DBRS Morningstar Assigns Provisional Ratings of BBB with Stable Trends to ARC Resources Ltd.

DBRS Limited (DBRS Morningstar) assigned a provisional Issuer Rating and provisional Senior Unsecured Notes (Senior Notes) rating of BBB, both with a Stable trend, to ARC Resources Ltd. (ARC or the Company). The provisional ratings assume the successful close of the strategic combination (the Combination) with Seven Generations Energy Ltd. (7G) announced on February 10, 2021, and expected to be completed in Q2 2021. Following the close of the Combination, 7G is expected to be amalgamated with ARC and the combined company will operate as ARC. The rating for the pro forma entity is underpinned by (1) enhanced scale in the liquids-rich Montney resource play with good access to processing and pipeline infrastructure; (2) competitive cost structure with the ability to flex capital expenditures (capex) and generate free cash flow (FCF; i.e., cashflow after capex and dividends) at lower commodity prices; and (3) ARC’s conservative financial policy, which has allowed the Company to maintain strong credit metrics through commodity price cycles. Key challenges to ARC’s rating include limited geographic diversification with exposure primarily to a single resource play (Montney) and a lower proved developed reserve life index with corresponding higher decline rates. The Stable trends reflect DBRS Morningstar’s expectation that, under DBRS Morningstar’s base case commodity price assumptions, the Company should be able to deleverage meaningfully through 2021 and 2022 and its financial risk profile will remain supportive of the rating.

The Combination enhances ARC’s strong competitive position in the low cost liquids-rich Montney resource play. Apart from a 110% increase in pro forma production, the Combination also provides ARC with exposure to higher value condensate production (approximately 21% of pro forma 2021 production). The Combination also enhances ARC’s existing infrastructure footprint in the Montney play with pro forma owned and operated natural gas processing capacity of 1,485 million cubic feet per day (MMcf/d) and liquids handling capacity of 100 thousand barrels per day (mbbls/d). Ownership of the infrastructure assets is a key element to reducing operating costs. ARC will also have access to contracted capacity on natural gas egress pipelines out of Western Canada for approximately 85% of its pro forma natural gas production, which mitigates some of the risks associated with regional pricing volatility.

ARC and 7G have reduced their operating costs over the last three years, which has allowed ARC and 7G to generate a FCF surplus in 2020 despite the steep decline in crude oil prices. DBRS Morningstar expects the cost structure to improve as the Company starts realizing expected annual synergies ($110 million by 2022) from the Combination. ARC’s pro forma capital program is flexible and the Company has the ability to adjust its capex in response to the prevailing commodity price environment. Both ARC and 7G have completed their large infrastructure build outs and capex in the near term is expected to be focused on sustaining production. In early 2020, ARC and 7G reduced their budgeted capex by 40% each in response to the steep decline in crude oil prices. ARC subsequently increased its budgeted capex by $50 million in Q4 2020 to take advantage of higher natural gas prices. DBRS Morningstar expects ARC to generate a FCF surplus even under its stress case West Texas Intermediate (WTI) crude oil price and natural gas spot price in Western Canada (AECO) assumptions of USD 40.00/bbl and $2.00 per thousand cubic feet (mcf), respectively.

While the proposed acquisition improves product diversification and economies of scale with a larger presence in the Montney, ARC’s pro forma business risk profile is constrained by a lack of geographical diversification. As a result, the Company is still exposed to potential region-specific risks, such as infrastructure and weather constraints or stricter environmental regulations. The Combination also has a negative impact on ARC’s pro forma reserve metrics. ARC has pursued a modest pace of development in the Montney and has consistently increased its proved reserve base over the past several years. However, 7G’s asset base is relatively less mature with higher decline rates. Given its shift in focus from growth to maintenance mode, 7G’s proved reserves decreased by 16% in 2020. As a result, the Combination has a negative impact on ARC’s pro forma reserve replacement metrics. ARC’s pro forma proved developed reserve life index of 4.3 years is also lower relative to its peers. DBRS Morningstar notes that, as a result of the shift in focus away from growth, 7G’s corporate decline rates have started to moderate and the amount of capex required to sustain production levels is trending lower. DBRS Morningstar expects ARC’s reserve replacement metrics to improve and the Company to maintain its proved developed reserve life at current levels, based on ARC’s budgeted capex of $1.0 billion to $1.1 billion in 2021.

ARC’s management team, which will lead the combined entity, has consistently followed a conservative financial policy that prioritizes maintaining balance sheet strength over growth. ARC has historically maintained its lease adjusted debt-to-cash flow ratio between 1.0 times (x) to 1.50x by operating within cash flow and using commodity hedges to reduce cash flow volatility. DBRS Morningstar expects the Company to continue to pursue a conservative financial policy and prioritize deleveraging the balance sheet before pursuing growth or increasing shareholder distributions.

ARC’s pro forma financial leverage, at close of the Combination, is expected to increase as a result of the higher leverage at 7G. However, DBRS Morningstar expects the Company to generate FCF surplus in 2021 and 2022 under DBRS Morningstar’s base case WTI crude oil (2021: USD 53/bbl, 2022: USD 52/bbl), New York Mercantile Exchange (NYMEX) natural gas (2021: USD 2.75/mcf, 2022: USD 2.75/mcf), and AECO (2021: $2.75/mcf, 2022: $2.75/mcf) price assumptions. DBRS Morningstar expects ARC to use the FCF surplus to reduce the overall level of indebtedness at the combined entity. Consequently, despite the increase in leverage at close of the Combination, DBRS Morningstar expects the pro forma lease-adjusted debt-to-cash flow ratio to return within the range of 1.0x to 1.50x in 2022.

ARC’s pro forma liquidity is expected to be favorable. The Company intends to avail itself of a new unsecured revolving credit facility of $2,000 million and refinance 7G’s existing higher cost senior unsecured notes with new, lower cost senior unsecured notes (New Senior Notes) and an unsecured term loan of $500 million. DBRS Morningstar notes that the New Senior Notes will be subject to a Special Mandatory Redemption provision and will have to be mandatorily repaid if the Combination has not occurred by October 15, 2021. ARC has scheduled debt repayments of $147 million in 2021 and $161 million in 2022 and DBRS Morningstar expects the Company to generate adequate FCF surpluses under DBRS Morningstar’s base case assumptions to meet these repayment obligations.

A rating upgrade is unlikely in the medium term absent a material improvement in the business risk profile. However, a negative rating action is likely if the Company’s reserve metrics deteriorate and/or the Company’s lease adjusted debt-to-cash flow ratio deteriorates materially and is consistently above DBRS Morningstar’s expected range of 1.0x to 1.50x..

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal methodologies are Rating Companies in the Oil and Gas and Oilfield Services Industries (August 17, 2020; https://www.dbrsmorningstar.com/research/365808/rating-companies-in-the-oil-and-gas-and-oilfield-services-industries), DBRS Morningstar Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (November 2, 2020; https://www.dbrsmorningstar.com/research/369167/dbrs-morningstar-criteria-rating-corporate-holding-companies-and-parentsubsidiary-rating-relationships), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (January 14, 2021; https://www.dbrsmorningstar.com/research/372344/dbrs-morningstar-criteria-guarantees-and-other-forms-of-support).Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

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