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Fitch Downgrades State Oil Company of the Azerbaijan Republic to 'BB+'; Outlook Negative

March 1, 2016
Fitch Ratings has downgraded State Oil Company of the Azerbaijan Republic's (SOCAR) Long-term Issuer Default Rating (IDR) to 'BB+' from 'BBB-', Short-term IDR to 'B' from 'F3' and senior unsecured rating to 'BB+' from 'BBB-'. The Outlook on the Long-term IDR is Negative.

The rating action follows the downgrade of the IDR of the sovereign rating of Azerbaijan (see 'Fitch Downgrades Azerbaijan to 'BB+'; Outlook Negative' dated 26 February 2016 on www.fitchratings.com). SOCAR is a wholly state-owned national oil company of Azerbaijan and its ratings are aligned with the sovereign's. SOCAR is a mid-size integrated oil company with 2015 hydrocarbon production of 276 thousand barrels of oil equivalent per day (mboepd), including JVs and a number of assets in midstream, downstream, chemicals and retail.

SOCAR controls Petkim, Turkey's only chemical producer, and is constructing a 10 million ton capacity STAR refinery in Turkey. It is also party to several production-sharing agreements (PSAs) in Azerbaijan and receives specified volumes of oil, natural gas and gas condensate free of charge.

We expect that SOCAR's leverage metrics may come under pressure in 2015-2016 under our oil price deck and following Azeri manat's devaluation in 2015. We forecast funds from operations (FFO) net leverage will increase to 3.6x in 2016 from 1.9x in 2014.

KEY RATING DRIVERS
Ratings Aligned with Sovereign
SOCAR's ratings are aligned with Azerbaijan's, as it represents the state's interests in the strategically important oil and gas industry. The company is 100%-state owned, accounts for 20% of Azerbaijan's oil and gas production, is the largest employer in the country and a significant contributor to state budget. The company maintains close ties with the government and State Oil Fund of the Republic of Azerbaijan (SOFAZ) in financial and investment decision-making. We view the operational and strategic ties between SOCAR and its parent as strong, while legal ties as medium (12% of total debt was state-guaranteed at end-2015).

Funding of SOCAR's Projects
Under a decree by the President of Azerbaijan signed in 2014, SOCAR set up a JV, Southern Gas Corridor CJSC (SGC). SOCAR holds a 49% share in SGC, with the remainder held by the Ministry of Economy and Industry of Azerbaijan. The purpose of the JV is to implement key Azeri gas projects, including the development of the Shah Deniz gas field, expansion of the South Caucasus Pipeline (SCP), and the construction of Trans-Anatolian and Trans Adriatic gas pipelines (TANAP and TAP).

We assume funding for the projects, as well as final equity payment for the construction of the STAR refinery (USD200m) and potential acquisition of Greek DESFA agreed in 2013, will come from the government. Should this not be the case and SOCAR's financial profile comes under pressure (FFO gross leverage above 5.0x for an extended period of time) due to higher-than- expected spending we would likely re-assess the ties between SOCAR and the state, which could lead to a rating downgrade.

STAR Refinery under Construction
In May 2014, SOCAR agreed funding for the 10 million ton, USD5.7bn STAR refinery in Turkey. The USD3.3bn project finance debt package, which is in two tranches, has a maturity of 18 and 15 years with a four-year grace period. The refinery is expected to come online in 2018 and supply the Turkish market, mainly with diesel and jet fuel. We view the planned cooperation between the refinery and Petkim, SOCAR's Turkish petrochemical subsidiary as positive for the project's profitability.

SOCAR issued a USD750m bond in 2015, which was mainly used to fund the development of STAR refinery. The remaining equity payment, related to the refinery, amounts to USD200m and is expected to be transferred by 2019.

Speculative Grade Standalone Profile
Fitch views SOCAR's standalone profile at the low end of the 'BB' rating category, reflecting its limited reserves, declining production, aged refineries, but also an extensive domestic pipeline network, expanding international downstream and retail portfolio.

