KazMunayGas Rating Lowered To ‘BB-‘ On Weakening State Support

KazMunayGas Rating Lowered To 'BB-' On Weakening State Support

MOSCOW (S&P Global Ratings) Nov. 23, 2017–S&P Global Ratings today lowered to
‘BB-‘ from ‘BB’ its rating on Kazakhstan’s 100% state-controlled national oil
company NC KazMunayGas (KMG) and its core subsidiary KMGEP. The outlook is

We also lowered our national scale rating on KMG to ‘kzA-‘ from ‘kzA’.

The downgrade reflects our view that the likelihood of timely extraordinary
government support for KMG has reduced, similarly to some other
government-related entities (GREs). Government support procedures via
Samruk-Kazyna (SK) are complex and time-consuming, in our view, and could be
further complicated by potential pressures from SK and by the potential
privatization of a minority stake in KMG. We believe that the Kazakh
government generally tolerates relatively high leverage at KMG, as well as at
some other GREs, and has provided only limited support to the company since
the 2015 downturn. The uncertainty related to KMG’s option to buy-back the
Kashagan stake from the parent remains unresolved, in our view, despite the
potentially significant impact on KMG’s leverage and liquidity.

The government controls KMG via SK, which we think makes government support
mechanisms complex. We continue to believe that the government, rather than
SK, is the ultimate decision maker regarding state support to KMG and that the
government ultimately influences the structure, asset composition, and
strategy of SK. We view SK as the government’s instrument for managing
state-controlled assets in various sectors rather than a stand-alone
industrial group.

KMG is large compared to other SK assets (about 60% of group EBITDA), which
means the group’s resources are hardly sufficient for KMG’s funding
requirements and any support would hinge on the government. Therefore, our
rating on KMG continues to be based on government support rather than group
support. We observe uncertainties around SK’s strategy to repay material debt
to banks and bondholders at the parent level, with large maturities in

In late 2015, KMG sold 50% of Kashagan BV (which holds a 16.8% interest in
Kashagan) to its shareholder SK. We understand that to fund the $4.5 billion
asset price, SK raised about $2 billion debt from banks and bondholders, and
the rest was a bond issued to the National Fund. Although this helped to
temporarily reduce KMG-level consolidated reported debt, we understand that
KMG holds an option to buy the asset back in 2018-2020, which management
intends to extend to 2020-2022. Before SK finds any alternative ways of
repaying or refinancing parent-level debt to third parties, we can’t rule out
the possibility of KMG exercising the option. If the option is exercised and
funded with debt, this would materially pressure KMG’s leverage and liquidity
and reduce covenant headroom unless offset by state support or other sources
(such as converting the government’s loan to SK into KMG’s equity). The asset
value is roughly equivalent to KMG’s EBITDA for two years. Also, we understand
that KMG provided loans to SK in the past to address amortization of
Kashagan-related debt, and may provide Kashagan-related financing to SK in
2018, which pressures KMG’s stand-alone financials.

We understand that the government is planning the privatization of a minority
stake in KMG in the coming years. Although we expect the government to retain
control, we believe privatization would make it more difficult for the
government to provide timely support, including if KMG needs to exercise the
option. At this stage, the timing of privatization is unclear, and it remains
to be seen whether the privatization proceeds could be used to reduce KMG’s
debt or partially fund the Kashagan repurchase.

Our rating on KMG factors in our expectation of a high likelihood of
extraordinary government support, resulting in a two-notch uplift above our
assessment of the company’s ‘b’ stand-alone credit profile (SACP), the highest
we currently have for government-related corporates held via SK. KMG is the
government’s main asset in the strategic hydrocarbon industry, with priority
access to new assets and stakes in all significant oil ventures in the
country. It is a large exporter, taxpayer, employer, and supplier of fuel to
the domestic market at low prices. In our view, KMG’s default would have
significant reputational repercussions for the government and other
government-related entities. The Kazakh government’s financial capacity to
support is underpinned by the ‘BBB-‘ sovereign rating. Still, KMG is only
responsible for 28% of the country’s oil production (12% if only
majority-owned production is included), with only minority stakes in the
country’s largest and most profitable internationally-led projects.

