TEXT-S&P rates Shelf Drilling corporate credit 'B'

Thu Dec 20, 2012 12:52pm EST

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Overview
     -- On Nov. 30, 2012, newly-formed Cayman Island-based oilfield services 
company Shelf Drilling Holdings Ltd. (Shelf Drilling) announced that it has 
completed the acquisition of 38 rigs from offshore drilling company Transocean 
Ltd. 
     -- We assess Shelf Drilling's business risk profile as "vulnerable," and 
its financial profile as "aggressive."
     -- We are assigning our 'B' long-term corporate credit rating to Shelf 
Drilling. 
     -- The stable outlook reflects our view of supportive industry conditions 
and Shelf Drilling's relatively stable credit metrics. 

Rating Action
On Dec. 20, 2012, Standard & Poor's Ratings Services assigned its 'B' 
long-term corporate credit rating to Cayman Island-based oilfield services 
company Shelf Drilling Holdings Ltd. (Shelf Drilling). The outlook is stable.

At the same time, we assigned an issue rating of 'B+' and a recovery rating of 
'2' to Shelf Drilling's first-lien $75 million term loan facility. The 
recovery rating of '2' indicates our expectation of substantial recovery 
(70%-90%) in the event of a payment default.

We also assigned an issue rating of 'B' and a recovery rating of '3' to Shelf 
Drilling's $475 million senior secured notes. The recovery rating of '3' 
indicates our expectation of meaningful (50%-70%) recovery in the event of a 
payment default.

Rationale
The assignment of ratings follows the successful closing of Shelf Drilling's 
acquisition of 38 rigs from offshore drilling company Transocean Ltd., as per 
Shelf Drilling's original announcement on Sept. 10, 2012. In particular, the 
ratings reflect: 
     -- The successful implementation of Shelf Drilling's funding structure, 
including appropriate commitments from its banks; and
     -- Our assessment of Shelf Drilling's liquidity as "adequate" under our 
criteria.

The ratings on Shelf Drilling also reflect our assessment of the company's 
business risk profile as "vulnerable" and its financial profile as 
"aggressive."

Our view of Shelf Drilling's financial risk profile is based on its leveraged 
cash flow ratios. We forecast that its funds from operations (FFO) to Standard 
& Poor's-adjusted debt will be about 13% in 2013. (Under our criteria, we 
treat preferred equity as debt-like in calculating this ratio.) However, we 
anticipate that the ratio will improve to 15%-20% from 2014. We consider Shelf 
Drilling's free operating cash flow (FOCF) generation to be modest in light of 
its sizable capital expenditure (capex), leading to modest deleveraging 
prospects. We assess the company as having "adequate" liquidity, but a limited 
cushion if it does not adjust its capex in line with actual operating cash 
flows. Because the company was established as a spin-off, it lacks audited 
financial information. 

These risks factors are mitigated by some positive features. The company has 
moderate headline leverage (debt to adjusted EBITDA of about 3.5x-4.0x) and 
its debt ratios are less leveraged when we exclude preferred equity. 
Additionally, we understand that there are no financial maintenance covenants 
and that the company has little meaningful debt amortization.

The "vulnerable" business risk profile is based on Shelf Drilling's lack of an 
established operating business track record as a stand-alone entity, and its 
participation in the competitive, fragmented, and capital-intensive oil and 
gas service industry. The "jack-up" segment in which it operates has 
historically been even more volatile than the oil and gas industry overall. 
The fleet of 38 rigs is relatively old, with an average time in service of 31 
years. Oilfield services companies depend heavily on the investment decisions 
made by exploration and production companies, which in turn depend on the 
outlook for cyclical oil prices; as a result, day rates can be volatile 
through the cycle. Shelf Drilling's fleet has limited diversification by 
depth. 

These constraints are partly mitigated by Shelf Drilling's sizable backlog of 
contracts, its sound market position as the No. 3 jack-up driller in the 
world, its geographic diversification, and its management's significant 
industry experience.

Liquidity
We assess Shelf Drilling's liquidity as "adequate" under our criteria, 
reflecting our expectation that cash sources will cover cash needs by about 
1.3x in the next 13 months. If this ratio falls to less than 1.2x, for example 
as a result of the company's operational performance or inability to curb 
capex, we would revise our assessment of liquidity downward to "less than 
adequate."

Our assessment of sources of liquidity over the 13 months from Dec. 1, 2012, 
includes: 
     -- Cash of about $400 million on hand, although at least $50 million of 
this may be tied to operations. In addition, we understand that the bulk of 
the opening cash balance is temporary, and intended to fund the exceptionally 
high working capital outflow in the first year of operations; and
     -- FFO of $120 million-$130 million in 2013.

Our assessment of liquidity needs includes:
     -- Scheduled debt maturities of less than $1 million a year;
     -- Capital spending of about $150 million, of which about $86 million is 
dedicated to maintenance purposes. Spending includes investment needed to 
restart the stacked rigs, for upgrades, or to prepare contracts to which 
management has not committed and therefore can be cut if the market conditions 
are not favorable.
     -- A one-off working capital outflow of about $180 million, because 
Transocean will collect and retain its existing receivables after the closure 
of the sale (offset by the high initial cash balance).

We consider it positive that Shelf Drilling will not have any financial 
maintenance covenants under its senior term loan.

Recovery analysis
The issue rating on the first-lien $75 million term loan facility is 'B+'. The 
recovery rating on the term loan is '2', indicating our expectation of 
substantial recovery (70%-90%) in the event of a payment default. 

