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TEXT - S&P cuts Milagro Oil & Gas to 'CCC'
Overview -- U.S. oil and natural gas exploration and production (E&P) company Milagro Oil & Gas Inc. might face a liquidity crisis in the next 12 months. -- We are lowering our corporate credit rating to 'CCC'. -- The outlook is negative and reflects the company's tight liquidity position and highly leveraged balance sheet. -- Rating Action Rating Action Nov. 27, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Houston-based Milagro Oil & Gas Inc. (Milagro) to 'CCC' from 'CCC+'. The outlook is negative. We lowered the issue-level rating on Milagro's second-lien secured notes to 'CCC' (same as the corporate credit rating) from 'CCC+'. The recovery rating remains '3', indicating our expectation of meaningful (50% to 70%) recovery in the event of a payment default. Rationale The rating action reflects our assessment that Milagro could face a near-term liquidity crisis. The company is likely to be in violation with the maximum leverage covenant under its revolving credit facility at the end of first-quarter 2013 as this covenant becomes more stringent and the company's ability to generate EBITDA remains weak. Access to this revolving credit facility is a key component of the company's capital structure and liquidity, as Milagro had less than $1 million of cash, $56 million available on its revolver, and no other source of liquidity as of Sept. 30, 2012. As of Nov. 1, 2012, the company's borrowing base was reduced to $160 million from $165 million and it will continue to shrink by $5 million each month until April 1, 2012. In addition, we believe that cash flow generation will weaken in the coming quarters due to a lack of drilling activity. In response to weak natural gas prices in 2012 and a tight liquidity position, Milagro has reduced its capital expenditures to a level which we deem insufficient to offset an annual 15% to 20% natural decline in the company's natural gas production. The rating on Houston-based Milagro Oil & Gas Inc. reflects the company's weak liquidity position and its cash flow conservation strategy, relatively small asset base and production levels, significant exposure to natural gas prices, historically weak reserve replacement metrics, and high leverage. We view Milagro's business profile as "vulnerable". The company's proved reserve base totaled a relatively small 224 billion cubic feet equivalent (Bcfe) as of Dec. 31, 2011, and we expect production to remain about 42 million to 45 million cubic feet equivalent per day (mmcfed) for 2012. Milagro's reserve base and production have a significant exposure to weak natural gas prices (about 60% of production in the first nine months of 2012). Still, reserve life was approximately 13 years in 2011, in line with the average for the sector. The company also has a fair amount of operating diversity with operations in Texas, Louisiana, and the Gulf of Mexico. The company derives almost all of its production from onshore assets, which we consider less risky than offshore operations. As is typical for Gulf Coast E&P companies, acquisitions have played a key role in the company's growth strategy and reserve replacement strategy, as production has far outpaced organic reserve replacement in the past several years. From 2009 through 2011, extensions and discoveries replaced only 32% of production. We expect reserve replacement to remain a key area of concern as Milagro's ability to make acquisitions and capital investments to grow its reserves is currently severely constrained by its weak liquidity position and high leverage. In addition, because of the lack of scale of its operations, Milagro has a relatively high cost structure, with cash costs (lease operating expenses, general and administrative, and production taxes) at about $3.91 per mcfe (thousand cubic feet equivalent) for the third quarter of 2012. Standard & Poor's classifies Milagro's financial risk as "highly leveraged" (as our criteria define the term). Total adjusted debt to annualized EBITDAX (EBITDA plus exploration expense) for the quarter ended Sept. 30, 2012, was aggressive at more than 6x and EBITDAX to interest coverage was about 2x. Given the persisting weak outlook for natural gas prices and the company's tight liquidity, we expect Milagro to maintain capital spending at a bare minimum, about $30 million annually. This level is deemed not to be enough to offset a 15% to 20% natural decline rate in its production and we therefore expect production to decline this year and next year. Under these assumptions and our price deck for crude oil and natural gas ($85 and $80 West Texas Intermediate for 2012 and 2013; $2.5 and $3 Henry Hub), we expect Milagro to generate about $70 million of EBITDA in 2012 and about $64 million in 2013. As a result of lower cash flow generation, we anticipate leverage to increase to about 8x at year-end 2013. Liquidity In our view, Milagro's liquidity position is "weak". Key assumptions and expectations of our liquidity analysis include: -- Milagro had less than $1 million of cash and $51 million available on its revolver as of Sept. 30, 2012. -- We expect the company to be cash flow neutral in 2013. -- The company's borrowing base was reduced to $160 million from $165 million on Nov. 1, 2012 and will be reduced by $5 million each month until April 1, 2012. -- Milagro is likely to be in violation with the maximum leverage ratio covenant contained in the credit facility for the first quarter of 2013. The company will have to obtain a waiver or seek an amendment to its banks which, if not granted, the lenders could declare a default and require Milagro to repay the outstanding amount in full. -- We do not anticipate any equity infusion from the company's equity sponsor at this point. Recovery analysis The issue-level rating on Milagro's senior unsecured debt is 'CCC', the same level as the corporate credit rating. The recovery rating is '3', indicating our expectation of meaningful (50% to 70%) recovery in the event of a payment default. For a complete recovery analysis, please see our recovery report on Milagro Oil & Gas Inc. published on RatingsDirect on May 30, 2012. Outlook The negative outlook reflects the company's fragile liquidity position and highly leveraged balance sheet. We would consider a negative rating action if a default appears inevitable in the next six months. A revision of the outlook to positive would require an improvement in the company's liquidity, which, barring a significant improvement in natural gas prices, is most likely to come from an equity infusion from the company's equity sponsors. 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: Standard & Poor's Revises Key Ratios Used In Global Corporate Ratings Analysis, Dec. 28, 2011 -- 2008 Corporate Criteria: Our Rating Process, April 15, 2008 Temporary telephone contact number: Ben Tsocanos (203-800-5146) Ratings List Downgraded To From Milagro Oil & Gas Inc. Corporate Credit Rating CCC/Negative/-- CCC+/Negative/-- Senior Secured CCC CCC+ Recovery Rating 3 3
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