Fitch Ratings has affirmed Strathcona Resources Ltd's Long-Term Issuer Default Rating (IDR) at 'B+', its secured revolving credit facility at 'BB+'/'RR1', its first-lien term loan at 'BB+'/'RR1' and affirmed its senior unsecured notes at 'B'/'RR5'.
The Rating Outlook is Stable.
Strathcona's ratings reflect its low decline asset base, proved reserve size, expected near-term positive FCF and leverage at or below 2.0x during Fitch's forecast period. The ratings also consider execution risks around its M&A growth strategy, the company's heightened liquidity risk in the near term, exposure to West Texas Intermediate (WTI) and Western Canadian Select (WCS) spreads, and the company's higher operating cost profile.
Key Rating Drivers
Complimentary Asset Acquisition: The acquisition of Pipestone Energy Corp. (Pipestone) compliments Strathcona's existing Montney production, adding approximately 35Mboepd of condensate and natural gas assets, which increases size and scale, is cashflow accretive while only adding a modest amount of debt, and provides commodity diversification, which is a natural hedge for Strathcona's heavy oil divisions.
Accretive Equity-Funded Acquisition: Fitch believes the all-stock transaction funded by the issuance of Strathcona shares is positive given the larger asset base and larger EBITDA generation capability along with giving Strathcona greater access to the capital markets going forward. Pipestone shareholders will own approximately 9% of Strathcona following the acquisition. The acquisition is expected to close early in the fourth quarter of 2023, following the necessary shareholder approval, regulatory approvals and satisfaction of other customary closing conditions.
Strathcona plans to fund the Pipestone transaction with primarily share issuance proceeds along with a revolving facility draw to fund the current outstanding Pipestone debt and transaction costs. Strathcona has received lender approval to increase its first lien revolving credit facility to $2.3 billion from $2.0 billion on closing of the acquisition, subject to customary closing conditions. Fitch views the share-funded acquisition as a positive, though the continued high revolver utilization, while not a primary funding source, continues to introduce liquidity risk to the credit profile.
Heightened Refinancing and Liquidity Risk: Fitch forecasts Strathcona to generate positive FCF in 2023 and 2024 at Fitch's USD75/bbl and USD70/bbl WTI price assumption, respectively, which should allow for the company's planned repayment of the $675 million term loan borrowing, which matures on Feb. 29, 2024. Fitch anticipates that Strathcona will be required to draw approximately $350 million on the revolver in 1Q24 to repay the outstanding term loan, which will be repaid through positive FCF generated throughout 2024.
The increase in the first lien revolving credit facility to $2.3 billion provides increased albeit limited availability in the near term given it is currently 80% drawn. The revolver allows a drawdown to repay the term loan subject to a minimum $150 million availability under the revolver facility. Fitch expects liquidity risk to remain heightened but manageable in the near term given the current hedging in place. Since Strathcona does not pay a dividend, Fitch does not expect any capital distributions allowing it to focus FCF to reduce debt.
Low Decline, Large Reserve Asset Base: Excluding any impact from the planned Pipestone acquisition, there are benefits of Strathcona's corporate decline rate in the high teens, which positions the company favorably against typical E&Ps and results in lower sustaining capital requirements for Strathcona. This balances a more intensive operating cost structure, reflected in its CAD36.3/boe expenses and Fitch-calculated unhedged netback of CAD18.2/boe in 1Q23. Pro-forma the Pipestone acquisition, Strathcona will have approximately 1.5 billion boe of proved reserves, consistent with the 'BB' rating category.
Exposure to Differential Risks: Excluding the approximately 35mboepd of production from Pipestone, Strathcona's operations consist of Cold Lake Thermal in Alberta, condensate-rich Montney and Lloydminster Heavy Oil. These three plays provide good operational diversification for an E&P of Strathcona's size. The overall basin diversification of these plays is tempered, as they are located in Canada's Western Canadian Sedimentary Basin, exposing Strathcona to sometimes volatile WCS-WTI spreads.
