Research Update:
Sheridan Fund I Downgraded To 'CCC'
From 'B+' On Expected Reassessment
Of Borrowing Base; Outlook Negative
Primary Credit Analyst:
Trevor T Martin, CFA, New York (1) 212-438-7286; [email protected]
Secondary Contact:
Thierry Grunspan, New York (1) 212-438-1441; [email protected]
Table Of Contents
Overview
Rating Action
Rationale
Outlook
Recovery Analysis
Related Criteria And Research
Ratings List
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Research Update:
Sheridan Fund I Downgraded To 'CCC' From 'B+'
On Expected Reassessment Of Borrowing Base;
Outlook Negative
Overview
• Sheridan Fund I's borrowing base is expected to be lowered in the near
future. As a result, we believe the asset coverage ratio will fall below
1.0x. The company will have six months to fund the shortfall before it is
considered an event default.
• As a result, we are lowering the issuer credit ratings to 'CCC' from 'B+'
on Sheridan Production Partners I-A, Sheridan Investment Partners I, and
Sheridan Production Partners I-M, reflecting the heightened risk to cash
flows from prolonged reduced oil prices. At the same time, we are
lowering the senior secured debt ratings to 'B-' from 'B+'.
• The negative outlook reflects our view that oil prices will stay low and
the company will continue to experience liquidity pressure through
further borrowing base reductions in 2016.
Rating Action
On Dec. 29, 2015, Standard & Poor's Ratings Services lowered its issuer credit
ratings on Sheridan Production Partners I-A, Sheridan Investment Partners I,
and Sheridan Production Partners I (collectively referred to as "Sheridan Fund
I") to 'CCC' from 'B+'. The outlook is negative.
At the same time, we lowered the issue-level rating on the fund's first-lien,
senior secured credit facilities to 'B-' from 'B+'. We revised the recovery
rating on this debt to '1' from '3'. The '1' recovery rating reflects our
expectation of "very high" recovery (90%-100%) for creditors in the event of a
payment default.
Rationale
The downgrade primarily reflects the expected reduction of the fund's
borrowing base as a result of the prolonged reduction in oil prices. Since we
believe total debt will be in excess of the borrowing base at the time of the
redetermination, the fund will have six months to make up the shortfall before
it is considered an event of default. While the fund still generates adequate
cash flow from operations, further reductions in the borrowing base in 2016
would likely put pressure on what we already consider to be a "weak" liquidity
position.
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Research Update: Sheridan Fund I Downgraded To 'CCC' From 'B+' On Expected Reassessment Of Borrowing
Base; Outlook Negative
Sheridan Fund I is a 15-year private equity vehicle, which invests in mature
oil and gas assets. The fund's original investment thesis was based on the
idea that public exploration and production companies were increasingly
looking to sell mature properties. In the third quarter of 2015, the fund had
reduced production volumes of 14,206 barrels of oil equivalent per day
(Boe/d), or 7% below its original plan.
Sheridan Fund I's borrowing base will most likely be reduced from $1.155
billion. The fund had $1.091 billion of debt outstanding in November 2015,
after pre-paying $25 million of term debt at a 68% discount to par through a
Dutch auction. We did not consider this a selective default at the time
because of the trivial amount of debt in relation to total borrowings.
In our opinion, the first line of defense is to generate cash flows from
operations. But the fund does have a few avenues available to it should the
forecasted cash flows from operations be insufficient to remedy a potential
shortfall. Lower capital budgets at exploration and production companies have
led to a drop in the U.S. active rig count (nearing its previous low in 2009),
which should allow the fund to lower its service costs. The fund anticipates
that operating costs will be about 10% below plan for the year. Currently, we
expect free cash flow after capital reinvestment to be approximately $60
million to $70 million. Furthermore, the fund has cut distributions to its
limited partner (LP) investors and has stated that it will not reinstate
distributions until it has a clearer picture of the financial plan.
Sheridan Fund I has hedged approximately 75% of its expected proved oil
production in 2016 and about 40% of expected proved gas production. In 2017,
the fund is unhedged on oil and has 10,000 MMBtu/d of gas hedges. As of Sept.
30, 2015, the fair value of the hedges was $149 million. As a second line of
defense, the fund could monetize the hedges and use the proceeds to reduce
outstanding debt. Although selling the hedges could allow for debt reduction,
this would also result in a lower borrowing base.
A final route for reducing debt would be asset sales. This, however, would not
be ideal while prices per barrel of oil are $30-$40 and would also lead to a
further reduction in the borrowing base. As of Sept. 30, 2015, the fair value
of the fund's oil and gas properties was $1.888 billion.
