Fitch Rates Nigeria’s Seven Energy ‘B-(EXP)’; Proposed Notes ‘B-(EXP)’

Fitch Ratings has assigned Seven Energy International Limited (Seven Energy) an expected Long-term Issuer Default Rating (IDR) of ‘B-(EXP)’ with a Stable Outlook. The expected IDR takes into account a USD255m equity placement and assumes a successful issue of dollar-denominated notes and repayment of certain existing debt.

Fitch has simultaneously assigned Seven Energy Finance Ltd’s proposed secured notes an expected senior secured rating of ‘B-(EXP)’ and a ‘RR4′ Recovery Rating. The company plans to use proceeds from the notes to refinance some of its existing indebtedness and to improve its capital structure and liquidity. The assignment of a final IDR is subject to the

confirmation of the size of the notes issue as the repayment of the upcoming maturities is key to maintaining the company’s adequate liquidity position. The assignment of a final rating for the notes is also contingent on the receipt of final documentation substantially conforming to the information already received.

The proposed notes will benefit from guarantees and security from the parent company, and a number of companies holding economic interest in the main oil-producing assets (Oil Mining Leases (OMLs) 4, 38 and 41) under the Strategic Alliance Agreement (SAA) contract and a gas production asset (Uquo Field). Revenues under the SAA agreement represented 100% of the company’s EBITDA in 2013.

The notes benefit from a separate security package under the Accugas II and Accugas III project finance facilities, which are secured on the property and assets associated with the gas distribution part of the business, which is currently in its early stages. The Accugas facilities benefit from an unsecured guarantee from Seven Energy and in our recovery analysis we have assumed that they will rank at least pari passu to the proposed secured notes in any restructuring scenario.

The notes also include a cross-default provision, restrictions on dividends and limitations on additional indebtedness, eg, total amount under other credit facilities not to exceed USD450m or 20% of adjusted net tangible assets.

 Seven Energy is an integrated indigenous Nigerian oil and gas company focused on onshore oil and gas upstream and midstream (gas processing and pipelines) in Nigeria (BB-/Stable). It is currently developing a number of gas assets in South-East Niger Delta. In 2014, it started delivering natural gas to a local power station and acquired a contract supplying gas to an industrial consumer. Both are under long-term fixed-price take-or-pay contracts. The company expects to expand its gas business over the next two years, particularly with the addition of another local power station as a customer that is expected to commence consuming gas by end-2014.

The Stable Outlook reflects our view that any improvement in Seven Energy’s credit profile may only come from the successful implementation of its gas strategy, which we do not expect until end-2015 at the earliest. The company faces inherent challenges to its growth ambitions eg, project execution risks and the gas offtakers’ potential failure to pay in a timely manner for contracted gas. We believe that after the successful gas strategy implementation Seven Energy will remain fairly small in size, will maintain a fairly complex structure and will continue relying on onshore operations in Nigeria, thus limiting its ratings to the mid-’B’ category in the medium term. We forecast that in 2014-2017 Seven Energy will maintain funds from operations (FFO) net leverage of 3x or below, commensurate with a mid-’B’ category rating.

KEY RATING DRIVERS

Small E&P Producer

Seven Energy is a small onshore-based Nigerian E&P company. Almost all of its existing oil and gas production and cashflows come from SAA, a service-type contract with the Nigerian Petroleum Development Company (NPDC), a fully-owned subsidiary of the state-owned Nigerian National Petroleum Corporation (NNPC).

Its entitlement after taxes and royalties averaged 10.4 thousand barrels of oil per day (Mbopd) in 2013. The small size of production and EBITDA relative to other Fitch-rated E&P companies, in particular, Afren plc (B+/Stable) with 2013 production of 47 thousand barrels of oil equivalent per day (Mboepd) or Alliance Oil Company Ltd. (B/RWN) with 2013 production of 52 Mboepd, caps Seven Energy’s ratings in the mid-’B’ rating category.

The SAA covers NPDC’s 55% interest in Nigeria’s North-West Niger Delta’s oil mining licences (OMLs) 4, 38 and 41, operated by Seplat Petroleum Development Company (Seplat), also a 45% stakeholder in these OMLs. Seven Energy sells its oil at market prices to a wholly-owned subsidiary of Royal Dutch Shell (AA/Stable) at the Shell-owned Forcados oil terminal. The company expects that its entitlements under the SAA will remain its principal production and revenue source at least until end-2015.

