TEXT - S&P cuts Milagro Oil & Gas to 'CCC'

Tue Nov 27, 2012 3:11pm EST

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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