TEXT - S&P cuts Connacher Oil & Gas to -B-'

Thu Dec 6, 2012 2:11pm EST

Overview
     -- We are lowering our long-term corporate credit rating on Connacher Oil 
and Gas Ltd. to 'B-' from 'B'.
     -- The outlook remains negative.
     -- We are also lowering our senior secured debt rating on the company's 
second lien debt to 'B+' from 'BB-'.
     -- The '1' recovery rating on the second-lien debt is unchanged. 
     -- Connacher has concluded its strategic review process without finding 
either a joint venture partner or purchaser, so we believe the company's 
prospective financial risk profile is no longer able to support the 'B' rating.


Rating Action
On Dec. 6, 2012, Standard & Poor's Rating Services lowered its long-term 
corporate credit rating on Calgary, Alta.-based oil and gas producer Connacher 
Oil and Gas Ltd. to 'B-' from 'B'. At the same time, Standard & Poor's lowered 
its issue-level debt ratings on Connacher's US$550 million and C$350 million 
second-lien debt to 'B+' from 'BB-'. The recovery ratings on the two debt 
issues are unchanged at '1', which indicates our expectation of very high 
(90%-100%) recovery under our default scenario. The outlook remains negative.

Our decision in September 2012 to revise the outlook to negative reflected our 
assessment of the execution risk associated with the timely completion of the 
company's strategic review process. Connacher has concluded this process 
without finding either a joint venture partner or purchaser, so we believe the 
company's prospective financial risk profile, and specifically its cash flow 
protection metrics, are no longer able to support the 'B' rating. In addition, 
we believe that, beyond its current liquidity, Connacher's existing operations 
are not able to generate sufficient funds from operations (FFO) to internally 
fund its minimum required maintenance capital spending beyond 2013. Although 
we believe it will continue to seek other forms of external financing, the 
uncertainty associated with the timing and success of this process further 
weakens the company's overall credit profile. 

Rationale
The ratings on Connacher reflect Standard & Poor's views of the company's high 
full-cycle cost structure, weak expected FFO generation, and highly leveraged 
balance sheet. In our view, these factors hamper Connacher's ability to fully 
realize the organic growth potential inherent in its large oil sands resource 
base. We believe that somewhat mitigating these weaknesses are the company's 
large oil sands resources, the good visibility to long-term drill-bit related 
production growth, and the potential for strong operating cash flows if it 
achieves better economies of scale, which we believe is possible with a larger 
production base. 

With the completion of its asset sales in fourth quarter of 2012, Connacher's 
business operations will focus solely on the development of its steam-assisted 
gravity drainage (SAGD) properties. The company's assets now consist of its 
wholly owned in-situ bitumen resources in northeast Alberta.

Connacher's vulnerable business risk profile reflects our view of the 
company's prospective cost structure, and the resulting strained 
profitability. Although we believe Connacher's pro forma adjusted year-end 
2011 410.7 million barrels reserves base, which includes its total net proven 
and probable SAGD bitumen reserves, would support a stronger rating, the 
company's limited financial resources will make it difficult to exploit the 
organic growth potential inherent in the SAGD reserves. 

Our assessment of Connacher's profitability incorporates the effect of the 
discounted realized prices for its heavy oil production, as well as its high 
cost structure. In our opinion, the company's unit production costs are high 
for its SAGD peer group. In addition, Connacher's cost structure reflects the 
recent increase in transportation costs, which we expect will persist 
throughout our forecast period. Transportation costs have increased because 
the company has supplemented its use of trucking with rail transport in an 
effort to access more distant markets with stronger pricing fundamentals. 
However, the heightened discounts to West Texas Intermediate (WTI) benchmark 
prices, which we believe will persist throughout 2013, have adversely affected 
Alberta netbacks. Based on Standard & Poor's calculated total cash operating 
costs (production, diluent, transportation interest,, and general and 
administrative costs) at Sept. 30, 2012, which we estimate at C$84.61 per 
barrel, we forecast Connacher's FFO will likely fund about half its required 
maintenance capital spending during our forecast period. Given its limited 
internal cash flow generation, we do not believe the company will be able to 
sustain its operations beyond 2013 without significant external funding. In 
our view, there is no flexibility in the capital structure to accommodate 
incremental debt; therefore, we believe Connacher will require substantial 
equity financing to continue developing its Great Divide project, without 
further weakening its financial risk profile and the ratings.

