Fitch Ratings has placed the Long-Term Issuer Default Rating (IDR) of Talos Energy Inc. (Talos) and Talos Production Inc. on Rating Watch Positive.

Fitch has also placed the first-lien revolver and the senior second-lien notes on Rating Watch Positive. The rating action follows Talos' announcement that it is acquiring EnVen Energy Corporation (EnVen). The IDR is currently rated 'B-', the first lien revolver is rated 'BB-'/'RR1' and the second lien notes are rated 'B'/'RR3'.

Talos' ratings reflect its higher margin, liquids-focused asset profile with current production in the low- to mid-60 thousand barrels of oil equivalent per day (mboepd). The ratings also consider a positive FCF profile over the forecasted period; conservative balance sheet; attractive exploitation and exploration inventory, and adequate liquidity. This is offset by potentially significant environmental remediation costs and relatively higher operating costs.

The Rating Watch Positive reflects the credit accretive nature of the acquisition and increased production scale.

Key Rating Drivers

Credit-Friendly Acquisition: Talos recently announced that it has entered into an agreement to acquire EnVen for $1.16 billion. The acquisition will be funded by the issuance of 43.8 million of Talos shares to the selling shareholders, $215 million of cash, and the assumption of net debt (approximately $50 million). The acquisition increases production scale by 30%, is credit accretive given the large equity component, provides for $30 million of expected synergies, and adds assets contiguous to Talos' existing portfolio. Fitch views the action as a credit positive to Talos, which may lead to an upgrade upon the close of the acquisition.

Enhanced Gulf of Mexico Position: Pro forma, Talos will materially expand the combined company's size and scale in the Gulf of Mexico with total net acreage of 947k (35% increase) and expected proforma 2022 production of 85Mboepd (72% liquids). Talos' focus in the offshore Gulf of Mexico results in an asset profile that is different from the typical shale-driven onshore exploration and production (E&P) issuer. Differences include relatively low asset acquisition costs, which may be offset by higher plugging and abandonment (P&A) obligations; lower decline rates; and typically, higher oil-price realizations. Challenges associated with the business model include execution risk associated with new exploration projects; substantial capital requirements; longer spud to first oil times; materially higher environmental remediation costs; the need to post significant financial assurances to third parties to guarantee remediation work; and the tail risks from hurricane activity and potential oil spills.

Improving Liquidity Situation: Talos has taken actions to improve its liquidity position, including the note refinancing in late-2020 and the note add-on stock offering in early-2021. The company has reduced borrowings under the credit facility by $175 million in 2022, and further reductions are expected. The next note maturity is not until 2026, and the revolver matures in 2024. Fitch estimates Talos will be FCF positive over the forecasted horizon and expects excess cash to be used to reduce revolver borrowings. Although Talos was able to access both the debt and equity capital markets over the past year, the bonds trade at a material discount to other energy issuers, which may limit future access.

Capex Supports FCF Generation: Talos is expected to generate positive FCF based on Fitch's price deck ($95/bbl - 2022; $81/bbl - 2023; $62/bbl - 2024). The low decline rate of its wells provides for enhanced capital efficiency that somewhat offsets the effects during a period of low oil prices and helps protect cash flow. The company's normalized unit economics coupled with lower capital-intensive projects, such as asset management, in-field drilling and exploitation, result in a cash flow profile that supports discretionary, exploratory capital, which may potentially transform the longer-term asset base in better commodity price environments. The capital program should support low, single-digit near-term production growth on average through the forecast, while maintaining longer term exploration upside.

Substantial Decommissioning Costs: Due to the company's focus on mature offshore assets and an active M&A strategy, Talos' environmental remediation costs for P&A are elevated compared with onshore peers. Asset retirement obligations (AROs) as of June 30, 2022 totaled $452 million. Fitch expects annual P&A costs of $60 million over the forecasted horizon. Fitch believes there is potential for reduced outlays to the degree the company is able to extend the lives of fields through recompletions and workovers.

Carbon Capture and Storage: Talos is creating a subsidiary to explore opportunities in Carbon Capture and Storage (CC&S) and use its expertise in conventional oil and gas geology, engineering and project delivery. The company has announced a letter of intent to develop a CC&S project with Freeport LNG Development, L.P. and was awarded a second project by the state of Texas. The subsidiary would be deemed unrestricted and non-recourse to Talos debt. Management plans to fund the venture with project financing debt, although there may be some equity contributions from the parent. The venture does not benefit the restricted group's credit profile directly, but Fitch sees potential benefits in that it may assuage investor ESG concerns, provides a new growth prospect, adds diversification.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

WTI oil prices of $95/bbl in 2022, $81/bbl in 2023, $62/bbl in 2024 and $50/bbl in the long term;

Henry Hub natural gas prices of $7.00 per thousand cubic feet (mcf) in 2022, $5.00/mcf in 2023, $4.00/mcf in 2024 and $3.00/mcf in 2025;

Premium differentials of $2.00 to WTI through the forecast;

Production slightly lower in 2022 due to drydocking and mid, single-digit increases thereafter;

Capex including P&A of $465 million 2022, and $450 million throughout the forecast;

FCF allocated toward paydown of revolver.

