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Fitch Rates MEG Energy's Proposed Senior Unsecured Notes 'B+'/'RR3'

CommoditiesJan 19, 2021 10:00
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(The following statement was released by the rating agency) Fitch Ratings-New York-19 January 2021: Fitch Ratings has assigned a 'B+'/'RR3' rating to MEG Energy's (MEG) eight-year senior unsecured notes. Proceeds, along with cash on hand, are intended to refinance the company's senior unsecured notes due 2024. MEG's Issuer Default Rating is 'B' and the Rating Outlook is Stable. Fitch views the refinancing as a positive given the extension of the bond maturity and a slight reduction in interest costs. MEG has strengthened its liquidity profile over the past two years, and its liquidity is further enhanced by the expectation of generating positive FCF at current Strip prices. MEG's ratings reflect improving credit metrics, below average refinancing risk, no major bond maturities until 2025 pro forma for the acquisition, adequate liquidity, the expectation that the company will generate positive FCF over the forecasted period, improved transportation logistics that should lead to higher realized prices, and an improving cost structure. This is offset by significant exposure to potentially wide and volatile West Texas Intermediate (WTI) and Western Canadian Select (WCS) spreads, lack of diversification, and exposure to a challenging regulatory environment managed by the Alberta and federal government. The Stable Outlook reflects MEG's conservative financial profile, ability to access debt capital markets and its solid liquidity profile, which should able the company to whether a period of lower commodity prices or widening differentials. Fitch would consider a positive rating action if MEG generates FCF in excess of expectations and the proceeds are applied to reduce debt. Key Rating Drivers Focus on Debt Reduction: MEG reduced leverage from 8.8x in 2018 to 3.3x in 2019 through a combination of increased production, improved differentials, and a wind down of its capital spend program. Although debt/EBITDA increased in 2020 due to the impact of the pandemic, MEG was able to reduce overall debt by CAD132 million and extending maturities, while keeping its revolver undrawn. Fitch believes FCF will be predominately used to reduce debt and fund growth initiatives. Improvements in debt reduction will be a function of the fluctuating WCS discounts and transportation issues. FCF Improvement: Historically, MEG has generated large FCF deficits to fund its growth objectives while also being subjected to modest discounts to WCS pricing. Fitch expects MEG to be neutral to slightly negative using a USD42/bbl WTI price assumption for 2021, although Strip prices suggest positive FCF. MEG's continued focus on cost reduction, opportunistic hedging program, and relatively low cost (approximately USD5/bbl) to sustain production levels should allow it the company to fund its capital program within operating cash flow. Growing Exposure to USGC: Fitch anticipates MEG will sell an increasing portion of its production into the more valuable U.S. Gulf Coast (USGC) and move away from the Western Canada market. MEG sold 27% of its 2018 production into the USGC, and Fitch is estimating that the apportionment will range from 30%-35% for the remainder of 2020 and 2021. MEG currently has a 100,000bbl/d of committed capacity on the Flanagan South/Seaway pipeline that transports crude to the Gulf Coast. The commitment is not contingent on the Enbridge Line 3 replacement project being placed into service or Enbridge's current contract discussions. This should result in increasing Gulf Coast sales to over 50% of production in 2021 from through pipeline, which should allow for a higher realized price for MEG's products. The USGC market has an approximate USD3.00-4.00 per barrel premium to the Western Canadian market after taking into account transportation costs in the current pricing environment. Pipeline Political Risk: There has been substantial timing risk around major pipeline projects in Canada, which have experienced numerous delays due to entrenched social and environmental opposition. These include Enbridge's Line 3 replacement (over 370,000bbl/d in incremental shipping capacity), the Keystone XL pipeline (over 830,000bbl/d) and the Trans Mountain Pipeline (over 590,000bbl/d). Pipeline delays were a key factor in the collapse in WCS differentials in the fall of 2018, which led to the need for quotas. As stated above, additional delays in new capacity could prolong the quota, create additional project deferrals, and increase reliance on rail to move product. Fitch expects that Enbridge's Line 3 will be the first of the major projects to come online in 2H20. Adequate Liquidity, Maturity Runway: MEG has an undrawn CAD800 million revolving credit facility and CAD500 million letter of credit facility with a maturity date of July 30, 2024. There is no financial maintenance covenant unless the revolver is drawn in excess of 50%, which would trigger a first-lien net debt/EBITDA covenant of 3.5x or less. Fitch does not expect material draws on the revolver given the expectation of FCF neutrality in 2021 and sufficient cash on hand. Fitch is comfortable with the liquidity given cash was at CAD49 million as of Sept. 30, 2020 and Fitch's expectation that the company will generate FCF over the forecasted horizon. The next bond maturity is not until January 2025. Derivation Summary Baytex Energy (B/Negative) is a predominately Canadian producer with production of 77,800 bbl/d in 3Q 2020, which is slightly higher than MEG's production of 71,500. Fitch expects MEG's production to grow to the 86,000 to 90,000 bbl/d range throughout the forecast period. MEG has a larger proved reserve base and a higher oil cut. In addition, MEG has no near-term financing risk, is not expected to borrow off of its CAD800 million revolver in the near term, and has a covenant-lite revolver that is not subject to a borrowing base redetermination. Baytex's next bond maturity is June 2024 and approximately 60% of its credit facility is drawn. Offsetting considerations include low diversification, given that MEG is essentially a single-play oil sands producer, and significant exposure to volatile WTI-WCS price differentials, given the lack of integration, particularly in relation to larger Canadian oil sands operators such as Suncor