WCS-WTI spreads have narrowed from approximately USD25/bbl in December 2022 to USD13-14/bbl currently, the exposure of which adds a layer of volatility to realized prices given the company's bitumen and heavy oil production is expected to represent approximately 60% of the company's proforma production.
Natural and Financial Hedges: Strathcona benefits from its ability to use natural gas and condensate that it produces in its Montney operations and from proposed Pipestone acquisition to partially cover fuel for steam generation and diluent requirements in its thermal and heavy oil operations. This hedge from its operations reduces exposure to pricing fluctuations in natural gas and condensate that otherwise would need to be sourced externally.
Additionally, Strathcona uses differential and price hedges to improve visibility on future cash flows. Strathcona has approximately 70% of WTI hedged for the remainder of 2023 at USD77/bbl and WCS is approximately 40% hedged for the remainder of 2023.
At Pipestone's close, Strathcona will continue to be required to hedge 50% of its next six months of production. The six-month 50% of production hedge is a rolling requirement as long as the term loan is outstanding.
Derivation Summary
Pro-forma the Pipestone transaction, Strathcona's 2024 production is expected to be approximately 195mboepd to 205mboepd. This compares against other 'B+' rated Canadian heavy oil producers MEG Energy who produced 107mboepd in 1Q23 and Baytex at 87mboped. It is above Canadian producer Vermilion's (BB-) 1Q23 82mboepd, whose rating benefits from its international diversification and higher price exposure.
Strathcona has a notably large reserve base for the 'B+' rating category with proforma Pipestone at approximately 1.5 billion boe proved reserves. This is larger than MEG at 1.2 billion boe and is materially above Baytex and Vermilion's respective proved reserves.
At YE2023 EBITDA leverage is forecast to be approximately 1.6x and expected to remain at or below 2.0x through the remainder of Fitch's forecast, which is slightly higher than the peer group of MEG, Baytex and Vermilion, who each are forecast to be at or below 1.0x leverage.
Key Assumptions
Base case WTI oil prices of USD75/bbl in 2023, USD70/bbl in 2024, USD65/bbl in 2025, USD60/bbl in 2026, and USD57/bbl thereafter;
Henry Hub prices of USD3.00/mcf in 2023, USD3.50/mcf in 2024, USD3.00/mcf in 2025 and USD2.75/mcf thereafter;
WCS differential of USD15/bbl in 2023, which edges down to the USD 13.50-USD14.00/bbl range over the remainder of the forecast;
2023 capex of $1 billion, which increases year-on-year to approximately $1.75 billion by the end of the forecast;
Term loan repaid in 1Q2024 and the revolver and notes refinanced in 2026;
No distributions or additional M&A following the close of Pipestone, revolver balance reduction is prioritized;
G&A scale efficiencies on a per BOE basis.
KEY RECOVERY RATING ASSUMPTIONS
The recovery analysis assumes that Strathcona would be reorganized as a going-concern (GC) in bankruptcy rather than liquidated. Fitch has assumed a 10% administrative claim and 100% drawn on its upsized $2.3 billion secured revolving facility, reflecting Strathcona's revolving credit facility is not affected by redetermination risk. The $675 million term loan is assumed to be $350 million drawn to reflect its short-term maturity of February 2024 and excess cash flow sweep feature.
Going-Concern Approach
Strathcona's GC EBITDA estimate reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which we base the enterprise valuation (EV).
Strathcona's bankruptcy scenario considers a structurally lower-priced crude oil and natural gas environment, resulting in reduced operational and financial flexibility, in line with stress case assumptions beyond Strathcona's existing financial hedges in 2023. The lower stress case price environment results in a maintenance capital program that benefits from Strathcona's relatively lower decline rate and experiences negative FCF.
