Fitch Ratings-Moscow-31 March 2014: Fitch Ratings has affirmed Russia-based Joint Stock Oil Company Bashneft’s (Bashneft) Long-Term foreign currency Issuer Default Rating (IDR) at 'BB' with a Positive Outlook. The rating action follows Bashneft’s acquisition of Western Siberia’s Burneftegaz (BNG), a small oil producer with significant oil resources for USD1bn (RUB35.6bn), including debt

A full list of rating actions is provided at the end of this commentary.

While we believe that the transaction should benefit Bashneft’s upstream in the medium term, it will also increase its leverage. We expect Bashneft’s funds from operations (FFO) net leverage to approach 2.3x in 2016, up from around 1x at end-2013, leaving the company with little scope for further debtfunded acquisitions on its current ratings trajectory.

Bashneft is a second-tier Russian oil producer that accounts for 3% of oil production and 8% of oil refining output in the country, with assets located mainly in the Republic of Bashkiria. Its ratings reflect concentrated reserves, increasing leverage, high capex and generous dividends but also stable upstream and downstream operations and solid operating cash flows.

The Positive Outlook reflects Bashneft’s progress with the development of the Trebs and Titov (T&T) oilfields in the north of Russia and our expectation that T&T will start generating positive free cash flows after 2017–2018. Bashneft’s ratings include a two-notch discount to reflect Russia-specific and regulatory risks, in line with our approach to Russian issuers.

Key rating drivers

Acquisition Drives Leverage Higher

In 2013, BNG produced 6 thousand barrels of oil per day (mbbl/d), or 2% of Bashneft’s total. It has 390 million barrels of C1+C2 reserves and resources under the Russian standards. While the BNG acquisition improves Bashneft’s upstream operations we conservatively expect it to be cash-neutral in the medium term due to incremental development capex required to boost production.
We expect the acquisition to increase adjusted net leverage to 1.9x-2.3x in 2014–2018 from an estimated 1x at end-2013, based on our conservative production and oil price assumptions. Bashneft’s FFO interest cover, in its turn, may decrease to 7x-8x, down from an estimated 11x in 2013.

Stable Brownfield Production

In 2013 Bashneft’s crude production reached 321 mbbl/d, up 4% yoy, compared with the Russian average growth of 1%. Production from Bashkiria, the company’s stronghold, contributed one half of this increase. We recognise Bashneft’s efforts in boosting upstream output by applying the latest oil recovery techniques, but believe that it has limited potential to further increase oil output from Bashkiria’s brownfields.

T&T Benefits Upstream

We view Bashneft’s strategy of upstream diversification as key to achieving its long-term production targets. Bashneft continues to develop its T&T oilfields in a joint venture (JV) with OAO LUKOIL (BBB/Negative), in which it has a 75% stake. T&T’s aim is to balance Bashneft’s lagging upstream with its more sizable downstream. In 2013, T&T produced 291,000 tons of oil, averaging 14mbbl/d in 4Q13. Bashneft expects to achieve peak production of 95mbbl/d by 2019–2020. Over the next three to four years we do not expect cash flows from the JV to be available to service Bashneft’s debt as the JV will need to finance its own capex first.

Competitive Reserves and Costs

Bashneft’s proved reserves of 2 billion barrels of oil at end-2013 imply a 17.5-year reserve life, in line with that of its Russian peers. In 9M13 its lifting costs were USD7.9 per barrel of oil (bbl), below that of most international peers but above that of the Russian majors, due to Bashneft’s smaller, more mature oilfields. We expect that company’s operational metrics will remain sound in the medium term.

