DBRS Limited (DBRS Morningstar) assigned a provisional Issuer Rating of B (high) to Obsidian Energy Ltd. (Obsidian or the Company). DBRS Morningstar also assigned a provisional instrument rating of B (high) with a Recovery Rating of RR4 to the proposed Senior Unsecured Notes (Senior Notes) to be issued by the Company. All trends are Stable. In connection with Obsidian’s proposed issuance of the Senior Notes, DBRS Morningstar expects the Senior Notes to be on terms consistent with draft documentation provided by Obsidian to DBRS Morningstar and satisfactory to DBRS Morningstar, including guarantees (if any). Further, the provisional ratings are based on the assumption that (1) the Senior Note issuance will close successfully and will rank subordinate to the new Senior Secured Credit facility (Credit Facility) and the Senior Secured Term Loan (Term Loan); (2) concurrent with the issuance of the Senior Notes, Obsidian will establish a new Credit Facility of $175 million (including the operating facility of $25 million) with a maturity date of 364 days from closing; and (3) the existing Private Placement notes (the Existing Notes) and the Peace River Oil Partnership (PROP) limited recourse loan will be fully repaid.
The Company’s Issuer Rating is supported by its (1) higher netbacks from its oil-weighted production mix; (2) relatively lower decline rates providing the Company with the ability to flex capital expenditures (capex) in a volatile price environment; (3) relatively stronger reserve metrics; and (4) relatively stronger financial risk profile, which, under DBRS Morningstar’s base case commodity price assumptions, provides an uplift to the rating. Obsidian’s rating is constrained by its size (2022 mid-point production guidance of 32,000 barrels of oil equivalent per day (boe/d)), relatively higher operating costs, and some exposure to heavy-light price differentials and relatively higher asset retirement obligations (ARO). The Stable trend reflects DBRS Morningstar’s expectation that the Company will continue to deleverage and its financial risk profile will continue to support the rating under DBRS Morningstar’s base case price assumptions, which are very conservative compared with current spot and strip prices.
Obsidian’s primary producing assets are located in the Cardium (74% of production in Q1 2022, which consists of light oil and natural gas) and the Peace River (22% of production in Q1 2022, which consists of heavy oil) development areas of Alberta. The Company is the largest acreage holder in the Cardium and the acquisition of the remaining 45% PROP interest in 2021 provides the Company the flexibility to increase heavy oil production if commodity prices stay supportive. The Company has access to adequate gathering and processing infrastructure in its primary development areas to accommodate the Company’s moderate medium-term growth plans. In Q1 2022, liquids accounted for approximately 66% of the Company’s production with light oil accounting for approximately 38% of the Company’s production mix, allowing the Company to realize higher prices for its production. The Company’s reserves are also liquid rich (67% of year end 2021 gross proved reserves), which should allow it to maintain a liquids-rich production profile. The Company’s overall decline rates of approximately 21% is lower relative to its other liquids-rich peers. Lower decline rates also provide the Company the flexibility to reduce capex in response to the prevailing commodity price environment as demonstrated during the downturn in 2020 when the Company almost halved its capex relative to 2019 and generated a modest free cash flow (FCF; cash flow from operations less capex and dividends) surplus. Obsidian’s reserve metrics over the last three years have also shown consistent improvement. The Company has consistently replaced over 100% of its production over the last three years through organic growth, which has led to an improvement in its reserve life index (RLI). The Company’s reserve replacement costs have also trended lower over the same period and the Company has maintained reserve recycle ratios well in excess of 1.0 times (x) over the same period.