The GC assumption reflects Fitch's stressed case price deck, which assumes WTI oil prices of USD47/bbl in 2024, USD32/bbl in 2025, USD42/bbl in 2026 and USD45/bbl in the long-term. An EV multiple of 4.0x EBITDA is applied to the GC EBITDA to calculate a post-reorganization enterprise value. The choice of this multiple considered the following factors:
The historical bankruptcy case study exit multiples for peer companies ranged from 2.8x-7.0x, with an average of 5.2x and a median of 5.4x;
The 4.0x multiple is consistent with MEG Energy and Baytex Energy, who similarly are producers of Canadian heavy oil. Further upside to the multiple is likely limited by a less concentrated asset base, which may limit potential buyers in a stressed environment. Baytex and MEG each also have covenant based revolving facilities with USD1.1 billion and CAD600 million commitments compared to CAD2.3 billion for Strathcona.
Liquidation Approach
The liquidation estimate reflects Fitch's view of transactional and asset-based valuations, including recent transactions in the Canadian oil sands, Montney and Western Saskatchewan on a CAD/boepd basis. This data was used to determine a reasonable sale price for the company's assets during a stressed environment. Metrics from Husky Energy and Cenovus Energy's merger, as well as Strathcona's own acquisition of Caltex Resources and Tucker from Cenovus informed the heavy oil portion valuation.
The allocation of value in the liability waterfall results in a 'RR1' recovery rating for Strathcona's first lien revolving credit facility and term loan, notching up three levels to 'BB+'. The senior unsecured notes have a 'RR5' recovery, notching one level below the company's IDR at 'B'.
At 1Q23, first lien debt was $2,405 million. Pro-forma the expected Pipestone acquisition, first lien debt is expected to increase to fund Pipestone's current outstanding debt and related transaction costs and expected to be approximately 75% drawn by year-end 2023. The effect of this increase is partially offset in Fitch's analysis by the EBITDA benefit from the proforma Pipestone increase in production under Fitch's Stress Case.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Proactive management of maturity profile and timely repayment of the term loan;
More conservative financial policy leading to less reliance on the revolver facility and increased liquidity;
Improving relative cash netback through lower and sustainable operating costs;
Mid-cycle EBITDA leverage maintained below 2.5x.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Deteriorating liquidity and financial flexibility, including inability to reduce revolver borrowings;
Deviation from stated M&A and financial policy, especially in regards to funding of future acquisitions;
Loss of operational momentum leading to production sustained below 120mboepd;
Mid-cycle EBITDA leverage sustained above 3.0x.
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
Tight Liquidity: At 1Q23, Strathcona had liquidity of $264.1 million, which was the availability under its $2.0 billion credit facility.
Strathcona is upsizing its revolver to $2.3 billion from $2.0 billion, which will take effect at the closing of the Pipestone transaction. Strathcona is expected to draw on its revolver to fund Pipestone's current outstanding debt and related transaction costs. The revolver is expected to be approximately 75% drawn by year-end 2023. In addition, Fitch anticipates Strathcona to draw on the revolver to fund the remaining outstanding balance on the term loan in 1Q24, which is anticipated to be subsequently repaid with positive FCF in 2024.
Liquidity risk is heightened in the short term given revolver usage to fund the Pipestone acquisition and term loan repayments as Strathcona would be challenged to meet unexpected liquidity requirements until FCF can be generated and applied to debt at its credit facilities. Since the revolving credit facility is covenant based, there is no risk of negative reserve base redeterminations affecting liquidity.
Strathcona's term loan matures in February 2024 and the revolving credit facility matures in February 2026, ahead of the USD500 million senior unsecured notes that mature in August 2026.
Issuer Profile
Strathcona is a private E&P company with operations in western Canada that are focused on thermal oil, enhanced heavy oil recovery and condensate-rich natural gas. Strathcona has three core operating areas: Cold Lake Thermal Division, Montney Division and Lloydminster Heavy Oil Division.
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
Strathcona Resources Ltd. has an ESG Relevance Score of '4' for Governance Structure due to the WEF ownership concentration, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' 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. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.
MEG ENERGY CORP. 
