Markets & Finance

A Healthy Flow in Europe's Oil Patch


The 2005 preliminary financial results of Europe's oil and gas companies have been without surprises: Results were solid and financial flexibility ample. Standard & Poor's took several positive rating actions in 2005, including the upgrade of European refiner Preem to BB-, and various upgrades and outlook revisions to positive on the Russian majors (TNK-BP, BB; LUKoil OAO, BB; and OAO Gazprom, BB+). No exploration and production (E&P) or vertically integrated majors were upgraded, and the ratings on Royal Dutch Shell (RDS.A) (AA) were lowered in February, 2005 for the second time in less than a year, owing to reserve revisions.

Are further positive rating actions likely in 2006? The short answer is that ratings on Western oil and gas companies are more likely to enjoy stability than upgrades, despite the high financial flexibility currently enjoyed and the favorable outlook for prices and refining margins. Russian oil and gas companies are probably the most likely candidates for positive rating actions in 2006.

Although the overall rating trend is stable, negative rating actions cannot be excluded. Factors that could weigh on credit quality include reserve replacement issues and, to a lesser extent, M&A activity. Notably, both Repsol-YPF S.A. (BBB+) and Norsk Hydro ASA (A) suffer from a reserve replacement rate that is below those of peers and a rapidly declining proven reserve life.

Here is our outlook for the European oil outfits we rate, as of Mar. 21, 2005:

Integrated Companies

BP PLC (AA+)

In 2006, funds from operations (FFO) and key credit measures will continue to benefit from a strong environment and, together with asset disposals, will easily finance some $15 billion of capital expenditures and $7 billion in dividends, as well as ongoing share repurchases. FFO reached a record $31 billion in 2005.

Eni SpA (AA)

Eni's performance should remain strong in 2006 (record FFO of more than ??16 billion was posted in 2005). Capital expenditure and dividends nevertheless will strongly increase to, respectively, ??8.8 billion per year and over ??4 billion.

Repsol-YPF S.A. (BBB+)

The company's placement on CreditWatch negative was triggered by the weak organic reserve replacement rate of 11% in 2005, together with the earlier large restatement of proven reserves. The risk of a downgrade over coming months is limited to one notch. Repsol's 2005 operating performance benefited from very strong Spanish downstream operations, raising FFO to ??6.3 billion, and resulting in ??1.4 billion in discretionary cash flows. Similar strong financial performance is expected for 2006.

Royal Dutch Shell PLC (AA)

In 2006, in a still strongly favorable environment, Shell's unadjusted FFO is likely to match 2005's $35 billion record, and to fully finance both capital expenditures (up to $19 billion excluding Sakhalin-II minorities) and generous shareholder distributions (including some $7 billion in dividends).

Sasol Ltd. (BBB+)

Fiscal 2006 cash flows (ending June 30, 2006) should be at record levels, benefiting from the combination of high oil prices and favorable chemical prices. FFO could exceed South African rand (R)20 billion ($3.2 billion), which compares with R15.9 billion for fiscal 2005, and should exceed rising capital expenditure and dividends (respectively forecast at R14 billion and close to R4 billion).

Despite strong financials, negative developments included the risk of a windfall tax on Sasol's highly profitable synfuel operations -- being studied by the government -- as well as the competition tribunal's blockage of Sasol's liquid fuel business merger plans with Engen. For fiscal 2007, profits are expected to come down, but nevertheless should benefit from the completion of the Turbo project.

Total S.A. (AA)

Total's 2006 performance should remain very solid (after record 2005 FFO of about ??17.4 billion), benefiting from a continued favorable price and refining margin outlook. Further strong production growth is, however, only expected in 2007 and onward. Discretionary cash flow generation should decrease as capital expenditure and dividends are forecast to rise to ??11.2 billion and close to ??4.5 billion.

Exploration And Production-Focused Companies

BG Energy Holdings Ltd. (A-)

We expect a continued strong performance for BG in 2006, thanks to strong targeted production growth of 600,000 barrels of oil equivalent per day (504,000 boepd in 2005) in combination with an upward trend in gas prices. FFO in 2006, therefore, could exceed record 2005 cash flows of ??1.9 billion ($3.5 billion). BG was net debt-free at yearend 2005. For 2006, we can expect net debt to rise again (remaining at very low levels) in light of the ??1 billion share buyback and limited discretionary cash flow, due to strong rises in capital expenditure (to ??2.0 billion for 2006 vs. ??1.5 billion in 2005 including share of associates).

