Rating Action Overview

• Australia-based oil and gas exploration and production (E&P) company Karoon Energy Ltd. is planning to issue five-year senior secured second-lien notes of US$400 million. It will use the proceeds to diversify debt funding sources, lengthen its maturity profile, and repay the drawn amount (US$274 million as of Dec. 31, 2023) in its existing US$340 million reserve-based lending facility (RBL facility).
• Karoon benefits from the low-cost position of its 100%-owned Bauna project, located in the Santos Basin off the coast of Brazil, and its recently acquired 30% noncontrolling interest in the Who Dat asset, located in the Gulf of Mexico. However, the relatively small size of the company's reserves and production levels compared with rated global peers constrain the ratings.
• On April 23, 2024, S&P Global Ratings assigned its 'B' long-term issuer credit rating to Karoon and 'B+' long-term issue rating to the company's proposed senior secured second-lien notes. The '2' recovery rating on the notes indicates our expectation of substantial recovery (rounded estimate: 80%) in the event of a default.
• The stable rating outlook incorporates our view that Karoon will maintain its financial discipline as it seeks to increase production and reserves through asset enhancements, developments, and strategic asset acquisitions. Our base case incorporates a ratio of average funds from operations (FFO) to debt of more than 45% and a ratio of debt to EBITDA of below 2.0x over the next two years.

Rating Action Rationale

Karoon's small scale and limited reserve life compared with peers weigh on our assessment of its business risk.  We view the company's smaller proved reserve base and production level relative to peers, and its asset concentration, as limiting factors for the ratings. Karoon's asset portfolio consists of its 100%-owned Bauna project in the Santos Basin off the coast of Brazil, and its recently acquired 30% noncontrolling interest in the Who Dat asset in the Gulf of Mexico.

Karoon's proved reserves are about 58 million barrels of oil equivalent (mmboe) and annual production of 10.5 mmboe-12.5 mmboe projected in 2024. At current production levels, factoring in some inherent level of natural decline, this implies a reserve life of about five to six years, excluding unproved reserves. This is at the lower end of the range for 'B' rated peers such as Talos Energy Ltd., and EnQuest PLC. Accordingly, Karoon is exposed to a material risk of reserve depletion unless it can replenish its reserves via asset enhancements, developments, or asset acquisitions. We also note the operational risks related to offshore oil production, and asset retirement obligations, which elevate spending relative to onshore producers.

We expect Karoon to remain prudent in its approach to managing growth to augment its reserve base and maintain production. The short reserve life of the company's key asset, Bauna, means we expect Karoon will seek to replace these depleting reserves over the next few years. Accordingly, Karoon will likely pursue a combination of asset enhancements, developments, and strategic asset acquisitions. We believe the company will prefer mid-life producing assets, as it targets opportunities arising from the major oil and gas companies shedding smaller nonstrategic assets from time to time.

Karoon's low operating costs and ability to generate strong EBITDA margins will support its creditworthiness in the next one to two years.  Our base case forecasts Karoon's average operating costs per barrel of about US$12.0 (US$15.4 at Bauna and US$5.7 at Who Dat) in 2024 and about US$13.4 (US$16.8 at Bauna and US$6.5 at Who Dat) in 2025. This compares favorably with similar rated peers such as Gran Tierra Energy Inc. (B/Stable/--), EnQuest PLC (B/Stable/--), 3R Petroleum Oleo e Gas S.A. (B+/Stable/--), and GeoPark Ltd. (B+/Stable/--).

We believe these lower production costs will be key for Karoon to maintain its strong EBITDA margins over the next two years or so. We expect group EBITDA margins to remain at 75%-78% in fiscal 2024 and 2025 (year ending Dec. 31). At these margins, our base case reflects an expectation the company will generate EBITDA of about US$685 million in 2024 and about US$650 million in 2025. Such earnings mean we expect the company to comfortably manage its capital spending requirements over the next few years. We project capital expenditure (capex) of US$175 million-US$200 million in 2024, decreasing to about US$120 million-US$130 million in fiscal 2025. We anticipate a debt-to-EBITDA ratio of about 1.4x and 1.3x and FFO-to-debt ratio of 60% and 55% in fiscal 2024 and 2025, respectively.

Liquidity and balance sheet strength should help Karoon pursue its growth strategy.  Karoon is planning to launch a five-year senior secured second-lien debt issue of up to US$500 million. It envisages using the issue proceeds to diversify its debt funding sources, lengthen its maturity profile, and repay its drawings under the existing US$340 million RBL facility.

