Fitch Ratings-Chicago-November 02: Fitch Ratings has placed the ratings of Encana (NYSE: ECA; BBB-) on Rating Watch Positive following the announcement that ECA would acquire Newfield Exploration (NYSE: NFX: BBB-/Stable) in a transaction with an EV of approximately $7.7 billion, comprised of a $5.5 billion stock for stock transaction of ECA for NFX equity, as well as the assumption of $2.45 billion in NFX gross debt (approximately $2.2 billion in net debt).
Fitch expects to resolve the Rating Watch upon conclusion of the transaction, which is expected to close in the first quarter of 2019 following standard shareholder votes and regulatory approvals; however, that date could be extended if delays are encountered. A total of approximately $4.5 billion in ECA debt and obligations is affected by today's rating action. A full list of rating actions follows at the end of this release. The RWP reflects a number of positives to ECA's business and operational profile that Fitch expects should result from the acquisition of Newfield, including: increased size and scale; efficiency gains from the application of Encana's cube resource development model to the acquired
SCOOP/STACK position; a faster transition to higher value liquids; improved unit economics; increased geographic and basin diversification; and stronger leverage metrics stemming from the conservative financing of the deal. Ratings concerns are limited and include the company's still sizable gas exposure, the need to continue to execute to convert premium drilling locations into proved reserves and a historical track record of negative FCF.
KEY RATING DRIVERS
Increased Size and Scale: ECA will see a material increase in size and scale following the NFX acquisition. On a pro-forma basis as of third-quarter 2018 (Q3), ECA's production will increase from 378,200 boepd to approximately 577,000 boepd, making the combined entity the second-largest producer of unconventional resources in North America, which meets Fitch's previous size sensitivity for an upgrade (size approaching 500,000 boepd).
The addition of the SCOOP-STACK adds a large, low-cost growth resource to ECA's portfolio that lends itself to further efficiency gains through the application of Encana's cube resource development model. The company is projecting that approximately half of total run rate synergies of $250 million will stem from application of cube development to the SCOOP-STACK.
ECA's PF proved reserves will increase by approximately 85%, from 795 million boe to just under 1.5 billion boe, while its percentage of proved developed reserves (which require less capex to develop) should also increase. Faster Transition to Liquids: The acquisition will accelerate ECA's transition to liquids and away from lower value AECO natural gas. As of Q3, stand-alone Encana's production was comprised of approximately 47% liquids, versus 41% in 2017 and 35% in 2016. On a pro-forma combined basis, the acquisition will push ECA's liquids mix up to 52% and further benefit the company's netbacks. The combined company's liquids production is approximately 300,000 bpd. In addition to oil, growth in NGLs has been a major driver of ECA's increased liquids output. While U.S. NGLs trade at a significant discount to West Texas Intermediate (WTI), NGLs (condensate) in the Montney in Western Canada enjoy stronger pricing, given their link to local diluent requirements for oil sands blending. Greater Basin Diversification: The acquisition will expand ECA from four basins to eight basins by adding the SCOOP/STACK, Williston, Uinta and Arkoma to ECA's existing positions in the Permian, Montney, Duvernay and Eagle Ford. While this is a large number of positions for a company ECA's size, the bulk of capex will be focused on just three core growth assets: the Permian, Montney and SCOOP-STACK.
Fitch expects the other assets may either be developed at lower intensity levels for FCF, retained for option value, or potentially monetized, similar to the recent San Juan sale. Fitch generally views the transition to a multi-basin set of core assets favorably, as having depth and scale in individual formations allows for efficiency gains, yet being in multiple basins allows the ability to shift capital between basins to optimize value.
Conservatively Financed: The deal is de-leveraging given its conservative, all-stock financing, NFX's relatively lower leverage versus ECA (Q2: NFX-1.9x, ECA-2.2x), and the impact of expected synergies and combined growth on forward looking metrics. In Fitch's base case, leverage is expected to drop to around 1.5x, which meets our previous sensitivity for an upgrade to 'BBB' of leverage at or below 2.0x. As a result of the assumption of NFX debt by Encana, at transaction close, Fitch also anticipates it will transfer NFX's unsecured debt to ECA, including $750 million in 5.75% 2022s, $1.0 billion in 5.625% 2024s and $700 million in 5.375% 2026s. While the company announced a $1.5 billion buyback program and higher dividend concurrent with the transaction, Fitch expects that both will be managed within existing cash balances and FCF, and the buyback program will be completed after the transaction close. Reserve Life Increasing: As calculated by Fitch, ECA's reserve life is somewhat shorter than liquids-focused peers at seven years. Fitch has noted that premium drilling inventory at ECA has grown much faster than proved (1p) reserves, particularly in the high-growth Permian and Montney. On a stand-alone basis, ECA had a remaining premium inventory of approximately 17 years and 43 years, respectively, using the company's stand-alone five-year drilling plan.
The NFX acquisition should increase the company's proved reserve life moderately, and Fitch expects relatively robust reserve replacement gains over the next few years will also help close the gap (2017 organic reserve replacement was 227%). Track Record of Defending the Rating: ECA has taken numerous steps to defend the rating in the downturn, including deep capex and dividend cuts, asset sales, significant gross debt reduction (as calculated by Fitch and including capital leases, down from $7.9 billion in 2014 to approximately $4.5 billion currently), and approximately $2.2 billion in equity raises in 2015 and 2016. Fitch believes that additional asset sales prospects are possible, given the large number of basins the company will own following the NFX acquisition.
