Fitch Takes Medco Off Rating Watch; Outlook Positive; Affirms at 'B+'

(Fitch Ratings - Singapore - 24 May 2022)--Fitch Ratings has affirmed PT Medco Energi Internasional Tbk's Long-Term Issuer Default Rating (IDR) at 'B+' and has placed the rating on Positive Outlook. Fitch has also affirmed the ratings on Medco's senior unsecured US-dollar notes at 'B+' with a Recovery Rating is 'RR4'.

All ratings are now off Rating Watch Positive, as Medco has completed the acquisition of ConocoPhillips Indonesia Holding Ltd. ConocoPhillips owns a 54% working interest in the Corridor block production sharing contract (PSC), an operating asset in South Sumatra, and a 35% interest in Transasia Pipeline Company Pvt Ltd.

The Positive Outlook reflects Medco's improved operating profile post the acquisition, with a larger scale and a more favourable earning mix due to a higher share of fixed-price contracts. We expect Medco's EBITDA from fixed-price contracts to remain above 2.5x of interest expense, up from around 1.0x prior to the acquisition, until 2025. Medco's rating is underpinned by a low-cost position, earnings stability and healthy free cash flow generation, which support the company's strong financial profile under Fitch's oil and gas (O&G) price assumptions.

Key Rating Drivers

Higher Fixed-Price Volume, Larger Scale: The Corridor block PSC acquisition has boosted the share of gas in Medco's output to 75%, from 60%. The majority of the gas from Corridor is sold via fixed-price, long-term take-or-pay contracts with strong counterparties, including PT Perusahaan Gas Negara Tbk (BBB-/Stable) and PT Pertamina (Persero) (BBB/Stable); Medco's share of fixed-price contracts in its output is now around 55%, from below 40%.

Corridor also adds up to 70,000 barrels of oil equivalent (boe) per day to Medco's production of 100 million boe per day, leaving Medco's operating scale larger than that of most rated upstream O&G producers in the 'B' rating category.

Room for Reserve Life Improvement: We estimate Medco's pro forma proved (1P) reserve life was below our positive rating action guideline of seven years at end-2021, due to the weak 1P reserve life of the Corridor block PSC, which we assess at less than four years. This will entail higher investments for Medco to improve its reserve life; Medco plans to develop its Block B, Senoro Phase 2 and Block A drilling in the aim of adding reserves in the medium term. The company says its Corridor integration is progressing as planned and it expects to finalise its investment plan for Corridor during 2H22.

Medco has a long history of replenishing its reserves organically and inorganically and aims to maintain a proved and probable reserve life of nine years. The company's strong financial profile provides resilience against capex, while the high proportion of developed proved reserves lowers its capex requirements and provides flexibility during oil-price downturns.

Competitive Cost Position: Medco's low cash-cost position improved with the acquisition of the Corridor block PSC, which has a cash-cost position of USD4-5/boe, lower than Medco's previous cash cost of around USD9/boe. This, along with contracted volume, supports robust and predictable cash flow.

Improving Financial Profile: Incremental earnings from the Corridor block PSC and strong oil prices should boost EBITDA to USD1 billion or above until 2025 (2021E: USD640 million), despite a drop in working interest in the Corridor block to 46% after 2023, from 54%. We expect net leverage, measured as net debt/EBITDA and excluding Medco's fully owned subsidiary, PT Medco Power Indonesia (MPI), to fall below 2.0x in 2022 (2021E: 3.3x, 2020: above 4.0x).

Tender Offer, Lower Debt: Medco has made a capped tender offer to buy back USD150 million of its 2026 and 2027 US-dollar notes using internal cash. It prioritises its 2026 notes, which are the most expensive in its capital structure. Hence, a successful buyback will improve its interest cover metrics. We have not baked the buyback into our base case and forecast average EBITDA-based interest cover at 6.4x until 2025 (2021E: 2.8x). Medco's debt will also fall after it repays its two-year amortising bank loan of USD450 million to fund the Corridor acquisition using operating cash flow.

Gas Agreements Renewal: The gas sale and purchase agreements for the Corridor block PSC expire in 2023. Some of the agreements have been extended, but a large portion remain under discussion. We believe volume risk from renewals is low, considering the importance of the block to Indonesia's domestic gas supply.