The issue rating on the $475 million senior secured notes is 'B'. The recovery 
rating on the senior secured notes is '3', indicating our expectation of 
meaningful (50%-70%) recovery in the event of a payment default.

The recovery rating on the term loan is primarily supported by first-lien 
security on at least 27 of the total 38 rigs and by pledges on the equity of 
five restricted subsidiaries owning five of the company's remaining 11 rigs. 
The aforementioned security will be put in place within 90 days of the closing 
of the acquisition. The recovery rating on the senior secured notes is 
supported by second-lien ranking on the same security package. However, the 
recovery rating on the term loan and senior secured notes is constrained by 
substantial jurisdictional risk because the rigs are located in the waters of 
several different jurisdictions throughout Africa, Asia, and the Middle East. 

The 38 rigs are located in 12 different countries worldwide, primarily in 
Saudi Arabia, India, Egypt, and Thailand. We anticipate that arresting these 
assets and enforcing security in case of a default could prove challenging. In 
addition to the existing $75 million prior ranking term loan, the 
documentation for the credit facility allows for an incremental term facility 
of $50 million that is subject to a 3.25x total net leverage ratio, and 
additional second-lien debt that is subject to a 2.0x fixed-charge coverage 
ratio and a 2.0x secured leverage ratio. 

The senior secured notes' documentation includes restrictions on additional 
indebtedness subject to a 3.25x total net leverage ratio and a 2.0x 
fixed-charge coverage ratio. Pro forma for the transaction, the net leverage 
ratio is 2.1x, which would allow for some additional borrowing under the 
documentation. The documentation also includes covenants that restrict 
dividend payments such that they cannot exceed an income basket of 50% of 
consolidated net income. Income starts to accumulate from the first quarter 
after the issuance of bonds. 

In assigning recovery ratings, we simulate a payment default scenario. We 
consider that the key risk Shelf Drilling faces is its ability to secure 
contracts on the rigs as existing contracts expire. Furthermore, we believe 
the company has exposure to volatility in market rates as contracts come up 
for renewal, and has limited flexibility to reduce underlying operating costs 
without taking rigs out of operation. Given that most of the rigs are at least 
30 years old, we expect relatively high maintenance capex. We assume these 
pressures would depress Shelf Drilling's utilization and day rates, revenues, 
and profitability, and lead to a hypothetical payment default in 2014. 

We believe that Shelf Drilling would remain a going concern in default because 
of its good market position in the jack-up drilling rigs business; its 
distinct operating activities; and the contract-based nature of its drilling 
activities, which provides short- to medium-term earnings visibility. 
Nevertheless, we have used a discrete asset valuation methodology to estimate 
the company's value, because we believe it has an extensive asset base, and 
this method provides insight as to the company's likely value at default. We 
estimate the stressed enterprise value of the company at default by stressing 
its assets. Given the volatility of the industry and the fleet age of these 
rigs (on average 31 years), we estimate a stressed enterprise value of $618 
million for Shelf Drilling at the point of hypothetical default. 

From the gross enterprise value, we deduct administrative costs and 50% of 
pension costs as priority liabilities. The net stressed enterprise value would 
be sufficient to provide substantial (70%-90%) recovery for the first-lien 
term loans of $129 million (including the incremental facility and six months' 
prepetition interest); and meaningful recovery (50%-70%) for the second-lien 
senior secured notes of $496 million (including six months' prepetition 
interest). Although the numerical coverage is higher than 90% for the term 
loans and 70% for the notes, we have kept the recovery rating on the term loan 
at '2' and senior secured notes at '3' to reflect our view of the high 
jurisdictional risk in exercising the security.

Outlook
The stable outlook reflects our view that industry conditions are 
strengthening after two weak years. Slightly higher day rates should allow 
Shelf Drilling to stabilize its EBITDA, which has declined in recent years. We 
anticipate that the oil price will remain supportive for operators overall, 
despite the uncertain global environment. On a pro forma basis, we view a 
sustainable adjusted ratio of FFO to debt (including preferred equity) of 
15%-20% as commensurate with the current ratings. We anticipate that the 2013 
ratio will be low for the ratings, but will improve thereafter. 

We could raise the ratings in the medium term, once Shelf Drilling has built 
an operating track record. If management can successfully contain costs, 
especially if Shelf Drilling can lock in higher average day rates as the 
market strengthens, FFO to debt could rise sustainably to the "significant" 
category--that is, between 20% and 30%. Raising the ratings would also depend 
on the new owners pursuing supportive financial policies. 

We could lower the ratings if we see FFO to debt of 12% or below on a 
sustainable basis or if day rates or utilization levels fall. This could occur 
because new rigs are competing with Shelf Drilling's older rigs. That said, 
Shelf Drilling currently has an adequate contract line-up for the next 12-18 
months. However, falling day rates remain a key risk factor in view of the 
sensitivity of Shelf Drilling's cash flows. 

Related Criteria And Research
All articles listed below are available on RatingsDirect on the Global Credit 
Portal, unless otherwise stated.
     -- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 
2012
     -- Key Credit Factors: Global Criteria For Rating Oilfield Services And 
Equipment Companies, July 30, 2012
     -- Methodology And Assumptions: Liquidity Descriptors For Global 
Corporate Issuers, Sept. 28, 2011
     -- Hybrid Capital Handbook: September 2008 Edition, Sept. 15, 2008
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 

Ratings List
New Rating; CreditWatch/Outlook Action

Shelf Drilling Holdings Ltd.
 Corporate Credit Rating                B/Stable/--        
  Senior Secured                        B+                 
   Recovery Rating                      2                  
  Senior Secured                        B
   Recovery Rating                      3


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.
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