Energy in Focus

Energy In Focus

 

This week we highlight a few notable financial developments in the energy sector; (i) the Encore Acquisition Corporation bond issue, (ii) 2009 year-to-date E&P bond issuance, (iii) Rosetta Resources’ second lien loan amendment, and (iv) downstream asset valuations.

 

Encore Acquisition Corporation

This week saw EAC price $225 mm of B rated senior subordinated bonds with a 9.5% coupon due May 1, 2016 (7 years).  The bonds were priced at 92.22% of par to yield 11.125%.  They are already actively trading in the secondary market (a good sign) with yields ranging from 10.47% (price = 95.25) to 10.67% (price = 94.25). 

 

There are several take-aways from this deal.  One, in a pattern consistent with other offerings this year, issuers must offer bond investors good value.  The pop in price of 2 to 3 points is a healthy mark-to-market for holders.  In this case the yield enhancement was about 50 bp, which is less than many deals earlier this year.

 

Two, EAC is a known issuer, now with four issues outstanding totaling $825 mm.  This is consistent with the pattern this year; only known issuers are not coming to market.

 

Three, the use of proceeds is to reduce (reload) bank lines.  Although this is a financial purpose, as opposed to an economic purpose (ie acquisition of assets), the net debt position of EAC remains almost unchanged at $1.324 billion. 

 

The Standardized SEC PV-10 for EAC as of 12/31/08 was $1.2 billion (after tax and P&A) and the pre-tax PV-10 was $1.4 billion.  The proved reserves are 80% PDP.  Excluding probables and acreage, EAC has an LTV of 1.1x ($1.32/$1.2) and 0.94x ($1.32/$1.4).  Although we have not adjusted for changes in the PV-10 price decks, it seems the bondholders have adequate asset coverage. 

 

As we have discussed before, B rated issues have suffered this year in a flight to quality compared to BB rated issues.  We believe there are several other B rated E&P issuers waiting in the wings to tap the markets.  Now that the log jam seems to be breaking, we expect more B rated issues in the weeks to come. 

 

E&P Bond Issuance in 2009

So far in 2009 we have tracked 11 E&P bond issues from domestic US companies.  Pemex also issued two bonds, but as a national oil company we will put them aside for this review.  We provide a table that shows 2009 E&P bond issuance year-to-date.

 

There are not many surprises in the results, but we do point out that the volume and average maturity decline with rating.  The average yield spread between BBB (6.649%) and BB (9.772%) issues is about 3.125%.  This is considerable when compared to the 55 bp step-up from a BB to a B (10.327%). 

 

Furthermore, it’s no surprise that the average maturity of BBB bonds (7.8 years) is longer maturity than the BB (6.5 years) or the B bonds (5.7 years).  Given the rising yield curve, if we were to adjust for differences in maturity, then the yield spreads would be even wider.

 

We also find the yield dispersion on the bonds to be interesting.  We can see the impact of maturity on BBB yields with Devon; five years difference in maturity results in a 100 bp increase in yield.  Moreover, Devon and Noble Energy both have comparable 9.8 year maturities and differ in credit rating by 1 notch, yet there is a rather significant 140 bp difference in yield. We also see that the BB rated PXP bond with 6.8 years life is yielding higher than single B rated issues from Encore and Forest Oil, and almost as much as Petrohawk.

 

The impact of liquidity premium can be seen between two bonds that are equally rated B-; the $1.4 billion Chesapeake (CHK) 9.5% issue and the $420 mm Denbury (DNR) 9.75% issue.  The liquidity premium is about 60 bp.  The yield differential of the CHK bond compared to the Plains Exploration (PXP) bond, also rated B-, is even wider at about 160 bp. 

 

The PXP bond definitely shows signs of poor treatment in the market compared to DNR and CHK.  The best explanation for this, in our opinion, lies in the rating dispersion.  PXP has a split rating between Moodys (B1) and S&P (BB).  The result is a composite rating of BB-, but in fact the market is pricing PXP at the lower of the two ratings.   By contrast, both DNR and CHK have solid BB ratings from both rating agencies.

 

Second Lien Loans

Rosetta Resources^[1] (ROSE) announced this week (April 21) that it increased its borrowing under the Second Lien Term Loan Agreement from $75 mm to $100 mm. This increased was achieved in two ways.  One, a fixed rate loan bearing interest at 13.75% for $20 mm, and two, an added $5 mm in a floating rate.

 

Given the general interest in second lien loans in the E&P sector, we thought it might be interesting to review ROSE from the perspective of creditors.

 

As background, the Houston-based oil and gas company has acreage in several Basins, of which the core plays are in the Bakken, the D-J, San Juan, South Texas (Eagle Ford shale), and the Sacramento basins.  As of Friday’s close, the company has market capitalization of $362 mm, and an Enterprise Value of $639 mm. 

 

Based on the most recently released financials, year-end 2008, the company has LTM EBITDA of $367 mm. However, EBITDA dropped from $96.80 mm in 3Q08 to $55.3 mm in 4Q08.   Using the 4Q09 numbers as a better indicator of performance in the current environment, we get last quarter annualized (LQA) EBITDA of $221.2 mm. 