Despite the inability to exploit the organic growth potential inherent in its 
oil sands resource base, we believe the company's business risk profile could 
strengthen in the medium and long terms if it can continue exploiting its 
proven and probable bitumen reserves. Standard & Poor's rating methodology for 
upstream oil and gas companies with meaningful oil sands resources includes 
total net proven reserves and probable oil sands reserves in our analysis of 
the company's competitive position and overall business risk profile. Based on 
our adjusted reserves base of 410.7 million barrels, which includes 147.8 
million barrels of net proven and 262.9 million barrels of probable bitumen 
reserves, we believe there is above-average visibility to organic production 
growth inherent in Connacher's upstream portfolio. 

Although we do not incorporate contingent and prospective oil sands resources 
into our corporate credit rating analysis, we factor them into our recovery 
rating analysis, and they contribute to our estimated enterprise value in our 
default scenario. In our opinion, the very long reserve life index and 
potential for production growth without the same geological risks associated 
with conventional oil and gas assets carry strong credit attributes, which 
should be unchanged in our business risk profile analysis in the medium and 
long terms.

The company's highly leveraged financial risk profile reflects our view of its 
high debt levels, with fully adjusted debt-to-capital of 75.9% at Sept. 30, 
2012, relative to its current and expected operating cash flow. The profile 
also reflects our analysis of the financial risks associated with the large 
capital requirements to develop oil sands projects. Based on our discounted 
crude oil price assumptions, which incorporate heavy oil price differentials 
of 22.5% for 2013, in conjunction with its high total cash operating costs, we 
expect Connacher's cash flow protection metrics, specifically its fully 
adjusted FFO-to-debt, will remain very weak throughout our forecast period, 
since we do not expect the company will be able to reduce its debt during 2012 
and 2013. Connacher might improve its leverage position if it can secure 
external equity funding. In our view, this would alleviate some of the 
financial risk inherent in the continued development of the company's 
capital-intensive oil sands project. 

Liquidity
In our opinion, because it has not been able to complete a joint venture or 
sale, Connacher's liquidity position will continue to deteriorate through 
2013. Nevertheless, we believe the company's existing resources will remain 
sufficient to fully fund its financing and announced capital spending through 
year-end 2013, so liquidity should remain adequate during this timeframe. In 
isolation, its forecast EBITDA in 2012 and 2013 should exceed its financing 
requirements; however, our forecasts indicate FFO would not be sufficient to 
fund its minimum maintenance capital spending. Connacher was able to greatly 
enhance near-term liquidity with the proceeds of the sale of its conventional 
upstream properties and U.S. refinery. As a result, total current sources of 
liquidity will exceed expected uses. Pro forma the asset sales, our assessment 
of the company's liquidity and after repayment of its 2012 debt maturity, 
estimates net sources of liquidity will cover total expected uses about 2.5x. 
In our opinion, this provides sufficient resources to meet its expected 2013 
spending requirements.

Recovery analysis
For the complete recovery analysis, see the recovery report published Sept. 
24, 2012, on RatingsDirect on the Global Credit Portal. 

Outlook
The negative outlook reflects our opinion that Connacher's internal cash flow 
generation is not sufficient to sustain its current operations. Without the 
liquidity enhancement from the sale of its conventional oil and gas assets and 
refinery (completed in fourth-quarter 2012), we do not believe the company 
would be able to fully fund its ongoing financing and maintenance capital 
spending requirements. Although we believe Connacher's cash resources, pro 
forma the asset sales, should allow it to fund its announced capital spending 
through year-end 2013, its liquidity position will begin to deteriorate within 
the next 12 months if it cannot secure external equity funding to sustain its 
current operations and continue expanding its multiphase SAGD project. We 
believe the liquidity position will deteriorate more rapidly in the second 
half of 2013. Standard & Poor's now believes there is significant uncertainty 
regarding the company's ability to secure external equity financing during our 
12-month forecast period for Connacher; so we believe there is heightened risk 
of a further negative rating action. Based on the company's cash flow profile 
relative to its financing and maintenance capital spending requirements, there 
is no likelihood of a positive rating action without a transformative 
transaction.

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: Liquidity Descriptors For Global Corporate 
Issuers, Sept. 28, 2011
Canadian Oil Sands Projects: How We Rate Them, And Why, March 17, 2011

Ratings List
Connacher Oil and Gas Ltd.

Ratings Lowered/Recovery Rating Unchanged
                                        To                 From
 Corporate credit rating                B-/Negative/--     B/Negative/--
 Senior secured debt                    B+                 BB-                
  Recovery rating                       1                  1
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