OREANDA-NEWS. Fitch Ratings has downgraded Unit Corporation's (Unit; NYSE: UNT) Long-term Issuer Default Rating (IDR) to 'B+' from 'BB'. The Rating Outlook has been revised to Negative. Fitch has also affirmed the ratings for Unit's senior unsecured bank revolver and senior subordinated notes. A full list of rating actions follows at the end of this release.

The downgrade reflects Fitch's downward revision of its energy price deck on February 24 and its potential impact on Unit's liquidity profile and forecasted credit metrics. Another consideration is the company's declining size, scale and diversification, as well as the potential for a material loss of operational momentum given the 73% reduction to capital spending.

The Negative Outlook reflects the risks to the company's liquidity with the possibility of commitment reductions following the April redetermination as well as Fitch's forecasted leverage covenant violation in 2016. This may require Unit to enter into accommodative terms with its banking group to preserve liquidity.

Approximately $928 million of debt is affected by today's rating action.

KEY RATING DRIVERS

LOSS OF REVENUE DIVERSIFICATION

Unit has historically benefited from a modestly diversified business mix with approximately 30% of EBITDA coming from non-exploration and production (E&P) segments. Fitch expects the contract drilling segment and the midstream segment to contribute approximately 20% of a lower year-over-year EBITDA in 2016. Due to heightened recontracting risk and further rig fleet rationalization, the contract drilling segment is expected to represent the majority of the non-E&P EBITDA loss. The midstream segment benefits from its 68% fee based contract mix, but the remaining portion is at risk of lower volumes in 2016.

The E&P segment (about 63% of EBITDA) reported an almost 25% year-over-year decline in net proved reserves (1p) to 135 million barrels of oil equivalent (MMboe; 85% developed) for the year-ended 2015. A key driver of the decline was the impact of sharply lower prices on reserve calculations, with the largest reduction in proved undeveloped reserves. Production increased 9% in 2015 to 54.7 thousand boe per day (Mboepd; 45.3% liquids mix) resulting in a reserve life of nearly 7 years.

The contract drilling segment (about 27% of EBITDA) reported a modest increase in revenue per day to $20,950 mainly due to the placement of higher margin, new BOSS rigs into service during the first half of 2015. This was offset by the rapid decline in rig utilization from 63% in 2014 to 38% in 2015. At the end of 2014, Unit had 75 rigs operating and as of February 12, 2016 that number had dropped to 20. Fitch expects further rig rationalization to continue.

The midstream segment (about 10% of EBITDA) reported a revenue decline of 43% year over year mostly due to lower commodity prices. NGL volumes sold decreased as the company operated their processing facilities in full ethane rejection mode. Offsetting these declines, the company's gas gathering and processing volumes increased 11% and 13% over 2014, although if oil and gas prices remain low the effect of further reductions in drilling activity could result in lower volumes.

Credit metrics weakened for the year ended 2015. The Fitch-calculated debt/EBITDA, debt/proved developed reserves (PD), and debt/flowing barrel were approximately 2.3x, $8.05/boe, and $16,946, respectively. Fitch notes that the upstream credit metrics allocate all outstanding debt to the E&P segment. Fitch expects these metrics to erode over the next few years as the impact of lower oil prices continues to strain metrics. Fitch's base case, assuming a West Texas Intermediate (WTI) price of $35, forecasts debt/EBITDA of 4.6x in 2016.

NEAR-TERM LIQUIDITY RISKS

As of Feb. 12, 2016, UNT had $262.9 million outstanding under their credit agreement, down slightly from the $281 million outstanding at year end. The company sold approximately $37.4 million of non-core oil and gas properties since year end and has used the proceeds to pay down the borrowings under the credit agreement. The credit facility is unsecured but is subject to a redetermination every April 1 and October 1 based on the value of the oil and gas properties and the midstream cash flows. In the October 2015 redetermination, the credit facility commitment was reduced from $725 million to $550 million. Fitch believes that management recognizes this as an issue and has matched capital spending to stay within cash flows, considering strip prices, and reduced outstanding revolver borrowings. Fitch's base case forecasts leverage of 4.6x in 2016 which is greater than the credit agreement's leverage ratio covenant of less than 4.0x (Actual of 2.58x at YE 2015). Fitch expects Unit to receive covenant relief as part of their semi-annual redetermination.

