Fitch Ratings has affirmed Vermilion Energy Inc.'s Long-Term Issuer Default Rating (IDR) at 'BB-' and the company's senior unsecured rating at 'BB-'/'RR4'.
The Rating Outlook is Stable.
Vermilion's ratings reflect its diversified asset base and exposure to higher priced European oil and gas indices compared with North American peers, which results in peer leading netbacks and sub-1x EBITDA leverage. The ratings are tempered by the company's smaller production size for its rating category, lack of scale in fields outside of North America and uncertainties around the introduction of European Union windfall taxes.
Key Rating Drivers
Peer Leading Netbacks: Vermilion's European price exposure, which the company guides 18% of total 2023 production will be from European gas and 15% from Brent linked oil, resulted in the highest unhedged half cycle cash netbacks in Fitch's E&P portfolio at USD71.4 during 3Q22. Although 3Q22's realized prices were abnormally high, due to current supply constraints affecting Europe, the exposure to price advantaged oil and gas has historically supported Vermilion's strong cash netbacks, which are a credit differentiator compared to similarly gas-to-oil weighted North American E&P producers.
Fitch expects that the company's strong FCF for its relative production size should allow Vermilion to achieve its sub CAD1 billion net debt target in 2023 or early 2024. Fitch forecasts EBITDA leverage of approximately 0.5x in 2023 and 2024.
Windfall Taxes add Uncertainties: The temporary European Union windfall tax enacted in 2H22 targeting oil and gas companies reflects the less supportive environment Vermilion's European operations face compared to its North American operations. Uncertainty on the longer-term status and structure of these taxes, as well as the rate that specific countries within the EU will ultimately apply them, heightens regulatory and to a lesser extent, FCF risks, because by design they apply in periods of outsized profitability.
Vermilion is guiding CAD250 million of windfall taxes for 2023 following an estimated approximately CAD300 million in 2022. The tax is calculated against a baseline of 20% above average taxable earnings between 2018 and 2021, with the EU setting a minimum rate of 33% and individual EU countries having the discretion to set rates above this. For example, at the high end, Ireland, where Vermilion's Corrib asset is located, has proposed a 75% tax rate. EU countries have the option to apply the tax to 2022 and or 2023.
Diversified Asset Base: Vermilion has a unique asset profile among peers given its high level of geographic diversification relative to its size. Its asset base is focused on the three following regions: North America, Europe and Australia. Production at 3Q22 is split between Canada (62%), France (8%), Germany (7%), the Netherlands (6%), the U.S. (6%), Australia (6%), Ireland (5%), and the remainder in Central and Eastern Europe, which should become more a contributor to production in late 2023 or 2024 once Vermilion's Croatian gas plant is commissioned.
Vermilion's geographic diversification is linked to the company's practice of seeking the highest return projects regardless of location. Geologically, many of the plays tend to be shallow, lower cost conventional resource plays (France, Netherlands) or lower cost fracking plays (Williston Basin in Southeast Saskatchewan).
Challenges to Scaling Up: A downside of Vermilion's heavily diversified portfolio is a limited ability to organically scale up in most of its plays outside of North America properties. Growth prospects for its international portfolio vary significantly, ranging from regions in decline (e.g. France and Netherlands) to areas with good geology but challenging permitting environments (Germany and Netherlands).
The acquisition of Leucrotta Exploration in 2022 provides an avenue of Montney production growth that Vermilion anticipates ultimately scaling up to 28Mboepd. Production in 2022 through 3Q of approximately 85Mboepd is at the bottom end of the general 'BB' rating range, where production typically ranges between 75Mboepd-175Mboepd.
Corrib Expected to Close End of 1Q23: Closing of the Corrib acquisition, which was originally expected in 2H22, and will increase Vermilion's interest by 36.5%, is now anticipated to close by the end of 1Q23. Clarity on the closing of the acquisition improved in January 2023 when Vermilion announced it had obtained formal Irish government consent for the acquisition. The final purchase price is expected to be approximately CAD200 million to CAD300 million cash compared to the original purchase price of CAD600 million after netting out FCF's generated since the transaction's effective date of Jan. 1, 2022.
Hedging Program: Historically, Vermilion has targeted 25%-50% of production hedges over a rolling four quarters with natural gas being more hedged than oil. For 2023, excluding Corrib, around 22% of European natural gas and 18% of North American natural gas was hedged, reflecting a reduction in overall positions and an exit from oil hedges. The reduced hedging increases volatility in potential cash flows and is directionally consistent with recent E&P sector trends. Some producers, who typically have been able to improve their financial position over the past 12 months, have reduced hedging practices with the expectation their stronger balance sheets can support against potential downside risks from more cash flow volatility.
