The company has maintenance covenants under its debt. Under our standard oil price scenario of $90 per barrel (bbl) for Brent in 2013 and $80 perbbl in 2014 and beyond, those covenants could be breached and annual maturities may exceed the amount of free cash flow generated. Compared with other rated Russian companies, Russneft’s asset quality is somewhat lower, as the company operates relatively mature fields with lower economies of scale and its operating costs are slightly above average for Russia. Like its peers, Russneft is exposed to oil price fluctuations and faces a heavy tax burden, so that the majority of all-in costs are effectively set by the government.
These constraints are partly offset by the adequate profitability of Russneft’s upstream operations and by our expectation of positive free cash flow. Russneft enjoys an imperfect natural hedge because the majority of Russneft’s taxes are linked to the Urals price and the Russian ruble negatively correlates with the oil price. Russneft’s assets are fairly diversified across Russian oil-producing regions. We understand that capital spending is relatively modest as Russneft’s production growth mainly comes from efficiency gains, as the company is catching up after the difficult period of 2008-2009 and does not have any large costly new projects.
The company’s financial policy is aimed at deleveraging, as highlighted by the absence of dividends and by gradual deleveraging in recent years, as illustrated by Russneft’s sale of its refining and marketing assets to reduce debt by $1.1 billion in 2011. Still, we see some long-term uncertainty over how Russneft’s shareholding structure and financial policy will evolve in coming years. Currently, Russneft’s shareholders are Russian company Sistema (JSFC) (BB/Stable/--; 49%), CEO and founder Mikhail Gutseriev (49%), and the Russian state-owned Sberbank (not rated; 2%). Significant minority stakes in operating subsidiaries are held by the international trader Glencore International PLC (BBB/Stable/A-2).
S&P base-case operating scenario
We expect Russneft to generate about $1.5 billion EBITDA in 2012. Under our standardized price assumptions of $80 per bbl for Brent in the long term, we expect Russneft’s EBITDA to be about $1.1 billion.
We expect Russneft’s oil production to grow as the company catches up after the difficult 2008-2009 period, when it faced a decline in production on the back of underinvestment and shareholding uncertainties. After the company’s shareholding structure was settled in 2010, Russneft demonstrated impressive production growth thanks to efficiency gains, which we expect to continue.
S&P base-case cash flow and capital-structure scenario
Russneft’s credit measures have improved markedly in 2009-2012, and we expect the positive trend to continue. Under our standard price assumptions, we expect Russneft to generate positive free operating cash flow (FOCF) of about $300-500 million and gradually reduce debt. This should translate into funds from operations (FFO) to adjusted debt of about 15%-20% and adjusted debt to EBITDA of 3.5x-4.5x, in our view.
We view Russneft’s liquidity as “less than adequate”. Although the company’s ratio of liquidity sources to liquidity needs is above 1.2x, covenant headroom is tight and the company is still in the process of establishing its standing in the credit markets.
At June 30, 2012, the key sources of liquidity for the next 12 months included expected FFO of about $1.1 billion. We believe that cash balances ($108 million) were largely tied to operations and hardly available to repay debt. In addition, the company has some flexibility thanks to a $300 million unused short-term revolving trade finance facility from Glencore. The key liquidity needs included $367 million debt amortization in 2012 and about $0.5 billion in capital spending. In addition, the company faces relatively sizable maturities of $257 million in 2013 and $364 million in 2014, which we believe carry refinancing risks. Essentially all Russneft’s debt comes from only two lenders, Sberbank and Glencore, and we view reliance on those key lenders as a risk.
Russneft faces tight maintenance covenants under its existing debt facilities. Under our price scenario, we see the risk of a covenant breach. Our base-case expectation is that Russneft should be able to obtain a waiver, as it did before, or to refinance.
We believe that Russneft’s current efforts to optimize its debt structure and diversify borrowing sources should be positive for liquidity and possibly provide for ratings upside potential after they are implemented.
The positive outlook reflects some upside potential for the rating if Russneft improves its liquidity by addressing potential covenant issues, extending its maturity profile, and diversifying its funding sources. It also reflects our expectation that Russneft will continue to generate positive FOCF and use it for deleveraging. We expect Russneft to refrain from any sizable acquisitions or dividends, at least as long as its adjusted debt to EBITDA is above 3x.
Under our price scenario, we expect adjusted debt to EBITDA to be about 3.5x-4.5x and FFO to adjusted debt to be about 15%-20%. In the event of any shifts in the shareholding structure, we will evaluate the impact on the company’s financial policy.
Downside pressure could stem from a further increase in liquidity pressures. Downside pressure could also materialize if the company’s leverage were to increase, for instance in the event of very low oil prices, higher-than-expected capital expenditures, or in the event of any unforeseen acquisitions, which are not part of our base-case scenario.