We initiate coverage of the Kurdistan exploration and production (E&P) sector, assigning Buy recommendations to OILFLO 22s, DNONO 23s, DNONO 24s and Hold recommendations to GULFKY 23s, HKNENG 24s and SNMCN 23s, as well as reiterating our Buy on GENLLN 22s. Kurdistan E&Ps can be categorised into two distinctive groups – companies with high production coming from mature highly cash-generative assets offering high returns on investment; and companies with assets at an early stage of development, low production and high capex. Leverage is generally low, but bond yields incorporate high risk premiums, reflecting Iraq country risk and a ‘surcharge’ for the Iraq-Kurdistan tensions. We suggest a bond-selection approach to minimise the country/region risk and gain exposure to operationally strong and reserve- and cash-rich E&P companies.
The strongest stand-alone credits: DNO, Genel and Oil Flow. DNO is our top pick in the Kurdistan E&P sector. The company offers a compelling combination of strong stand-alone credit metrics and exposure to the (relatively politically stable) North Sea region, which could become the main trigger for DNONO 23s and 24s outperformance in the next 12 months. Genel supplements its self-funding, highly profitable operations with a net cash position sufficient to repay all its debt at once. Oil Flow offers one of the shortest-term exposures to the sector, with monthly bond amortisation funded by a dedicated volume of the KRG’s oil exports.
Transformative growth stories: HKN and Gulf Keystone. HKN Energy is on its way to joining the ranks of the leading producers in Kurdistan, but only after significant capex outlays in 2019-20. If production increases as planned, HKN could outperform its peers in 12-18 months. Gulf Keystone’s massive oil reserves, high cash generation and substantial accumulated liquidity (which significantly exceeds outstanding debt) are offset by the absence of a long-term oil sales agreement and the potential amendment of the production-sharing contract (PSC). With these obstacles gone, Gulf Keystone could quickly close the valuation gap to DNO and Genel.
Risks to our recommendations stem from the uncertainty around KRG-Iraq negotiations on disputed issues, the security situation in Iraq and Kurdistan, and oil prices, which, on the way down, could complicate the political landscape more than operating environment for the E&P companies. Most break even before capex with Brent at US$25-45/bbl.
Read the full report here.
Recap of the week’s key credit developments
Lebanon (LEBAN): On Tuesday, Moody’s downgraded Lebanon’s long-term foreign currency rating to Caa2, with a negative watch, from Caa1. The previous rating had a negative watch since 1 October, and was downgraded from B3 in January. S&P’s rating is currently at B-, but with a negative watch since 24 October, and Fitch’s rating has been at CCC since 23 August. Moody’s cited an increased likelihood of debt restructuring, coming from widespread protests and the resignation of Prime Minster Saad Hariri last week. The more austere fiscal budget, which received a lukewarm reception from the IMF, now seems less likely to pass, and reforms needed to secure investment and essential financial support from allies in the Gulf Cooperation Council now seem less likely. The economy has relied on capital inflows, including FDI and remittances. Declining inflows in recent years have led to drawings on central bank reserves, which declined by 18% in the 12 months to June (reserves ex-gold), and recovered slightly in the months since. Moody’s expects deposit outflows to accelerate, while increasing dollarisation threatens the currency regime. The current negative watch gives Moody’s an expected three months to consider a further downgrade.
Brazil (BRAZIL): On Monday, Brazil priced its new dual-tranche US$ bond. This comprises: 1) a US$500mn add-on to the existing bond due 30 May 2029; and 2) new US$2.5bn bonds due 14 January 2050. They were priced at 3.809% and 4.914%, respectively, a spread of 265bps over US Treasuries. Proceeds are expected to be used for: 1) refinancing, repurchase, redemption or retirement of Brazilian sovereign bonds ‘from time to time’, by which Brazil may purchase, pursuant to a tender offer, on the terms and subject to the conditions set forth in the offer to purchase, dated 4 November 2019; and 2) general budgetary purposes. US$1bn of the 2050 bond proceeds will be used to refinance older debt. Brazil announced on Monday a tender offer for seven series of bonds with maturities between 2027 to 2047. The issuance comes after pension reforms were completed and further fiscal reform is planned; Finance Minister Guedes proposed three constitutional amendment to Congress on Tuesday. See our recent report here.
