Fitch Places Medco Energi on Rating Watch Positive

(Fitch Ratings - Singapore - 21 Dec 2021)-- Fitch Ratings has placed the 'B+' Long-Term Issuer Default Rating (IDR) of PT Medco Energi Internasional Tbk (Medco) on Rating Watch Positive (RWP). Fitch has also placed the 'B+' rating on the company's outstanding senior unsecured US dollar notes on RWP. The Recovery Rating is 'RR4'.

The RWP follows Medco's announcement of signing a conditional sales and purchase agreement to acquire ConocoPhillips Indonesia Holding Ltd (CIHL), which holds a 54% working interest in the Corridor Block production sharing contract (PSC), an operating asset in South Sumatra, and a 35% interest in Transasia Pipeline Company Pvt Ltd. We view the transaction as credit-accretive, as the acquisition will add an average of about 45 thousand barrels of oil equivalent per day (mboepd) to Medco's existing production of 100mboepd while almost doubling the proportion of fixed-price contracts.

We expect Medco's financial profile to remain robust given Fitch's oil price assumptions, even though about 63% of the acquisition cost will be funded by debt and remaining through equity in the form of internal cash and a proposed equity raising of up to USD200 million. We expect EBITDA from fixed-price contracts after the acquisition to be about 3x Medco's interest expenses, significantly higher than the around 1x previously.

However, the acquisition will further weaken Medco's reserve profile, with proved (1P) reserves falling below six years (around seven years pre-acquisition) based on 2020 production.

Resolution of the RWP is contingent on the successful completion of the transaction, which the company expects to occur in March 2022, subject to meeting certain conditions and shareholder approvals. Positive rating action may arise if Medco presents an achievable plan to increase its proved reserve life while maintaining its financial strength.

Key Rating Drivers

Acquisition to Improve Metrics: We expect Corridor Block PSC to contribute annual EBITDA of above USD400 million until 2023 (around USD250 million after 2023), which will help improve Medco's credit metrics relative to the USD850 million of debt added to fund the purchase. Fitch expects Medco's net leverage (net debt/EBITDA) to fall from above 4.0x at end-2020 and stay at about 2x post-acquisition, even considering a drop in CIHL's working interest in Corridor Block PSC to 46% after 2023. We exclude Medco's fully owned subsidiary, PT Medco Power Indonesia (MPI), when calculating leverage.

Additional Cash Flows Cover Maturities: Medco recently issued USD400 million of US dollar notes and secured a two-year amortising bank loan of USD450 million to fund the debt portion for the acquisition of CIHL. For the next two years, Medco's main debt maturity will be the amortising bank loan and based on Fitch's estimate, Medco can cover this via Corridor Block PSC's cash flows.

Operating Profile to Strengthen: Corridor Block PSC produces mainly gas, and will raise the share of gas in Medco's output to 75% from 60% now. Almost all the gas from Corridor Block is sold via fixed-price, long-term take-or-pay contracts with strong counterparties like PT Perusahaan Gas Negara Tbk (BBB-/Stable), PT Pertamina (Persero) (BBB/Stable) and Gas Supply Pte Ltd, which will enhance Medco's earnings visibility. Medco has a larger scale and more-favourable earnings mix via fixed-price contracts than most 'B' category upstream oil and gas producers. The acquisition will bolster this position.

Fitch expects Medco's low cash-cost position to improve with the acquisition of Corridor Block PSC, which has a cash cost position of USD4 to USD5 per barrel of oil equivalent (boe), lower than Medco's current cash cost of around USD9/boe.

Relatively Short Proved Reserve Life: We expect Medco's pro forma 1P reserve life to fall below six years after the acquisition. Corridor Block PSC is estimated to have less than five years of 1P reserve life. This will entail higher investments for Medco over the medium term to improve its reserve life. However, a high proportion of developed reserves (85% of 1P reserves) should provide flexibility during oil price downturns.

Medco expects that the recent extension of the PSC for its Senoro-Toili working area and expected final investment decision on Senoro phase-2 by early 2023 to add to its reserve base. The planned capex on Senoro phase-2 is already included in Fitch's base case. We also expect more visibility on the reserve replenishment plan at Corridor Block PSC after renewal of its gas sale and purchase agreements (GSPAs).

GSPA Renewal and Integration: GSPAs for Corridor Block PSC expire in 2023. While we believe there are minimal risks to volumes from renewals considering the importance of the block to Indonesia's domestic gas, price risks remain. Further there are risks to integration considering the size of Corridor Block PSC relative to Medco's existing operations. However, the transfer of most existing key personnel at Corridor Block PSC as part of the acquisition and Medco's record in integrating the Ophir assets in 2019 mitigate the risks.

