Fitch Ratings has affirmed Strathcona Resources Ltd's Long-Term Issuer Default Rating (IDR) at 'B+' and secured revolving credit facility at 'BB+'/'RR1'.
In addition, Fitch has assigned a 'BB+'/'RR1' rating to Strathcona's planned CAD700 million first-lien term loan, and has downgraded its senior unsecured notes to 'B'/'RR5' from 'B+'/'RR4'. The Rating Outlook is Stable.
The senior unsecured notes have been downgraded due to the amount of higher priority debt Strathcona is adding to its capital structure to fund the acquisition of Serafina Energy Ltd.
Strathcona's ratings reflect its low decline asset base, proved reserve size, FCF, and expectations and leverage trending to 1.0x during Fitch's forecast period. The ratings also consider execution risks around the company's M&A growth strategy, exposure to West Texas Intermediate (WTI) and Western Canadian Select (WCS) spreads, and the company's higher operating cost profile.
Key Rating Drivers
Complimentary Asset Acquisition: The acquisition of Serafina compliments Strathcona's existing Lloydminster production, adding an approximately 40Mboepd of heavy oil assets that are similar steam assisted gravity drainage (SAGD) to Strathcona's existing thermal production, but lower viscosity, which reduces steam injection requirements and benefiting cost structure.
Debt Funded M&A: Strathcona plans to fund the CAD1.9 billion due at closing of the CAD2.3 billion purchase price by increasing its first lien revolving credit facility from CAD1.5 billion to CAD2.0 billion and drawing it to CAD1.8 billion, which is an increase of CAD927 from 1Q21. Concurrently, Strathcona is adding a first-lien CAD700 million 18-month term loan that has an excess cash sweep feature. The revolver size and utilization as a funding source is atypical at Strathcona's rating level and introduces liquidity risk to its credit profile until drawings can be reduced. Once this occurs, Fitch could review the rating.
FCF Provides Debt Reduction Ability: Proforma the acquisition, Fitch expects positive cash flow through its forecast period. This includes in excess of CAD1 billion generated in 2023 with a full year of production contributions from the Serafina acquisition. This provides a path under Fitch's base case for meaningful revolver balance reductions, although liquidity risk is heightened until this occurs. Since Strathcona does not pay a dividend, Fitch does not expect any capital distributions allowing it to focus FCF to debt.
Fitch forecasts a temporary leverage increase towards 2.0x in 2022 due to the mid-year timing of the Serafina acquisition before reducing to approximately 1.0x leverage through the forecast period under its base case, which assumes USD100/bbl WTI in 2022, USD81/bbl in 2023, USD62/bbl in 2024 and USD50/bbl longer-term. Strathcona targets a longer term 1.0x to 1.3x leverage at USD70/bbl and has identified a 2.0x leverage target at USD40 WTI as a threshold for potentially distributing a dividend.
M&A Growth: The Serafina acquisition is expected to close on Aug. 29, 2022. This, along with the closing of the Caltex Resources Ltd. and the Tucker thermal asset transactions, and subsequent acquisition of outstanding economic interests in these in March 2022, has grown Strathcona's gross of inter-field transaction production to approximately 150mboepd, which is a meaningful production level for the 'B' rating category.
Fitch anticipates Strathcona will continue utilizing M&A as an active element of its strategy, and would look for asset cohesion in any further transactions. Its success to date in finding good value assets stuck in challenging corporate situations may be more difficult to emulate under the current strength of the oil and gas prices.
Low Decline, Large Reserve Asset Base: Excluding any impact from the planned Serafina acquisition, the benefits of Strathcona's corporate decline rate of 18%, which positions favorably against typical E&P's, results in lower sustaining capital requirements for Strathcona. This balances a more intensive operating cost structure, reflected in its CAD37.1/boe expenses and Fitch calculated unhedged netback of CAD44.3 in 1Q22. Pro-forma the Serafina acquisition, Strathcona will have approximately 1.3 billion boe of proved reserves, although a large portion of the asset base is lower value proved undeveloped (PUD) reserves associated with oil sands. Strathcona's reserve base size is consistent with the 'BB' rating category.
