OREANDA-NEWS. December 15, 2015. Fitch Ratings has affirmed Polski Koncern Naftowy ORLEN S.A.'s (PKN) Long-term foreign currency Issuer Default Rating (IDR) at 'BBB-'. The Outlook is Stable. A full list of rating actions is available at the end of this rating action commentary.

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

Funds from operations (FFO) net adjusted leverage amounted to 3.0x in 2014 (including adjustments for inventory-holding losses and sales of obligatory reserves of crude oil), which was above our guidance of 2.5x for the current rating. However, we forecast leverage ratios of around 1.0x in 2015, on the back of strong refining and petrochemical margins, and to remain below 2.5x in the medium term despite a forecast decrease in refining and petrochemical margins from exceptionally high levels in 2015.

KEY RATING DRIVERS
Strong Macro Environment in 2015
PKN's downstream EBITDA LIFO (last in first out) in 9M15 increased 90% yoy on the back of favourable refining and petrochemical margins and a 11% increase in downstream sales volume. Fitch expects refining margins to moderate in 2016 from the highs of 2015, but unlikely to revisit the lows seen in 2H13 and 1H14, due to depressed oil prices supporting demand for fuel and the lower cost of oil for refineries' own consumption.

Oversupply in Europe to Return
The longer-term outlook for the refining sector is more uncertain. Excess refining capacity, structural decline in fuel consumption because of growing engine efficiency and environmental policies, and stronger competition from new refineries in emerging markets are likely to put pressure on the European refining sector in the medium- to long-term.

Competition in Crude to Benefit
The discount of Urals crude oil to Brent widened in 4Q15 and exceeded USD3.5/bbl in late October and November 2015 compared with the average of USD1.3/bbl in 2012-2014. The widening gap reflected higher availability of Russian crude in the Baltic Sea region as production in Russia reached post-Soviet highs. Saudi crude oil deliveries to PKN and Preem in early November might have also contributed to the widening Urals discount.

Expected renewed supplies of predominantly lower quality Iranian crude following the sanctions relief in 2016 should result in greater competition between sour crude oil types. Suppliers based in other Middle Eastern countries remain interested in growing their sales in Europe. This is likely to support the wider Brent-Urals differential, benefitting central European refiners. We forecast a differential of USD1.8-2/bbl.

Upstream Segment Growth Rating-neutral
In 2015 PKN 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 kboe/d production in 1H15.

We view those acquisitions as rating-neutral. Greater business diversification is rating-positive and we forecast that leverage ratios will be comfortably below our guidance for 'BBB-' rating in 2015 even if assume both acquisitions will close by year-end. On the other hand, upstream operations with fewer, unconventional assets are vulnerable to operational and financial risks. We understand from PKN that the company plans to grow its upstream segment gradually, which reduces overall risks.

Rated on Standalone Basis
PKN 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 USD55/bbl in 2015 and 2016, USD65/bbl in 2017, USD70/bbl in 2018 and USD75/bbl thereafter
-USD/PLN of 3.7 in 2015, 4 thereafter
-Brent/Ural spread of USD1.5/bbl in 2015, before gradually widening to USD2/bbl over the next 12-24 months
-Modest EBITDA contributions by the energy and upstream segment, 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. 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 30 September 2015, PLN0.9bn of short-term debt was fully covered by PLN4.9bn of cash and PLN7bn of unutilised credit lines. Approximately, 63% of the debt was euro-denominated, 27% was in Polish zloty, with the remainder denominated in various currencies - Czech korunas, US and Canadian dollars. The bulk of the debt matures post-2019.

PKN refinanced and diversified its debt sources throughout 2014 by extending an unsecured revolving credit facility of PLN6.4bn, issuing the last tranche of its PLN1bn domestic retail bond programme and tapping the eurobond markets for an amount of PLN2.1bn. The transactions indicated that the company's strong access to international and domestic capital markets, allowing it to extend the maturity of its debt into the future.

FULL LIST OF RATING ACTIONS

Polski Koncernt Naftowy ORLEN S.A.
Long-term foreign currency IDR affirmed at 'BBB-'; Stable Outlook
Long-term local currency IDR affirmed at 'BBB-'; Stable Outlook
Short-term foreign currency IDR affirmed at 'F3'
Short-term local currency IDR affirmed at 'F3'
Foreign currency senior unsecured rating affirmed at 'BBB-'
Local currency senior unsecured rating affirmed at 'BBB-'
National Long-term rating affirmed at 'A-(pol)'; Stable Outlook
National senior unsecured rating affirmed at 'A-(pol)'

ORLEN Capital AB (publ)
Foreign currency senior unsecured rating affirmed at 'BBB-'