ focused companies, and integrated oil and gas companies, have a number of common risks associated with the industry, including:

• depleting asset bases and a need to continually reinvest in operations;

• cyclical earnings and cash flows stemming from:

o commodity price exposure;

o fluctuations in demand associated with the business cycle;

Analysts European Corporates Jeffrey Woodruff, CFA, FRM +44 20 7682 7322 [email protected]

Erwin Van Lumich, CFA +34 93 323 8403 [email protected]

Andrew Steel +44 20 7682 7486 [email protected]

US Corporates Sean T. Sexton, CFA +1 312‐368‐3130 [email protected]

Mark Sadeghian, CFA +1 312‐368‐2090 [email protected]

Adam M. Miller +1 312‐368‐3113 [email protected]

Asia/Pacific Corporates Steve Durose +61 2 8256 0307 [email protected]

RelatedResearch Applicable Criteria • Corporate Rating Methodology

(November 2009) Other Research • US Exploration and Production ‐ Recovery

Rating Methodology (March 2008) • Parent and Subsidiary Rating Linkage

(June 2007) • Evaluating Corporate Governance

(December 2007)

This report is an addendum to the overarching master “Corporate Rating Methodology”, dated 24 November 2009. The Corporate Rating Methodology describes the criteria applied by Fitch Ratings when assigning corporate ratings. This addendum provides a high‐ level overview of how those criteria are most frequently applied to companies in this sector. Users are referred to the Limitations section on page 9 of this report.

/creditdesk/reports/report_frame.cfm?rpt_id=489018




Corporates

Rating Oil and Gas Exploration and Production Companies April 2010 2

• geopolitical considerations, including: changing tax structures/regimes; potential expropriations of assets; and exposure to man‐made disasters (war);

• environmental policy exposure and resultant taxes/charges;

• impact of extreme weather on production and shipment;

• technological development enhancing the ability to exploit new and existing resources.

In addition to the common risk features impacting all firms in the sector, the following summary of inherent risks for entities operating in the oil and gas sector indicates acceptable risk parameters commensurate with the following rating categories:

Oil & Gas Exploration & Production (E&P) Entities – typically ‘AAA’ to ‘AA’ Rating Categories • Typically large global operators with economies of scale.

• Diverse operations across fuel mix, geographic locations, and business lines (downstream, chemical, liquid natural gas (LNG), pipelines etc).

• Minimal financial leverage throughout industry cycle.

• Strong full‐cycle economics and positive free cash flows.

• Strategic importance of entities ‐ often evidenced by international (sovereign) negotiations on their behalf for long‐term projects, and a clearly stated sovereign goal, demonstrating long‐term financial stability.

Oil & Gas E&P Entities – typically ‘A’ to ‘BBB’ Rating Categories • Typically large operators with diverse upstream operations.

• Lacking diversity beyond upstream operations (not present across the entire value chain).

• Increased focus on growth in reserves and production driving higher levels of capital expenditures relative to operating cash flows and resulting in higher reserve replacement metrics.

• Increased use of balance sheet to finance growth.

• Strong full‐cycle economics and positive/neutral FCF across industry cycles.

Oil & Gas E&P Entities – typically ‘BB’ to ‘B’ Rating Categories • Small, less diversified operators and potentially single asset risk.

• Primarily upstream focus with more volatile (and often negative) cash flows, as these firms are heavily growth‐focused.

• Focus on smaller legacy assets resulting in extreme cost management focus.

• Increased use of hedges to mitigate cash flow volatility.

• Reserve development requires large initial capital investment.

Key Credit Factors • Type of entity and size

• Reserve size and quality

• Reserve replacement and reserve life

• Full cycle and F&D costs

• Production measures

• Financial metrics, through the cycle

Corporates


1,500 <1.0 <1.0 >5.0 ‐‐ ‐‐ Very Small >USD20/boe (as per BB) B

Other Factors Sector Risk Profile Financial Profile (Historical where relevant and forecast, mid points) Company‐Specific Traits

Building Blocks ‐ Oil & Gas Sector (Integrated Companies)

4.500

9,000

15,500

36,600

Size (Annual) EBITDA ‐

USDm)

1.0 <1.0 >5.0 10 >2.5

Small >USD20/boe • Small • <60%

developed • FD&A costs:

>USD25/boe

BB

1.3 >1 ‐ <3 2.0 – 5.0 15 1.5

Medium to Small

>USD10 ‐ <20/boe

• Medium • <60% or

>80% developed

• FD&A costs: >USD15 – <USD25/boe

BBB

1.7 >1 ‐ <3 2.0 – 5.0 20 1.3

Medium >USD10 ‐ <20/boe

• Medium • 60% ‐ 80%


>USD15 – <USD25/boe

A

1.7 >3 2.0 25 1.0

Large <USD10/boe • Large • 60‐80%

developed • FD&A Costs:

