TEXT - S&P rates Southern Pacific Resources Corp
Overview -- We are assigning our 'B-' long-term corporate credit rating to Calgary, Alta.-based oil and gas company Southern Pacific Resources Corp. -- We are also assigning our 'B+' senior secured debt rating and '1' recovery rating to the company's proposed C$300 million second-lien debt issue. -- The ratings reflect our view of Southern Pacific's small regionally focused operations, its inability to absorb adverse operational issues as it proceeds with the ramp-up of its McKay project, limited discretionary free cash flow generation during our forecast period, and highly levered balance sheet. -- The stable outlook reflects Standard & Poor's view that the company's credit profile should remain fairly stable following the McKay project ramp-up. Rating Action On Jan. 11, 2013, Standard & Poor's Ratings Services assigned its 'B-' long-term corporate credit rating to Calgary, Alta.-based oil and gas company Southern Pacific Resources Corp. The outlook is stable. At the same time, Standard & Poor's assigned its 'B+' senior secured debt rating and '1' recovery rating to the company's proposed C$300 million second-lien debt issue. The '1' recovery rating indicates our expectation of very high (90%-100%) recovery in a default scenario. Rationale The ratings reflect Standard & Poor's view of the company's small regionally focused operations, its inability to absorb adverse operational issues as it proceeds with the ramp-up of its McKay steam-assisted gravity drainage (SAGD) development project, limited discretionary free cash flow generation during our 2013-2014 ratings forecast period, and highly levered balance sheet (which we do not expect will strengthen materially during the forecast period). We believe the organic growth prospects inherent in the company's reserves base; the competitive cost profile; and profitability associated with its Senlac operations, which we believe should remain unchanged as the company continues to expand its in-situ oil sands production base, offset these weaknesses somewhat. Southern Pacific focuses on the exploration and production of in-situ bitumen in the Athabasca oil sands fairway, and thermal production of heavy oil in Senlac, Sask. The STP-McKay (in-situ project) and the STP-Senlac (thermal oil project) are the company's core assets. Southern Pacific also has oil sands leases in the McMurray and Peace River areas in northeast Alberta. In our opinion, the company's vulnerable business risk profile reflects the early stage development of its small regionally focused upstream operations, and limited ability to withstand unexpected operational issues. With the completion of the first McKay development phase, Southern Pacific is ramping up production at its 12,000 barrel per day in-situ oil sands project, although it does not expect to operate at full capacity there until the end of fiscal 2014. As a result, our forecasts for the company, which include daily average production from both its existing Senlac thermal project and its new McKay SAGD project, have production exceeding 10,000 barrels per day in fiscal 2014, and continue increasing in the subsequent year. At these production levels, we expect Southern Pacific should be able to generate sufficient operating cash flow to sustain its Semlac and McKay Phase 1 operations. Nevertheless, under Standard & Poor's forecasting assumptions, which include a reduction in realized crude oil prices due to both falling West Texas Intermediate prices and heavy oil price differentials maintained at about 20% throughout our forecast period, we believe the company will have limited ability to withstand unexpected operational issues. Any delay in production ramp-up or unexpected shutdown at McKay, which keeps bitumen production below 80% of design capacity could cause it to generate negative free cash flow, under our hydrocarbon price assumptions. In our opinion, these weaknesses in Southern Pacific's business risk profile are offset by the good organic reserves and production growth potential inherent in its 120 million barrels of gross proven and 249 million barrels of proven and gross probable oil sands reserves; the company's competitive full-cycle cost profile; and the associated profitability, which we measure using both earnings before interest and taxes and return on capital employed. Based on the company's fiscal year-end 2012 (June 30) proven and probable oil sands reserves, the company's reserve life index (RLI) could exceed 20 years, assuming production levels reach and remain at peak design capacity. This represents an above-average RLI for an exploration and production company, and is one of the strongest components in our assessment of Southern Pacific's business risk profile. In addition, the full-cycle costs associated with the Senlac operations are fairly competitive, and allow the company to generate robust netbacks, despite lower