OREANDA-NEWS. Fitch Ratings has assigned Orlen Capital A. B. (publ)'s upcoming issue of euro-denominated notes a final senior unsecured 'BBB-' rating. The notes are guaranteed by Polski Koncern Naftowy ORLEN S. A. (PKN ORLEN, BBB-/Stable).

The notes are expected to be used for general corporate purposes, including the repayment of some of existing debt. The notes are rated in line with PKN ORLEN's Long-Term Issuer Default Rating as they represent direct, unconditional and unsecured obligations of the oil company.

The ratings reflect the company's business diversification, with operations in the refining, petrochemical and fuel retail sectors, a strong position in the Polish market, and moderate leverage. The ratings are mainly constrained by the cyclicality of the refining and petrochemical operations.

KEY RATING DRIVERS

Strong Downstream Performance in 2015

PKN ORLEN posted solid 2015 financial results on the back of high refining and petrochemical margins. Reported EBITDA LIFO before assets impairments (last-in first-out) amounted to PLN8.7bn, an increase of 68% yoy, mainly due to a sharp increase in downstream EBITDA LIFO. Refining margin increased to USD10/bbl in 2015 from USD5.1/bbl in 2014 (including Brent/Ural differential), while petrochemical margin was EUR964/tonne, 23% higher than 2014.

Refining Margins to Moderate

PKN ORLEN's EBITDA LIFO before asset impairments remained broadly stable in 1Q16 (PLN1.9bn). We expect refining margins to moderate in 2016 and beyond as the problem of overcapacity and strong competition from overseas persists. In 2015, the north-west European refining margin averaged USD7.2/bbl, up from USD4.5/bbl in 2014 and USD4/bbl in 2013. We assume margins to average USD5.5/bbl in 2016 and USD5/bbl in 2017-19 and a Brent/Urals differential of USD2/bbl in 2016-2019.

Competition in Crude to Benefit

Competition between sour crude oil types is intensifying due to higher availability of Russian crude in the Baltic Sea region and renewed supplies of predominantly lower-quality Iranian crude following the end of sanctions in 2016. Suppliers based in other Middle Eastern countries remain interested in growing their sales in Europe. This supports the wider Brent-Urals differential, benefitting central European refiners. The differential totalled USD2.7/bbl in 4Q15 and 1Q16 compared with the average of USD1.3/bbl in 2012-2014. We assume a differential of USD2/bbl for 2016-2019 in our forecasts.

Upstream Growth Neutral to Ratings

In 2015 PKN ORLEN continued to grow its upstream segment with two acquisitions of small E&P companies with assets in Canada and Poland, valued at PLN1.5bn. The acquisitions added oil and gas production of 4.2 thousand barrels of oil equivalent per day (kboe/d) to the company's 7.1 kboe/d average production in 2015.

We view those acquisitions as rating-neutral. Greater business diversification is rating-positive, but upstream operations with fewer, unconventional assets are vulnerable to operational and financial risks. PKN ORLEN plans to grow its upstream business gradually, which will reduce overall risk.

Potential Sales Tax Rating Neutral

The Polish government plans to introduce a retail sales tax in Poland calculated as percentage of retail revenue. PKN ORLEN estimates taxable turnover at PLN20bn. Details of the charge are not yet known and the proposals floated by the government in recent months have varied considerably. According to the most recent proposal, the tax would be set at 1.4% of revenue, which could translate into PLN0.3bn cost for PKN ORLEN or 4% of reported 2015 EBITDA before impairments (11% of EBITDA before impairments for 2014). We view this potential expense as largely rating-neutral for PKN ORLEN, but additional taxation could decrease PKN ORLEN's financial headroom during years with weaker refining margins.

Rated on Standalone Basis

PKN ORLEN is 27.5%-owned by the Polish state (A-/Stable), but Fitch rates it on a standalone basis because we assess legal, operational and strategic links with the state as moderate based on our Parent and Subsidiary Rating Linkage criteria.

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, USD55/bbl in 2018 and USD65/bbl thereafter

-USD/PLN of 3.9 and Brent/Ural spread of USD2/bbl in 2016-2019

-Modest EBITDA contributions by the energy and upstream businesses, driven by two co-generation plant completions in 2016 and 2017 and rising upstream output

RATING SENSITIVITIES

Positive: Potential rating upside is currently limited by the cyclicality of the refining and petrochemical operations. However, positive rating action may result from a material improvement in the company's business profile resulting in lower cyclicality of operating cash flows, with FFO-adjusted net leverage not exceeding 2.0x (2015: 1.1x). This credit ratio is calculated by Fitch excluding the effect of inventory holding gains/losses and reversing the sale of compulsory crude oil inventory to third parties.

Negative: Future developments that could lead to negative rating actions include:

- Deterioration in cash flows and an increase in FFO-adjusted net leverage (excluding inventory holding gains/losses and compulsory crude stock sales) to above 2.5x on a sustained basis, for example, due to substantially weaker-than-expected conditions for refining and petrochemicals operations.

- Capex substantially above FFO, resulting in heavy negative free cash flow in the medium term.

- An aggressive dividend policy.

LIQUIDITY

As of 31 March 2016, PLN1bn of short-term debt was fully covered by PLN3.5bn of cash. The Eurobond issue of EUR750m strengthens PKN Orlen's liquidity.