<USD15/boe

Integrated players: benefit from diversity and spread of projects – smoothes out volatility

• Essential global commodity • Depleting resource • Natural hedge to

commodity price fluctuations from diversity across fuel types

• Commodity price exposure • Significant cost focus due to

commodity nature of industry

• Cyclical industry

AA

AAA

CFO/Capex (x)

Debt/ Proved

reserves ($/boe)

FFO Gross interest

cover (x)

FFO Lease‐ adjusted

leverage (x) Production size

Cost of production Reserves Sub‐Sector

Indicative factors observed or extrapolated for rated issuers in developed markets. Ratio levels refer to the midpoint of a throughthecycle range; actual observations are likely to vary from these. Certain subsectors may contain a small number of observations; where no observations currently exist, guidelines for a category are extrapolated based on Fitch judgement. The factors give a highlevel overview and are neither exhaustive in scope nor uniformly applicable. Additional factors will influence ratings, particularly in emerging markets and where group relationships constrain or enhance a rating level.

Cycle ratio (x)

Cycle ratio: (CFO/boe) / (FD&A/boe) (x)

1,500 <1.0 <1.0 >5.0 ‐‐ ‐‐ Very Small >USD20/boe (as per BB) B

Other Factors Sector Risk Profile Financial Profile (Historical where relevant and forecast, mid points) Company‐Specific Traits

Building Blocks ‐ Oil & Gas Sector (Integrated Companies)

4.500

9,000

15,500

36,600

Size (Annual) EBITDA ‐

USDm)

1.0 <1.0 >5.0 10 >2.5



>USD25/boe

BB

1.3 >1 ‐ <3 2.0 – 5.0 15 1.5

Medium to Small

>USD10 ‐ <20/boe

• Medium • <60% or

>80% developed

• FD&A costs: >USD15 – <USD25/boe

BBB

1.7 >1 ‐ <3 2.0 – 5.0 20 1.3

Medium >USD10 ‐ <20/boe

• Medium • 60% ‐ 80%



A

1.7 >3 2.0 25 1.0

Large <USD10/boe • Large • 60‐80%

developed • FD&A Costs:

<USD15/boe

Integrated players: benefit from diversity and spread of projects – smoothes out volatility



• Commodity price exposure • Significant cost focus due to

commodity nature of industry


AA

AAA

CFO/Capex (x)

Debt/ Proved

reserves ($/boe)

FFO Gross interest

cover (x)





Cycle ratio (x)


Corporates





• Commodity price exposure • Significant cost focus due

to commodity nature of industry


Upstream E&P companies – fewer projects, vulnerable to price volatility, cost overruns, production delays

Other Factors Sector Risk Profile Financial Profile (Historical where relevant and forecast, mid‐points) Company‐Specific Traits

Building Blocks ‐ Oil & Gas Sector (E&P Upstream Companies)

1,600

6,100

6,200

Size (Annual EBITDA ‐

USDm )

<1 <1.0 >5.0 10 >2.5



>USD25/boe

BB

>1 ‐ <3 1.0 2.0 – 5.0 15 2.0

Medium to Small

>USD10 – <20/boe

• Medium • <60% or >80%



BBB

>1 ‐ <3 1.5 2.0 – 5.0 20 1.5

Medium >USD10 – <20/boe

• Medium • 60% ‐ 80%


>USD15 – <USD25/boe A

Upstream E&P companies – more diverse projects, less vulnerable to price volatility, but still subject to cost overruns and production delays

AA

AAA

Cycle ratio (x)

CFO/Capex (x)

Debt/Proved reserves ($/boe)

FFO Gross Interest

cover (x)








• Commodity price exposure • Significant cost focus due

to commodity nature of industry


Upstream E&P companies – fewer projects, vulnerable to price volatility, cost overruns, production delays

Other Factors Sector Risk Profile Financial Profile (Historical where relevant and forecast, mid‐points) Company‐Specific Traits

Building Blocks ‐ Oil & Gas Sector (E&P Upstream Companies)

1,600

6,100

6,200

Size (Annual EBITDA ‐

USDm )

<1 <1.0 >5.0 10 >2.5



>USD25/boe

BB

>1 ‐ <3 1.0 2.0 – 5.0 15 2.0

Medium to Small

>USD10 – <20/boe

• Medium • <60% or >80%



BBB

>1 ‐ <3 1.5 2.0 – 5.0 20 1.5

Medium >USD10 – <20/boe

• Medium • 60% ‐ 80%


>USD15 – <USD25/boe A

Upstream E&P companies – more diverse projects, less vulnerable to price volatility, but still subject to cost overruns and production delays