Vermilion Energy Inc. has an ESG Relevance Score of '4' for Exposure to Social Impacts due to Vermilion's small-to medium-sized production profile, offshore production, and operations where there exists a more stringent climate-related regulatory framework and increase social resistance, including the approval of a temporary windfall tax measure aimed at EU companies with activities in the hydrocarbon sector. This has a negative impact on the credit profile and is relevant to the ratings in conjunction with other factors.
Derivation Summary
Vermilion's positioning against high-yield oil and gas peers is mixed. In terms of geographic diversification, it is peer-leading with operations in North America, Europe and Australia. However, smaller positions across its international assets and exposure to European regulatory risk reduce the credit risk benefit of this diversification. Vermilion's overall production size is on the low end of the 'BB-' level, with its Canadian operations of 52Mboepd in 3Q22 the largest contributor to production.
At a 3Q22 average of 84.2Mboepd, Vermilion is smaller than 'BB-' rated E&P peers Civitas Resources (BB-/Positive) at 176.3Mboepd and SM Energy (BB-/Stable) at 137.9Mboepd. Vermilion's size is more in line with Canadian peers Baytex Energy (B+/Stable) and MEG Energy (B+/Stable), which averaged 83.2Mboepd and 102.0Mboepd in 3Q22 respectively.
Vermilion's netbacks, which have historically been relatively strong due to its exposure to Brent-linked premiums for its international oil and higher European natural gas pricing, increased materially through 2022 with the benefit of record high European gas prices. Vermilion's 3Q22 netback of USD71.4 (54% liquids) leads pure play Permian producers Pioneer Resources USD55.6 (79%) and compares to Canadian peers Baytex (84% liquids) and MEG (100% liquids), which had unhedged cash netbacks of USD36.8. and USD40.1.
Key Assumptions
WTI/bbl oil price USD81 in 2023, USD62 in 2024, USD50 in 2025 and longer term;
Brent/bbl oil price USD85 in 2023, USD65 in 2024, USD53 in 2025 and longer term;
HHUB/mcf natural gas USD5 in 2023, USD4 in 2024, USD3 in 2025 and USD2.75 longer term;
TTF/mcf natural gas of USD40 in 2023, USD20 in 2024, USD10 in 2025 and USD5 longer term;
Production between 86Mboepd-93Mboepd through the forecast;
Excess cash is applied to fully repay revolver facility and 2025 notes are refinanced;
Shareholder dividend and share buybacks increase once debt targets achieved;
Corrib acquisition closed in 1H23;
Windfall taxes extended through forecast period.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Production approaching 150Mboepd;
Increased scale in existing positions, with greater drilling inventory, a higher reserve life and the ability to develop new inventory while maintaining high margins;
Mid-cycle EBITDA leverage below 2.0x.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Loss of operational momentum with organic production trending below 70Mboepd or materially increasing production costs.
Impaired financial flexibility;
Mid-cycle EBITDA leverage above 3.0x;
Deviation from a financial policy that emphasizes debt reduction before Vermilion's stated targets are met.
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
Reduced Revolver Utilization and Supportive FCF: Through the first three quarters of 2022 Vermilion reduced its revolver draw to CAD478 million from CAD1.285. The reduced revolver draw is attributable to a combination of a 2Q22, USD400 million senior unsecured issuance, where proceeds were applied to repaying revolver debt, and discretionary repayments from FCF. CAD1.121 billion of available liquidity on Vermilion's CAD1.6 billion facility was available at 3Q22.
Vermilion holds minimal cash and cash equivalents that totalled approximately CAD8 million at 3Q22. Positive pre-distribution FCF expectations through Fitch's forecast period helps place Vermilion in the position to further reduce total debt to meet its internal CAD1.0 billion net debt target. Vermilion's credit facility matures in May 2026, and it has no maturities until the 5.625% notes come due in 2025 followed by the 6.875% notes in 2030.
Vermilion has steadily increased its quarterly $0.10/share dividend since reintroduction in 2021 after cancelling it in 2020 to conserve liquidity. This dividend is modest in relation to forecast FCF generation, and along with potential share buybacks or special dividends is targeted at up to 25% of FCF in 2023. Distributions are expected increase once the company's CAD1.0 billion net debt target is met.
Issuer Profile
Vermilion Energy Inc. (NYSE/TSE: VET) is a small-to-medium sized diversified international E&P company with producing properties primarily in North America, Europe, and Australia.
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
Vermilion Energy Inc. has an ESG Relevance Score of '4' for Exposure to Social Impacts due to Vermilion's small-to medium-sized production profile, offshore production, and operations where there exists a more stringent climate-related regulatory framework and increase social resistance, including the approval of a temporary windfall tax measure aimed at EU companies with activities in the hydrocarbon sector. This has a negative impact on the credit profile and is relevant to the ratings in conjunction with other factors.
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.
VERMILION ENERGY INC. 
