Fitch Downgrades QGOG Constellation to 'B+'; Outlook Negative

CHICAGO--()--Fitch Ratings has downgraded the Long-Term foreign and local currency Issuer Default Ratings (IDRs) of QGOG Constellation S.A. (QGOG, or the HoldCo) to 'B+' from 'BB-'. The Rating Outlook is Negative. The rating action affects the long-term rating on the company's USD700 million of senior unsecured notes due 2019, which were also downgraded to 'B+/RR4' from 'BB-'.

QGOG's downgrade reflects the deeper than previously expected downturn in the offshore drilling services industry as well as the increased uncertainty about the company's medium-term cash flow generation created by the potential contract renegotiation with Petrobras, its main off-taker. Furthermore, the rating action incorporates Petrobras' credit quality deterioration over the past 18 months as well its efforts to reduce capex and expenses by downsizing its drilling rig fleet in line with the current deterioration of the oil market. As a result, Fitch expects more contract renegotiation in its backlog, which could affect QGOG's future cash flow generation and slow down its deleveraging process. This risk is heightened by the short- to medium-term need to renew some of QGOG's contracts as they expire.

The Negative Outlook reflects the high uncertainty surrounding the company's contractual position over the medium term as well as the potential for a deeper and longer offshore drilling-rig market down-cycle.

KEY RATING DRIVERS

Roll-Over and Day-Rate Risk

Throughout the oil and gas industry, companies are feeling the pressure to renegotiate day rates. While this could impact QGOG, a larger concern is renewal of its contracts with Petrobras that expire in 2018, given Petrobras' decision to reduce capital expenditures. The contract with Petrobras for the deep-water rig Olinda Star expired in December 2015 and QGOG was only able to re-contract for a short period of time with Karoon Petroleo e Gas Ltda for the third quarter of 2016. Five out of nine of the company's operating offshore drilling rigs (the OpCos) have contracts that expire over the next two years. QGOG's credit quality would be under pressure if it faces difficulties in finding new contracts for its drilling rig assets as they expire.

Oil Price Pressures

Offshore drillers continue to face depressed market conditions due to lower demand and a significant oversupply of rigs. The severe decline in oil prices has compounded the effects of the offshore-rig oversupply cycle, resulting in continued global market day-rate deterioration. Fitch believes that demand for drill rigs will rebound in the medium to long term and absorb the newer high-quality assets. Fitch also believes that an uptick in demand for rigs will lag oil & gas price levels (estimated at USD65 - USD70/barrel for deep water) by at least six to 12 months.

Expected Deleveraging at Risk

QGOG's previously expected deleveraging trajectory is at risk from an early renegotiation of contracts at lower day rates. As of the last 12 months (LTM) ended March 31, 2016, consolidated gross leverage reached 3.5x, down from 5.0x as of year-end 2013 as a result of OpCo level debt repayment. In its base case, Fitch expects QGOG's leverage could increase to approximately 5x in 2017 if the company renegotiates its contracts early with a significant reduction in its day rates, and leverage could return to current levels by 2019 or 2020. Total consolidated debt as of March 31, 2016 was USD2.56 billion, of which approximately USD925 million was at the HoldCo, down from USD3 billion as of year-end 2013, while LTM EBITDA spiked to USD733 million.

Structural Subordination

The potential retention of cash flows after debt service at the OpCo level makes cash flow to the HoldCo less stable and less predictable than cash flow from operations of the subsidiaries. Some of the project finance debt at the OpCos has cash sweep provisions and minimum debt service coverage ratios (DSCR) (e.g. 1.2x or above) restricting cash flow distributions to the HoldCo. Cash distributions to Constellation are sensitive to the operating performance of the OpCos (i.e. the rigs) uptime performance. Under Fitch's base case assumption of an average uptime rate of 94%, and an early renewal of contracts at day rates of between USD275,000 to USD300,000, net cash flow distributions to QGOG from its OpCos could range between USD40 million to USD80 million per year over the next four years. This is a significant decrease from the average USD160 million per year average reported over the past three years.

KEY ASSUMPTIONS

--WTI and Brent oil price trend up from an average of USD35/barrel in 2016 to a longer-term price of USD65/barrel;

--The majority of QGOG's contracts are negotiated effectively in 2017 to a lower day rate in exchange for longer contract tenures; OpCo level creditors agree to contract renegotiation;

--Market day rates are assumed to be USD275,000 for higher-specification ultra-deepwater rigs, with other rig classes seeing similarly steep price discounts;

--Operating expenditures are assumed to remain in line with recently reported levels;

--Capital expenditures average approximately USD70 million to USD80 million over the next four years and are entirely earmarked for maintenance.

RATING SENSITIVITIES

--Through-the-cycle consolidated debt/EBITDA of 5.0x or above on a sustained basis;

--Contracts are not rolled over at expiration or are unilaterally terminated by the off-taker before the expiration date.

No positive rating actions are currently contemplated over the near term given the weak offshore oilfield services outlook.

LIQUIDITY

Constellation's liquidity is supported by the company's cash on hand. As of March 31, 2016, QGOG's cash, cash equivalent and short-term investments amounted to USD498.8 million, up from USD423.4 million as of YE 2015, when there was approximately USD336.2 million at the HoldCo level, with the balance at the OpCos. This compares with a relatively manageable debt maturity profile at the HoldCo level, which has a USD226.7 million bank loan with Bradesco due in 2017 and the USD700 million senior unsecured note due in 2019. QGOG capex for the upcoming years is expected to average between USD70 million to USD80 million per year and is intended for maintenance as the company has no contracted orders for newbuilds.

FULL LIST OF RATING ACTIONS

Fitch has downgraded QGOG Constellation S.A.'s ratings as follows:

--Long-Term Foreign Currency Issuer Default Rating (IDR) 'B+' from 'BB-'; Outlook Negative;

--Long-Term Local Currency IDR to 'B+' from 'BB-'; Outlook Negative;

--Senior Unsecured notes due 2019 to 'B+/RR4' from 'BB-'.

Date of Relevant Rating Committee: June 2, 2016.

Additional information is available at www.fitchratings.com

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

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Contacts

Fitch Ratings
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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
+5511-4504-2616
or
Committee Chairperson
Ricardo Carvalho
Senior Director
+55 21-4503-2627
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
+5511-4504-2616
or
Committee Chairperson
Ricardo Carvalho
Senior Director
+55 21-4503-2627
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com