OREANDA-NEWS. Fitch Ratings has downgraded UK-based energy group Afren plc's Long-term Issuer Default Rating (IDR), as well as its senior secured ratings, to 'C' from 'B-', reflecting our view that default is imminent. The Recovery Rating for the company's senior secured notes has been downgraded to 'RR6' from 'RR4', reflecting our view that bondholder recoveries may not be as high as originally estimated given the current oil price environment.

Fitch has withdrawn the senior unsecured rating of 'B-'/Rating Watch Negative as there is no outstanding senior unsecured debt in the company's capital structure.

All ratings, except the senior unsecured rating, have simultaneously been removed from Rating Watch Negative.

The rating action follows Afren's announcement that the company Board is now considering utilising a 30-day grace period under its 2016 bonds with respect to USD15m of interest due on 1 February 2015. This latest announcement comes after the company earlier confirmed that it is seeking a deferral of a USD50m amortisation payment due at the end of January 2015. The company has confirmed it has been reviewing with its advisors its capital structure, liquidity and funding requirements and that liquidity available to the company is significantly lower than the USD235m cash on balance sheet at 31 December 2014 as a result of restricted and segregated cash balances. As part of that process Afren is in discussions with its lenders regarding amendments to its existing lending facilities.

KEY RATING DRIVERS

Lower Production, Higher Leverage
Afren's credit metrics have weakened since the beginning of the year, reflecting lower output in 2014 compared with 2013 and lower oil prices. Its funds from operations (FFO) adjusted gross leverage was at 2.8x at end-9M14 (1.8x at end-2013), and we believe it will exceed 4x in 2015, assuming moderate production growth, Brent price of USD50/bbl in 2015 and the company's hedging arrangements.

Reserve Revision Adds to Rating Pressure
In January 2015 Afren announced it has revised down gross 2P reserves at the Barda Rash field in the Kurdistan region of Iraq by 190 million barrels of oil equivalent. The movement in reserves and resources is due to the 2014 reprocessing of 3D seismic shot in 2012 and processed in 2013, as well as results from the company's drilling campaign. Although we have not factored in the potential production in Kurdistan in our model, this change removed a potential source of flexibility for the company or recovery for creditors.

Possible Acquisition by Seplat
Additional factors that could affect the company's financial position include a takeover by Seplat, a small-scale Nigerian oil producer, which recently confirmed that it is in preliminary talks with Afren. Seplat will need to formally declare its intention by the end of January to comply with London Stock Exchange listing rules. Fitch will need confirmation of this possible merger agreement, and a view on the potential financial and strategic direction of the combined group, before taking any potential rating action.

Finding New Management Critical
Finding suitable replacements for dismissed executives is a significant challenge for Afren. This is particularly important in view of the company's reduced output in Nigeria and interrupted operations in Kurdistan. Fitch is seeking more information on Afren's strategy and direction to stabilise and increase output, especially if oil prices remain at their depressed levels - which may be difficult in the absence of a permanent CEO with a clear strategic vision.

Production to Stabilise
Afren's net production has declined to 27.2 thousand barrels per of oil per day (mbpd) in 3Q14 from 49.6mbpd in 3Q13, reflecting a lower production share after initial cost recovery but also due to lower gross production at Ebok, its major asset.

We expect that in 2014 Afren's net production would have been at or slightly below 32mbpd, 15% lower than we had projected in May. Afren explains that the lower-than-expected production mainly results from operational delays with installing the Central Fault Block Extension platform at Ebok, and maintenance works in 3Q14. The platform, which is set to be finally completed in January 2015, should enable Afren to increase output of the field. Other projects, including the North Fault Block at Ebok and ramping-up OML26, should help Afren stabilise its net oil production in the medium term. We expect the company's net production to average 37mbpd in 2015.

Concentrated Production
Afren's production remains highly concentrated. In 9M14, Ebok accounted for 68% of Afren's total production, and it had no material oil output outside Nigeria. Any swift progress in Kurdistan, where Afren has material reserves, is now less likely than we previously expected due to Kurdistan's unstable political and security environment and higher-than-expected water content. Other challenges include a lack of access to a secure transportation channel and an absence of the associated gas treatment infrastructure. We assume that Nigeria is likely to dominate Afren's output in the medium term. Such concentration exposes Afren to elevated regulatory and tax risks.

Tax Holiday Benefits Cash-Flows
Oil companies are generally heavily taxed in Nigeria - they pay substantial royalties and are subject to the petroleum profit tax (PPT), which normally varies from 50% to 85% of pre-tax profits. Afren's Ebok field is exempt from paying PPT up to May 2016, which significantly benefits Afren's cash flows and should help finance new projects while keeping leverage at a moderate level. However, the recent production decline at Ebok and lower oil prices could make this strategic advantage less pronounced. We expect that Afren's cash tax payments will materially increase in 2017.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Default under the company's obligations, including the Ebok facility or bond interest
- Restructuring of a bond or loan facility under circumstances that constitute a distressed debt exchange (DDE) under Fitch's methodology (see Distressed Debt Exchange - Global Cross Criteria (June 2014) available at www.fitchratings.com for more details)

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Financial restructuring that does not qualify as a DDE
- Liquidity support from potential new shareholder

LIQUIDITY AND DEBT STRUCTURE

Fitch views Afren's liquidity risk as high. The company is in discussions with its lenders regarding deferral of interest payments due 1 February 2015 and amendments to its existing facilities, in addition to seeking a deferral of a USD50m amortisation payment due at the end of January 2015. At 31 December 2014 Afren reported that it had a cash balance of approximately USD235m. The company has now confirmed that actual liquidity available is significantly lower than cash on balance sheet as a result of restricted and segregated cash balances in place to address operational requirements.

The rating actions are as follows:

Long-term IDR: downgraded to 'C' from 'B-/RWN'; off RWN
Senior secured bonds: downgraded to 'C'/'RR6' from 'B-'/'RR4/RWN'; off RWN
Senior unsecured rating: 'B-/RWN' rating withdrawn