FORECASTED LEVERAGE METRICS WIDEN

Management's current leverage levels, in conjunction with the downsizing of the capital budget to be substantially in line with anticipated cash flows, reduce the need for additional debt. Fitch's base case, assuming a WTI price of $35, projects that Unit will be free cash flow (FCF) neutral. The Fitch base case results in debt/EBITDA of 4.6x in 2016. Debt/PD and debt per flowing barrel metrics are forecast to increase to approximately $8.53/boe, subject to any revisions, and $19,048, respectively. Fitch's base case WTI price forecast assumption of $45 in 2017 and $65 long-term suggests that the company may selectively increase drilling activity in 2017. In 2017, the Fitch base case considers that the company may be free cash flow positive given supportive pricing signals resulting in a debt/EBITDA of 3.6x.

HEDGES FORECAST TO PROVIDE SOME CASH FLOW UPLIFT

Unit utilizes a combination of swap and collared hedges to manage cash flows and support development funding. As of Feb. 12, 2016, the company's 2016 oil and gas hedges accounted for around 33% and 64%, respectively, of its estimated 2016 production. Hedges are estimated to provide about $22 million in additional uplift in 2016 but hedge coverage rolls off substantially in 2017.

LIMITED OTHER LIABILITIES

Unit does not have a defined benefit pension plan. Asset retirement obligations (AROs) were $98 million, as of Dec. 31, 2015, which is lower than the $101 million reported at year-end 2014. This is mainly due to a favorable revision of cost estimates associated with plugging wells based on actual costs over the preceding year. The company does not have any material additional liabilities.

KEY ASSUMPTIONS

--WTI oil that trends up from $35/barrel in 2016 to $45/barrel in 2017 and a long-term price of $65/barrel;
--Henry Hub gas that trends up from $2.25/mcf in 2016 to $2.50/mcf in 2017 and a long-term price of $3.25/mcf;
--Production decline of about 14% in 2016 with a 6% and 3% decline in 2017 and 2018, respectively;
--Drilling segment EBITDA is forecast to decline by over 90% in 2016 due to lower U.S. onshore activity with some BOSS rig margin offset;
--Midstream EBITDA shows more resiliency through downturn, but volumetric and commodity pricing exposure will pressure margins;
--Capital spending is forecast to be $153 million in 2016, consistent with guidance, followed by an operating cash flow outspend generally consistent with historical levels given supportive pricing signals;
--No additional asset divestiture proceeds are forecast given the challenged onshore drilling conditions

RATING SENSITIVITIES

Positive to 'BB-': Future developments that may, individually or collectively, lead to a positive rating action include:
--Increased size, scale, and diversification of Unit's E&P operations with some combination of the following metrics;
--Mid-cycle debt/EBITDA below 3.0x on a sustained basis;
--Mid-cycle debt/PD of $12.00/boe and/or debt/flowing barrel below $18,000 on a sustained basis;
--Favorable oil & gas services outlook and heightened rig utilization and day rates signal an improvement in asset quality and mix.

Future positive rating actions are unlikely without a material increase to the company's reserve base and production profile, in conjunction with improved leverage metrics. Management's budget suggests that the E&P operations will struggle to grow sufficiently over the near-term to help facilitate a positive rating action given the current weak pricing environment. Without an improvement in business diversification, production would need to trend towards 75 mboepd before a positive rating action.

The Negative Outlook could be removed if the company is able to preserve liquidity or enter into accommodative terms under their existing credit facility following the April redetermination.

Negative to 'B': Future developments that may, individually or collectively, lead to a negative rating action include:
--Mid-cycle debt/EBITDA above 4.5x - 5.0x on a sustained basis;
--Mid-cycle debt/PD of $14.00/boe and/or debt/flowing barrel approaching $22,500 on a sustained basis;
--Reduction in size, scale and diversification or loss of operational momentum in key plays;
--Material reduction in available liquidity.

Future negative rating actions remain a possibility and will be closely linked to the company's ability to retain financial flexibility through the downcycle. Fitch understands, however, that the company's midstream assets, if sold, could generate considerable liquidity. These types of asset sales due have been executed by peers to improve financial flexibility. While a midstream asset sale is not contemplated in the rating, Fitch recognizes that embedded liquidity option value is present.

FULL LIST OF RATING ACTIONS

Fitch has taken the following actions:

Unit Corporation
--Long-term Issuer Default Rating downgraded to 'B+' from 'BB';
--Senior unsecured bank revolver affirmed at 'BB'; Recovery Rating revised to 'RR2' from 'RR4';
--Senior subordinated notes affirmed at 'BB-'; Recovery Rating revised to 'RR3' from 'RR5';

The senior unsecured notes and senior subordinated notes recovery rating was revised following the completion of a bespoke recovery analysis for issuers with a long-term IDR in the 'B' category, consistent with Fitch's 'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers.'

The Rating Outlook was revised to Negative from Stable.