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that Talos Energy, Inc. would be reorganized as a going-concern in bankruptcy rather than liquidated. We have assumed a 10% administrative claim.

Going-Concern (GC) Approach

Fitch assumed a bankruptcy scenario exit EBITDA of $300 million. This estimate considers a prolonged commodity price downturn ($32/WTI and $2.00/mcf gas lows in 2024, increasing to $42/bbl WTI and $2.25/mcf gas in 2025) causing liquidity constraints and inability to access capital markets to refinance debt. The GC EBITDA estimate reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which we base the enterprise valuation.

An EV multiple of 3.75x is applied to the GC EBITDA to calculate a post-reorganization enterprise value versus the historical energy upstream sub-sector multiple of 2.8x-5.6x for recent E&P bankruptcies, and median EV/EBITDA multiples in observed offshore transactions in the 2.0x-4.0x range. The lower multiple also reflects the impact of Asset Retirement Obligations and Surety bonds.

These assumptions lead to an EV of $1,125 million, greater than the liquidation valuation.

Liquidation Approach

The liquidation estimate reflects Fitch's view of the value of the company's E&P assets that can be realized in sale or liquidation processes conducted during a bankruptcy or insolvency proceeding and distributed to creditors. Fitch used historical transaction data for the GoM blocks on a $/bbl, $/1P, $/2P, $/acre and PDP PV-10 basis to attempt to determine a reasonable sale, based on Talos' recent M&A transactions, other recent offshore M&A transactions, and valuations from emerging, offshore bankruptcies of Fieldwood Energy, Stone Energy and Arena Energy.

Fitch assumed a 25% advance rate on A/R given that in a pro-longed downturn, A/R would likely decrease. Fitch valued the oil & natural gas assets at $1,094 million.

Waterfall Analysis

Fitch assumed the $806 million revolving credit facility was drawn at 80% to account for downward borrowing base redeterminations as the company approaches a bankruptcy scenario. The senior secured revolver recovers at an 'RR1' level while the second lien notes recovers at an 'RR3' level.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Upon completion of the EnVen acquisition, Talos' rating will likely be upgraded;

Material reduction of the revolving credit facility through proceeds from FCF generation;

Increased size and scale evidenced by production trending above 75mboepd-100mboepd;

Demonstrated ability to manage P&A obligations and reduced AROs per flowing barrel or proved reserves;

Midcycle debt/EBITDA sustained below 2.5x and FFO leverage below 3.0x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Loss of operational momentum, evidenced by production trending below 45mboepd;

Reduction in liquidity due to lower bank commitments or increased revolver borrowings;

Midcycle debt/EBITDA above 3.5x on a sustained basis and FFO leverage above 4.0x;

Unfavorable regulatory changes, such as increased bonding requirements, or accelerated P&A spending;

Implementation of a more aggressive growth strategy operating outside FCF;

Inability to manage P&A obligations.

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

Adequate Liquidity, Clear Maturities: The second-lien notes issuance in late 2020 and early 2021 extends the next bond maturity to 2026, while reducing borrowings under the credit facility. The reserve-based loan (RBL) matures in November 2024 and Fitch believes Talos' strong asset coverage should allow for an extension. The RBL has a borrowing base of $1.1 billion and current commitments of $806.3 million. As of June 30, 2022, there was $200 million outstanding on the credit facility, a reduction of $175 million in 2022.

Fitch expects Talos will generate positive FCF over the forecasted horizon and use proceeds to further reduce the outstanding amounts on the revolver. Management stated that capital budgets would be determined on the ability to generate FCF even in commodity price declines. The company's hedging program provides some protection, but an enhanced program would provide more comfort.

Issuer Profile

Talos is a publicly traded, technically driven independent exploration and production company with operations in the U.S. Gulf of Mexico (GoM) and offshore Mexico. The company's focus in the GoM is the exploration, acquisition, exploitation and development of deep and shallow water assets near existing infrastructure.

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

Talos Energy Inc. has an ESG Relevance Score of '4' for Waste & Hazardous Materials Management; Ecological Impacts due to the enterprise-wide solvency risks that an offshore oil spill poses for an E&P company.

Talos Energy Inc. has an ESG Relevance Score of '4' for Energy Management that reflects the company's cost competitiveness and financial and operational flexibility due to scale, business mix, and diversification.

These factors have 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

RATING ACTIONS

Entity / Debt

Rating

Recovery

Prior

Talos Production Inc.

LT IDR

B-

Rating Watch On

B-

senior secured

LT

BB-

Rating Watch On

RR1

BB-

Senior Secured 2nd Lien

LT

B

Rating Watch On

RR3

B

Talos Energy Inc.

LT IDR

B-

Rating Watch On

B-

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VIEW ADDITIONAL RATING DETAILS

Additional information is available on www.fitchratings.com

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