OREANDA-NEWS. Fitch Ratings has assigned OOO Burovoya Kompaniya Eurasia's (BKE) prospective rouble-denominated bonds an expected local currency senior unsecured rating of 'BB(EXP)' and an expected National senior unsecured rating of 'AA-(rus)(EXP)'. The planned notes will be issued under BKE's RUB100bn bond issuance programme. The final bond ratings are contingent on the receipt of final documents conforming materially to information already received and details regarding the amount and tenor of the bonds.

BKE is the indirectly wholly owned operating subsidiary of Eurasia Drilling Company Limited (EDC, BB/Negative) and is EDC's principal onshore drilling service provider in Russia. BKE's customers include PJSC Lukoil (BBB-/Negative), PJSC Gazprom Neft (GPN, BBB-/Negative) and others. We expect EDC to provide BKE with a legally binding irrevocable offer to purchase the prospective bonds in case of certain events of default. According to its audited 2015 IFRS accounts, BKE had revenues and EBITDA of USD998m and USD259m, or 57% and 56% of EDC's consolidated numbers for the period, respectively.

EDC is Russia's leading drilling and oilfield services (OFS) company by onshore metres drilled, with a market share of approximately 21% in 2015. The Negative Outlook on EDC's rating reflects the expected deterioration in its financial performance in 2016-2017, eg, funds from operations (FFO) adjusted net leverage of around 3x and FFO interest coverage of around 5x, exceeding our negative rating guidance, as well as medium-term market pressures that OFS providers face on volumes and rates, and EDC's high current FX risk exposure. We forecast that in 2018-2019 EDC's leverage and coverage will return to within our guidance levels of 2.5x and 6x, respectively.

EDC's other ratings are Long-term local currency Issuer Default Rating (IDR) of 'BB', National Long-term rating of 'AA-(rus)' and Short-term foreign and local currency IDR of 'B'. The Outlook on the Long-term ratings is Negative.

KEY RATING DRIVERS

Stable Recent Operating Performance

In January-April 2016, EDC's total metres drilled were down 1.7% on 4M15, while its horizontal metres drilled edged up 8% over the same period. The fairly stable 4M16 operating results are in contrast with 2015, when total footage declined 17% yoy, whereas horizontal metres were 27% up compared to 2014. The overall decrease in 2015 volumes was mainly the result of weaker orders from Lukoil, EDC's anchor customer, which accounted for 61% of EDC's gross revenues and 53% of total metres drilled in 2015.

BKE's total footage dropped by 6% in 4M16 yoy while its horizontal footage was up nearly 20% yoy. BKE's 2015 total metres drilled were 3.6m, or 18% down on 2014, while its horizontal metres drilled were up 27% and reached 35% of total metres drilled. Fitch expects BKE to benefit from the rebound in Lukoil's drilling volumes in 2016, which is likely to occur if oil prices stabilise at the current levels of USD50 per barrel (bbl) of Brent.

Rouble, Metres Drive Financial Results

EDC's total revenue from drilling and related services in 2015 was down 41% yoy to USD1.8bn on a significantly weaker rouble, lower total drilling metres and a deteriorating Caspian Sea drilling market. We estimate that the company's 2015 rouble-denominated revenue declined 6% yoy, while the average USD/RUB exchange rate dropped 37% yoy. GPN, EDC's second-largest customer, accounted for nearly 14% of the company's gross 2015 revenues, up from 9% in 2014, and made up the largest share of EDC's horizontal drilling orders in 2015.

BKE's rouble-denominated revenues fell 10% and its EBITDA decreased 19% in 2015, primarily a result of lower total drilling volumes and flat drilling rates.

Post-Buyout Leverage Increases

EDC paid USD370m to holders of global depository receipts (GDR) in 2015 and projects further total payments of USD107m to dissenting GDR holders in 2016, with USD28m already paid to date. We include the remaining USD79m cash outflow in our 2016 forecast as the most likely outcome.

To finance the buyout, EDC used its cash balances and raised debt, ie, a USD150m amortising secured loan from Rosbank (BBB-/Negative) due in 2018 and a USD150m short-term bullet loan from LUKOIL, due in late 2017. The Rosbank loan was guaranteed by EDC and BKE. The LUKOIL loan is secured on the BKE stake, valued at USD180m (around 23% of BKE's book value at end-2015) and has an option for LUKOIL to convert the loan principal into a stake in BKE at any time until the loan is repaid in full. We do not expect LUKOIL to convert its loan into BKE equity.

Capex, Dividend Reduction Boost FCF

EDC's 2015 capex dropped by 60% yoy on rouble depreciation, the end of expansionary investments in marine jack-up rigs and lower land rig orders. EDC's 2015 Fitch-calculated free cash flow (FCF) reached a record high of USD240m. The company's management does not expect large capex in 2016-2019 as its rigs are among the newest in Russia. Our estimates of EDC's future capex are higher than the company's. However, we expect that capex could be reduced due to weakening rouble and fewer fleet upgrades in the medium term.

EDC's management intends to pay no dividends in 2016-2019 until the company substantially reduces its leverage and improves cash flow generation. EDC did not pay dividends for 2015 and plans no dividends for 2016. We will assess the impact on EDC's credit profile should the company deviate from its no-dividend policy.

Positive Long-Term Market Fundamentals

We expect EDC to remain the largest onshore driller in Russia over the medium term, despite competitive pressures. As production from Russian brownfields continues declining, we expect Russian oil companies to intensify drilling across all traditional oil regions to maintain overall production levels. We also forecast a pick-up in greenfield production drilling following a number of fields being ramped up. According to the Russian Energy Ministry, total drilling meterage in Russia increased by 10% in 2015, with OJSC OC Rosneft's metres drilled up 32% and GPN's up 6%, while LUKOIL drilled 27% fewer metres than in 2014.