Obsidian’s operations lack the benefit of scale, consequently, its operating (including transportation) costs are relatively higher compared with its liquids-weighted peers. DBRS Morningstar expects operating costs in 2022 (Q1 2022: $17.99 boe) to trend higher relative to 2021 as a result of inflationary pressures on raw materials and labour costs across the basin. However, on a per boe basis, DBRS Morningstar expects the impact of higher operating costs to be partially offset by higher production. DBRS Morningstar also notes that the Company generates processing fees and road-use recoveries (Q1 2022: $1.28/boe), which reduces gross operating costs. Processing fees are primarily generated by processing third-party volumes at the Company’s facilities and the Company collects road-use recoveries as it operates and maintain roads that are also used by third parties. Nevertheless, the Company is still expected to generate relatively higher operating netbacks (Q1 2022: $47.65/boe before the impact of hedging) because of its oil-weighted production mix. Obsidian also has exposure to heavy-light differentials as approximately 20% of its production mix consists of heavy oil and its natural gas production is primarily linked to the AECO pricing benchmark with limited ability to access U.S. markets. Obsidian has ARO obligations related to inactive wells (Q1 2022: $285 million), which requires mandatory spending of approximately $12.0 million every year. DBRS Morningstar notes that the Company has reduced its inactive ARO obligations over the last three years through the help of government support programs and voluntary spending. In addition to the Alberta Energy Regulator’s (AER’s) liability management framework mandated annual closure spend, Obsidian has chosen to spend the additional amount necessary to satisfy the voluntary spend component, approximately 0.3% of inactive liability, with the intention of accelerating the reduction in its inactive ARO.
In the first half of 2020, the Company’s liquidity was under severe pressure as a result of lower commodity prices which resulted in lowering of its borrowing base limit and term-out of a part of its reserve based credit facility. The Company also had to extend the repayment date on its existing senior secured notes from 2020 to November 2022 while also increasing the interest payable on the notes by 2.1%, and had to amend its financial covenants. However, Obsidian’s financial risk profile has improved considerably in 2021 and 2022 as a result of higher commodity prices. The Company generated a meaningful FCF surplus in 2021, which was used to reduce indebtedness. Consequently, the Company’s liquidity position and overall credit metrics have both improved in 2021. As part of its refinancing plan, Obsidian expects to establish a new Credit Facility of $175 million, issue an amortizing Term Loan of $50 million (maturity December 2022), and senior notes of $125 million (maturity 2027). Proceeds from the issuance of the Term Loan and Senior Notes will be used to repay the Existing Notes (US$34.7 million), PROP limited recourse loan ($6 million), and reduce borrowings under the existing borrowing base credit facility. Following completion of the refinancing, the Company will have a smaller Credit Facility (~$40 million available at close of the refinancing) with adequate buffer under the assessed borrowing base limit to absorb lower commodity prices without triggering a term-out as experienced in 2020. The refinancing also improves the Company’s maturity profile.
Based on DBRS Morningstar’s base case commodity price assumptions, we expect the Company to generate a meaningful FCF surplus over the next three years. DBRS Morningstar notes that the Company intends to hedge up to 50% of its near-term production if prices remain constructive. DBRS Morningstar expects the Company to use part of the surplus to reduce borrowings under the Credit Facility. DBRS Morningstar expects the Company’s financial risk profile to be strong and provide an uplift to the overall rating even under its base case commodity price assumptions, which are well below current spot and strip prices. DBRS Morningstar expects the Company will maintain its lease adjusted debt-to-cashflow ratio below 2.0x over the forecast horizon.
A rating upgrade would require a material improved in the Company’s size as measured by production. Given the support provided by the Company’s financial risk profile to the overall rating, a material deterioration in Obsidian’s lease adjusted debt-to-cash flow ratio which could be caused by significantly lower oil prices or a material deterioration in liquidity could trigger a negative rating action.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Environmental (E) Factors
DBRS Morningstar considered carbon and greenhouse gas costs as a relevant environmental factor. This factor is relevant because compliance with ever-increasing environmental regulations and standards limits the growth potential and adds costs for all oil and gas companies, including Obsidian.
There were no social or governance factors with a significant or relevant impact on the credit ratings.
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/396929.
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 16, 2021; https://www.dbrsmorningstar.com/research/383104), DBRS Morningstar Criteria: Recovery Ratings for Non-Investment-Grade Corporate Issuers (August 19, 2021; https://www.dbrsmorningstar.com/research/383238), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (April 4, 2022; https://www.dbrsmorningstar.com/research/394683), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929).
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