TEXT-S&P rates Trilogy Energy 'B+', proposed notes 'B'
Overview -- We are assigning our 'B+' long-term corporate credit rating to Trilogy Energy Corp.. -- We are also assigning our 'B' issue-level rating to the company's proposed offering of up to C$300 million senior unsecured notes, with a '5' recovery rating. -- The ratings reflect our view of Trilogy's operations in the highly cyclical, capital-intensive industry; weak profitability compared with those of peers; competitive cost profile; increasing liquids production; and improving credit measures. -- The stable outlook reflects our expectation that Trilogy's liquid production and cash flow will rise in the next 12-18 months, lowering its debt-to-EBITDAX measure below 2x through 2014. Rating Action On Nov. 30, 2012, Standard & Poor's Ratings Services assigned its 'B+' long-term corporate credit rating to Calgary, Alta.-based independent oil and gas exploration and production (E&P) company Trilogy Energy Corp. The outlook is stable. At the same time, Standard & Poor's assigned its 'B' issue-level rating to the company's proposed C$300 million senior unsecured notes with a '5' recovery rating, indicating an expectation of modest (10%-30%) recovery for debtholders in a default scenario. Rationale The rating on Trilogy reflects Standard & Poor's view of the company's "weak" business risk profile and "aggressive" financial risk profile. We view the company's management as "fair". The ratings also reflect our view of Trilogy's operations in a highly cyclical, capital-intensive, and competitive industry; weak profitability compared to its peers; and limited geographic and operational diversity. We believe the company's competitive cost structure and increasing liquids production offset these weaknesses somewhat. In our opinion, Trilogy's aggressive financial risk profile reflects the company's improving credit measures and high fixed costs. Trilogy is a midsize E&P company (it had about 64 million barrels of oil equivalent of gross proved reserves at year-end 2011 and about 33,400 barrels per day production for third-quarter 2012) that operates mostly in Alberta. About 95% of the company's reserves and production are from the Kaybob region in Alberta. Pro forma the proposed notes offering, Trilogy will have about C$730 million in adjusted debt (our adjustments include asset retirement obligations [about C$139 million] and operating leases [about C$12 million]). The company's cash flow is exposed to the highly volatile and capital-intensive oil and gas E&P industry. In peak periods, hydrocarbon prices rise markedly and large profits result. Currently, E&P companies are benefiting from elevated oil prices; however, in the long term, the risk remains that oil prices could decline. Trilogy's profitability (per boe)is weaker than that of its 'B+' rated peers. Nevertheless, in the next 12-18 months we expect it to improve because we forecast liquids, which are more profitable than gas, to be about 50% of the company's 2013 production from 40% in 2012. However, we forecast Trilogy's profitability to remain weak compared to peers due to the Canadian crude discount to West Texas Intermediate (WTI) and pressure on lighter natural gas liquids prices. At the same time, low natural gas prices will continue to weigh on the company's profitability. We believe Trilogy's limited operational diversity is a credit weakness. The company's existing operations are focused in the Kaybob region of Alberta. Any production downtime in the region would hurt the company's production, since Trilogy would be unable to replace production from elsewhere. For example, infrastructure delays in the area lowered the company's 2012 expected production to 34,000 bpd compared with the original 40,000 bpd. Trilogy has a competitive cost structure. We expect the company's cash operating costs (includes operating, transportation, and general and administrative costs) to remain competitive and stable as it increases its liquids production. We also expect Trilogy's future levered costs (combination of cash operating costs, depreciation and exploration costs, and interest expense) to remain a competitive C$32 per boe, allowing it to continue to generate positive netbacks. If the company cannot maintain its competitive cost structure as it increases production, a negative rating action could follow. We view as credit positive Trilogy's increasing liquids production due to their higher netbacks compared with those of gas, and rising contribution to future cash flow. Between the Kaybob's Montney oil pool and South-Montney Gas development, we expect 2013 liquids production to be about 19,000 bpd, up from approximately 12,500 bpd in third-quarter 2012. Montney oil pool production has high netbacks (above C$40 per boe) when compared with the company's consolidated netback of C$18 per boe. Therefore, we expect Trilogy's EBITDA and funds from operations (FFO) to improve significantly in 2013 as Trilogy brings the Montney oil pool production online. We believe the completion of the infrastructure in Kaybob region should allow the company to be able to grow its production without any significant bottlenecks in the near term. The presence of multiple geological formations within its geographically concentrated reserves provides significant opportunities for growth in the long term. Under our July 2012 price