Exposure to Differential Risks: Excluding the 40mboepd Saskatchewan heavy oil production expected from Serafina, Strathcona's operations consist of Cold Lake Thermal in Alberta, condensate-rich Montney and Lloydminster Heavy Oil. These three plays provide good operational diversification for an E&P of Strathcona's size. The overall basin diversification of these plays are tempered, as they are located in Canada's Western Canadian Sedimentary Basin, exposing Strathcona to sometimes volatile WCS-WTI spreads.
WCS-WTI spreads have expanded to approximately USD20/bbl, the exposure of which adds a layer of volatility to realized prices given the company's bitumen and heavy oil production represented approximately 2/3rds of the companies proforma production 1Q22 production. The addition of Serafina includes a 50mboepd rail facility, which facilitates shipping crude by rail to the U.S. without the need to blend condensate. Production shipped by rail will help reduce overall exposure to WCS-WTI spreads.
Natural and Financial Hedges: Strathcona benefits from its ability to use natural gas and condensate that it produces in its Montney operations to partially cover fuel for steam generation and diluent requirements in its thermal and heavy oil operations. Excluding the impact of Serafina, natural gas production in excess of consumption needs and condensate production in excess of 20% of consumption needs act as these natural hedges.
This hedge from its operations reduces exposure to pricing fluctuations in natural gas and condensate that otherwise would need to be sourced externally. Additionally, Strathcona uses differential and price hedges to improve visibility on future cash flows. Prior to the Serafina acquisition these hedges were generally on 25% to 30% of the following 12 to 18 months expected production. At Serafina's close, Strathcona will be required to hedge 50% of its next six months of production and 30% of the six months following that. The six-month 50% of production hedge is a rolling requirement as long as the CAD700 term loan is outstanding.
Derivation Summary
Pro-forma the Serafina transaction Strathcona will produce approximately 150mboepd gross of intercompany uses. This compares against other 'B+' rated Canadian heavy oil producers MEG Energy which produces 101.1mboepd in 1Q22 (in 2Q22 MEG production decreased 67mboepd due to down time at Christina Lake) and Baytex at 83.1mboped. It is above Canadian producer Vermilion's (BB-) 1Q22 86.2mboepd, whose rating benefits from its international diversification and higher price exposure.
Strathcona has a notably large reserve base for the 'B+' rating category with proforma Stickney and Serafina at approximately 1.3 billion boe proved reserves. This is in line with MEG at 1.3 billion boe and is materially above Baytex and Vermilion respective proved reserves.
At YE 2022, debt/EBITDA is forecast at approximately 1.8x, then trending at or below 1.0x through the remainder of Fitch's forecast, which is comparable within the peer group of MEG, Baytex, Vermilion, which are each forecast at or below 1.0x leverage. In terms of debt/flowing barrel, proforma Serafina at CAD20.8M/bbl Strathcona trails the peer group with the exception of MEG energy at 24.3M/bbl, whose absolute debt level of CAD2.5 billion will now be below Strathcona's CAD3.2 billion.
Key Assumptions
WTI prices of USD100/bbl in 2022, USD81/bbl in 2023, USD62/bbl in 2024 and USD50/bbl thereafter;
Henry Hub prices of USD6.25/mcf in 2022, USD4/mcf in 2023, USD3.25/mcf in 2023 and USD2.75/mcf thereafter;
Intercompany eliminations grow in step with bitumen and heavy oil growth;
Capex between CAD700-CAD800 million in 2023 to 2025;
Term loan repaid in 2023;
No distributions or M&A, revolver balance reduction is prioritized;
G&A scale efficiencies on a per BOE basis.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Improved financial flexibility including materially reduced revolver utilization and allocation of FCF to absolute debt;
Improving relative cash netback through lower and sustainable operating costs;
Production sustained above 125mboepd;
Mid-cycle total debt/operating EBITDA maintained below 2.5x.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Deviation from stated M&A and financial policy, especially in regards to funding of future acquisitions;
Loss of operational momentum leading to production sustained below 80mboepd;
Deteriorating liquidity and financial flexibility, including inability to reduce revolver borrowings;
Mid-cycle total debt/operating EBITDA sustained above 3.0x.
Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity and Debt Structure
Tight Liquidity: At close of the Serafina acquisition, Strathcona is expected to have drawn its revolver 90% to CAD1.8 billion. Positive FCF forecast in excess of CAD1.1 billion in 2023 would allow Strathcona to fully repay its CAD700 million term loan during the year and reduce revolver utilization. Liquidity risk is heightened in the short term given revolver usage to fund the Serafina acquisition as Strathcona would be challenged to meet unexpected liquidity requirements until FCF can be generated and applied to debt at its credit facilities. Since the revolving credit facility is covenant based, there is no risk of negative reserve base redeterminations affecting liquidity.
18 Month Term Loan: The new CAD700 term loan matures in 18 months from Serafina close at February 2024. The term loan ranks pari passu with the revolving credit facility and has an excess cash sweep feature of EBITDA - CAPEX - ARO - lease payments - cash taxes - interest - deferred acquisition payments. These payments are made quarterly and due approximately 90 days after year end and 60 days after a quarter. Strathcona's revolving credit facility matures in February 2026, ahead of the USD500 million senior unsecured notes that mature in August 2026.
KEY RECOVERY RATING ASSUMPTIONS
The recovery analysis assumes that Strathcona would be reorganized as a going-concern (GC) in bankruptcy rather than liquidated. Fitch has assumed a 10% administrative claim and a 100% drawn on its secured revolving facility, reflecting Strathcona's revolving credit facility is not affected by redetermination risk. The CAD700 million term loan is assumed to be $380 million to reflect its short- term and excess cash flow sweep feature.
Going-Concern Approach
Strathcona's GC EBITDA estimate reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which we base the enterprise valuation (EV).
Strathcona's bankruptcy scenario considers a structurally lower priced crude oil and natural gas environment, resulting in reduced operational and financial flexibility, in line with stress case assumptions beyond Strathcona's existing financial hedges in 2023. The lower stress case price environment results in a maintenance capital program that benefits from Strathcona's relatively lower decline rate and experiences negative FCF's.
The GC assumption reflects Fitch's stressed case price deck, which assumes WTI oil prices of USD42.00 in 2023, USD32.00 in 2024 and USD42.00 in 2025. An EV multiple of 4.0x EBITDA is applied to the GC EBITDA to calculate a post-reorganization enterprise value. The choice of this multiple considered the following factors:
The historical bankruptcy case study exit multiples for peer companies ranged from 2.8x-7.0x, with an average of 5.2x and a median of 5.4x;
The 4.0x multiple is consistent with MEG Energy and Baytex Energy's, who similarly are producers of Canadian heavy oil. Further upside to the multiple is likely limited by a less concentrated asset base, which may limit potential buyers in a stressed environment. Baytex and MEG each also have covenant based revolving facilities with USD850 million (CAD1.1 billion) and CAD800 million commitments compared to CAD2.0 billion for Strathcona.
Liquidation Approach
The liquidation estimate reflects Fitch's view of transactional and asset-based valuations, including recent transactions in the Canadian oil sands, Montney and Western Saskatchewan on a CAD/boepd basis. This data was used to determine a reasonable sale price for the company's assets during a stressed environment. Metrics from Husky Energy and Cenovus Energy's merger, as well as Strathcona's own acquisition of Caltex Resources and Tucker from Cenovus informed the heavy oil portion valuation.
The allocation of value in the liability waterfall results in a 'RR1' recovery rating for Strathcona's first lien revolving credit facility and term loan, notching up three levels to 'BB+'. The senior unsecured notes have a 'RR5' recovery, notching one level below the company's IDR at 'B'. This downgrade in senior unsecured recovery rating from the previous 'B+'/'RR4 results from the increase in first lien debt added to fund the Serafina acquisition that has priority over the senior unsecured notes.
At 1Q22 first lien debt was CAD873 million, proforma the Serafina acquisition first lien debt increased approximately CAD1.6 billion to CAD2.5 billion. The effect of this increase is partially offset in Fitch's analysis by the EBITDA benefit from the proforma Serafina increase in production under Fitch's Stress Case.
Issuer Profile
Strathcona is a private E&P company with operations in western Canada that are focused on thermal oil, enhanced heavy oil recovery and condensate-rich natural gas. Strathcona has three core operating areas: Cold Lake Thermal Division, Montney Division and Lloydminster Heavy Oil Division.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
Strathcona Resources Ltd. has an ESG Relevance Score of '4' for Governance Structure due to WEF ownership concentration}, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg
MEG ENERGY CORP. 