AA

AAA

Cycle ratio (x)

CFO/Capex (x)

Debt/Proved reserves ($/boe)

FFO Gross Interest

cover (x)





Corporates


CompanySpecific Traits A review of company‐specific traits encompasses the size and quality of the assets, and discerns features which lead to differences in the cash flow‐generating capabilities of the company throughout industry cycles. Quantitative measures that are examined include: the percentage of developed reserves; full‐cycle economics, including upstream realisations relative to finding, development & acquisition (FD&A) costs; production costs, taxes and debt service costs; reserve life; and ratios related to the capital intensity of the reserve base.

Reserve Size and Quality Fitch considers an entity’s reserve base as its most important asset and one which will ultimately drive the other operating factors of the company. Reserves, together with the ability to extract them, are clearly an indicator of future production potential, and therefore of future revenue and cash flow. Upstream companies operate in a high‐risk environment, dealing with uncertain probabilities of discovering commercially viable reserves, and often long time‐lags between licence acquisition and ultimate production.

As Table 1 below demonstrates, Fitch divides a company’s proven reserve base into three categories:

Table 1: Reserve Size Proven oil and gas reserves in billion

barrels of equivalent oil (bn boe) Observations Large More than 5 bn boe ‘AA’/‘AAA’ rating categories Medium 1‐5 bn boe ‘BBB’/‘A’ rating categories Small Less than 1 bn boe Less than ‘BBB’ rating categories

Source: Fitch

Whilst the size of an oil and gas company does not necessary impact its ability to be efficient and profitable, Fitch has positioned companies in certain rating categories to reflect their exposure and vulnerability to the market cycle; this is not however an absolute rule and exceptions can occur. For example, an entity may be rated investment‐grade despite having reserves below 1bn boe, if asset economics remain intact.

Fitch views a constant proportion of 60%‐80% of developed reserves in the proven reserves base as an optimal level (see Table 2) as it signifies a balanced portfolio of assets, enabling a company to generate ongoing cash flow (a factor which lends itself to a robust investment‐grade rating). A ratio of developed reserves below 60% may indicate future large capex and lead times to bring new projects on‐stream, if the company is to continue to grow; a ratio of over 80% may signal low discovery rates and indicate declining future production potential, often leading to a lower grade rating and Negative Outlook as the business contracts over time.

Table 2: Developed vs. Undeveloped Reserves Observations Developed vs. undeveloped Description Less than ‘A’ rating categories Less than 60% developed Leads to greater costs ‘AAA’ to ‘A’ rating categories 60%‐80% developed Optimal Less than ‘A’ rating categories More than 80% developed Possible difficulty finding new reserves

Source: Fitch

Reserve Replacement and Reserve Life A distinctive characteristic of E&P companies is their depleting reserve base, meaning that they have to constantly invest in exploration and development to maintain or increase reserves and production life. E&P companies can follow either an organic growth path or an acquisition‐driven expansion.

Corporates


In Fitch’s view, the reserve replacement ratio (RRR) indicates future production potential and sustainability of the business. The ratio should ideally be 100% or higher on average, to demonstrate a stable or expanding business profile (although expansion is not necessarily a precondition to high credit quality). Simply put, a declining ratio over time would tend to indicate falling future production potential and possibly the need for higher finding and development costs, if the scale of the company’s business is to be sustained at current levels.

Fitch also assesses the reserve life (a reserve‐to‐production ratio) of an entity, defined as the total volume of proven reserves divided by annual production (R/P), and expressed in years. This measure over time is a good indication of the operational stability and sustainability of a company.

While evaluating the reserve life, Fitch focuses on the underlying reasons for the ratio level. A decline in reserve life to significantly lower than 10 years might be of concern, as it may indicate that a company is experiencing sustained declines in production. At the same time, a very long reserve life (in excess of 20‐30 years) is not necessarily an enhancement to the ratings, since it may indicate that the company faces very high production costs or difficulties relating to reserve extraction. The trend in reserve life over time is often seen as important (growing, stable, or declining) as it should reflect management policies in relation to the business profile of the company.