Power Business Neutral: we assess the risk dynamics of MPI to be neutral to Medco's credit profile, as its investment in the power company falls outside the restricted group structure defined in its bond documentation. The documents limit Medco's investments outside the restricted group to USD300 million, half of which has been utilised. It also limits cash outflow from Medco to MPI and other investments outside the restricted group and there are no cross-default clauses linking MPI's debt to Medco.

Derivation Summary

The acquisition of Corridor block PSC makes Medco's business profile comparable with that of exploration and production peers in the 'BB' rating category.

Around 80% of Canacol Energy Ltd.'s (BB/Stable) sales volume comes from long-term, fixed-price take-or-pay gas sales contracts. In comparison, the proportion of fixed-price contract sales in Medco's portfolio is around 55%. This is partly offset by Medco's larger production scale and EBITDA generation. Both companies have a moderate 1P reserve life of around six years.

GeoPark Limited (B+/Stable) and Medco have limited geographic diversification and moderate reserve lives. Medco's profile, however, benefits from a larger production scale and the presence of fixed-price contracts.

Key Assumptions

- Brent prices of USD100 a barrel in 2022, USD80 a barrel in 2023, USD60 a barrel in 2024 and USD53 a barrel thereafter, as per Fitch's O&G price deck. Gas prices in line with fixed-price contracts where applicable; see Fitch Ratings Raises Short- and Medium-Term Oil & Gas Price Assumptions.

- Total production volume, including the Corridor block PSC, of above 160 million boe per day until 2023, then dropping amid lower working interest in the Corridor block PSC.

- Cash production costs of less than USD9/boe

- Average annual capex of USD260 million over the next five years

- Annual dividend pay-out of 10% of net income

Recovery Analysis:

- The recovery analysis assumes that Medco would be reorganised as a going concern in bankruptcy rather than liquidated.

- We assume a 10% administrative claim.

- Medco's post-acquisition going-concern EBITDA, excluding MPI, is based on the average EBITDA we expect over 2025-2026. This reflects a sustainable earnings level for the company based on our long-term oil price assumption.

- An enterprise value multiple of 5x is used to calculate a post-reorganisation valuation and reflects a mid-cycle multiple for O&G, metals and mining companies globally, which is higher than the observed lowest multiple of 4.5x. The higher multiple reflects that a large proportion of Medco's production volume stems from long-term fixed-price and indexed take-or-pay gas contracts, which provide more cash-flow visibility across economic cycles than the average global upstream O&G production company.

- We assume prior-ranking debt of USD154 million will be repaid before Medco's senior unsecured creditors, including investors in its US-dollar bonds. Prior-ranking debt includes project-finance debt at non-guarantor subsidiaries, PT Medco E&P Tomori Sulawesi and PT Medco E&P Malaka.

- The payment waterfall results in a recovery rate corresponding to a 'RR1' Recovery Rating for the unsecured notes. However, we rate the senior unsecured bonds at 'RR4' because Indonesia falls into Group D of creditor friendliness under our Country-Specific Treatment of Recovery Ratings Criteria, and the Recovery Rating on instruments of issuers with assets in this group are subject to a cap of 'RR4'.

RATING SENSITIVITIES

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

- A sustained improvement in the P1 reserve life to seven years or above, while maintaining leverage (net debt/EBITDA, excluding MPI) below 2.5x.

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

-We will revise the Outlook to Stable if the positive rating guidelines are not met in next 12 months.

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

Strong Liquidity: We estimate that Medco, excluding MPI, had cash of around USD795 million at end-2021, which could comfortably cover the USD348 million of debt maturing within a year. Medco's liquidity profile benefits from committed undrawn facilities of USD550 million as of end-2021. The company has significant annual debt maturities of USD500 million-700 million during 2025-2027, when its US-dollar notes matures. Medco has a history of refinancing bond maturities well ahead of schedule. We expect Medco to generate sufficient cash flow from operations to cover its capex plan.

Issuer Profile

Medco is an Indonesian upstream O&G company, with some international presence. It produced 94 million boe per day of O&G in 2021.

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

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. (ends)