We apply "Corporate Methodology," published Nov. 19, 2013, in conjunction with
"Key Credit Factors For The Oil and Gas Exploration And Production Industry,"
published Dec. 12, 2013, to determine the issuer credit rating for the debt
issued by the funds. Accordingly, we will be applying the scoring factors that
are indicated in the corporate methodology. Through application of those
criteria, we view the oil and gas integrated, and exploration and production
industry as having an "intermediate" industry risk profile under our criteria,
given its "moderately high" cyclicality risk and "intermediate" degree of
competitive risk and growth. In assessing the competitive position of an
exploration and production company, we put particular emphasis on the size,
quality, and mix of its reserves base; the growth prospects inherent in its
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Research Update: Sheridan Fund I Downgraded To 'CCC' From 'B+' On Expected Reassessment Of Borrowing
Base; Outlook Negative
oil and gas reserves portfolio; its full cycle cost profile; and associated
profitability. We view a company's ability to generate sufficient cash flow to
replace and grow its reserves (at both peaks and troughs of the hydrocarbon
price cycle) as the principal factors in our assessment of its financial risk
profile, given the industry's capital-intensive nature and the need to
continually replace produced reserves. Our assessment of the financial risk
profile takes into account historical ratios for the previous two years and
notable forecasts for the current and two subsequent years based on our price
assumptions for oil and natural gas prices (see "Methodology For Crude Oil And
Natural Gas Price Assumptions For Corporates And Sovereigns," published Nov.
19, 2013).
Given that the issuers are not corporate entities but funds, we apply the
section of criteria applied to financial institutions, "Rating Private Equity
Companies' Debt And Counterparty Obligations," published March 11, 2008, that
applies to analysis of liquidity of funds in conjunction with the corporate
methodology. Typically the corporate methodology is applied without
adjustment. We apply the private equity fund criteria pertaining to liquidity
when investors' ability to redeem shares or a defined time period to liquidate
assets of the funds to repay debt has been set within our rating horizon. This
assessment of cash flow patterns from realization of investments cannot
improve our assessment of liquidity but could lower our initial rating
assessment of the corporates liquidity score by one or more assessment
categories (i.e., exceptional, strong, adequate, less than adequate, weak) if
the maturity structure of the instruments it has issued to finance its
investments relative to the cash position of the fund or ability to monetize
assets before the fund liquidation date, in our opinion, could affect the
credit quality of the fund. The number of categories would depend on our view
of the extent of the limitation.
We apply general criteria, "Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And
'CC' Ratings," published Oct. 1, 2012, when applicable, and we apply "Revised
Assumptions For Assigning Recovery Ratings To The Debt Of Oil And Gas
Exploration And Production Companies," published Sept. 14, 2012, after
determining the issuer credit rating of the fund when we assign issue credit
ratings to debt issued by the fund.
Outlook
The negative outlook reflects our view that further borrowing base reductions
could add to the fund's liquidity strain. Although we believe the fund will be
deficient in its asset coverage ratio, it still has the ability to make up the
difference through operating cash flows, unwinding its hedges, or through
asset sales. We are unlikely to revise the rating to stable unless oil and gas
prices show growth and stability. We could lower the rating if we believed the
fund could not make up the difference between the debt and the borrowing base
over the next six months. We could also lower the ratings to signal a default
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Research Update: Sheridan Fund I Downgraded To 'CCC' From 'B+' On Expected Reassessment Of Borrowing
Base; Outlook Negative
if the fund pursues a distressed debt exchange.
Recovery Analysis
• We have lowered the issue-level ratings on Fund I's first-lien debt to
'B-' from 'B+', with a recovery rating of '1' (revised from '3'),
reflecting our expectation of "very high" (90%-100%) recovery to
creditors in the event of a payment default.
• Standard & Poor's simulated default for Fund I assumes a sustained period
of low commodity prices, consistent with past defaults in this sector.
Simulated default assumptions
• Simulated year of default: 2016
Simplified waterfall
• Net enterprise value (after 5% administrative costs): $1.0 billion
• Valuation split in % (obligors/nonobligors): 100/0
• Secured first-lien debt claims: $1.1 billion
• --Recovery expectations: 90%-100%
• Value available to unsecured claims: $0
Notes: All debt amounts include six months of prepetition interest.
Related Criteria And Research
Related Criteria
• Criteria - Corporates - General: Methodology And Assumptions: Liquidity
Descriptors For Global Corporate Issuers, Dec. 16, 2014
• Criteria - Corporates - Industrials: Key Credit Factors For The Oil And
Gas Exploration And Production Industry, Dec. 12, 2013
• General Criteria: Group Rating Methodology, Nov. 19, 2013
• General Criteria: Methodology: Industry Risk, Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions,
Nov. 19, 2013
• General Criteria: Methodology For Crude Oil And Natural Gas Price
Assumptions For Corporates And Sovereigns, Nov. 19, 2013
• Criteria - Corporates - General: Corporate Methodology: Ratios And
Adjustments, Nov. 19, 2013
• Criteria - Corporates - General: Corporate Methodology, Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors
For Corporate Entities And Insurers, Nov. 13, 2012
• Criteria - Corporates - Industrials: Revised Assumptions For Assigning
Recovery Ratings To The Debt Of Oil And Gas Exploration And Production
Companies, Sept. 14, 2012
• General Criteria: Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC'
Ratings, Oct. 1, 2012
• Rating Private Equity Companies' Debt And Counterparty Obligations, March
11, 2008
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Research Update: Sheridan Fund I Downgraded To 'CCC' From 'B+' On Expected Reassessment Of Borrowing
Base; Outlook Negative
Ratings List
Downgraded
Sheridan Investment Partners I, LLC
Sheridan Production Partners I-M, LP
Sheridan Production Partners I-A, LP
Counterparty Credit Rating
Senior Secured
Recovery Rating
To
From
CCC/Negative/-B1
B+/Negative/-B+
3H
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