Full‐Cycle Costs As oil and gas companies primarily deal with globally traded commodities ‐ and as a single entity, have a limited ability to impact commodity prices ‐ cost control becomes an essential component of their financial policies. Exploration and development is the most capital‐intensive part of an upstream business, and Fitch uses a number of measures to evaluate a company’s ability to find and produce reserves (with the ultimate goal of bringing the commodities to market to generate cash flows). Finding and development (F&D) costs, production and lifting costs, taxes and financing costs all impact the overall cost structure of a company. In addition, upstream realisations (sales of the commodity) are important for ultimately determining margins. Key drivers to realisations include fuel mix, distance to market, quality and/or additional processing required, and geographical location, which can impact who owns the reserves and the ultimate ability of the upstream company to realise full market value of the reserves.

Finding and Development (F&D) Costs Fitch uses F&D costs to measure a company’s performance regarding the efficient deployment of capex. F&D costs are the costs of adding proven reserves of oil and gas, through exploration and development activities. These costs are measured as a ratio of exploration and development expenditure to proven additions to reserves (including revisions, extensions and discoveries) over a specified period of time. F&D costs are calculated as an average over a period of three years and on a per unit basis (USD per boe). Fitch also considers finding, development and acquisition (FD&A) costs (see Table 3). Comparing F&D with FD&A‐related measures indicates the extent to which a company is reliant on organic, versus acquisition‐driven, growth.

Fuel mix, size of reserves and a host of other factors can influence the ultimate level of FD&A costs; hence, it is also important to evaluate the overall costs on a full‐cycle basis (in conjunction with realisations) as well as on a stand‐alone basis. High FD&A costs can be offset by such things as low production costs, favourable tax regimes or, in the case of oil, high price realisations, resulting in adequate margins. Likewise, low FD&A costs associated with natural gas shale plays can be offset by low price realizations on the sale of the natural gas (as is currently being witnessed in the US).

Corporates


Table 3: FD&A‐Related Measures Observations FD&A 3 yr average (USD/boe) ‘AAA’/‘AA’ rating categories Less than 15 ‘A’/‘BBB’ rating categories 15‐25 Less than ‘BBB’ rating categories More than 25

Source: Fitch

Lifting and Production Costs A key cost control indicator used to compare a company to its peers is cost of production. Specifically, production costs as calculated by Fitch are the total costs arising from operating and maintaining the wells and their related equipment, measured per boe of oil and gas produced. These costs per boe include lifting costs (costs associated with bringing oil to the surface), transportation costs, general and administrative costs (related to the upstream portion of the business), workover costs, severance taxes, and other expenses.

As Table 4 below shows, Fitch would expect larger and higher rated companies to display lower production costs due to their greater economies of scale, while smaller and lower rated companies would tend to display higher production costs on average. These costs, however, vary significantly according to type of field and location of production (different cost dynamics in different countries/regions).

Table 4: Production Costs Observations Production Costs (USD/boe) ‘AAA’/‘AA’ rating categories Less than 10 ‘A’/‘BBB’ rating categories 10‐20 Less than ‘BBB’ rating categories More than 20

Source: Fitch

Production Size and Dynamics Oil and gas production dynamics are an essential indicator of a company’s scale and operating performance. In its assessment of production size, Fitch categorises upstream companies by scale, with “the majors” capable of operating larger projects and enjoying economies of scale which, other things being equal, results in lower costs per barrel. However, this scale advantage can be outweighed by the geographical location of a company’s operations, with some countries providing a relatively low‐cost environment.

Table 5: Upstream Production Profile Oil and gas production by barrels of oil equivalent per day (boe pd) Observations

Small Less than 500,000 (boe pd) Less or equal to ‘BBB’ rating categories Medium 500,000‐2.5 million (boe pd) ‘A’ to ‘BBB’ rating categories Large More than 2.5 million (boe pd) ‘AAA’/‘AA’ rating categories

Source: Fitch

Nevertheless, the size and geographic diversification of operations does provide some comfort in terms of a company’s overall stability and its ability to withstand operational disruptions. Table 5 shows how Fitch categorizes the size of production by rating category.

Financial Profile Fitch’s analysis of a company’s current and projected financial profile is critical to the process of narrowing down the range of rating possibilities. Industry‐specific quantitative measures that are examined include debt‐to‐reserve ratio, profitability per boe, and capex requirements.

Corporates


Leverage For financial leverage ‐ measuring a company’s long‐term creditworthiness and solvency ‐ Fitch analyses the dynamics of various leverage ratios (including the ratio of gross debt‐to‐EBITDA, net debt‐to‐EBITDA, and FFO‐to‐gross debt); these are generic for all corporates.

