Fitch assigns Karoon First-Time 'B' /Stable Rating; Proposed Notes Rated B+ / RR3

https://www.fitchratings.com/research/corporate-finance/fitch-assigns-karoon-energy-first-time-b-stable-rating-proposed-notes-rated-b-rr3-23-04-2024

Karoon Energy's rating is constrained by its small operational scale and relatively short proven (1P) reserve life, which is concentrated across the Santos Basin and the US Gulf of Mexico (GoM). The constraints are alleviated by the company's lower counterparty and volume risks from a long-term volume off-take arrangement with Shell plc (AA-/Stable) and its low-cost position. The Stable Outlook reflects our expectation that Karoon Energy will acquire production assets and/or explore new fields to address the reserve depletion at its Brazilian assets while maintaining a conservative capital structure.

The proposed senior secured notes will be guaranteed by Karoon Energy and its subsidiaries, with the proceeds used to repay drawn balances under a reserve-based lending facility with the remainder for general corporate purposes. The notes are rated one-notch higher than Karoon Energy's IDR following the application of a weighted-average country-specific recovery rating cap of 'RR3' based on a production profile that is between the Brazilian and US GoM assets towards the end of the rating horizon in 2027.

KEY RATING DRIVERS

Small Scale; Limited Reserves: Karoon Energy's Bauna project in Brazil will make up around 65% of total production until 2027, with the remainder from its 30% interest in the US GoM Who Dat/Dome Patrol asset operated as a joint venture (JV) with LLOG Exploration Offshore LLC, LLOG Omega Holdings LLC and the Westlawn Group.

Its 1P reserves of around 60 million barrels of oil equivalent (boe) as of 31 December 2023 translate into a 1P reserve life of around five years based on the company's 2024 production guidance. Fitch expects net production to decline from around 32,000boe/day in 2024 to 28,000boe/day in 2027 due to the depleting reserves at Bauna.

Lower Counterparty, Volume Risks: Karoon Energy's long-term volume off-take agreement with Shell is for all of its oil produced at Bauna, with the cargoes lifted by Shell and sold to customers globally. Under this arrangement, with Shell as the off-take counterparty, Karoon Energy typically realises a price discount of around 5% to Brent on a net back basis after marketing and delivery costs. The discount is usually narrower than that of its peers. Therefore, counterparty and volume risks are lower for Karoon Energy.

Efficient, Low-Cost Producer: Karoon Energy has one of the lowest costs among the producers operating in the Santos Basin. We expect Bauna's unit operating costs to be around USD15/boe in 2024. Who Dat/Dome Patrol has a stable production history and lower unit operating costs of around USD5/boe, resulting in a blended unit operating cost of around USD12/boe. However, we expect the unit operating cost to increase to around USD15/boe by 2027, given the decline in net production to 2027 and a largely fixed cost base.

Acquisitions to Drive Growth Strategy: We believe Karoon Energy plans to acquire working interests in assets with stable production in the Americas, increasing its operational scale by an extent similar to the recent Who Dat/Dome Patrol acquisition and unlocking synergies with its portfolio. We have not included the capital outlay or the potential earnings upside in our rating case due to the uncertainty over the plans. We expect Karoon Energy to fund the acquisitions using cash and debt with a commitment to target EBITDA net leverage of less than 1.5x.

Exploring New Fields: Karoon Energy may also step up exploration at Who Dat East, West and South to time the start of production around the planned reduction in scale at Bauna, with the incremental production potentially offsetting Bauna's decline. Still, the project has yet to reach a final investment decision with its JV partners, while exploration-related risks could lead to delays in the plan. Therefore, we have not included the unapproved capital outlay or the likely earnings in our rating case.

Conservative Capital Structure: Fitch believes Karoon Energy will maintain a financial profile with EBITDA leverage of between 0.9x and 1.6x to 2027 (2023: 0.6x; 2024E: 0.9x) as its capital expenses are largely funded by operating cash. We expect EBITDA interest coverage to fall to 6.4x by 2027 from 14.7x in 2024. These will be driven by normalised earnings as commodity prices fall from their peak and its capital structure remains stable. We expect Karoon Energy to return to a net cash position by end-2024 due to strong cash generation from favourable oil prices.

DERIVATION SUMMARY

We consider GeoPark Limited (B+/Negative), SierraCol Energy Limited (B+/Stable), 3R Petroleum Oleo e Gas S.A. (B+/Stable), Pt Medco Energi Internasional Tbk (B+/Positive), Frontera Energy Corporation (B/Stable), Gran Tierra Energy Inc. (B/Stable) and PT Saka Energi Indonesia (B+/Stable, Standalone Credit Profile: b-) to be comparable with Karoon Energy given their similarities in scale and, other than Indonesia-based Medco Energi and Saka Energi, they all operate in Latin America as independent oil and gas exploration and production companies. These peers have a larger production profile and 1P reserves than Karoon Energy over the rating horizon but are still rated within the 'B' category. However, we have assessed Karoon Energy's navigator factors one- to two-notches lower than that of its peers in consideration of its lower production and reserves.

