DBRS Upgrades Baytex Energy Trust to STA-5 (low)

DBRS has upgraded the Stability Rating of Baytex Energy Trust (Baytex or the Trust) to STA-5 (low) from STA-6 (high). The rating upgrade reflects DBRS’s view that the Trust will continue to gradually grow its cash distributions per unit, underpinned by its improved credit metrics and good operating performance. As a result, the Trust’s Growth profile has also been upgraded to Moderate from Weak.

Baytex’s debt-to-cash flow and interest coverage ratios have improved to 1.2 times and 9.8 times respectively for the 12 months ended March 31, 2008, attributable to the strong commodity pricing environment and the Trust’s relatively low payout ratio (declared distributions to operating cash flow). The coverage ratios should continue to improve going forward, benefiting from favourable crude oil prices, which DBRS expects to continue over the medium term.

With one of the lowest payout ratios in the industry, in the 50% to 55% range (before DRIP proceeds), compared with an average of 70% for the larger trusts, Baytex is in a better position to maintain stable distributions and fund ongoing capex. Since inception, the Trust has increased cash distribution per unit three times, once in 2006 and twice in 2008 (by 11% to $0.20 in March 2008 and by 25% to $0.25 in June 2008). The June increase followed the closing of the Burmis Energy Inc. (Burmis) purchase, which was accretive to cash flow and production per unit. The current distribution level is expected to remain stable with payout expected to be below the lower end of the guidance of 60% to 70%. Baytex expects cash flow from operations in 2008 to fully fund the planned $170 million capital program ($149 million in 2007) and distributions, which should be achievable given DBRS’s view of favourable commodity prices in the near to medium term.

The Trust has a good track record in fully replacing production through the drill bit since inception in 2003 (117% in 2007), and raising reserve life to above average in 2007 (9.8 years on a proved basis versus 7.1 years in 2004). Baytex has also generally maintained a fairly stable ratio of proved reserves per unit compared with a declining trend for most of its peers. The Trust’s ongoing effort to rebalance its focus on heavy oil with more natural gas and light crude oil production through bolt-on acquisitions should enhance production diversification and mitigate in part the impact of the light-heavy crude pricing differential over time. The Burmis transaction is a case in point, adding an estimated 6.5 million barrels of oil equivalent (boe) (6% of total reserves) of proved reserves and about 3,650 boe/d of production (10% of total production - 72% natural gas, 28% light oil and natual gas liquids (NGL)), resulting in a pro forma heavy oil component of production of 55% versus 61% (based on 2007 levels). The transaction closed in early June and was financed through a share exchange (0.1525 Baytex Trust units for each Burmis common share) for total consideration of approximately $181 million (including assumed debt of $29 million).

Baytex’s operational strengths are further reflected by growth in new areas and its ability to control production and operating costs fairly well. The Trust has solid landholdings, including Seal in the Peace River oil sands region, which provides significant development and drilling inventory. In addition, approximately 40% of proved reserves are undeveloped, representing opportunities to replace production at lower costs relative to purchasing assets in the highly competitive market. High operatorship (60% to 90%) of its properties also allows for better cost control as the Trust maintains one of the lowest operating costs in the trust industry.

The Trust, however, also faces several challenges going forward, including the following. (1) The significant concentration in heavy oil (55% pro forma) will remain an issue due to pricing differentials and generally lower netbacks relative to light crude production. Baytex has reduced the pricing differential risk somewhat through a series of physical sales contracts, which fixes the price differential of heavy oil received at about 33% of WTI price for approximately half and one-third of Baytex heavy crude production projected in 2008 and 2009 respectively, leaving the remaining production exposed to market differential risks (current pricing differential is about 20%). (3) Although net production has remained fairly stable since 2004, Baytex has experienced a gradual dilution in per unit production, similar to its peers, from 0.16 boe in 2004 to 0.14 boe in 2007 through equity issuance to support in part the capital programs. (4) The US$180 million Senior Unsecured Subordinated Debt maturing in 2010 ($185 million outstanding at March 31, 2008) represents re-financing risk, although interest on the debt partially offsets the impact on crude sales due to the strengthening Canadian dollar.

Note:
All figures are in Canadian dollars unless otherwise noted.