Fitch Downgrades Schahin O&G's IDRs to 'B+'; Outlook Negative

CHICAGO--()--Fitch Ratings has downgraded Schahin Oil and Gas Ltd.'s (Schahin or Holdco) foreign and local currency Issuer Default Ratings (IDRs) to 'B+' from 'BB-'. The Rating Outlook is Negative.

The downgrade reflects the company's liquidity deterioration and higher levels of refinancing risk as the company has delayed obtaining permanent long-term financing at the holding company level. Schahin has entered into two bridge loan financings to meet its short-term refinancing needs after postponing its long-term debt issuances. The company currently has a bridge loan with Mizhuo Bank Ltd for USD460 million, which becomes due in October 2015. This bridge loan has an increasing interest rate, which, together with the short-term maturity, increases the company's short to medium term refinancing risk. Further pressuring Schahin's liquidity is approximately USD340 million of short-term bank debt at Deep Black Drilling LLC, an intermediate holding company.

In addition to the delay the company has experienced in obtaining permanent long-term financing at the holding company level, the Negative Rating Outlook also reflects the delayed financial reporting. Fitch will continue monitoring the company's timing reporting of financial statements to resolve the Negative Outlook.

Schahin's ratings reflect the company's high consolidated leverage and structural subordination to its operating subsidiaries' project finance debt. Consolidated leverage is expected to decline over time as the project finance debt at the operating companies amortizes. The operating companies (OpCos) assets have long-term contracts in place that allow them to better match project debt with the life of the assets, which results in low debt service requirements and greater cash flow distributions to the holding company.

KEY RATING DRIVERS

Schahin's ratings reflect the company's high consolidated leverage and structural subordination to its operating subsidiaries' project finance debt. Positively, consolidated leverage is expected to decline over time as the project finance debt at the operating companies amortizes. The OpCos assets have long-term contracts in place that allow them to better match project debt with the life of the assets, which results in low debt service requirements and greater cash flow distributions to the holding company. Upstream distributions from the four cash generating assets are not expected to be disrupted, nevertheless they are subject to various distribution tests.

Schahin's ratings also reflect the stable and predictable cash flow generation of the company's OpCos offshore drilling assets, which are supported by long-term contracts with investment grade rated Petroleo Brasileiro S.A. (Petrobras; IDR 'BBB'). The ratings also incorporate the favorable demand prospects for oil and gas services in Brazil driven by Petrobras's aggressive capital expenditure program as well as new exploration and production entrants to the market.

HIGH LEVERAGE AND LOW LIQUIDITY

Schahin Oil & Gas Ltd's (HoldCo) consolidated leverage is considered high for the rating category and is expected to decrease over time, as debt at the OpCos level amortizes to levels more consistent with the rating category. Total debt as of June 30, 2014 amounted to approximately USD3.7 billion, including approximately USD700 million of a capital lease for Victoria drilling rig. As of June 30, 2014, the company's unrestricted cash and cash equivalent position was low at approximately USD15 million while consolidated short-term debt amounted to approximately USD727 million.

As of the last 12 months ended June 30, 2014, the company reported an EBITDA of approximately USD525 million, in line with initial expectations. Fitch expects that consolidated leverage, as measured by total debt to EBITDA, will gradually decrease to approximately 5.0 times (x) or below during the next three to four years from the reported 7.0x as of June 30, 2014.

STRUCTURAL SUBORDINATION TO OPERATING COMPANIES' DEBT

The potential retention of cash flows after debt service at the OpCos level makes cash flow to the Holdco somewhat less stable and predictable than the cash flow from operation of its subsidiaries. Most of the project finance debt at the OpCos have cash sweep provisions and minimum debt service coverage ratios (DSCR) (e.g. 1.2 or above) that must be met before cash flow distributions are allowed to be made to the Holdco. Specific assets (S.S. Panatanal and S.S. Amazonia) are not expected to distribute excess cash to the holding company until after the current contracts are renewed above a threshold day rate pre-established under these assets sale-leaseback agreement.

PREDICTABLE REVENUES AND STRONG BACKLOG

Schahin's consolidated revenues and cash flow from operations are stable and predictable, reflective of its long-term contractual structure with Petrobras. The company provides offshore oil and gas drilling services through its different subsidiaries. The average remaining contract life for its existing offshore drilling assets is approximately eight years. The company currently operates six offshore drilling units under long-term contracts with Petrobras. The bulk of the HoldCo's expected cash flow will come from dividends from its 100% owned OpCos as well as from cash flow from operations from its leased asset, Victoria.

Cash distributions to Schahin are sensitive to the operating performance of the OpCos (the rigs') uptime performance. For example, in the case of the Cerrado and Sertao operating assets, a decline in the uptime rate to 86% and 85% for three and six months, respectively, will likely prevent these assets from distributing cash to the Holdco. Under Fitch's base case assumption of an average uptime rate of 95%, these two assets are not expected to trap cash. Also, under Fitch's base case assumptions, net cash flow distributions to Schahin from its OpCos, after holding company operating expenses and SG&A, is expected to range between approximately USD80 million and USD280 million and to average approximately USD150 million per year over the next four years. Net distributions to Schahin are expected to increase starting 2017 as some project finance debt is fully amortized and should increase if uptime rates are higher than projected.

RATING SENSITIVITIES

Factors that could lead to a negative rating action are: Failure to put in place permanent long-term financing at the holding company to refinance intermediate subsidiaries obligations and or failure to lower leverage to 5.0x or below in the medium term or an overly aggressive growth strategy that could pressure credit metrics.

Although a positive rating action is not expected in the short- to medium term, key considerations for a positive rating action or Outlook would be a faster deleveraging process coupled with a reduction of the holding company's structural subordination to its operating assets.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014);

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=925535

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Contacts

Fitch Ratings
Primary Analyst
Lucas Aristizabal
Senior Director
+1 312-368-3260
Fitch Ratings, Inc.
70 W Madison Street
Chicago, IL 60602
or
Secondary Analyst
Alexandre Garcia
Associate Director
+ 55 11 4504 2616
or
Committee Chairperson
Daniel R. Kastholm, CFA
Managing Director
+1 312-368-2070
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Lucas Aristizabal
Senior Director
+1 312-368-3260
Fitch Ratings, Inc.
70 W Madison Street
Chicago, IL 60602
or
Secondary Analyst
Alexandre Garcia
Associate Director
+ 55 11 4504 2616
or
Committee Chairperson
Daniel R. Kastholm, CFA
Managing Director
+1 312-368-2070
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com