Fitch Affirms Vermilion at 'BB-'; Outlook Remains Negative
(The following statement was released by the rating agency)Fitch Ratings-Chicago-16 March 2021:
Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR) of Vermilion Energy Inc. (VET) at 'BB-' and the company's senior unsecured rating at 'BB-'/'RR4', but maintained the company's Negative Outlook.
The main driver for the Negative Outlook is the company's high secured credit facility balance (currently 74% drawn), which stands out versus U.S. high-yield (HY) exploration and production (E&P) peers. Balances are trending down (YE 2020: CAD1.555 billion versus a highwater mark of CAD1.73 billion in Q2), but remain high on an absolute basis, and a high revolver balance may keep refinancing risk elevated if inadequately addressed through repayment or other structural improvements. Headroom on key covenants has also tightened given higher debt and weaker pandemic-linked results. Planned revolver repayments to increase headroom are a potential catalyst for the removal of the Negative Outlook.
VET's rating reflects its diversified international asset base; above-average price realizations stemming from its exposure to higher priced international oil and natural gas indices; reasonable netbacks; moderate base decline rate; and track record of defending its credit profile. Offsetting considerations include the company's currently elevated revolver borrowings; limited headroom on covenants, particularly total debt/EBITDA; moderate size; and lack of scale in most plays outside North America. The company's historically high dividend payout is also a consideration but has been suspended in the current environment.
Key Rating Drivers
Revolver Balance High, But Trending Down: The draw on VET's CAD2.1 billon revolver as of YE 2020 was CAD1.555 billion, $175 million below its high of CAD1.73 billion in Q2 but still high on an absolute basis (74%). VET has historically kept higher revolver balances given its view of the revolver as a cheap funding source. There are several mitigants to a high balance, including its lack of a borrowing base, which eliminates the risk of redeterminations; the lack of springing liens, and a supportive bank group. The facility was also extended last year to March 2024. Nonetheless, Fitch views a high revolver balance as a differentiating source of risk versus peers.
Lower Covenant Headroom: The incorporation of weaker pandemic-linked results has reduced headroom on key revolver covenants. As of YE 2020, headroom under the company's tightest covenant, total debt/EBITDA had shrunk, with leverage of 3.48x versus a maximum of 4.00x. Fitch expects the metric may tighten further in Q1 as weaker quarters are incorporated into the LTM calculation, but should begin to decline relatively rapidly thereafter as more robust 2021 quarters are included and planned debt reductions take hold.
Managing for Debt Reduction: VET has announced that debt reduction and maintaining liquidity is its first financial priority as it exits the downturn, and to that end it both suspended its dividend, and announced a capex budget of CAD300 million, which is 17% below 2020 levels. This combination should boost 2021 FCF for debt repayment materially. The company maintains a long-term goal of net debt to FFO of less than 1.5x.
Shift to International: While most of VET's 2021 capex budget is still allocated to North America, the budget represents a shift towards international, with a 35% increase in international spending (CAD135 million vs CAD100 million in 2020) and a 37% decrease in North America relative to 2020. Most 1H21 spending is focused on gas fields in the Netherlands (1.5 net wells), with smaller allocations to Croatia and Hungary (1.0 net well each), and workover activity in France and Germany. North American activity is focused on condensate-rich gas fields in Alberta (9.6 net wells planned), Saskatchewan (22.1 net light oil wells), and Wyoming (4 light oil wells, with incremental expansion activity possible in 2H21 if market conditions remain constructive). VET's exploration and development budget is fully funded at a WTI oil price of approximately $37/bbl on an unhedged basis. Fitch notes that budget is moderately below maintenance levels, and will result in an expected production decline from around 95,190 barrels of oil equivalent per day (boepd) to the 83-85,000boepd range.
Good Netbacks: VET has above-average cash netbacks among lower rated E&P peers. As calculated by Fitch, at Sept. 30, 2020, VET's cash netbacks were CAD12.74/boe, versus CAD5.33/boe for MEG Energy, CAD11.12/boe for Baytex, and USD 0.29/boe for Southwestern Energy. VET's netbacks benefit from Brent-linked premiums for international oil, as well as higher international pricing for natural gas. Higher margins remain a key credit protection in the current low-priced environment.
Diversified Asset Base: Vermilion has a unique asset profile given the high level of geographic diversification relative to its size. VET's asset base is focused on three main regions: North America, Europe and Australia, with production split among ten countries, including Canada, France, the Netherlands, Ireland, Australia, Germany and the U.S. as well as prospective inventory in Central and Eastern Europe (Hungary, Croatia, Slovakia). This is linked to the company's philosophy of seeking out the highest return projects regardless of location. Geologically, many of the plays tend to be shallow, lower cost conventional resource plays (France, Netherlands) or lower cost fracking plays Williston Basin in Southeast Saskatchewan).
Challenges in Scaling Up: The downside of Vermilion's heavily diversified portfolio is a limited ability to scale up in most of its plays outside properties in the U.S. and Canada. This contrasts with most of the company's shale-centric North American peers, which are focused on building returns by scaling up in individual shale basins. VET's growth prospects for its international portfolio vary significantly, ranging from regions in decline (Corrib field in Ireland) to areas with good geology and well prospectivity, but challenging permitting environments (Germany and Netherlands) to those with good infill and brownfield expansion opportunities (Australia).