scenario, and assuming the current correlations between WTI prices and realized crude prices hold (about 15%-20% discount), Standard & Poor's expects Trilogy to generate EBITDA of C$375 million-C$425 million in 2013 and 2014. We expect the company to end 2014 with its debt-to-EBITDA below 2x and its (FFO-fixed charges)-to-debt at 20%-30%. Our assumptions include the following: -- Standard & Poor's WTI price assumptions are US$85 per boe for 2012, US$80 for 2013, and US$75 for 2014; Henry Hub gas price assumptions are US$2.50 per million BTU for 2012, US$3.00 for 2013, and US$3.50 for 2014. -- Production in 2013 and 2014 will increase 15%-20% with gas remaining at 50%-55% of total production. -- Unit full-cycle costs will be unchanged. -- Fixed costs (maintenance capex and dividends) for 2013 and 2014 are C$200 million. -- We expect that the company will fund its negative discretionary free cash flow (free cash flow minus cash dividends) with debt. Pro forma the proposed notes offering, we expect Trilogy's cash flow strength to remain relatively strong compared with our guidelines for an "aggressive" financial risk profile (total adjusted debt-to-EBITDA of 3x and total adjusted FFO-to-debt of 30%). Its fixed charges are high, in our view, and include a maintenance capex (to keep production flat) of C$150 million-C$180 million and dividend of about C$50 million. Taking these fixed charges into account, Trilogy's (FFO-maintenance capex-cash dividends)-to-debt drops to below 0%. If we remove cash dividends, FFO and maintenance capex-to-debt still remains near 0%, which we believe is weak. However, we believe the company's lower balance-sheet debt compared with that of similarly rated peers is beneficial; we believe it offsets the risks associated with Trilogy's lack of diversity and seasonal limitations on annual production common to most Alberta-based producers Liquidity We believe the company's liquidity is adequate, pro forma the C$300 million notes offering. Our assessment of the liquidity profile incorporates the following expectations and assumptions: -- We expect Trilogy'ssources of liquidity, which includes funds from operations, availability under the revolving facility, and proceeds from notes, to be 1.2x total uses in the next 12-18 months. -- We expect the company to fund its uses even if EBITDA dropped 15%, due to a drop in hydrocarbon prices. -- It has adequate flexibility in its capital program to reduce it to its maintenance capital expenditure of C$150 million-C$180 million, to preserve liquidity. Trilogy has about C$62 million available under its C$650 million revolving facility. Following the notes offering, its revolving facility will fall to C$610 million and liquidity will increase to about C$300 million. We view the company's sources of liquidity as including positive funds from operations and credit line availability. We calculate minimum fixed charge for Trilogy at about C$200 million (includes maintenance capex and dividends), which it should be able to cover by its funds from operations. Following the notes placement, we expect the facility's financial maintenance covenants to include a maximum senior debt-to-EBITDA ratio of below 3x and maximum consolidated debt-to-EBITDA ratio of below 4x. Recovery analysis For the complete recovery analysis, see the recovery report to be published on RatingsDirect on the Global Credit Portal following this report. Outlook The stable outlook reflects our view that Trilogy's capital spending program in the Kaybob region will result in increased oil production and reserves. Given its increasing liquids production, we foresee the company maintaining credit protection measures that are adequate for the rating, with leverage projected to be below 2x in the next two years. Because we factor expected reserves and production growth into the ratings, there is little likelihood of an upgrade during this period. A positive rating action for Trilogy would depend on an improving business risk profile: for example, as the company increases its reserves and expands its operations such that its increased liquids production leads to the doubling of netbacks. We would also expect that the balance-sheet profile will not deteriorate materially through this period of growth. We could lower the ratings if Trilogy cannot achieve the expected production growth (15%-25%) in 2013, profitability deteriorates significantly either due to lower realized commodity prices or higher cost profile, or if its debt-to-EBITDA deteriorates to above the 4.0x-4.5x range. Trilogy's current debt-to-EBITDAX ratio provides it with ample financial flexibility to outspend its internally generated cash flow. Based on our forecasts we view a downgrade as unlikely through 2014. Related Criteria And Research -- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Revised Assumptions For Assigning Recovery Ratings To The Debt Of Oil And Gas Exploration And Production Companies, Sept.14, 2012 -- Standard & Poor's Raises Its U.S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, July 24, 2012 -- Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Recovery: Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ratings Assigned Trilogy Energy Corp. Corporate credit rating B+/Stable/-- Senior unsecured debt Sr unsecd nts due 12/31/2019 B Recovery rating 5 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.