Following the planned issuance, the company's minimal near-term debt maturities, undrawn RBL facility, and cash of about US$670 million, will support the group's liquidity position. We believe the company will use this liquidity strength to increase production and reserves. Notwithstanding our expectation the company will undertake acquisitions to bolster scale, we do not expect the company's adjusted peak leverage to exceed about 2.5x before it uses operating cash flow to de-lever to below 2x.

Outlook

The stable outlook reflects S&P Global Ratings' expectation that Karoon will continue to benefit from supportive crude oil prices, as it generates positive free operating cash flow (FOCF) and maintains daily production throughout 2024 and 2025. We forecast adjusted financial metrics averaging close to 55% for the FFO-to-debt ratio with a debt-to-EBITDA ratio of below 1.5x.

We also expect the company to maintain its reserve levels by continuing to invest in offshore producing assets.

Downside scenario

We could lower our rating if we expected the debt-to-EBITDA ratio to exceed 3.0x and FFO-to-debt ratio to fall below 30% for a sustained period without a credible deleveraging path, or if liquidity deteriorated. This would most likely occur due to:

• A material deterioration in oil prices, resulting in lower EBITDA generation;
• Production falling significantly below our expectations due to operational interruptions or delays, or the company being unable to execute asset life extension initiatives;
• Reserves materially decreasing and the company being unable to sufficiently replace them; or
• The company demonstrating a more aggressive acquisition or growth strategy, significantly increasing leverage and reducing free operating cash flow.

Upside scenario

We could raise our rating on Karoon if the company is able to diversify its asset base and increase its production and reserve levels such that the risk of reserve depletion significantly diminishes. Factors supporting this would include the company maintaining its conservative balance sheet leverage, adequate liquidity, and financial discipline in the deployment of capital.

Company Description

Karoon Energy Ltd. is an oil and gas E&P company with operations focused on Brazil and the U.S. Karoon was founded in 2003 and is headquartered in Melbourne, Australia.

Our Base-Case Scenario

Assumptions

• Our price assumptions for West Texas Intermediate (WTI) oil of US$80 per barrel (bbl) for the remainder of 2024, US$75/bbl in 2025, and US$75/bbl in 2026.
• Our price assumptions for Brent crude of US$85/bbl for the remainder of 2024, US$80/bbl in 2025, and US$80/bbl in 2026.
• Our price assumptions for Henry Hub natural gas of US$2.50 per million Btu (mmBtu) for the remainder of 2024, US$3.50/mmBtu in 2025, and US$4.25/mmBtu in 2026.
• We forecast average daily production of approximately 34,000 barrels of oil equivalent (boe) per day in 2024, and 32,000 in 2025.
• Capex of US$175 million-US$200 million in fiscal 2024, and US$120 million-US$130 million in fiscal 2025.
• Average realized sale price for WTI (post transportation costs) of about US$78.0 per boe in 2024 and 2025, and US$82.5 per boe for Brent in 2024 and US$82.0 in 2025.
• We expect a material uplift in revenues in fiscal 2024 following a full year contribution from the recently acquired 30% stake in the Who Dat asset in the Gulf of Mexico. Our base case incorporates an increase in revenue of about 32% to US$890.0 million in fiscal 2024, declining thereafter to US$830.0 million in 2025 and US$780.0 million in 2026.
• Absent any acquisitions, we expect Karoon to be in a net cash position under our current oil price assumptions.
• Our base case assumes no dividend distributions over the next few years.

Key metrics

Based on these assumptions, we arrive at the following credit metrics:

• EBITDA margins in the 75%-80% range for the next two years;
• Debt-to-EBITDA ratio of 1.4x in fiscal 2024 and 1.3x in 2025;
• FFO-to-debt ratio of about 60% in fiscal 2024 and 55% in 2025;
• FOCF-to-debt ratio of about 45% in fiscal 2024 and about 40% in 2025.

Liquidity

We assess Karoon's liquidity as adequate given our estimate that liquidity sources will exceed uses by at least 1.2x over the next 12 months. In addition, we believe that sources will exceed uses even if forecast EBITDA falls by 15%

As of Dec. 31, 2023, we assess Karoon as having the following sources and uses of liquidity for the following 12 months:

Principal liquidity sources:

• Cash and liquid investments of about A$170.0 million;
• FFO of US$525.0 million-A$550.0 million; and
• Undrawn committed credit facilities maturing in more than one year of about US$75.0 million.

Principal liquidity uses:

• No debt maturities;
• Capex of US$175.0 million-US$200.0 million; and
• Contingent consideration payments of about US$86.0 million.

