Fitch Ratings has upgraded Russia-based PJSOC Bashneft’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) to 'BB+' from ‘BB’. The Outlook is Stable. A full list of rating actions is provided at the end of this commentary.

An upgrade to ‘BB+’ reflects our assessment that Bashneft will maintain a strong operational and financial performance over the medium term despite depressed oil prices. We believe that there are no material credit risks stemming from Bashneft’s nationalisation in December 2014. We expect Bashneft’s upstream output to keep rising at its newly operational Trebs and Titov (T&T) and Burneftegaz (BNG) sites while its production in the Republic of Bashkiria (Bashkortostan), its stronghold, is likely to remain stable.

We forecast Bashneft’s financial profile to remain robust as progressive taxation in the Russian oil industry and a flexible rouble exchange rate partially alleviate the negative effect of low oil prices, even after considering the recently announced 2016 tax increase. We continue rating Bashneft on a standalone basis and do not incorporate any uplift for state support as we view its legal, operational and strategic ties with Russia (BBB-/Negative), its majority shareholder, as limited.

Bashneft is a medium-scale Russian oil producer that accounts for 5% of country’s oil production and 8% of oil refining output, with assets located mainly in Bashkiria. Following the 2014 nationalisation, the company is controlled by the Russian Federal Property Management Agency (50%) and Bashkiria (25%). Bashneft’s ‘BB+’ rating includes a two-notch discount for Russian corporate governance and systemic eg taxation risks.

KEY RATING DRIVERS

Rising Upstream Production

We positively view the company’s efforts to diversify its reserves and production and to boost upstream output. In 2014 Bashneft’s crude production was 356 thousand barrels per day (mbpd), up 11% yoy, compared with the Russian average growth of 1%; it was up a further 12% yoy in 9M15. Higher production mainly comes from newly operational Trebs and Titov fields in Timan-Pechora and Burneftegas in Western Siberia acquired in March 2014. These two assets produced on average around 30mbpd in 2014 and 60mbpd in 9M15. We assume the company’s upstream production to average 390mbpd in 2015 (+10% yoy) and to exceed 400mbpd in 2016.

Competitive Reserves and Costs

Bashneft’s proven oil reserves of 2.1bn barrels at end-2014 imply a 17-year reserve life, in line with that of large Russian peers. We believe the company should be able to replenish its reserves organically as its greenfield projects in Timan-Pechora and Western Siberia have a substantial exploration potential. The company believes its brownfields in Bashkiria can also provide exploration upside. Bashneft’s 6M15 lifting costs per barrel of oil (bbl) stayed at USD4.9, down 35% yoy, on the rouble depreciation, and is significantly below that of most international peers.

Improving Downstream Performance

Bashneft is the fourth-largest refiner in Russia; its three Bashkiria-based refineries have 480mbbl/d total primary capacity and a Nelson index of 8.93 (Russian overage: 5.1). We positively view Bashneft’s lower exposure to possible changes in refining margins due to rising upstream production, as in 9M15 its refining-to-upstream production ratio reduced to 1x, down from 1.2x in 9M14. In 2014, the downstream segment accounted for 37% of Bashneft’s EBITDA.

Oil refining in Russia underperformed in 1Q15 as domestic prices on oil products remained significantly below the export netback (export price minus export duty and transportation costs). This resulted from a combination of several factors, including the tax manoeuvre undertaken by the Russian government, the rouble depreciation and the seasonal pattern. The situation started to improve in 2Q15, and we expect that the refining and retail margins will further stabilise in 3Q15-4Q15. Bashneft’s downstream EBITDA contribution dropped to 7% in 1Q15 and recovered to 26% in 2Q15 as the seasonal demand picked up and Bashneft optimised its product mix.

Updated Development Strategy

Bashneft’s updated 2016–2020 strategy approved by the board provides better visibility of its post-nationalisation policies, and is generally credit positive. It calls for expanding Bashneft’s resource base through exploration, maintaining brownfield production in Bashkiria at around 300mbpd and boosting overall upstream production by ramping up Trebs and Titov (expected plateau production of 100mbpd by 2019) and the Burneftegaz assets (expected production of 30mbpd starting from 2016). Bashneft intends to continue enhancing refining complexity and to fully stop fuel oil production.