Dividend Reduction: VET historically had a relatively large dividend, which is unusual for an E&P its size but reflects its legacy as an income trust. Following the collapse in oil and gas prices, management cut the dividend by 91%, and then suspended it entirely in April, conserving approximately CAD400 million per year. Given this, remaining levers in the event of another downturn are limited, and would likely include additional capex and operating cost cuts. Fitch does not believe asset sales are a viable option for VET given a limited buyer pool.
Refinery Conversion: In September, Total announced plans to convert its 101,000 barrel per day (bpd) Grandpuits refinery into an industrial center and discontinue oil refining operations there by 2024. The Grandpuits refinery processes half of VET's French crude production. While VET has an arrangement to sell the oil to Total to be used at other refineries, the change is expected to reduce netbacks by about $5/barrel given higher incremental transportation fees.
Hedging Program: VET maintains a reasonable hedging program. As of the end of January, 2021 total volumes were about 30% hedged, including a larger natural gas hedge (around 70% of European natural gas and 50% of North American natural gas), but only around 20% of projected oil production. Oil hedges have been impacted by the strong backwardation in the forward market, which limits incentives to hedge volumes further out the curve.
Vermilion's positioning against high-yield peers in the independent E&P space is mixed. In terms of geographic diversification, VET is peer-leading with a presence in three regions and ten countries. However, scale is an issue given this variable approach, and the company has scale in just one region currently: Canada (59,000boepd in 2020).
In terms of size, VET is on the smaller end of the spectrum. At 95,500 boepd of production (Q320), it is smaller than peers Murphy (BB+/Stable; 162,700boepd) and Southwestern Energy (BB/Stable; 400,200boepd), but larger than Baytex (B/Negative, 77,800boepd) and MEG Energy (B/Stable, 71,500boepd). Production is set to drop moderately in 2021 as the company lowers capex to maximize FCF for debt reduction.
Growth prospects are also below average. However, price realizations and unit economics are above average versus lower rated peers. At Sept. 30, 2020, VET's cash netbacks were CAD12.74/boe, versus CAD5.33/boe for MEG Energy, CAD11.12/boe for Baytex, and USD0.29/boe for Southwestern Energy. VET's netbacks benefit from Brent-linked premiums for international oil, as well as higher international pricing for natural gas. Higher margins remain a key credit protection in the current low price environment. The company's dividend also sets its credit profile apart from high-yield peers, although it has been suspended. No Country Ceiling, parent/subsidiary or operating environment aspects have an impact on the rating.
- WTI oil price of $42 in 2021, $47 in 2022, and $50 in 2023 and 2024;
- Henry Hub natural gas prices of $2.45 per thousand cubic feet (/mcf) across the forecast;
- Production declining from 95,190boepd in 2020 to 84,000boepd in 2021 and rising slightly over the remainder of the forecast;
- Capex cut to below maintenance levels of CAD300 million in 2021, rising to CAD390 million 2021 and CAD410 million thereafter;
- FCF used to repay revolver debt over the life of the forecast;
- Shareholder dividends suspended until 2024;
- Fitch also tested the company's credit profile using a range of other price scenarios.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
To remove the Negative Outlook:
- Continued trend of material reductions in revolver borrowings to increase availability and lower refinancing risk while maintaining the leverage profile within rating tolerances
To be upgraded to BB:
- Production approaching 150mboepd;
- Improved financial flexibility;
- Increased scale in existing positions, with greater drilling inventory, a higher reserve life and the ability to develop new inventory while maintaining high margins;
- Mid-cycle debt/EBITDA below 2.0x;
- Mid-cycle FFO leverage below 2.2x.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
- Failure to re-establish borrowing headroom over the next several quarters through gross debt reduction
- Impaired financial flexibility;
- Mid-cycle debt/EBITDA above 3.0x;
- Mid-cycle FFO leverage above 3.2x;
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
Limited Headroom: VET's current liquidity is tight, and headroom on key covenants has tightened. Cash and equivalents at Dec. 31, 2020 were CAD7 million, which reflects the company's policy of relying primarily on the revolver for liquidity needs. The draw on VET's CAD2.1 billon revolver was still high at YE 2020 at CAD1.555 billion, but is trending in the right direction. Covenant headroom on the revolver has tightened due to the inclusion of weaker Covid quarters (total debt/EBITDA rose to 3.48x at YE 2020 vs. a maximum of 4.0x). Headroom is expected to tighten further in Q1 before trending downward as stronger post-Covid results are incorporated into the covenant calculation.
The credit facility was also extended last year to March 2024. Besides the revolver, the company has no maturities until its 5.625% 2025 notes come due.
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.
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/
Vermilion Energy Inc.; Long Term Issuer Default Rating; Affirmed; BB-; Rating Outlook Negative
----senior unsecured; Long Term Rating; Affirmed; BB-
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