Table 6: Leverage and Debt Ratios

Observations Gross

leverage (x) Observations

Total debt / proven reserves

(USD/boe) ‘AA’/‘A’ rating categories Less than 1.5 ‘AAA’/‘AA’ rating categories Less than 2.0 ‘BBB’ rating category 1.5‐2.5 ‘A’/‘BBB’ rating categories 2.0‐5.0 Less than ‘BBB’ rating categories More than 2.5 Less than ‘BBB’ rating categories More than 5.0

Source: Fitch

Fitch also considers reserve leverage ratios, such as gross debt‐to‐proven reserves, and gross debt‐to‐proven developed reserves. These are good indicators of a company’s capacity for debt, and its ability to finance obligations compared with its oil and gas peers. Because of the liquid market for asset sales, these ratios are viewed relative to Fitch’s distressed asset recovery valuations of USD10/boe in developed markets.

Given the operating characteristics of oil and gas companies, and their exposure to volatile prices, Fitch views positively those companies which maintain a conservative financial profile with moderate leverage throughout the cycle. Entities whose leverage increases towards the peak of the cycle are viewed negatively, due to the higher exposure to market price risk which their credit metrics will face when the cycle turns downwards.

Cash Flow and Liquidity The agency’s analysis is focused on stability and sustainability of earnings and cash flow, which underpin a company’s ability to repay debt and finance operations. Cash flow from operations (CFO) is a more secure credit protection than external sources of capital. Using CFO divided by production of hydrocarbons during the same period, Fitch measures how much money is available for reinvestment per barrel after all cash costs have been paid. In addition to the analysis of an upstream company’s ability to generate cash inflows, Fitch also assesses actions related to cash outflows. These include investment programmes, acquisitions, as well as shareholder‐friendly actions (ie dividends and/or share buybacks), which can lead to increased external borrowing.

Capital Expenditure Upstream ventures are generally characterised by large initial capital investment needs and a high rate of capital investment throughout the life of an asset, as well as long lead times to initial production. In Fitch’s view, whilst the implementation of intensive capex programmes on a fully‐ or partially debt‐financed basis can be feasible under favourable industry conditions, their sustainability can come under pressure in a cyclical downturn. Therefore, it is important to consider a company’s ability to finance capex with internally generated funds (see Table 7). Additionally, Fitch analyses the flexibility of capex, ie the breakdown between growth and maintenance, as well as required and discretionary capex. It is important to estimate the portion of discretionary capex, as this reflects a company’s flexibility to scale down investment in the case of an industry downturn.

Factors impacting the scalability of capex include the operator of a specific project and its size/location. For example, large, internationally‐focused projects or deepwater offshore projects often have multi‐year investment horizons, making year‐to‐year capital outlays less flexible (due to the operational issues created by

In order to calculate forecast credit metrics and ratios, Fitch formulates mid‐cycle oil and gas price views (called Price Decks) and publishes these routinely throughout the year.

These are not forecasts of oil and gas prices per‐se, nor are they expectations of market‐ related price movements. Rather, the Price Deck is the longer‐term average realized price oil companies are anticipated to achieve over the course of a complete business cycle, based on expectations of supply/ demand fundamentals in conjunction with marginal cost assumptions.

Corporates


repeatedly stopping/starting projects). As a result, large, integrated companies will tend to have larger, less‐flexible capital expenditure profiles and therefore need to maintain greater financial flexibility to preserve a strong investment‐grade rating.

Table 7: Operating Cash Flow to Capital Expenditure Observations CFO/capex median ratio (x) ‘AA’/‘A’ rating categories 1.7 ‘BBB’ rating categories 1.3 Less than ‘BBB’ rating categories 1.0

Source: Fitch

Revenue and Profitability Trends in revenue and profitability set a pattern for cash flow dynamics. Given that E&P companies lack business chain integration, their revenues ‐ and thus cash flows ‐ are exposed to volatile oil and gas prices. In some countries however, a government may employ a market price mechanism which restricts E&P companies’ profits (usually via price setting or taxes). In such instances ‐ eg where there is a cap on the price at which E&P businesses can sell their product to downstream businesses ‐ Fitch considers the impact of the price mechanism on revenue predictability and control over profitability on a case‐by‐case basis, throughout the cycle.

Limitations This report outlines indicative factors observed or extrapolated for rated issuers in developed markets. Ratio levels refer to the mid‐point of a through‐the‐cycle range, and actual observations may vary from these. Certain sub‐sectors may contain a small number of observations overall, or at any given rating category. Where no observations currently exist, guidelines for a category are extrapolated based on Fitch judgement. The weighting of factors will vary substantially over time, both for a given issuer and between issuers, based on relative current significance agreed upon by the rating committee. The factors give a high‐level overview and are neither exhaustive in scope nor uniformly applicable. Additional factors will influence ratings, particularly in emerging markets and where group relationships constrain or enhance a rating level.

Corporates


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oil and gas sector exploration and production rating methodology

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