Focus on Monetising Gas

Seven Energy’s strategy is to monetise natural and associated gas, which it plans to supply to local power stations and industrial consumers. The company aims to produce 73.3 million cubic feet per day (MMcfpd) of gas in 2H14. In 2014 it has already begun supplying gas to consumers under long-term fixed-price take-or-pay contracts. We believe that, when fully operational, the gas business should improve Seven Energy’s credit profile as it will provide a stable and predictable revenue stream, assuming that its offtakers pay for gas fully and on time. Seven Energy’s gas operations are aimed at the domestic market and are, therefore, subject to infrastructure constraints due to a fairly under-developed gas pipeline network. Furthermore, one of Seven Energy’s gas offtakers, a local power station, is in the process of being partly privatised and, as such, does not have an extended track record of payments for gas.

The company’s project finance loans contain specific completion targets eg, Uquo-Oron pipeline is to deliver gas to the Calabar NIPP power station by 1 January 2015; a failure by Seven Energy to achieve these targets would be an event of default. The company’s management believes that the pipeline is nearly complete and therefore considers the risks of not meeting these deadlines as minimal.

Complex Structure, Strong Shareholders

Seven Energy has a complex legal structure. It does not directly own or operate any of the upstream assets that are currently generating its cashflows; its economic interest in its principal oil asset is governed by the SAA. It is also a minority shareholder in its gas production assets; neither does it operate these assets. However, Seven Energy is entitled to up to 90% of production and revenue until it recovers its costs and achieves a 15% internal rate of return, while it pays 100% of associated project costs. While OMLs 4, 38 and 41 fields have been producing oil for over 40 years, future successful production from these fields depends on the partners’ ability to develop contingent resources. We also note that there is no operating history of the gas assets that Seven Energy is currently developing.

Seven Energy has recently secured USD255m in new equity from Temasek Holdings (USD150m), the IFC (International Finance Corporation ) (USD75m) and the IFC ALAC Fund (IFC African, Latin American and Caribbean Fund) (USD30m), further strengthening its shareholder base. This brings total equity contributions to over USD1bn to date. The company plans to use the cash to fund development expenditure on its project.

New Pipeline Improves Security

Risks remain over breaches of security in the Niger Delta region, where Seven Energy has operations under the SAA. The recent partial closure of the single sales channel for Seven Energy’s production entitlement under the SAA – Shell’s Forcados terminal for nearly 40 days in March-April 2014 due to repairs to sub-sea linkages damaged by bunkering resulted in a dramatic drop in oil production on OMLs 4, 38 and 41 in March 2014 and during the first seven days of April 2014 to 10.3Mbopd from 59.7Mbopd in February 2014. Thereafter, production resumed to pre-shutdown levels.

To address security risks, in 1Q14 Seplat completed constructing a pipeline to the Warri refinery in Nigeria to provide a second export route. Seven Energy states that it will continue relying on the pipeline to Forcados for its offtakes, while benefitting from the reduced shutdown of the field production and may use the pipeline to the Warri refinery for partial offtake, if necessary.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

-Successful implementation of gas strategy, both upstream and midstream, with a track record of timely payment for gas by offtakers by end-2015

-Maintaining at least stable production volumes from the SAA, and successful development of contingent oil and gas resources, over the medium term

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

-Security-related shutdowns similar to the Forcados closure in the spring of 2014 that would stop SAA’s production for a considerable period of time

-Failure to achieve gas production targets and / or obtain timely payments for natural gas from offtakers over the medium term

-FFO adjusted net leverage of 4.5x and higher and FFO fixed charge cover of 4x or lower on a sustained basis

LIQUIDITY AND DEBT

As of end-May 2014 Seven Energy’s cash balance was USD76m, of which USD30m was restricted. Reported cash does not include proceeds from the IFC/Temasek equity placement. Its convertible bonds with a face value of USD150m mature at end-2014 and if this is not repaid or refinanced the reserve based lending facility then becomes payable, which combined with SAA’s cash calls and ongoing gas capex, create significant cash demands. In total, the company could face USD353m in debt maturities in 2014. Assuming that Seven Energy successfully places the notes, we view the remainder of 2014 as fully funded, with excess liquidity significantly declining in 2015 and 2016. In the medium term the company intends to operate below 3.0x net debt/EBITDA and during capital-intensive periods up to 3.5x.

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