Norsk Hydro ASA (A)

Norsk Hydro's 2006 financial performance should remain strong, with a 9% production increase targeted (to 615,000 boepd), after a record 2005 FFO of about Norwegian krone (Nkr)32 billion ($5 billion). Free cash flow generation may, however, turn negative as the company substantially increased 2006 capital expenditure to Nkr30 billion (including a very ambitious Nkr5 billion exploration budget), compared with Nkr7.5 billion in 2005. The pressure on reserve replacement may lead to further acquisitions. Despite strong financial flexibility, any expectations of continued weak reserve replacement rates (RRR) for 2006-2007 (2005 RRR of 60%) may pressure the ratings.

Statoil ASA (A)

After a record 2005, with FFO of Nkr61 billion ($9.5 billion), Statoil's 2006 cash flow generation should remain robust, thanks to a rising share of international production, which is substantially more profitable. FFO should continue to easily fund capital expenditures (which should remain in the area of Nkr35 billion), although dividends (including exceptional ones) were raised very substantially to Nkr18 billion.

Oilfield Service Companies

Aurelia Energy N.V. (BB-)

The company's placement on CreditWatch negative follows the acquisition of a shuttle tanker for $129.5 million. This follows on from last year's $210 million acquisition of a 55% share in a floating production, storage, and offloading (FPSO) unit, and reflects management's growth-oriented strategy to take advantage of the current upturn in demand for FPSO. A one-notch rating downgrade may occur in the coming months, given the company's weak financial metrics and aggressive financial policy.

Compagnie Generale de Geophysique (BB-)

For 2006, CGG's FFO should continue growing, as reflected by the strong fourth-quarter 2005 performance, as market conditions for seismic services remain favorable. Moreover, more important contributions from the Exploration Resources seismic vessels acquisitions are expected from second- and third-quarter 2006 onward.

Technip (BBB+)

The outlook for 2006 remains favorable, underpinned by a record ??11.2 billion backlog at the end of 2005 and management's target to see operating margins rise to at least 5%. FFO should trend upward in 2006 and further in 2007-2008 from the 2005 level of ??286 million, which was impacted by a substantial ??71 million net charge related to additional costs on a subsea umbilicals, risers, and flowlines (SURF) contract (now 99% complete).

Refining And Marketing Companies

Magyar Olaj-es Gazipari Rt. (BBB-)

MOL's 2006 outlook remains positive, underpinned by favorable refining markets. In 2005, MOL delivered a strong set of operating results, and net debt to EBITDA remained low at 0.8 times (well within the rating target of 2 times). Financial flexibility, however, will be absorbed by expected share repurchase policies (as the company has an option to buy back 17.5% of its registered capital for some $1.5 billion), which could be partially regained through the expected disposal proceeds of its gas business. The recently proposed ??600 million hybrid issuance will not provide material additional benefits, as it was assigned minimal equity content. In light of MOL's ambitious 2006-2010 strategic plan, acquisition risk will need to be monitored.

Petrol Ofisi A.S. (B+)

Thanks to 2004-2005 debt reduction and improved distribution margins, we expect Petrol Ofisi to stay comfortably within the rating target for full-year 2005 and for 2006. In the short to medium term, however, we will closely monitor any unexpected changes in strategy following the recently announced ownership change. The Austria-based refinery group OMV will purchase a 34% stake in Petrol Ofisi. Even though we think Petrol Ofisi will benefit from the involvement of OMV, the ratings could come under pressure if the owners were to change Petrol Ofisi's financial policies or if capital expenditure were to increase. In this regard, Petrol Ofisi has announced that it is investigating the possibility of building a refinery in Turkey, which would imply a multibillion-dollar investment.

Preem Holdings AB (BB-)

The 2006 outlook for Preem remains particularly favorable, as refining margins should remain good, and Preem's operating performance should materially benefit from the completion of its hydrocrackers, forecast for the first half of 2006.

Rompetrol Group N.V. (B-)

From an operational point of view, we expect the Rompetrol Group to be in line with the rating when the full-year 2005 results are published. Our main concern is the ongoing investigation of Rompetrol's key managers and owners. The CEO was in court for a hearing in February, but although the judge declined the prosecutor's claim for an arrest, the investigation is still ongoing. The negative pressure on the rating would increase if the investigation led to a more challenging operating environment for the group, or if it resulted in a material cash outflow or a weakening of the liquidity position.

