Fitch Downgrades Royal Dutch Shell to 'AA-'; Upgrades BG to 'A+'; Outlook Negative; Off Rating Watch
OREANDA-NEWS. Fitch Ratings has downgraded Royal Dutch Shell plc's (Shell) Long-term Issuer Default Rating (LT IDR) to 'AA-' from 'AA'. The Outlook is Negative. The ratings have been removed from Rating Watch Negative.
Simultaneously, Fitch has upgraded BG Energy Holding Limited's (BG) LT IDR to 'A+' from 'A-'. The Outlook is Negative. The ratings have been removed from Rating Watch Positive. The ratings of BG Energy Capital plc's unsecured subordinated bonds (GBP600m, EUR500m and USD500m bonds due 2072) have been upgraded to 'A-' from 'BBB', ie, two notches below BG's IDR, due to the bonds' deeply subordinated position relative to BG's senior obligations; while the issuer can defer coupon payments.
A full list of rating actions is available at the end of the commentary.
Shell's one-notch downgrade follows our re-assessment of the group's financial profile following the completion of its BG acquisition on 15 February 2016. Using Fitch's latest Brent price deck of USD45 per barrel (bbl) in 2016, USD55/bbl in 2017 and USD60/bbl in 2017, we forecast that the combined group's funds from operations (FFO) net adjusted leverage will peak at end-2016 at under 2.5x before moderating to 2.1x at end-2017, and gradually to 1.9x-2x in 2018-2019, ie, to the upper leverage range of our 'AA-' rating guidance.
The Negative Outlook reflects risks stemming from Shell materially missing the targeted level of asset disposals in a competitive market environment, expectations of fairly stable dividend payouts, increase in leverage due to recurring negative free cash flow (FCF), lower oil prices and weaker cash generation.
BG's upgrade to 'A+' reflects strong strategic and operational, but weak legal ties with Shell. The Negative Outlook on BG mirrors that on Shell. We expect BG to be eventually fully integrated into Shell's group structure with limited operational and financial autonomy. However, in the absence of legal ties, such as financial guarantees, we rate BG one notch below Shell, in line with Fitch's parent-subsidiary rating linkage. We will review this rating approach when we have more clarity on BG's legal structure within Shell, specifically, on the recovery prospects for existing BG's bondholders.
Fitch has also withdrawn the ratings of Royal Dutch/Shell Group as they are no longer relevant to the agency's coverage.
KEY RATING DRIVERS
Leverage Improves to Under 2x
Shell's downgrade reflects the group's deteriorating financial profile following the completion of the BG acquisition. In addition to Brent price assumptions listed above, our rating case is based on our assumptions around the announced USD30bn divestment programme, projected reductions to the combined capital and operating expenditures, cash and scrip dividend payouts as well as the scale and timing of announced share buybacks from 2017. In this oil price environment, the expected improvement to Shell's upstream profile post-BG acquisition does not, in our view, fully offset the forecast deterioration of its credit metrics, as the group's higher post-acquisition leverage exceeds our negative rating action trigger of above 1.5x on a sustained basis.
Cost Saving Measures Are Necessary
Shell's EBITDAX (EBITDA before exploration expense) plunged 40% yoy in 2015, mainly driven by weaker average oil and gas prices. To improve profitability in 2016, Shell plans to reduce operating costs by USD3bn through supply chain and personnel optimisation, slash USD3bn of capital investment for the combined group on project deferrals, ownership dilutions and re-negotiations with suppliers and service providers. Additionally, Shell targets further synergies with BG, eg, lower operating and exploration expenses of at least USD3.5bn annually by 2018. We estimate that further capex and opex cuts might be needed for Shell to preserve its 'AA' category credit profile if the group is unsuccessful in meeting its asset disposal goals.
Gas Business Boosts Upstream
In 2015, Shell produced nearly 3 million barrels of oil equivalent a day (mmboepd), including equity affiliates, half of which was in natural gas and liquefied natural gas (LNG), making it the largest European oil and gas major by production. We expect that the combination with BG will further strengthen Shell's upstream business as natural gas, including LNG, is more resilient to price shocks than liquids (crude oil and gas condensate). After the BG acquisition, Shell's average daily oil and gas production, including equity affiliates, should increase by about 20% and its proved oil and gas reserves, including equity affiliates, should increase by about a quarter compared to 2014, according to Fitch's estimations.
