OREANDA-NEWS. Fitch Ratings has placed Kosmos Energy Ltd.'s (Kosmos) ratings, including its Long-term Issuer Default Rating of 'B', on Rating Watch Negative (RWN) following the confirmation of damage to its infrastructure at the company's offshore Jubilee oilfield in Ghana. A full list of rating actions is available at the end of this commentary.

We aim to resolve the RWN within the next six months, when there is more clarity on the impact on Kosmos's short- and long-term production, projected leverage and liquidity.

Tullow Oil, the Jubilee field operator, confirmed on 8 April 2016 that the floating production, storage and offloading vessel (FPSO) turret bearing has been damaged. The company said that oil production can continue though operating and off-take procedures will need to be revised. In March 2016 Tullow Oil was forced to defer two liftings that normally take place every fortnight due to the issue. The use of a dynamically-positioned shuttle tanker and a storage tanker has been suggested as a short-term solution, potentially allowing partners to resume production in the next two weeks while minimising FPSO movement around the turret. However, it is not yet clear what the long term solution will be.

Our base case scenario is for production at the Jubilee field, Kosmos's only producing asset, to resume in the next several weeks and to not fall significantly below 100 thousand barrels of oil per day (mbpd) over the longer term. We also expect the Jubilee field partners to come up with a long-term solution for the bearing problem in the nearest future, and that any significant incremental operating and capital costs associated with the required repairs will largely be absorbed by insurance. The RWN reflects the possibility of an alternative less favourable outcome, which we believe is less likely but cannot be ruled out (e.g. Jubilee's capacity falling significantly below 100mbpd or any significant delays with the insurance reimbursement).

Kosmos is a small but growing oil and gas exploration and production (E&P) company focused on the offshore Atlantic margin, with 2015 net production of 23mbpd from the offshore Jubilee field in Ghana (B/Negative). The company has a 24.1% working interest in the Jubilee field, which produces around 100 mbpd. In 2015 Kosmos generated USD500m in EBITDAX (EBITDA before exploration expenses).

KEY RATING DRIVERS
Hedging Mitigates Falling Oil Prices
We expect Kosmos's earnings to decline further in 2016 on weaker oil prices but this will be partly offset by the company's strong hedging position and rising production, though the latter may be subject to revision due to the Jubilee FPSO turret bearing issue.

The hedging should allow Kosmos to proceed with its ambitious exploration and development programme. Kosmos has hedged 6 million barrels in each of 2016 and 2017 at an average floor price of USD82/bbl and USD61/bbl, respectively. At our current price deck we expect that these oil derivative contracts will contribute around USD280m to operating cash flow over the next two years.

We assume that oil prices will rebound from the current level of around USD40/bbl for Brent, as we see this level as unsustainable in the long term. Our base case scenario is for Brent to average USD35/bbl in 2016, gradually recover to USD45/bbl in 2017, USD55/bbl in 2018 and USD65/bbl over the long term.

Production Set to Increase
Kosmos's small scale of operation and lack of geographic diversification are dominant drivers of the company 'B' rating. Kosmos intends to boost production by developing two sites in close proximity to the Jubilee field, TEN (Tweneboa, Enyenra, Ntomme) and possibly MTA (Mahogany, Teak, Akasa). TEN is currently greater than 85% complete and should start production in 3Q16. MTA, which would constitute the Greater Jubilee field development plan, may be approved later this year. The approval, however, could be delayed until resolution of the bearing issue.

We may consider upgrading Kosmos to 'B+' if the company successfully brings the TEN project on stream and its overall production sustainably exceeds 35-40mbpd.

Ghana-Ivory Coast Border Dispute
Ghana and Ivory Coast have never officially agreed on their maritime border, and in September 2014 Ghana took legal action under a UN convention to resolve the dispute as it could affect the TEN project. In April 2015 the Hamburg-based International Tribunal for the Law of the Sea ordered to suspend all new drilling in the disputed area until the final decision is taken in 2017; however, it allowed production from wells already drilled.

Kosmos announced it expects TEN to proceed as planned as all the wells required for the 'first oil' phase have been drilled. We agree that the risks there are limited; however, we are unlikely to give Kosmos the full credit for the project until the issue has been resolved.

Adequate Reserves
At end-2015 Kosmos had proved oil and gas reserves of 76 million barrels (MMboe). Its proved (1P) reserve life of nine years and proved and probable (2P) reserve life of 17.5 years are in line with the median for Fitch-rated speculative-grade peers (10 and 18 years, respectively). Kosmos's per-barrel profitability is strong due to a favourable tax regime, fairly low lifting costs and concentration on liquids. In 2015, its funds from operation (FFO) per barrel produced amounted to USD36/bbl and USD9/bbl, with and without derivative hedges, respectively.

Elevated Country Risk
Kosmos is exposed to high country risks, as its operations are concentrated in Ghana. Ghana has a strong business environment relative to other African countries, ranking 114 out of 189 in the World Bank's 2015 Doing Business Survey. It is also safer compared with some other parts of Africa such as the Niger Delta. However, the country's public finances are weak.