Russia-Based Companies

LUKoil OAO (BB)

LUKoil's 2006 performance should continue to benefit from recurring production growth, and favorable prices. In 2005, FFO is expected to have exceeded $7 billion (up from $5.5 billion in 2004), which fully financed capital expenditure of close to $4 billion and the $2 billion Nelson acquisition, while maintaining strong financial flexibility. Going forward, we expect LUKoil to remain active on the M&A front, possibly to expand its downstream presence in Europe or the U.S. The positive outlook denotes the possibility of an upgrade in 2006, if the group's financial policy track record and Russian operating risk developments are satisfactory.

OAO AK Transneft (BB+)

Transneft's performance in the first nine months of 2005 continued to benefit from stable and predictable crude transportation volumes on the existing routes. The company has gradually been deleveraging following the completion of the BTS pipeline and in anticipation of new debt required to finance new large projects. Standard & Poor's will consider the implications of these projects on Transneft's credit quality as soon as full documentation becomes available.

OAO Gazprom (BB+)

The outlook for 2006 for Gazprom remains positive, underpinned by expected strong further rises in export gas prices, and contributions from new oil subsidiary Sibneft. This should help improve the group's free cash flow generation ability, which remains modest as capital expenditure (notably on gas transport) has strongly increased. The positive outlook reflects the potential for a one notch upgrade, after first-half 2006 results, and to the extent free cash flow and credit metrics improve further. Gazprom's appetite for acquisitions, including for buying a downstream presence in Europe, will also need to be assessed.

In December, 2005, Gazprom received the $7 billion cash payment from Rosneftegaz for its treasury stocks, which helped to refinance a part of debt drawn following the Sibneft acquisition. As a result, Gazprom managed to limit increases in yearend parent debt to about $23 billion (closer to $28 billion-$30 billion including subsidiary debt).

OAO NOVATEK (BB-)

Ratings were assigned on Mar. 17, 2006. The stable outlook factors in expectations of continuing and rising free operating cash flow and commitment to maintain net debt at below 1.0 times EBITDA. At Sept. 30, 2005, Novatek reported net debt to EBITDA of 0.3 times on a last-quarter-annualized basis.

OAO Siberian Oil Co. (BB)

Sibneft's solid free cash flow generation should continue to benefit in 2006 from the current strong oil-price environment. Yearend 2005 net debt will likely remain relatively moderate at about $1.5 billion, despite the $2.3 billion dividend paid. At the same time, the one notch rating differential between Sibneft's rating and that on its 74% parent OAO Gazprom reflects the fact that Gazprom's strategy regarding Sibneft has yet to be been finalized. Standard & Poor's will reassess the relative status of Sibneft's creditors compared with those of Gazprom, and the future strategic importance of Sibneft's oil business to the Gazprom group and its integration within the group, before it considers equalizing the ratings on the two companies.

OJSC Oil Company Rosneft (B+)

The key event for 2006 will be whether the Rosneft IPO will take place in the second half of 2006, proceeds of which would be partially allocated to repay a ??7.5 billion loan at its parent holding company, Rosneftegaz. Rosneft's operating performance should strongly improve after the integration of Yugansk, but the company remains highly indebted. The lack of transparency, and risks related to tax liabilities and Yugansk guarantees remain key negative rating factors. The positive outlook reflects the upside potential, should any of the aforementioned factors improve.

Tatneft OAO (B-)

Standard & Poor's is concerned that Tatneft has neither published its 2004 U.S. GAAP accounts nor disclosed any reliable interim financial information for 2005. This is likely to be a consequence of still unresolved corporate-governance issues which remain a constraint for the company's credit rating. In addition, there is no information on a new refinery in Tatarstan, the company's largest project estimated at $3.5 billion, which is expected to be commissioned in 2008. Should the company bear the major risks and costs of this project, the rating might come under pressure.

TNK-BP International Ltd. (BB)

TNK-BP's 2006 production growth is likely to ease, after an impressive 7% over the first nine months of 2005. FFO in 2005 is estimated to have exceeded $6.5 billion. A key issue for 2006 will be the group's track record in operating in Russia, including further clarification on 2002-2003 tax claims and the outcome of negotiations with Gazprom on Kovytka.


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