In 2015, upstream production generated significant losses for Shell while integrated gas operations made profits. Shell reported a large USD3.4bn loss (adjusted for one-off items) from upstream (excluding integrated gas) on a USD46.5/bbl average realised oil price in 2015, despite a 7% upstream production cost drop per barrel of oil equivalent to USD16.7/boe. At the same time, its integrated gas business (including LNG marketing and trading) generated USD5.2bn in clean earnings in 2015. Realised gas prices are less volatile than oil prices, eg, between 2013 and 2015 Shell's realised gas prices fell 31% while its realised oil prices collapsed 52%. This is partly attributed to time lag, but more importantly trading hub gas prices in the US and in much of western Europe have largely become de-linked from those of crude oil and oil products.
Downstream Supports Cash Generation
Cash flow from operations (excluding working capital changes) at Shell's downstream business more than doubled in 2015 to reach USD10.6bn. Solid downstream performance was underpinned by the group's refining operations, which benefited from strong refining cracks globally, among other factors. Marketing and chemicals divisions also made substantial contribution to the overall downstream results in 2015. We expect that operating cash flow from downstream will decline in 2016 as we forecast global refining margins to moderate from record 2015 levels.
BG Contributes LNG, Liquids
BG's two largest ongoing projects are Queensland Curtis LNG (QCLNG) in Australia and the pre-salt deep offshore fields in Brazil. They should strengthen Shell's positions in the LNG market and boost upstream liquids production, particularly if oil and gas prices start to recover from the current multi-year lows, as we expect. The BG acquisition significantly advances Shell's strategy to grow its presence in LNG and deepwater offshore upstream.
In 2015 BG reported a 16% yoy increase in upstream production, mainly on the production ramp-up at QCLNG and in Brazil. Located in Queensland, Australia, QCLNG is a 2-train 8.5 million ton per annum (mtpa) coal-bed-methane-to-LNG project. In Brazil, BG has made multi-billion dollar investments in several large pre-salt discoveries in the Santos Basin, including Lula, Iracema area, Sapinhoa, Lapa and former Greater Iara area. In addition, BG serves as an operator in 10 blocks in the Barreirinhas Basin.
Fitch's key assumptions within our rating case for Shell include:
-Fitch's latest oil and gas price deck (USD45/bbl of Brent oil in 2016, USD55/bbl in 2017, USD60/bbl in 2018, and USD65/bbl thereafter).
-Shell's total hydrocarbon production (excluding affiliates) up by about 30% in 2016 to include BG's volumes and stays broadly flat afterwards.
-Capital expenditure of USD27bn in 2016 as further capex reduction is expected; 2017-2019 annual capex averaging USD27bn.
-Asset disposals totalling USD23bn in 2016-2019.
-Aggregate share repurchases of USD9.4bn in 2017-2019.
-Average annual cash dividend of USD11bn in 2016-2019.
Positive: Future developments that could lead to the Outlook being revised to Stable include:
-Recurring daily production volume growth starting in 2017.
-Reserve replacement rates averaging above 100%.
-Positive free cash flow (FCF) generation on a sustained basis.
-FFO adjusted net leverage consistently below 2x.
Negative: Future developments that could lead to negative rating action include:
-Further deterioration in global oil and gas price outlook, beyond our current forecast.
-Failure to maintain stable production or reserve base.
-Financial profile with FFO adjusted net leverage greater than 2x and FFO fixed coverage below 8x on a sustained basis (Fitch's current expectations - leverage of 1.9x and coverage of 8.6x by 2019).
-Negative FCF due to higher-than-expected capex or lower proceeds from asset disposals.
Shell's cash and cash equivalents were USD31.8bn at 31 December 2015, according to 2015 unaudited financials. Fitch estimates that in 2016 the group will be able to finance its short-term debt repayments, and cover the cash portion of the BG acquisition's consideration and the expected negative FCF before disposals from its cash reserves.
FULL LIST OF RATING ACTIONS
Royal Dutch Shell plc
Long-term IDR: downgraded to 'AA-' from 'AA'; off RWN; Outlook Negative
Senior unsecured debt: downgraded 'AA-' from 'AA'; off RWN
Shell International Finance
Senior unsecured debt: downgraded to 'AA-' from 'AA'; off RWN
Royal Dutch/Shell Group
Long-term IDR: 'AA'; RWN; withdrawn
Senior unsecured debt: 'AA'; RWN; withdrawn
BG Energy Holdings Limited
Long-term IDR: upgraded to 'A+' from 'A-', off RWP; Outlook Negative
Short-term IDR: upgraded to 'F1' from 'F2', off RWP
BG Energy Finance Inc.
Short-term debt rating: upgraded to 'F1' from 'F2', off RWP
BG Energy Capital plc
Senior unsecured rating: upgraded to 'A+' from 'A-', off RWP
Short-term debt rating: upgraded to 'F1' from 'F2', off RWP
Subordinated hybrid debt: upgraded to 'A-' from 'BBB', off RWP