Fitch Affirms Schahin Oil and Gas' IDRs at 'BB-'; Revises Outlook to Negative

Fitch Ratings has affirmed Schahin Oil and Gas Ltd.'s (Schahin or Holdco) foreign and local currency Issuer Default Ratings at 'BB-'. The Rating Outlook has been revised to Negative from Stable.

The Negative Outlook reflects higher levels of refinancing risk as the company has delayed obtaining permanent long-term financing at the holding company level. Schahin has entered into two bridge loan financings to meet its short-term refinancing needs after canceling its proposed USD685 million debt issuance last year. The company currently has a bridge loan with Mizhuo Bank Ltd for USD460 million, which becomes due in October 2015. This bridge loan has an increasing interest rate, which, together with the short-term maturity, increases the company's short to medium term refinancing risk.

Schahin's ratings reflect the company's high consolidated leverage and structural subordination to its operating subsidiaries' project finance debt. Positively, consolidated leverage is expected to decline over time as the project finance debt at the operating companies amortizes. The OpCos assets have long-term contracts in place that allow them to better match project debt with the life of the assets, which results in low debt service requirements and greater cash flow distributions to the holding company. Upstream distributions from the four cash generating assets are not expected to be disrupted, nevertheless they are subject to various distribution tests.

Schahin's ratings also reflect the stable and predictable cash flow generation of the company's OpCos' offshore drilling assets, which are supported by long-term contracts with investment grade rated Petroleo Brasileiro S.A. (Petrobras; IDR 'BBB'). The ratings also incorporate the favorable demand prospects for oil and gas services in Brazil driven by Petrobras's aggressive capital expenditure program as well as new exploration and production entrants to the market.

HIGH LEVERAGE AND LOW LIQUIDITY

Schahin Oil & Gas Ltd's (HoldCo) consolidated leverage is considered high for the rating category and is expected to decrease over time, as debt at the operating companies' (OpCos) level amortizes to levels more consistent with the rating category. Total debt as of September 2013 amounted to approximately USD3.8 billion, including approximately a USD700 million capital lease for the Victoria drilling rig. As of the last 12 months ended Sept. 30, 2013, the company reported EBITDA of approximately USD550 million, in line with initial expectations. Fitch expects that consolidated leverage, as measured by total debt to EBITDA, will gradually decrease to approximately 5.0 times (x) or below during the next three to four years from the reported 6.8x as of Sept. 30, 2013. Schahin's liquidity is supported by the dividend distributions from its subsidiaries. As of Sept. 30, 2013, the company's unrestricted cash position was low at approximately USD30 million of cash and cash equivalents while consolidated short-term debt amounted to approximately USD460 million.

PREDICTABLE REVENUES AND STRONG BACKLOG

Schahin's consolidated revenues and cash flow from operations are stable and predictable, reflective of its long-term contractual structure with Petrobras. The company provides offshore oil and gas drilling services through its different subsidiaries. The average remaining contract life for its existing offshore drilling assets is approximately eight years. The company currently operates six offshore drilling units under long-term contracts with Petrobras. The bulk of the HoldCo's expected cash flow will come from dividends from its 100% owned OpCos as well as from cash flow from operations from its leased asset, Victoria, and the potential minority investments in three new FPSOs. Schahin has a good operating track record in the drilling sector. During the first 11 months of 2013, average uptime for Schahin fleet was approximately 94%.

Schahin's current contract backlog, excluding contract renewal options, of approximately USD6 billion bodes well for the company's credit profile as it supports cash flow predictability. Of the company's current backlog, approximately USD5 billion relate to the existing offshore drilling assets, where the company has majority participation, all of which are contracted with Petrobras. The balance of the backlog relates to three FPSOs for which the company has acquired the option to purchase between 10% and 15% equity participation upon construction completion.

STRUCTURAL SUBORDINATION TO OPERATING COMPANIES' DEBT

The potential retention of cash flows after debt service at the OpCos level makes cash flow to the Holdco somewhat less stable and predictable than the cash flow from operation of its subsidiaries. The project finance debt at the OpCos either have cash sweep provisions or minimum debt service coverage ratios (DSCR) (e.g. 1.2 or above) that must be met before cash flow distributions are allowed to be made to the Holdco. Specific assets (S.S. Panatanal and S.S. Amazonia) are not expected to distribute excess cash to the holding company until all project finance debt and subordinated debt is repaid due to cash sweep provisions.

Cash distributions to Schahin are sensitive to the operating performance of the OpCos' (the rigs') uptime performance. For example, in the case of the Cerrado and Sertao operating assets, a decline in the uptime rate to 86% and 85% for three and six months, respectively, will likely prevent these assets from distributing cash to the Holdco. Under Fitch's base case assumption of an average uptime rate of 95%, these two assets are not expected to trap cash.

Under Fitch's base case assumptions, net cash flow distributions to Schahin from its OpCos, after considering planned investments and holding company operating expenses, is expected to range between approximately USD40 million and USD280 million and to average approximately USD125 million per year over the next five years. Total debt to net dividend distributions at Holdco is expected to average approximately 2.9x over the next five years. Net distributions to Schahin are expected to increase starting 2017 as some project finance debt is fully amortized and should increase if uptime rates are higher than projected.

STRONG DEMAND FOR DRILLING RIGS IN BRAZIL

Long-term demand prospects for oil and gas services in Brazil, including demand for offshore drilling rigs and production equipment, are strong. Driven by a government initiative to increase the country's oil and gas production, Petrobras has embarked on an aggressive capital investment program of up to USD236 billion over the next four years. Further, the government has implemented requirement that a high percentage of the work and materials provided for these expenditures be from 'local' sources in order to boost economic activity. The combination of higher demand and the local content mandate for oil and gas related services support long-term demand prospects for the company as well as its ability to renew contracts at favorable rates.

SENSITIVITY/RATING DRIVERS

Factors that could lead to a negative rating action are: Failure to put in place permanent long-term financing at the holding company to refinance intermediate subsidiaries obligations and/or failure to lower leverage to 5.0x or below in the medium term or an overly aggressive growth strategy that could pressure credit metrics.

Key considerations for a positive rating action or Outlook would be a faster deleveraging process coupled with a reduction of the holding company's structural subordination to its operating assets.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 8, 2012);

--'Parent and Subsidiary Rating Linkage' (Aug. 8, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=817351

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