DERIVATION SUMMARY
Encana is reasonably positioned versus peers in the independent E&P space. At 378,200 boepd in Q3 (577,000 boepd on a PF basis including the NFX acquisition), its size is above average versus BBB peers, and on a pro-forma basis it is the second-largest producer of unconventional resources in North America. Diversification is well above average for the peer group, and includes its four North American shale plays (Permian, Eagle Ford, Montney, Duvernay), which will be supplemented by positions in the SCOOP-STACK, Bakken, Uinta and Arkoma. Of these assets, the Permian, Montney and SCOOP-STACK are expected to serve as the primary growth assets. As calculated by Fitch, ECA's cash netbacks continue to improve but remain below those of more oily peers such as MRO (BBB/Stable) and HES (BBB-/Negative), reflecting the ongoing transition to liquids. While natural gas is still a large portion of overall production, the NFX acquisition should further improve ECA's liquids mix and unit margins. Encana's stand-alone reserve life is somewhat below average at approximately seven years, and reflects the impact of both asset sales and the fact that drilling locations have grown faster than proved reserves over the last few years.
KEY ASSUMPTIONS
Fitch's Key Assumptions Within Our Rating Case for the Issuer - Base case WTI oil prices of $60/barrel in 2019, and $55 in 2020-2021 and in the long term; - Base case Henry Hub natural gas price of $3.00/mcf from 2019 onwards and in the long term; - Acquisition closes with an effective date of Jan. 1, and no incremental debt funding beyond assumed debt; - Sale of San Juan assets closes before YE for approximately $480 million; - Run-rate synergies of $250 million achieved over a multi-year period.
RATING SENSITIVITIES
Developments That May, Individually or Collectively, Lead to Positive Rating Action To be upgraded to 'BBB': - Completion of the NFX acquisition; - Conservative financing of the transaction remain in place; - Expectations for mid-cycle debt/EBITDA below 2.0x. Developments That May, Individually or Collectively, Lead to Negative Rating Action To Stabilize at 'BBB-': - Failure to complete the NFX acquisition. To be downgraded to 'BB+': - Mid-cycle debt/EBITDA above 3.0x; - Inability to reduce gross leverage through increased production volumes and cash flow or proceeds from asset sales; - Mid-cycle debt/flowing above $16,000-$17,000/boe.
LIQUIDITY
Strong Liquidity, Minimal Near-Term Maturities: At Sept. 30, 2018, ECA had $615 million in cash and full availability on its $4.0 billion in unsecured credit facilities, leading to liquidity of approximately $4.6 billion. The revolvers are split into a $2.5 billion Encana revolver and a separate $1.5 billion revolver held at Encana's main U.S. subsidiary, Alenco. In March, Encana extended the facilities to July 2022. Maturities over the next few years are manageable and include $500 million due in 2019 and $600 million due 2021. Financial Covenant: ECA's main financial covenant is a 60% maximum consolidated debt/capitalization ratio on its unsecured credit facilities. The facility definition of debt excludes nonrecourse debt, and the Bow Office lease. The covenant calculation also allows for the add-back of approximately $7.75 billion in impairments originally taken when the Canadian company converted to GAAP accounting in 2011. Other features include a negative pledge, restrictions on changes in the nature of the business (unless the successor entity is investment grade) and restrictions on the ability to issue secured debt (maximum of 17.5% of consolidated tangible assets). Other Liabilities: ECA's other obligations are manageable. The deficit on the funded status of its pension benefit obligation (PBO) (Fair Value Pension Assets-PBO) was just $16 million at YE 2017 versus $17 million at YE 2016. The deficit is not material to the credit profile. ECA's asset retirement obligation (ARO) declined to $514 million at YE 2017 versus $687 million the year prior. The decline was largely due to divested liabilities through asset sales.
FULL LIST OF RATING ACTIONS
Fitch has placed the following ratings on Rating Watch Positive: Encana Corporation -
Long-term IDR 'BBB-'; -
Senior Unsecured Notes 'BBB-'; -
Senior unsecured Revolver 'BBB-'; -
Short-Term IDR 'F3'; -
Commercial Paper 'F3'. Contact: Primary Analyst Mark Sadeghian, CFA Senior Director +1-312-368 2090 Fitch Ratings, Inc. 70 W Madison St Chicago, IL 60602 Secondary Analyst Cody Molnar Associate Director +1-312-368 5451 Committee Chairperson John Kempf, CFA Senior Director +1-646-582-4710 Summary of Financial Statement Adjustments - Fitch has made no material adjustments that are not disclosed in the company's public filings. Media Relations: Sandro Scenga, New York, Tel: +1 212 908 0278, Email: sandro.scenga@fitchratings.com. Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10023785 Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10024585 Sector Navigators (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10023790 Additional Disclosures Solicitation Status https://www.fitchratings.com/site/pr/10050843#solicitation Endorsement Policy https://www.fitchratings.com/regulatory
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