DBRS Confirms Canadian Oil Sands at BBB, Stable, Confirms Stability Rating at STA-4 (low)

DBRS has today confirmed the Senior Unsecured Long-Term Debt rating of Canadian Oil Sands Limited (COS or the Company) at BBB with a Stable trend and concurrently confirmed the stability rating of its parent, Canadian Oil Sands Trust (the Trust), at STA-4 (low). The rating confirmations followed the trend change to Stable from Positive on January 29, 2009 for the Company, and two single-notch downgrades for the Trust from STA-4 (high) to STA-4 (middle) in October 2008 and to STA-4 (low) in January 2009 due to their reduced financial flexibility and liquidity as a result of the substantially lower commodity prices versus its fairly fixed capex programs and upcoming debt maturities. Furthermore, higher-than-expected cuts to the quarterly per-unit distributions occurred (from $1.25 in August 2008 to $0.75 in November 2008 and $0.15 in January 2009).

With improved capital markets and crude oil pricing, COS successfully refinanced approximately US$500 million of debt maturities due in Q2 2009 and Q3 2009 with a new issue, improving its liquidity position. The Trust also increased per-unit distributions to $0.25 in August 2009 and $0.35 in October 2009 from $0.15 in January 2009 (after two substantial cuts from $0.75 in November 2008 and $1.25 in July 2009). Furthermore, the Company continues to maintain a solid operating profile, with well-defined long-life reserves, relatively low maintenance capex over time and no major expansion plans in the short term. The key to improving performance and, therefore, the credit rating profile is the ability of Syncrude Canada Limited (Syncrude) to grow production to design levels (70% achieved at the end of the nine months ending September 30, 2009 (9M 2009)) by year-end 2010 as planned by improving plant reliability, thus reducing operating costs and, to a lesser extent, to manage the environmental compliance requirements without undue capital costs.

Given a 100% oil-weighted operation and unhedged volumes, the Company’s financial profile has been adversely affected by the significantly lower crude oil prices that have resulted from the global economic downturn since Q3 2008. Credit metrics deteriorated as debt-to-cash flow rose to 2.4 times for the nine months ending September 30, 2009 (9M 2009), although the trailing ratio of 1.80 times for the last 12 months (LTM 9M2009) and debt-to-capital of 23% remain satisfactory.

With a slower-than-expected ramp-up in production and higher operating costs resulting from extensive turnaround activities, DBRS does not expect significant improvement in cash flow coverage ratios until 2010. With no debt maturities until 2013 and assuming current commodity prices prevail, potential higher per-unit distributions could occur in order to preserve tax pools (approximately $2 billion) to shelter taxes post-2010, when the proposed trust taxation commences. In addition, the Company has reaffirmed its targeted net debt of $1.6 billion by 2011 from $1.1 billion at 9M 2009, providing $500 million additional funding for distribution purposes, although achieving the target will depend on a number of factors, including operating results, commodity prices and economic conditions. The Company’s 2010 guidance, based on the WTI (West Texas Intermediate) price of US$70 per barrel (b), 90% of the design capacity being achieved in 2010 (70% at 9M 2009) and $540 million of capex would result in incremental debt. Under this scenario, DBRS estimates credit metrics will likely be maintained at acceptable levels for the current rating, with debt-to-capital of less than 30% and debt-to-cash flow of less than 2.0 times. Should crude prices fall below the guidance level, DBRS would expect the Company to adjust its distributions as seen in the past year to manage its credit profile. Its dividend reinvestment program (DRIP) could be reinstated to provide supplemental cash flow (used during 2009 and recently terminated), if required.

The Trust intends to convert to a corporate structure post-2010. DBRS will review final implementation and information details concerning capitalization and payout ratios, when available. In the near term, DBRS believes that this should not affect the Company’s credit rating.

The Company benefits from the following:

(1) The Trust’s 36.74% share in Syncrude’s long-life reserves (28 years, based on proven reserves) are well defined, with no exploration risk, compared to conventional royalty trusts or exploration and production (E&P) companies, which have depleting reserves and much shorter reserve lives.

(2) The Company’s potential liquidity concerns have been addressed with the new debt issue in May 2009 for refinancing purposes as mentioned above. With cash balances of $74 million at 9M 2009 and $840 million undrawn under its credit facilities, the Company retains sufficient liquidity. However, with the aforementioned potential increase in debt to reach the Trust’s $1.6 billion net debt target by 2011, leverage will likely creep up, although pro forma credit metrics are still consistent with the current rating.

(3) Ramp-up from the additional production capacity (37% net to the Trust for total gross productive capacity of 129,000 b/d or 350,000 b/d for Syncrude) associated with the completion of Stage 3, expected by the end of 2010, should enhance cash flow and reduce per barrel operating costs, partly offsetting volatility in commodity prices. Medium- to long-term prospects include de-bottlenecking for incremental production volumes of 50,000 b/d (up to 18,400 b/d net to COS, or 14% of current design capacity) by 2016 (delayed from the previously anticipated 2012) and Stage 4 expansion of 100,000 b/d post-2016. Both of these projects require unanimous consent of all joint-venture partners, including the Company.

(4) Strong sponsors/partners in Syncrude, including executives seconded from Imperial Oil Limited (Imperial Oil) and ExxonMobil Corporation (ExxonMobil) under a ten-year management services agreement expiring in 2017, provide project management experience and operational expertise.

There are several challenges that are considered manageable: (1) With 100% of production unhedged and weighted toward oil (albeit high-quality light sweet crude), the Company’s cash flow is highly sensitive to the price of oil. A US$1.00/b increase in the WTI crude price would raise cash flow by $33 million in 2010 ($31 million in 2009). In addition, operations are based solely in Alberta, which adds to concentration risk. (2) COS has high operating leverage as a large portion of total operating costs are fixed, with the remaining costs tied mainly to volatile natural gas prices (although lower prices have helped operating costs in 2009). (3) There are potential operating challenges associated with running complex cokers as unplanned outages may occur, the risk of which is partially mitigated by the benefits of having three cokers (as opposed to one) as well as the experienced operations team, helped by the strong partner in Syncrude. During 9M 2009, production was affected by a comprehensive turnaround of the coker and units associated with the Stage 3 expansion and reliability issues with another coker during the second quarter.

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

The applicable methodology is Rating Oil and Gas Companies, which can be found on our website under Methodologies.

This is a Corporate (Energy) rating.

This rating is based on public information.