Fitch Ratings expects oil and gas companies to tap the securitization market for funding as early as this year, and it has developed ratings criteria for bonds backed by royalties, though such transactions would be capped at the ‘A’ category.
Historically, oil and gas companies have raised money through master limited partnerships, a type of business venture that is taxed like a partnership - profits are taxed only when partners receive distributions - and trade on an exchange, like stocks and bonds. A number of factors, including the lowering of the corporate tax rate, have reduced the appeal of master limited partnerships in recent years. As a result, oil and gas companies are looking for ways to supplement their funding.
In a report published Thursday, Fitch said it believes that rated securitizations backed by proven developed and producing (PDP) reserves will receive traction in 2019. Potential issuers include traditional exploration and production companies, private equity companies, and holders of portfolios of non-operating working interests.
Fitch recently enhanced its rating framework for oil and gas royalties including volumetric production payments (VPPs), overriding royalty interests (ORRIs), and non-operating working interests. “Revenues generated from PDP volumes are proving to be stable sources of cash flow,” the report states. “That coupled with very predictable depletion rates on diversified portfolios aligns oil and gas royalties with securitization fundamentals.”
The rating agency said PDP-type production is in line with a GC1 (going concern) profile and investment-grade ratings, depending on overall leverage. “PDP production aligns with Fitch's GC1 definition of continued business operation on default of the originator is almost certain or very likely, with only a minor element of doubt present,” the report states. “This type of production is less sensitive to oil prices as production is no longer in the development phase and the majority of capex payments have been made. Breakeven oil price for continued production is much lower as only production and transportation costs are needed to be considered.”
As with the oil and gas sector itself, production, price and counterparty risks need to be accounted for when analyzing oil and gas royalty securitizations. So while the ratings of these transactions are based predominantly on volumetric and price risk, they can be limited due to counterparty risks and overall leverage. Fitch believes diversified transactions involving mature fields that hedge the majority of price risk can achieve 'A' category ratings. Conversely, Fitch would cap unhedged transactions predominately utilizing debt service coverage ratios at the 'BBB' rating category.
Furthermore, Fitch will apply several stress tests to run sensitivity scenarios for each transaction on production levels, expenses, and the relevant commodity price.