While demand for oilfield services by Russian oil companies should benefit EDC over the medium to long term, we conservatively estimate that its total onshore drilling metres will edge lower by 5% in 2016 before improving by around 5% per year from 2017. EDC's management expects a 1% total onshore meterage decline in 2016. Furthermore, we forecast a very modest annual increase in rouble-denominated onshore drilling rates, as the OFS industry operates under a significant cost pressure from the oil companies, exacerbated by the risk of a taxation increase in Russia potentially forcing oil and gas producers to optimise opex including drilling.

Customer Diversification Slowly Improving

EDC's ratings are constrained in the 'BB' category due to high but declining customer concentration, and limited geographical diversification. In 2015, LUKOIL accounted for 53% of EDC's total onshore metres drilled (63% in 2014, 57% in 2013), GPN for 35% (22% in 2014, 12% in 2013) and Rosneft for 3% (7% in 2014, 24% in 2013). LUKOIL's share in EDC's revenues has historically been higher as it also includes EDC's drilling services on the Caspian Sea shelf as well as other onshore non-metre drilling services such as workover.

Rosneft has considerably increased drilling orders from EDC in 2016, which should strengthen EDC's operating profile. EDC's total meterage already contracted by Rosneft increased four times in 2016 yoy. Rosneft, EDC's second-largest customer in 2013, contributed 1.5% to EDC's total revenues in 2015. We understand that EDC is bidding or has already been awarded drilling work for a number of other Russian oil companies, eg, PJSOC Bashneft (BB+/Stable). We expect its customer diversification to improve gradually over the medium term.

Foreign Currency Debt Exposure

EDC has traditionally had a significant portion of its borrowings in US dollars, or 92% at end-2015, while most of its cash flow, or nearly 90% in 2015, has been generated in roubles. Thus, EDC is substantially exposed to fluctuations in the rouble-US dollar exchange rate, which weakens its credit profile. We expect EDC to reduce its FX exposure in 2016.

EDC's management considers both derivative instruments and refinancing of FX debt with RUB borrowings or domestic bonds to mitigate the FX debt exposure. We believe that this is the right step for the company and, once completed, it will strengthen the company's balance sheet.

Corporate Governance Weakens

As a private company, EDC does not disclose the names of the directors, but we understand that there is one at least independent director on its board. We believe that although EDC's corporate governance has weakened since the company became private, it is still commensurate with a 'BB' rating for a Russia-based issuer. EDC is committed to regularly publishing accounts and disclosing other operating and financial data. Should the quality of EDC's corporate governance or financial disclosures worsen considerably, we may review the company's ratings and introduce an additional notch down.

KEY ASSUMPTIONS

Fitch's key assumptions for EDC include:

- Moderate drop in total onshore drilling volumes in 2016 and moderate increase starting in 2017.

- Increases in RUB-denominated onshore drilling rates in line with changes in Russia's producer price index.

- Offshore segment revenues falling 35% in 2016 and gradually recovering by 2019 due the increase in orders driven by higher oil prices.

- EBITDA margin averaging 25% in 2016-2019.

- Average exchange rate of RUB70/USD in 2016 and thereafter.

- Capex for 2016-2019 gradually increasing from USD130m in 2016 to USD180m in 2019, excluding payments for rigs delivered on credit.

- No dividends paid to shareholders in 2016-2019.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to stabilisation of the Outlook on EDC:

- FFO adjusted net leverage below 2.5x (2015: 2.6x) and FFO interest cover above 6x (2015: 7.8x) on a sustained basis.

- Positive free cash flows in 2016 and thereafter (2015: positive USD198m).

- Improved customer diversification.

- More limited FX exposure.

Negative: Future developments that may, individually or collectively, lead to a downgrade of EDC's rating:

- FFO adjusted net leverage above 2.5x on a sustained basis due to high dividend payout, sizeable capex or weak operating performance.

- FFO interest cover below 6x on a sustained basis.

- Material weakening of corporate governance or financial transparency, timeliness and completeness of information disclosures to a level weaker than that of the average Fitch-rated Russian corporate.

LIQUIDITY

Liquidity Supported by Bank Facilities

At end-2015, EDC's unrestricted cash balance of USD259m broadly matched its short-term debt of USD279m. EDC's liquidity improved significantly after the company extended maturity of the USD150m loan from LUKOIL to 2017 from 2016 and USD40m shareholder loan to 2019 from 2016. Rouble balances accounted for 36% of EDC's cash of USD265m at end-February 2016, with US dollars largely accounting for the rest. For 2016, we forecast that EDC will generate FCF of USD132m and we estimate that it will be able to maintain sufficient liquidity over the medium term. EDC has a good track record of accessing banks and capital markets for liquidity. It has large undrawn uncommitted facilities from several international and Russian banks, which it may draw to cover its 2017 debt maturities of roughly USD330m. EDC has negligible repayments in 2018-2019 before its USD600m Eurobond is due in 2020.

BKE's cash and cash equivalents equalled RUB6.6bn at 30 April 2016, according to the company's management. BKE's short-term maturities at 30 April 2016 included financial debt of RUB5.6bn, mainly the RUB5bn bond, plus RUB2.2bn in liabilities for purchased equipment. Funds from operations generated by BKE were equal to RUB15.1bn in 2015.