realized prices for its heavy crude output. Standard & Poor's estimates the company's levered full-cycle costs (total operating, financing, and three-year average finding and development costs) at Sept. 30, 2012, were C$31.29 per barrel of oil equivalent (boe). This cost structure, relative to its fiscal 2013 first-quarter average realized price of C$60.61 per boe, provides a profitability profile that is commensurate with those of its North American peers rated at the middle and upper end of the 'B' category. The McKay production's realized prices will likely exceed price realizations for the Senlac production, and although we expect differences in some costs (specifically, transportation), profitability metrics could strengthen if McKay's full-cycle costs remain largely consistent with the company's existing cost structure. In our view, Southern Pacific's highly leveraged financial risk profile reflects the high debt in its capital structure, which Standard & Poor's does not expect will decrease materially during our forecast period; and the company's expected negative free cash flow generation, as capital spending will remain above forecasted funds from operations (FFO) throughout most of our forecast period. Although we expect total gross adjusted debt to continue rising throughout our forecast, cash flow protection metrics should improve because both EBITDA and FFO will strengthen in tandem with increasing production levels. Our forecasts include fully adjusted debt-to-EBITDA and FFO-to-debt being at their weakest levels at fiscal year-end 2013, and improving materially by fiscal year-end 2014. Assuming McKay production ramps up as expected, debt-to-EBITDA should fall below 5.0x and FFO-to-debt increase above 10% in fiscal 2014. We believe these cash flow metrics would be sufficient to support the 'B-' rating. Liquidity We believe Southern Pacific's liquidity will be adequate to meet its required operational and financing obligations throughout our forecast period. we expect bitumen production from its recently completed McKay SAGD project will continue ramping up through the remainder of fiscal years 2013 and 2014, so cash flow generation, which we forecast using our current hydrocarbon price and differential assumptions, should be sufficient to fund substantially all of the company's spending requirements. Although we are forecasting about C$20 million of negative free cash flow generation in the current fiscal year, availability under Southern Pacific's upsized C$75 million revolving credit facility will adequately bridge the expected near-term cash flow shortfall. Overall, we are forecasting the ratio of net liquidity sources to required financing and operating funding obligations to remain above 1.2x, even with a 15% reduction to our base case EBITDA. At the expected sources-to-uses ratio levels, we believe the company's liquidity will remain adequate throughout our forecast period. Recovery analysis For the complete recovery analysis, see the recovery report to be published on RatingsDirect on the Global Credit Portal following this research report. Outlook The stable outlook reflects Standard & Poor's view that Southern Pacific's credit profile should remain fairly stable following the McKay project ramp-up. We expect internal cash flow generation should largely fund total spending requirements throughout our forecast period and beyond. As a result, the company's cash flow protection metrics, which we forecast to improve in fiscal 2014, should remain fairly stable under our assumed hydrocarbon price, production, and cost assumptions. We do not expect Southern Pacific will be able to increase EBITDA and FFO materially above the levels we are forecasting, based on the production capacity at its Senlac and McKay operations. In addition, we are not expecting meaningful positive discretionary free cash flow in the near-to-medium term, based on our assumed operating cash flow generation and capital spending requirements for the company. Under these assumptions, Southern Pacific is unlikely to strengthen its cash flow protection metrics (through material debt reduction) beyond the levels we are forecasting at fiscal year-end 2014. Nevertheless, if the company is able to decrease its fully adjusted debt-to-EBITDA below 3.5x and increase FFO-to-debt above 20%, while maintaining its full-cycle cost profile and profitability at levels we view as commensurate with a 'B' rating, we would raise the corporate credit rating to 'B'. Conversely, if deteriorating production economics or capital cost escalation causes debt-to-EBITDA to increase above 6.0x and FFO-to-debt to fall below 10%, we would lower the rating to 'CCC+'. 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 Ratings Assigned Southern Pacific Resources Corp. Corporate credit rating B-/Stable/-- Prop. C$300 mil. 2nd-lien issue B+ Recovery rating 1
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