Energy and Canadian Natural Resources Limited. Despite its lack of diversification, MEG has substantial proved and probable reserves and has the ability to greatly expand capacity if industry conditions are favorable. Key Assumptions --Base case WTI oil prices of USD38 in 2020, USD42 in 2021, USD47 in 2022, and a long-term price of USD50; --Base case Henry Hub natural gas price of USD2.10 in 2020 and a long-term price of USD2.45; --Production decline of 12% in 2020 and growth of 7% in 2021; --Capex of CAD150 million in 2020 and CAD288 million in 2021; --No share repurchases, equity issuance, acquisitions, or divestitures. Key Rating Recovery Assumptions: --The recovery analysis assumes that MEG Energy would be reorganized as a going-concern (GC) in bankruptcy rather than liquidated. --Fitch has assumed a 10% administrative claim. GC Approach MEG's GC EBITDA assumption reflects Fitch's projections under a stressed case price deck, which assumes WTI oil prices of USD34.00 in 2020, USD32.00 in 2021, USD37.00 in 2022, and USD47.00 in 2023. The GC EBITDA estimate reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which we base the enterprise valuation (EV). The GC EBITDA assumption uses 2023 EBITDA, which reflects the decline from current pricing levels to stressed levels and then a partial recovery coming out of a troughed pricing environment. The model was adjusted for reduced production and varying differentials given the material decline in the prices from the previous price deck. An EV multiple of 5.0x EBITDA is applied to the GC EBITDA to calculate a post-reorganization enterprise value, resulting in a valuation of CAD2.9 billion. The choice of this multiple considered the following factors: --The historical bankruptcy case study exit multiples for peer companies ranged from 2.8x-7.0x, with an average of 5.6x and a median of 6.1x; --There were very few recent Canadian M&A transactions and multiple detail was either unavailable or not relatable; --Fitch uses a multiple of 5x, to estimate a value for MEG to reflect the relatively higher proved reserves that reduces resource and volumetric risks and provides for longer-term cash flow support despite shorter-term market impacts; Liquidation Approach The liquidation estimate reflects Fitch's view of the value of balance sheet assets that can be realized in sale or liquidation processes conducted during a bankruptcy or insolvency proceeding and distributed to creditors. Despite the lack of Canadian E&P peer companies, the announced transaction in which Devon Energy (NYSE:DVN) is selling its Canadian assets to Canadian Natural Resources is a very strong comparison given the facility's location, size, and similar operations. That asset was sold for USD2.8 billion during a difficult M&A environment, which makes the transaction a good proxy for a distressed sale. The value per production (boe) was USD22,000, which implies a valuation for MEG at USD2.7 billion. After including accounts receivable and inventory and adjusting for foreign exchange rates, the liquidation value was CAD3.0 billion, less than the going concern value. The revolver is assumed to be fully drawn upon default. The revolver is a first lien and senior in the waterfall. The allocation of value in the liability waterfall results in recovery corresponding to 'RR1' recovery for the first lien revolver and a recovery corresponding to 'RR1' for the senior second lien notes. The senior unsecured notes have a 'RR3' recovery. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: --Actual debt reduction through the application of FCF proceeds; --Mid-cycle debt/EBITDA in the 3.0x-3.5x range; --Mid-cycle lease adjusted net leverage less than 3.5x. Factors that could, individually or collectively, lead to negative rating action/downgrade: --Change in financial policy away from debt reduction at current credit metrics; --Mid-cycle debt/EBITDA above 4.5x; --Mid-cycle lease adjusted net leverage greater than 4.5x; --Prolonged dislocation in WTI-WCS spreads. Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Adequate Liquidity: MEG has CAD49 million of cash on hand as of Sept. 30, 2020. The credit facility consists of a CAD800 million revolver and a CAD500 million letter of credit facility that matures on July 30, 2024. There is no financial maintenance covenant unless the revolver is drawn in excess of 50%, which would trigger a first-lien net debt/EBITDA covenant of 3.5x or less. The next maturity is in 2025 when the 6.5% senior secured second lien notes are due. Date of Relevant Committee 19 March 2020 REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations MEG Energy has an ESG Relevance Score of '4' for Exposure to Social Impacts, due to high exposure to pipeline and logistics takeaway capacity, which has been delayed multiple times due to social resistance to pipelines in Canada. This has widened the Canadian oil price differential to record levels, which has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors. Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg MEG Energy Corp. ----senior unsecured; Long Term Rating; New Rating; B+ Contacts: Primary Rating Analyst John Kempf, CFA Senior Director +1 646 582 4710 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Rating Analyst Mark Sadeghian, CFA Senior Director +1 312 368 2090 Committee Chairperson Dino Kritikos, Senior Director +1 312 368 3150 Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). Corporate Monitoring & Forecasting Model (COMFORT Model), v7.8.0 (1 (https://www.fitchratings.com/site/re/986772)) Additional Disclosures Dodd-Frank Rating Information Disclosure Form (https://www.fitchratings.com/site/dodd-frank-disclosure/10149951) Solicitation Status (https://www.fitchratings.com/site/pr/10149951#solicitation-status) Additional Disclosures For Unsolicited Credit Ratings (https://www.fitchratings.com/site/pr/10149951#unsolicited-credit-ratings-disclosures) Endorsement Status (https://www.fitchratings.com/site/pr/10149951#endorsement-status) Endorsement Policy (https://www.fitchratings.com/site/pr/10149951#endorsement-policy) ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTPS://WWW.FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS (HTTPS://WWW.FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS). 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Fitch Rates MEG Energy's Proposed Senior Unsecured Notes 'B+'/'RR3'
 

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