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Fitch rates Kuwait Energy ‘B-‘; Proposed Notes ‘B-(EXP)’

Fitch Ratings has assigned oil exploration and production company Kuwait Energy plc a Long-term Issuer Default Rating (IDR) of ‘B-‘ with a Stable Outlook.

The agency has simultaneously assigned an expected senior unsecured rating of ‘B-(EXP)’ to Kuwait Energy’s proposed issue of notes (RR4). The notes are rated at the same level as the IDR in line with our rating criteria. Proceeds from the notes are expected to be used to refinance existing debt, fund capital projects, eg, in Iraq, and for general corporate purposes. The assignment of a final rating for the notes is contingent on the receipt of final documentation conforming to the information already received.

The ratings take into consideration Kuwait Energy’s good track record of producing hydrocarbons in difficult geographic areas in which it is present (Egypt, Yemen, Oman), its experienced management, and its prudent attitude to debt funding, with financial metrics on a par with oil & gas companies rated in the ‘BB’ rating category.

Constraints on the company’s ratings include its small size, limited reserves, operations mainly through quasi-PSAs (production-sharing agreements) with national oil companies, as well as its focus on a limited number of production areas, dominated by Egypt (B-/Stable), and a significant ongoing gas development project in Iraq.

The Stable Outlook reflects our expectation that over the medium term Kuwait Energy will be able to maintain adequate liquidity and sustain or grow output despite operating in countries with high geopolitical and economic risks.

Key Rating Drivers
Business Scale Determines Ratings
Kuwait Energy is a small company by production. Its oil production in 1Q14 of 22.5 thousand barrels of oil per day (mbopd) on the working interest basis came from three countries – Egypt (B-/Stable, 70%), Yemen (20%), and Oman (11%). It is also developing a number of assets in Iraq, mainly in gas. Kuwait Energy’s total hydrocarbon production is close to that of similarly-rated peers in the ‘B’ category. We conservatively forecast that once its development projects, in particular in gas, are completed, Kuwait Energy’s production will still remain under 30 thousand barrels of oil equivalent per day (mboepd), peaking at around 2016.

Move into Iraqi Gas
Most of Kuwait Energy’s 167MMboe 2P (proved and probable) reserves at end-2013 are located in Iraq (80%) and are predominantly made up of natural gas volumes (63%). To monetise these reserves, Kuwait Energy is currently developing gas assets in Iraq at the Siba field that is scheduled to come on-stream in mid-2015. Siba is located in the south east of Iraq, approximately 600 kilometers from the area currently under threat from the ISIS insurgency.

While the diversification of Kuwait Energy into gas is rating-positive, the company is entering a market that is highly dependent on its ability to obtain timely and full payments from its gas off-takers. Currently, the company has a long-term take-or-pay gas supply agreement with the Iraqi government. However, as this is a new venture for the company with no track record of production or payments, we treat the Iraqi gas assets as a future factor that may help improve Kuwait Energy’s creditworthiness once the project in fully operational and becomes cash-generative.

Receivable Collection in Egypt
Kuwait Energy has had large receivables in Egypt historically. Egyptian General Petroleum Corporation (EGPC), a national oil company of Egypt, acts as a primary off-taker to Kuwait Energy with respect to its production entitlement under the PSAs there and is responsible for the service agreement payments. EGPC’s payments to Kuwait Energy have historically been made on an irregular basis, and typically several months in arrears. In 2011, on sales of USD120m to EGPC, Kuwait Energy received only USD46m in cash. The amount of receivables due from EGPC peaked in mid-2012 and have gradually declined since. Kuwait Energy received a payment of USD64m in the form of oil cargoes in April and June 2014. We believe that although the receivables crisis has been largely resolved, the collection risk in Egypt remains given the weak state of the sovereign’s finances.

Operating Performance to Drive Leverage
The proposed notes issue will increase Kuwait Energy’s funds from operations (FFO)-adjusted gross leverage by about 1x, but will leave considerable headroom for the rating until at least end-2017. Thereafter, the combination of a failure to renew licenses, delays in the launch of Block 9 in Iraq despite high capex, and inability to acquire new acreage or replace reserves could lead to a spike in leverage immediately before the proposed notes become due in mid-2019.

Liquidity to Improve in 2015
After 2014, Kuwait Energy expects to reduce capex significantly, leading to strong free cash flow (FCF) generation with the Siba project coming on stream in mid-2015. Additionally, the company could draw (with the presence of co-investors) on an additional USD50m from the convertible loans outstanding with Abraaj. However, this represents expensive financing for the company and hence we do not expect this facility to be used further. Liquidity may become a risk if the proposed bond transaction does not go ahead.

Rating Sensitiviness
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Successful launch of the gas business in Iraq with a track record of full and timely payments of gas
-Successful renewal of licenses in Egypt that are set to expire in 2016-2017
-Maintaining strong liquidity and conservative financial profile given the company’s small scale, e.g., FFO-adjusted net leverage below 2x (FYE13: 0.97x) on a sustained basis

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Continued problems with cash collection in Egypt
-Failure to launch the gas business on time and within budget and problems with cost recovery
-FFO-adjusted net leverage above 3x on a sustained basis
-A downgrade of Egypt, Kuwait Energy’s principal production location