Power Investment Neutral: Fitch considers the risk dynamics of MPI to be neutral to Medco's credit profile, as its investment in the power company falls outside the restricted group structure defined in Medco's bond documentation. The documents limit Medco's investments outside the restricted group to USD300 million, most of which has been utilised. The structure limits cash outflow from Medco to MPI and other investments outside the restricted group. There are no cross-default clauses linking MPI's debt to Medco.

Derivation Summary

The RWP reflects Fitch's expectation that Medco's business profile will improve following the proposed acquisition, with significant increase in fixed-price contracts in the sales mix, and a larger production and earnings scale compared with exploration and production peers in the 'B' rating category.

Canacol Energy Ltd.'s (BB-/Positive) rating reflects that around 80% of its sales volume is from the long-term, fixed-price take-or-pay gas sales contracts. The proportion of fixed-price contract sales in Medco's portfolio will increase to around 60% after the acquisition, though it will remain less than Canacol's. This would be partly offset by Medco's much larger production scale and EBITDA generation compared to Canacol. Both the companies have a moderate P1 reserve life at around six years. The Positive Outlook on Canacol's rating reflects Fitch's expectation that Canacol's production scale would increase to around 40mboepd by 2022.

GeoPark Limited (GeoPark; B+/Stable) and Medco have limited geographic diversification and moderate reserve lives. Medco's profile, however, benefits from a much-larger production scale and presence of fixed-price contracts, which are well reflected in the RWP on its rating.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

- Brent prices of USD70 a barrel in 2022, USD60 a barrel in 2023 and USD53 a barrel thereafter, as per Fitch's oil and gas price deck. Gas prices in line with the fixed-price contracts where applicable. See Near-Term Oil & Gas Prices Raised, Long-Term Oil Price Unchanged, dated 7 December 2021.

- Total production volume (including Corridor Block PSC) of above 150mboepd until 2023 and drop slightly thereafter due to decline in working interest in Corridor Block PSC.

- Cash production costs of less than USD8 per boe

- Annual capex between USD250 million and USD300 million over the next five years

- Rights offering of USD150 million in 2022 to partly fund the acquisition

Fitch's Key Assumptions for Recovery Analysis:

The recovery analysis assumes that Medco would be reorganised as a going concern in bankruptcy rather than liquidated.

We assume a 10% administrative claim.

Medco's post-acquisition going-concern EBITDA, excluding MPI, is based on the average EBITDA we expect over 2022 to 2025, which is stressed by 30% to reflect the risks associated with oil-price volatility, potential challenges in maintaining output from its maturing fields and other factors.

An enterprise value multiple of 5x is used to calculate a post-reorganisation valuation and reflects a mid-cycle multiple for oil and gas, metals and mining companies globally, which is higher than the observed lowest multiple of 4.5x. The higher multiple reflects that a sizeable proportion of Medco's (post-acquisition) production volume will stem from long-term fixed-price and indexed take-or-pay gas contracts, which provide more cash-flow visibility across economic cycles than the average global upstream oil and gas production company.

We assume prior-ranking debt of USD179 million will be repaid before Medco's senior unsecured creditors, including investors in its US dollar bonds. Prior-ranking debt includes project-finance debt at non-guarantor subsidiaries, PT Medco E&P Tomori Sulawesi and PT Medco E&P Malaka.

The payment waterfall results in a recovery rate corresponding to a 'RR1' Recovery Rating for the unsecured notes. However, we rate the senior unsecured bonds at 'B+'/'RR4' because Indonesia falls into Group D of creditor friendliness under our Country-Specific Treatment of Recovery Ratings Criteria, and the Recovery Rating on instruments of issuers with assets in this group are subject to a cap of 'RR4'.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

- Successful completion of the acquisition as proposed while maintaining leverage (net debt/EBITDA excluding MPI) below 2.5x and a proved reserve life of 7 years.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

- Medco's rating will be affirmed if the proposed transaction is unsuccessful.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Adequate Liquidity: At end-June 2021, Medco, excluding MPI, had unrestricted cash of USD306 million compared with USD61 million of debt maturing in 2H21. Medco has US dollar bonds of between USD400 million and USD650 million falling due each year from 2025 to 2028. Medco also has a recent history of refinancing bond maturities well ahead of schedule. Fitch expects Medco (post-acquisition) to broadly generate positive free cash flows, and have the flexibility to curtail capex if needed, which would help its liquidity profile.

Issuer Profile

Medco is an Indonesian upstream oil and gas company, with some international presence. The company produces about 90mboepd of oil and gas.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. (ends)