Karoon Energy also compares favourably against its peers with the lower discount on Brent of around 5% while most of its peers' discounts are 10% or higher. It also operates on a more efficient cost structure with unit operating costs of around USD12/boe compared with peers' range of USD15/boe to USD30/boe, with Medco Energi the only peer rated in the 'B' category that has a lower unit operating cost of less than USD9/boe. We expect Karoon Energy's transition into a capex-light operating phase to result in largely positive cash flow after capex through the cycle. These attributes are similar to GeoPark's and stronger than that of the other peers.

Karoon Energy's long-term volume off-take agreement with Shell reduces its counterparty and volume risks in comparison with most of its peers. Karoon Energy also has a largely similar level of EBITDA as most of its peers. These factors translate to a stronger financial profile with a more conservative financial structure, offsetting the weakness in its business profile due to its smaller production and reserves.

Peers such as Prio S.A. (BB/Stable), Santos Limited (BBB/Stable) and Woodside Energy Group Ltd (BBB+/Stable) are rated between three- and seven-notches higher than Karoon Energy because of their stronger business profiles, in particular, their significantly higher production and reserves, well-diversified portfolios and strong cash flow cycle.

Talos Energy Inc. (B/Positive) has significantly higher production and reserves than Karoon Energy but it has substantial decommissioning costs and a poorer cash flow cycle. Karoon Energy also has a more conservative financial profile than Talos. Talos is on a Positive Outlook as a proposed acquisition would increase its production size. Therefore, this justifies an equalisation in the ratings.

KEY ASSUMPTIONS

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

- Oil and gas price assumptions as per Fitch's Brent, West Texas Intermediate and Henry Hub base-case price decks as of March 2024, adjusted for price realisation in line with historical discounts on the benchmarks.

- Total production of around 12 million boe in 2024 before gradually decreasing to around 10 million boe in 2027.

- Unit operating cost of around USD12/boe to USD15/boe over 2024 to 2027 due to the decline in production.

- Cash royalties of around 7% of revenue; US GoM production is net of royalties paid in kind.

- EBITDA margin of between 60% and 70% over 2024 to 2027.

- Capex (excluding contingent considerations) of USD163 million in 2024, including the uncommitted planned capex for Who Dat East/South/West exploration wells, and total of USD211 million between 2025 and 2027.

- Effective tax rate of around 30%.

- No dividend payments between 2024 and 2027 as Karoon Energy pursues its growth strategy.

RECOVERY ANALYSIS

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that Karoon Energy would be reorganised as a going-concern in bankruptcy rather than liquidated. Fitch has assumed a 10% administrative claim.

Going-Concern Approach

Fitch has assumed a going-concern EBITDA of USD320 million, which reflects mid-cycle oil and gas price deck assumptions and net production of around 10 million boe. Given the declining production profile at Bauna, an enterprise value multiple of 3.0x is used to calculate the post-reorganisation valuation, which is at the lower end of the band compared with an average 4.5x mid-cycle multiple for oil and gas and metals and mining companies globally.

For the purpose of the recovery analysis, we have assumed the senior secured reserve-based lending facility of USD340 million to be fully drawn and prior-ranking to the proposed senior secured bonds of USD400 million. The allocation of value in the liability waterfall results in recovery corresponding to a Recovery Rating of 'RR2' for the proposed senior secured notes. However, we have applied the weighted-average country-specific recovery rating cap of 'RR3', which results in a one-notch uplift for the bond rating from the IDR, based on the production profile between the Brazilian assets, which are in the D country grouping with an 'RR4' cap, and the US GoM assets, which are in the A country grouping with an 'RR1' cap, towards the end of the rating horizon in 2027.

RATING SENSITIVITIES

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

- We may consider taking positive rating action if there is a significant improvement in the business profile, potentially arising from an increase in gross production scale to above 45,000boe/day and a corresponding rise in reserves, while maintaining a 1P reserve life of at least seven years and a strong financial profile, with EBITDA leverage less than 2.5x on a sustained basis.

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

- EBITDA leverage above 3.5x on a sustained basis;

- EBITDA interest cover below 5.0x on a sustained basis;

- Sustainable gross production falls below 25,000boe/day;

- A significant deterioration in mid-cycle unit economics, leading to negative CFO to capex on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE

Adequate Liquidity: Karoon Energy had unrestricted cash of USD170 million as of 31 December 2023 (June 2023: USD75 million) and no material debt maturing over the next 24 months. Long-term debt relates to the committed USD340 million reserve-based lending facility, of which USD274 million was drawn to finance the Who Dat acquisition.

ISSUER PROFILE

Karoon Energy is an oil and gas production and exploration company with assets and interests in two oil and gas basins in Brazil and the US. It is headquartered in Australia and listed on the Australian Stock Exchange. Karoon Energy produced around 9 million boe in 2023 with around 60 million boe of 1P reserves as of December 2023.

Sources of Information

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

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

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.