Covenants

We expect Karoon will remain compliant with the financial covenants on its RBL, including a groupwide net debt-to-EBITDAX ratio of less than 3.25x and borrowing base obligor covenants including a minimum liquidity ratio of 1.1x (including the aggregate of the cash and equivalents of not less than US$20 million).

Environmental, Social, And Governance

Environmental factors are a negative consideration in our credit rating analysis on Karoon's as the E&P industry contends with the energy transition and adoption of renewable energy sources. Over the long term, we believe falling demand for fossil fuels will lead to declining profitability and a more difficult financing environment, especially for smaller independent operators.

As an offshore producer in Brazil and the Gulf of Mexico, Karoon works with multiple regulatory bodies to ensure the company's compliance with environmental and safety standards. Karoon's Carbon Management Action Plan tries to balance oil production with the minimization and offsetting of its carbon footprint. Karoon seeks to invest in or develop quality projects to offset residual emissions to help it achieve its sustainability target of net zero by 2035 for Scope 1 and 2 greenhouse gas emissions.

We also note that social obligations can be material for oil and gas companies. This stems from risk management related to offshore operations such as the possible exposure to fatal accidents. There are inherent risks in operating oil rigs, which involve air and water transportation of personnel, among other activities, which could be life-threatening without proper care.

Issue Ratings - Recovery Analysis

Key analytical factors

• We assigned our 'B+' issue rating to Karoon's proposed five-year senior secured second-lien notes, based on the 'B' issuer credit rating and a '2' recovery rating. The notes will be issued by Karoon USA Finance Inc., and unconditionally and irrevocably guaranteed by Karoon Energy Ltd. and its major subsidiaries.
• The issue-level rating is one notch above the issuer credit rating, given its collateral package and our expectation of substantial recovery (rounded at 80%).
• Our simulated default scenario for Karoon contemplates a default in 2027 and assumes a sustained period of low commodity prices, consistent with the conditions of past defaults in this sector.
• We base our valuation of Karoon reserves on a company provided mid-year PV-10 asset reports, which uses our recovery oil price deck assumptions of US$50/bbl and US$2.50/mmBtu for Henry Hub natural gas.
• We note the short reserve life of the company's key asset, Bauna, in the Santos Basin off the coast of Brazil. We base our valuation on the implicit assumption that Karoon will be able to replace reserves with those of similar value over the next few years. Our analysis assumes that the available balance of the US$340 million RBL facility would be fully drawn at default.
• In our default scenario, we expect the claims on the second-lien notes to be effectively subordinated to the claims relating to the RBL facility.
• We anticipate the company will issue US$400 million in debt, due in 2029. In the event the company accepts an oversubscription, we expect the recovery to be in the range of 70%-90%.

Simulated default assumptions

• Simulated year of default: 2027
• Jurisdiction (Rank A): The company's key asset is located in Brazil from which it derives a majority of its revenue; however, Karoon is headquartered in Australia where we expect the main reorganization proceeding for a rated debt obligation to occur.
• We adjusted our gross enterprise valuation to account for restructuring administrative costs (estimated at about 5% of the gross value).

Simplified waterfall

• Net enterprise value (after 5% administrative costs): US$780.0 million
• Senior secured US$340 million RBL:
• --Recovery expectations: Not applicable
• Total value available to second-lien claims: About US$420.0 million
• Second lien claims: US$530.0 million
• --Recovery expectations: 70%-90% (rounded estimate: 80%).

Note: All debt amounts include six months of prepetition interest.

Ratings Score Snapshot

Issuer Credit Rating: B/Stable/--

Business risk: Vulnerable

• Country risk: Intermediate
• Industry risk: Moderately high
• Competitive position: Vulnerable

Financial risk: Significant

• Cash flow/Leverage: Significant

Anchor: b+

Modifiers

• Diversification/Portfolio effect: Neutral (no impact)
• Capital structure: Neutral (no impact)
• Liquidity: Adequate (no impact)
• Financial policy: Neutral (no impact)
• Management and governance: Neutral (no impact)
• Comparable rating analysis: Negative (-1 notch)

Stand-alone credit profile: b

Related Criteria

• Criteria | Corporates | General: Corporate Methodology, Jan. 7, 2024
• Criteria | Corporates | General: Methodology: Management And Governance Credit Factors For Corporate Entities, Jan. 7, 2024
• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• General Criteria: Group Rating Methodology, July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
• Criteria | Corporates | General: Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 7, 2016
• Criteria | Corporates | Recovery: Methodology: Jurisdiction Ranking Assessments, Jan. 20, 2016
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
• General Criteria: Methodology: Industry Risk, Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• 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: Principles Of Credit Ratings, Feb. 16, 2011

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