In 2014, SOCAR's total hydrocarbon output (excluding equity stakes) was 253 thousand barrels of oil equivalent per day (mboepd), 1% down yoy. In 2015 production including JVs was 276mboepd, 3% lower than in 2014. While SOCAR's upstream is weaker and its lifting costs are higher than that of its Russian peers, this is partially compensated by profits from its midstream and downstream operations.

Operational Issues
The fire at Gunashli platform in December 2015 reduced SOCAR's oil output to 137 thousand tonnes or by 16% compared with the average output in 11M15. Production recovered to 154 thousand tonnes in January 2016 (6% lower than in 11M15). SOCAR plans to restore production at Gunashli in January 2017.

Higher Leverage
Under our oil price of USD35/bbl in 2016, USD45 in 2017 and USD55/bbl in 2018 we forecast that SOCAR will remain free cash flow (FCF)-positive, assuming that funding for key investments projects will come from the government. Lower oil prices and the manat devaluation will lead to an increase in FFO adjusted net leverage to 3.6x in 2016, up from 1.9x in 2014, before gradually declining to 3.2x in 2018.

Over 80% of SOCAR's debt is denominated in US dollars, but at the same time around 40% of revenues (excluding trading operations) and majority of trade receivables are also USD-linked, which will partly neutralise the impact of the manat's devaluation (down 30% in February 2015 and 50% in December 2015) on leverage ratios. The devaluation, and corresponding increase in manat-denominated revenues, will provide a cushion for a decline in oil prices as a significant portion of SOCAR's costs is also in manat. However, the positive impact on financial performance may be undermined in the medium term if wage and cost inflation pressures increase.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Brent price of USD35/bbl in 2016, USD45/bbl in 2017 and USD55/bbl in 2018
- USD/AZN of 1.63 over the next three years
- Revenue and EBITDA in 2016 lower by 33% and 29%, respectively, compared with 2014
- Capex of AZN5.2bn in 2015-2018
- Distributions to government flat at AZN400m over the next three years
- Flat upstream production over the next three years
- Key development projects funded by the government

RATING SENSITIVITIES
Negative: Future developments that may result in negative rating action include:
-Weakening state support
-An aggressive investment programme and/or acquisitions resulting in a significant and sustained deterioration of standalone credit metrics
- FFO gross leverage exceeding 5.0x for an extended period of time, coupled with signs of weakening state support
As The Rating Outlook is Negative the potential for a positive rating action is currently limited.

RATING SENSITIVITIES FOR THE SOVEREIGN RATING:
The main factors that could, individually or collectively, trigger negative rating action are:
- A failure to adjust expenditure or revenue to the lower oil price environment, resulting in a more rapid drawdown of oil fund assets.
- A regional geopolitical shock, such as full-scale conflict over Nagorno-Karabakh, or domestic instability that undermines the country's economic and financial institutions.
The main factors that could, individually or collectively, trigger positive rating action are:
- A sustained rise in hydrocarbon prices that restores fiscal and external buffers.
- Improvements in governance and the business environment, and progress towards diversifying the economy away from hydrocarbons.
- An improvement in the budgetary position, beyond the measures currently envisaged, sufficient to increase Fitch's confidence in the longer-term sustainability of Azerbaijan's sovereign balance sheet strengths.

LIQUIDITY
As of 30 June 2015, the group's liquidity position comprised AZN2.9bn of cash and cash equivalents, of which AZN2.4bn (83%) was in USD-denominated bank balances and AZN140m (5%) was in EUR-denominated bank balances. This was sufficient to cover SOCAR's short-term borrowings of AZN2.7bn, 68% of which was short-term facilities in USD. In January 2016 SOCAR redeemed USD400m bonds maturing in 2017. As of 30 June 2015, 86% of SOCAR's debt was USD-denominated and 38% of its total debt had floating rates.
Company — SOCAR
  • Full name
    State Oil Company of Azerbaijan (SOCAR)
  • Registration country
    Azerbaijan
  • Industry
    Oil and gas