We believe that KMG’s SACP is stabilizing at ‘b’. We expect KMG’s EBITDA to be
above $2 billion, after our adjustments. KMG’s mature and relatively high-cost
oil production assets are profitable under our oil price scenario, with about
$0.7 billion EBITDA. The contribution from oil and gas pipeline business
remains robust, as it is sufficiently resilient to oil price fluctuations. We
expect that, despite TCO’s largescale expansion capex, KMG will receive modest
dividends on its 20% stake in TCO at least in 2017, thanks to relatively
favorable oil prices. We also expect a higher-than-usual dividend from MMG in
2017. After the start of commercial oil production at Kashagan in November
2016, we do not expect any material dividends on KMG’s 8.4% stake before
Kashagan-level debt is repaid. At this stage, our base case does not include
any material increase in refining and marketing profits after modernization
capex is completed. We understand that KMG’s group structure has stabilized,
and disposals of Kazakh refineries are unlikely. We expect KMGI’s
deconsolidation to be completed in coming months, and possible disposals of
small assets won’t significantly influence KMG’s performance.

We expect KMG’s FOCF (as defined under S&P Global Ratings’ methodology) to
turn positive in 2018, after major capex in refinery modernization and gas
pipeline Beineu-Bozoy-Shymkent is completed. We also factor in possible loans
to SK to fund Kashagan-related debt repayments in 2018. Still, KMG’s adjusted
debt remains high at above $13 billion, following several years of negative
FOCF, and we expect any deleveraging to be only gradual, with expected FFO to
debt of 9%-12% in 2017-2019. In our calculation of adjusted debt, we include
prepayments for oil exports and only exclude cash at the parent level held
with foreign banks. This is because we believe that large cash reserves at
63%-owned KMGEP are not immediately available to repay the group’s debt, and
because we continue to view the Kazakh banking system as relatively weak.

Our base case scenario for the rating does not imply the exercise of the
Kashagan option. Because KMG’s leverage is already high, we believe that even
if KMG decided to exercise it, the impact on the rating would be driven more
by liquidity than by any further increase in leverage, which is already high.
Having said that, even if KMG’s leverage were to improve, our assessment of
the company’s SACP would factor in uncertainty related to this option.

Brent at $50/bbl in 2017-2018, $55 in 2019, in line with our oil price
KZT/USD of 320:325, in line with our base case for the sovereign.
Majority-owned oil production to gradually decline but cost and tax
structure to remain broadly stable; midstream assets (KTO, KTG) to
continue stable operations;
In our base case, we do not factor in any material increase in refining
profits because of market uncertainties.
Only limited dividends from joint ventures, because TCO focuses on large
expansion capex and Kashagan uses its cash to repay debt before paying
any dividends to KMG.
EBITDA to increase to above $2.4 billion in 2017 on one-off dividends
from MMG and TCO, and stabilize at about $2 billion or slightly above in
Capex of $1.5 billion-$1.7 billion in 2017, down to $0.9 billion in
KMGI to be deconsolidated in 2017-2018. We do not include any proceeds
from the asset sale because of ongoing litigation uncertainty in Romania.
In our base case, we treat cash at parent-level foreign banks as surplus
cash. In our view, sizeable cash balances at the level of 63%-controlled
KMGEP are not immediately available for debt service. We also believe
that KMG is exposed to Kazakhstan’s weak banking system.
KMG to pay only modest dividends to SK.
In our base case scenario, we do not include the Kashagan option,
privatization proceeds, or any material upstreaming of cash from
63%-controlled KMGEP.
Based on these assumptions, we arrive at the following credit measures:
FFO to debt of 9%-12% in 2017-2019.
Debt to EBITDA above 5x.
Negative FOCF in 2017 as KMG finalizes its key capex projects. Moderately
positive FOCF starting in 2018 when major capex is completed, and only
limited debt reduction after that.

The stable outlook reflects our expectation of stabilizing EBITDA, FFO to debt
of about 9%-12%, FOCF turning positive in 2018, and only gradual deleveraging
given already-high debt. Even if FFO to debt is somewhat above 12% thanks to
profits from recent investments or higher-than-expected oil prices, the
uncertainty about the Kashagan option would still constrain any upside. The
stable outlook also incorporates our expectation of continuing high likelihood
of government support.

Rating upside could be triggered by an improvement in the stand-alone credit
profile via a material reduction in consolidated adjusted leverage (with FFO
to debt consistently above 20%), consistently positive FOCF, sustainable
liquidity, and no risk of a debt-financed Kashagan buyback.

Rating upside could also result from a sovereign upgrade.

Rating downside could result from a material weakening in liquidity or
leverage, for example if KMG has to exercise its Kashagan option or undertake
large debt-financed investments without sufficient offsetting state support,
or if significantly lower oil prices undermine the company’s sustainable
EBITDA generation. Downside could also stem from SK’s pressuring KMG to repay
parent-level debt, for example via intragroup loans or the Kashagan option.
Given our expectation of high likelihood of state support, KMG’s SACP would
have to deteriorate to ‘ccc+’ or lower to trigger rating downside. These are
not our base-case scenarios for the rating, however.