 

Total Debt stood at $300 mm on 12/31/08, made-up of $225 mm in senior bank lines and $75 mm of Second lien debt.   This equates to a total debt multiple of 1.35x LQA, with senior debt at about 1x.  This may be leverage multiple that credit investors are looking at, as opposed to the 0.82x multiple based on LTM EBITDA. 

 

The Standardized SEC PV-10 on 12/31/08 was $741 mm, down from $954 mm at the end of 2007.  Proved developed reserves are 82% of total reserves, which suggests around $600 mm of the year-end 2008 PV-10 is related to PDP.  ROSE reports $269 mm is required in future development capex of PUDS and PDNP.  

 

The PV10 numbers alone show good asset coverage for debt holders.  Total debt has about a 50% LTV ratio based only on PDP PV-10 and excluding PUDS, acreage and other assets.  The extra $25 mm of second lien debt increases the LTV only a marginal 4.2%.

 

As of 12/31/08, ROSE had $43 mm in cash on its balance sheet, which equates to 0.2x LQA EBITDA, or 0.12x LTM EBITDA.  The company’s leverage multiples would be reduced by those amounts on a net debt basis to 1.15x and 0.7x respectively for TD/LQA EBITDA and TD/LTM EBITDA.

 

The impact of the upsized second lien should raise the TD to $325 mm, which would change its EBITDA leverage multiples to 1.47x based on LQA, and 0.885x based on LTM EBITDA, without adjustments for net debt.  No matter how you look at these metrics, ROSE is well within the second lien covenants of 4x.

 

The company has PDP reserves of 235 BCFE of gas, based mostly (135 BCFE) in South Texas and the Sac Basin.  After taking account of the $25 mm second lien increase and excluding adjustments for cash, the total debt load per PDP Mcfe of $1.38.  Plus, there is another 92 BCFE of PDNP reserves, which when added to the PDP reserves, gives a total debt per developed Mcfe of reserves of $0.99.

 

There are hedges in place for 2009 production at $7.65 and also collars for some 2010 production at $8 and $10.05.  This gives the company some stability yet still has exposure to the upside.  In December 2008 the company entered into a comprehensive settlement with Calpine whereby it paid $97 mm over a dispute related to sales of gas assets.

 

After spending between $233 mm and $335 mm per annum on capex the last 3 years, like many of its peers, ROSE announced it will now live within its means.  For 2009 capex will be funded through organic sources of cash flow. 

 

These numbers paint a portrait of ROSE’s financial position that is balanced and benign.  In fact, ROSE has unused borrowing capacity of $175 mm under its revolving line of credit.  The company is taking a prudent path in managing its total debt load and keeping its powder dry.

Downstream Valuations

Sunoco (SUN) announced that it will sell its 85k bpd Tulsa refinery to Holly Energy Corp. (HOC) for $65 mm plus adjustments for working capital.  On an annual through-put basis (bpa), that price comes to $2.09 per bpa.  Assuming, say a 10 year remaining life (there are no young refineries in the USA), the $65 mm investment can be recovered at a charge of about 21 cents a barrel processed.

We were not surprised when Fitch said they did not expect the sale to impact SUN’s credit ratings, which are senior unsecured BBB, commercial paper F2. However, Fitch did note that the low sale price indicates the tough conditions faced by sellers of brown-field refineries in the current stage of the economic cycle.  This is especially true for sellers of smaller facilities with limited conversion capacity and potentially significant capital exp-enditure requirements.

The $65 million refinery price tag comes to a price of just $745/bpd of refining capacity. This is sharply lower than metrics for other comparable recent refinery sales.  For example, in July of 2008 Valero sold its 85k bpd Krotz Springs refinery in Louisiana to Alon (ALJ) at a price of $3,920/bpd, and in July 2007 sold its 160k bpd refinery in Lima, OH to Husky (HSE, Toronto) for $11,875/bpa.  Moreover, Fitch describes both the Tulsa and Krotz Springs refineries as being less complex facilities.

Perhaps the key to understand the sale and valuation of the Tulsa refinery was SUN’s desire to dodge $400 mm in capex required to bring it into EPA compliance with off-road diesel rules. As a result, SUN had previously announced that it would sell or convert the refinery for other usage (eg storage terminal).

The low values in the downstream sector are driven by a combination of falling demand for refined product due to the global economic downswing, the near-term increases in U.S. and international refining capacity, and ongoing dislocations in capital (credit) markets. 

The capital costs for potential buyers have risen sharply since mid 2008 and 2007, the dates of the other sales mentioned above. The drop in equity prices in the energy sector also currently diminishes the usage of stock as a part of the consideration package, which further constrains deals.  Fitch remarks that the low price for the Tulsa refinery does not bode favorably for independent refiners or integrated oil companies looking to the sale of marginal refineries as a source of cash to fund other priorities in the current period.

Other refineries that could be sold in the near future include:

·        Western Refining’s 70k bpd refinery in Yorktown.

·        Valero’s 275,000 bpd Aruba refinery.

·        Dow’s sale of its stake in the 146.5k bpd Dutch refinery in Vlissingen, held in a jv with Total.

·        Petroplus’ 117k bpd Teesside refinery in the U.K., which will be sold or converted into a storage terminal.