We expect that the tax regime for oil companies in Ghana will not change over the medium term, and Kosmos's tax burden will not materially increase. However, the possibility of tax regime change cannot be ruled out due to Ghana's large budget deficit. We also assume that Kosmos's operations would not necessarily be affected by capital controls or other possible restrictive measures, since the company's proceeds do not flow through Ghana, and its cash assets are kept primarily outside Ghana. We therefore do not cap Kosmos's rating at the sovereign rating or the Country Ceiling. However, we may review this approach if the government attempts to revise the tax regime in Ghana.

Extensive Exploration Portfolio
Kosmos's exploration success offshore Mauritania / Senegal could help the company diversify its production base over time. In March 2016 Kosmos announced it drilled the fourth exploration well in the region, and that its estimated gross resource estimates for the Greater Tortue Complex increased to 20 trillion cubic feet (Tcf), or 566 billion cubic meters (bcm), a large field by industry standards. Potential commercialisation options include a farm out, and a floating LNG project.

The discovery has improved Kosmos's financial flexibility as the field can potentially be farmed down; however, depending on the commercialisation route yet to be chosen it could increase Kosmos's capital intensity and completion risks. It could be less of a risk if Kosmos has by then increased and diversified its production, e.g. by bringing TEN on stream.

Kosmos has an extensive exploration portfolio, including several licensed blocks in offshore west Africa, Portugal, Suriname and Sao Tome. It may help the company replenish its reserves, but success is not guaranteed and the company's exploration budget may put a strain on its free cash flow (FCF). A failure to translate exploration spending into increased proved reserves over time could negatively affect its credit position.

Manageable Mid-Cycle Leverage
Kosmos's leverage will increase over the next two years but will remain in line with that of other 'B' rated peers, provided there is no significant negative impact from the bearing damage. Its operating cash flow will decrease due to lower oil prices, but this will be partly offset by Kosmos's hedging programme. Capital intensity will remain high in 2016 before it starts falling in 2017.

We project funds from operations (FFO) adjusted net leverage to peak at 3.75x in 2017, but to fall below 3x in 2018-19 as capex moderates and oil prices recover. We also assume Kosmos will significantly improve its negative FCF in 2016, and to start generating positive FCF in 2017.

We expect Kosmos to respect its financial covenants, including maintaining net debt to EBITDAX below 3.5x. According to our base case projections this ratio should remain below 3x in 2016-17, and below 2.5x in 2018-19.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Brent oil price: USD35/bbl in 2016, USD45/bbl in 2017, USD55/bbl in 2018 and USD65/bbl thereafter
- Production growth: 5% yoy in 2016, 32% yoy in 2017 and 10% in 2018; output reaching 36 mbpd in 2018
- Cash flow from hedging based on existing hedging contracts: USD223m in 2016 and USD57m in 2017
- Zero dividend policy
- Capex peaking in 2016 on TEN development and continued exploration in Mauritania and Senegal and declining thereafter
- Successful resolution of the Jubilee FPSO turret bearing issue, with no significant long-term implications for field production and any material incremental costs largely absorbed by insurers

RATING SENSITIVITIES
Positive: We aim to resolve the RWN within the next six months. We will affirm the rating at 'B' if the bearing damage does not significantly impact the company's credit profile. This could be evidenced by a long-term solution involving limited costs and production shutdown, or by an adequate insurance reimbursement.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Unfavourable development of the Jubilee turret bearing, leading to significantly lower production or material additional costs
-Net production falling below 20mbpd
-Significant project delays and cost overruns at TEN
- Suspension of the TEN project or a material change in fiscal terms arising from the maritime border dispute between Ghana and Ivory Coast
-Deterioration in liquidity (e.g. cash and credit lines amounting to less than 50% of short-term debt and projected cash outflows)
-Leverage rising above expectations (e.g. consistently above 3.5x)
-Utilised balance under the reserve-based lending (RBL) facility exceeding USD1.1bn resulting in worse recovery prospects for 2nd lien creditors, including bondholders, which will trigger a downgrade of the senior secured rating

LIQUIDITY
At end-2015 Kosmos's liquidity comprised USD275m of cash and cash equivalents and USD1.5bn of undrawn credit facilities, including unutilised USD1.1bn balance under its RBL facility. This compares well with Kosmos's cash uses. The company has no maturities in 2016-17, and we expect its negative FCF to be below USD400m in the next two years.

SUMMARY OF FINANCIAL STATEMENT ADJUSTMENTS
-Fitch has adjusted the balance sheet debt by capitalising the annual operating lease of USD4.7m using the standard 8x multiple. As a result the debt increased by USD37.6bn.
-EBITDA has been adjusted upward by USD184m to account for equity-based compensation (USD75m), non-cash portion of exploration expenses (USD95m) and the difference between cash settlement on derivatives and the change in fair value of derivatives (USD14m).

-Cash interest has been adjusted upwards by USD52m to reflect capitalised interest expense, which was reported as part of capital expenditure. Capex has been reduced by the same amount.

LIST OF RATING ACTIONS:
Kosmos Energy Ltd.
Long-term foreign currency IDR of 'B': placed on RWN
Senior secured rating of 'B'/ 'RR4' (Recovery Rating): placed on RWN