Strong Downstream and Retail

Bashneft is the fourth-largest refiner in Russia; its three Bashkiria-based refineries have 480mbbl/d total primary capacity and a Nelson index of 8.65. In 9M13, refining and marketing contributed around 35% to the company’s EBITDA. The company’s 9M13 EBITDA per barrel of oil produced of USD28/bbl is one of the highest among Russian peers, partially due to its downstream volumes being 35% larger than upstream volumes in 9M13.
In 2015, the Russian government plans to increase export duty on dark oil products, eg, fuel oil and vacuum gasoil. This will have a negative effect on Bashneft’s downstream profits, which should not exceed 15%-20% of its EBITDA, in our view. Bashneft’s planned refinery upgrades should improve its refining complexity, increase light product yield and partially offset the negative effect of higher duties.

Uncapped Standalone Ratings

We rate Bashneft on a standalone basis and assess its linkage with its majority shareholder Sistema Joint Stock Financial Corp. (Sistema; BB-/Positive) as moderate. Bashneft remains a key asset for Sistema, along with OJSC Mobile TeleSystems (BB+/Positive). Although Bashneft’s ratings are not constrained, they cannot be more than two notches above Sistema’s under Fitch’s criteria.

Corporate Governance and Dividends

Bashneft continues to improve its transparency. In December 2013 it announced that it would eliminate cross ownership with ZAO Sistema Invest, a subsidiary of Sistema. This would moderately increase Bashneft’s leverage, because it has an obligation to buy back its own shares for up to RUB18bn, as per Russian law. Bashneft also has related-party transactions, which we view as a lowto-moderate risk, as the scale of these transactions is diminishing.
In 2013, Bashneft paid RUB51bn in dividends, including 2012 full-year dividends and 9M13 interim dividends but not taking into account the amounts subsequently returned by Sistema Invest. The gross dividends paid out in 2013 corresponded to 97% of Bashneft’s 2012 profits, up from 37% in the year before. In our rating case we assume an average dividend payout of 30% in the medium term, for leverage to remain within Bashneft’s internal guidance.

Rating sensitivities

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

FFO net adjusted leverage below 2.5x and FFO interest cover equal to or higher than 8x on a sustained basis;

Production growth at T&T throughout 2014;

Progress with integration and development of BNG, with incremental development capex being mainly financed by its operating cash flows;

Refinancing of short-term maturities falling due in 1H15 by end-2014 Negative: Future developments that may result in negative rating action include:

Failure to maintain crude production at current levels;

Sustained deterioration of credit metrics, ie, FFO net adjusted leverage above 2.5x and FFO interest cover below 8x on a sustained basis, owing to higher capex and dividends;

Considerable delays and/or cost overruns at T&T and BNG;

Inability to refinance 1H15 maturities by end-2014

Liquidity and debt structure

Stretched Liquidity

At 30 September 2013, Bashneft had cash of RUB16bn compared with short-term debt of RUB15bn.
The company also has RUB30bn in committed credit lines falling due in 1H15, some of which may have been used to finance the BNG acquisition. We believe that Bashneft should be able to refinance its upcoming maturities on the domestic capital market.

Rouble Depreciation Marginally Positive

The recent rouble depreciation has had a marginally positive effect on Bashneft, as it would have resulted in higher cash flows from higher USD-pegged revenues against fairly flat RUB-denominated operating expenditure. However, these higher cash flows would have been partially offset by higher gross debt (in rouble terms), as at end-2013 around 25% of Bashneft’s debt was denominated in US dollars. Generally, a weakening rouble should have a moderately positive effect on Russian oil companies, as their export and domestic revenues positively correlate with the foreign exchange rate.

List of ratings actions

Joint Stock Oil Company Bashneft

Long-Term IDR: affirmed at 'BB', Outlook Positive
Short-Term IDR: affirmed at 'B'
Local currency Long-Term IDR: affirmed at 'BB', Outlook Positive
Local currency Short-Term IDR: affirmed at 'B'
National Long-Term Rating: affirmed at 'AA-(rus)', Outlook Positive
Senior unsecured rating: affirmed at 'BB'
National senior unsecured rating: affirmed at 'AA-(rus)'