Stable Leverage Expected

In 2014 Bashneft’s funds from operations (FFO) net leverage rose to 1.6x from 1.0x in 2013 on Burneftegaz’s USD1bn acquisition, and we expect it to be relatively stable at around 1.5x in the medium term. While Bashneft announced its aim to maintain net debt-to-EBITDA leverage at below 2x, approximately equivalent to FFO net leverage of 2.5x, we expect that its leverage will stay below this target due to only moderate negative free cash flows, as well as funding constraints for Russian companies abroad and relatively high cost of rouble-denominated borrowings. As Bashneft’s debt is mainly denominated in roubles, rouble depreciation in 2H14-1H15 did not have a significant impact on its leverage. We treat as debt Bashneft’s prepayments received under a long-term oil supply agreement of RUB17bn that it reported at 30 June 2015.

We expect Bashneft’s dividends to stabilise at around RUB20bn p.a., in line with its strategy.

Taxation Reduces Earnings Volatility

Russian oil and gas companies’ earnings, including Bashneft’s, are less volatile than those of most international peers, primarily due to progressive upstream taxation and flexibility of the rouble exchange rate. In 1H15 Bashneft’s dollar-denominated upstream EBITDA per barrel of oil produced declined by 28% yoy while Brent collapsed by 46%. In rouble terms, Bashneft’s 1H15 upstream EBITDA per barrel increased by 19% yoy. The recently announced hike in oil taxation in 2016 will only have a moderate impact on the company due to its high exposure to downstream; and the negative effect should not exceed 5%-7% of Bashneft’s 2016 EBITDA.

A possible comprehensive revision of oil & gas taxation aimed at increasing the government’s take presents some risk, though we view this scenario as less likely at this stage.

KEY ASSUMPTIONS

Fitch’s key assumptions within our rating case for the issuer include the following.

• Oil price deck for Brent: USD55/bbl in 2015; USD65 in 2016, USD75 in 2017 and USD80 thereafter;
• USD/RUB average exchange rate: 60 in 2015; 55 in 2016 and 50 thereafter;
• Russian progressive taxation cushioning the effect of declining oil prices on Bashneft’s EBITDA;
• Upstream production rising to around 390mbpd in 2015 and exceeding 400mbpd in 2016;
• Dividend pay-out at around RUB20bn annually;
• Prepayments for long-term oil supplies included into financial leverage and treated as debt-like obligations.

RATING SENSITIVITIES

Negative

Future developments that may result in a negative rating action include:

• Oil production falling below 325mbpd;
• Sustained deterioration of credit metrics, ie, FFO adjusted net leverage above 2.5x (approximately equivalent to net-debt-to-EBITDA above 2x), on higher capex and dividends or lower cash flow from operations;
• Consistent underperformance of Bashneft’s refining business.

Positive

Future developments that may result in a positive rating action include:

• Oil production sustainably above 500mbpd
• Management’s commitments to maintain FFO adjusted net leverage below 1.5x, and net-debt-to- EBITDA below 1.25x on a sustained basis;
• FFO interest coverage above 8x.

LIQUIDITY

Sound Liquidity, Balanced Maturities (ïðîôèëüïîãàøåíèé).

We assess Bashneft’s liquidity as sound. At 30 June 2015, Bashneft had cash of RUB46bn and committed credit lines from Russian banks for RUB45bn compared with short-term debt of RUB18bn and dividends payable of RUB19.5bn. Also, Bashneft has good access to domestic bond market. It is not subject to US or EU financial sanctions and may borrow abroad; however, we assume that its access to international borrowings will remain limited.

Bashneft also has balanced debt maturities. Its repayments in each of 2016, 2017 and 2018 do not exceed RUB35bn (including the prepayment deal).

FULL LIST OF RATING ACTIONS PJSOC Bashneft

• Long-Term Foreign and Local Currency IDRs: upgraded to ‘BB+’ from ‘BB’; Outlook Stable
• Short-Term Foreign and Local Currency IDRs: affirmed at 'B'
• National Long-Term Rating: upgraded to ‘AA(rus)’ from 'AA-(rus)'; Outlook Stable
• Senior Unsecured Rating: upgraded to 'BB+' from ‘BB’
• National Senior Unsecured Rating: upgraded to ‘AA(rus)’ from 'AA-(rus)'