Turkey (TURKEY): On Friday, Fitch improved its outlook on Turkey’s BB- long-term foreign currency rating to stable from negative. It was negative for a year before the most recent downgrade in July 2019. The agency cited a decline in downside risks as the economy has stabilised: the current account, foreign reserves and growth have improved, while inflation has fallen and the lira has not depreciated sharply in response to interest rate cuts. Fitch reported a current account surplus of US$5.1bn in the 12 months to August (significant surpluses in July and August replicated similar surpluses in H2 18, while the last decade has mostly seen continual monthly deficits), the exchange rate has been stable relative to the total 10ppts interest rate cuts between July and October, and Fitch now expects the well diversified economy to shrink just 0.3% this year, and grow 3.1% in 2020 and 3.6% in 2021. Weaker economic activity this year should see the budget deficit expand to 3.3% of GDP, which is expected to be the same next year. The outlook is also improved by the US recently announcing the lifting of Syria-related sanctions.
South Africa (SOAF): Also on Friday, Moody’s changed its outlook on South Africa’s only remaining investment grade rating, of Baa3, to negative from stable. It was changed to stable in March 2018, after having been under review since November 2017, and previously negative before that, since June 2017. S&P and Fitch rate South Africa BB (stable) and BB+ (negative), respectively. Moody’s made the decision to reflect the risk that the government will not be able to improve public finances by boosting economic growth and fiscal consolidation. The country is facing high unemployment and growth and fiscal consolidation may be hindered by financing needs from SOEs, especially state power firm Eskom. The agency expects public debt to continue to rise (to 70% at end-FY 22, or 80% including SOEs, from 57% of GDP at end-FY 18,) and a credible fiscal strategy will be needed to maintain the current Baa3 rating. Moody’s reported 0.8% real GDP growth in 2018, and the IMF’s latest forecasts are 0.7% this year and a gradual annual rise towards 1.8% in 2023.
Mozambique (MOZAM): State-owned National Hydrocarbons Company (ENH) has plans to raise US$1.5bn in financing for a natural gas project, run by Total SA, in which ENH has a 15% stake. The roadshow will start next week in Johannesburg. The project would develop oil fields and Mozambique’s first liquified natural gas (LNG) plant. LNG is seen as key for the future of the national economy and the government’s public finances and debt repayment capacity. On 30 October, bondholders exchanged the defaulted MOZAM 23s for a new US$900mn 2031 step-up. On Thursday, Fitch upgraded the sovereign credit rating to CCC from RD, following the bond restructuring. S&P retains its SD since January 2017, and Moody’s its Caa2 since 20 September 2019. See our IMF Annual Meetings note here.
Ardshinbank (ARBANK): The lender disclosed that almost 90% of the aggregate principal amount of its 2020 bond was tendered. These bonds were tendered prior to the early participation deadline, and will be bought back at a price of 105. The issuer also announced that bondholders passed the extraordinary resolution, which will allow the bank to redeem the 2020 bond early, at a price of 104. The early redemption date is November 7 (today). We recall that the sovereign, Armenia, recently returned to the eurobond market, and bought back a significant part of a 2020 bond early. The sovereign and Ardshinbank were upgraded by Moody’s in August/September this year. We also recall that Ardshinbank previously stated that one reason for the tender was to (potentially) allow the bank issue a new bond, so it might be worth watching what happens next.
Mersin (MERSIN): Mersin, Turkey’s leading container port in 2018, is looking to issue five-year US$550mn notes. Proceeds from the issue will be used to refinance the US$450mn notes due August 2020 and for general corporate purposes, potentially including shareholder distributions. According to Bloomberg, IPT is in the high 5% area. We see Mersin as a strong stand-alone credit capable of generating high cash flows in a challenging market environment and partially protected from FX risk in Turkey. Our main concern relates to the high shareholder distributions and the reliance of bondholders on shareholders’ judgement about their magnitude within a 3x net leveraged covenant. We believe the new issue should pay a premium over an agglomeration of Turkish bonds maturing around 2024 – KCHOL, TUPRST, TURKTI – as their dividend policies are formalised and have been tested through the cycle. We believe Mersin’s bonds could be interesting at 6%, which puts them at a roughly equal spread over the sovereign to SISETI 26s – the bonds of a similarly rated listed Turkish issuer operating on a considerably bigger scale – but not much tighter than that. We have a Hold recommendation on the MERSIN 20s. See our recent report here.