DBRS Confirms Nexen Inc.’s Long-Term Unsecured Debt at BBB, Stable Trend

DBRS has today confirmed the Long-Term Unsecured Debt of Nexen Inc. (Nexen or the Company) at BBB and its Subordinated Unsecured Notes at BBB (low), both with Stable trends. The rating confirmations reflect DBRS’s expectation that the Company’s credit profile will benefit from the use of proceeds from the pending sale of its western Canadian heavy oil assets for net debt reduction and from reduced earnings and cash flow volatility following the exit from most of its power and natural gas energy marketing activities.

In May 2010, Nexen reached an agreement to sell its western Canadian heavy oil assets for approximately $975 million (before closing adjustments and costs). For the 12 months ending March 31, 2010, the properties produced 16,100 gross barrels of oil equivalent per day (boe/d) and generated $130 million of cash flow. The transaction is expected to close on June 30, 2010, and result in a reported gain in excess of $700 million. On a pro forma basis, DBRS estimates that this transaction would reduce the Company’s net debt-to-capital ratio from 39% to 33% and its net debt-to-cash flow ratio from 2.4 times to 2.2 times. DBRS expects the Company to reduce its net debt-to-cash flow ratio to below 2.0 times by year-end 2010 in order to retain the current ratings. The Company sold its European gas and power marketing business for net proceeds of $15 million in Q1 2010 and expects to close the sale of its North American natural gas marketing business in Q3 2010 for no cash proceeds, recognizing a non-cash loss on the sale of between $250 million and $290 million.

The planned exit from most of its energy marketing activities will result in reduced earnings and cash flow volatility and reduced potential for liquidity needs to meet collateral requirements from counterparties. Despite the minimal cash proceeds received, DBRS expects these developments to improve the Company’s business risk profile.

Nexen continues to benefit from its strong production base in the United Kingdom (U.K. North Sea). Beginning in 2008, the region has accounted for most of Nexen’s exploration and production (E&P) earnings, reflecting its rapid production ramp-up, and has one of the highest netbacks among the regions in which the Company operates. The U.K. North Sea accounted for 48% of total production and 64% of total E&P EBIT before depreciation, exploration and amortization (DE&A – EBITDEA) in 2009. Yemen was the next largest contributor, accounting for 14% of total production and 15% of E&P EBITDEA.

Production ramp-up of the Long Lake in-situ oil sands project (Long Lake) in Alberta, in which Nexen has a 65% operating interest (50% prior to late January 2009), has been slower than originally anticipated. Steam assisted gravity drainage (SAGD) bitumen operations started in mid-2008 and Long Lake began producing premium synthetic crude oil (PSC) from the upgrader in January 2009. In late April 2009, Nexen indicated that it expected Long Lake to reach full design rates of 72,000 b/d of gross bitumen production, upgraded to approximately 60,000 b/d (39,000 b/d net to Nexen) of PSC during 2010. However, in late October 2009, the Company indicated that full design rates were no longer expected to be achieved during 2010. Long Lake’s gross bitumen production increased from 14,000 b/d in Q4 2009 to 19,000 b/d in Q1 2010 and approximately 25,000 b/d in late April 2010. Given the track record to date, reaching the Long Lake full design rates over the next year will be challenging, although progress continues to be made.

The Company has several development projects that provide potential for future production growth. In December 2009, Nexen provided a net production guidance range of 200,000 boe/d to 250,000 boe/d for 2010 (compared with 213,200 boe/d in 2009). Subsequently, Nexen reached an agreement to sell its western Canadian heavy oil assets (which produced 16,100 gross boe/d over the 12 months ending March 31, 2010), with the transaction expected to close in July 2010. Long Lake production has continued to slowly ramp up, and total Q1 2010 production was 221,300 boe/d, 1.6% below Q1 2009 production.

DBRS expects 2010 net income (before extras) to be moderately higher than 2009 levels and the Company’s $2.5 billion capital program for 2010 to be funded by cash flow, based on mid-US$70 per barrel crude oil prices and on production in the lower half of the guidance range. However, these expectations are subject to downside risk in the event that crude oil prices decline substantially from the US$78 WTI average experienced in the first half of 2010 (US$78.71 in Q1 2010) and production nears the low end of the guidance range. Nexen has put options in place on 90,000 b/d of its 2010 crude oil production (40% of 2010 mid-point production guidance) at a floor price of US$50 per barrel, providing some downside price protection. The Company has maintained strong liquidity, with cash balances of $2.0 billion and availability under committed credit facilities of $1.2 billion at March 31, 2010, with no refinancing needs until 2013.

Medium-term production growth is expected to come from projects in Canada (e.g., the Long Lake ramp-up and expansion and the Horn River shale gas play in British Columbia), the deepwater of the United States Gulf of Mexico (U.S. GOM, although subject to delay after the recent suspension of drilling by the U.S. government, which was overturned and subsequently appealed), the U.K. North Sea (Golden Eagle) and offshore West Africa (Usan field offshore Nigeria). DBRS estimates that the U.S. GOM accounted for only 8% of Nexen’s production and 7% of its E&P EBITDEA in 2009 and that its current production will not be affected by the U.S. government’s recent actions.

Nexen’s production and reserve mix (84% and 93%, respectively, in 2009) is highly weighted to crude oil, although this has been partly hedged in 2010 as noted above. The Company’s large exposure to crude oil prices, while a positive factor at current low natural gas prices, results in greater cash flow volatility compared with companies with more balanced production profiles.

The Company has had high reserve replacement costs in recent years. While industry-wide cost inflation adversely affected E&P companies in recent years, Nexen’s three-year average conventional reserve replacement costs of $42.43/boe from 2007 to 2009 ($30.29/boe, excluding the U.S. Securities and Exchange Commission (SEC) transition rule writedown of Long Lake reserves) compares poorly with those of its peer group, in part due to the nature of Nexen’s projects that have long lead times with heavy upfront capital requirements and subsequent delays prior to proved reserve additions. (The SEC transition rule writedown noted above refers to the fact that reserves are now based on the final product sold after field upgrading rather than on the product initially produced, resulting in Long Lake oil reserves being presented as synthetic oil barrels rather than bitumen barrels). Annual conventional reserve replacement costs ($20.86/boe, excluding the SEC transition rule writedown of Long Lake reserves, in 2009 compared with $51.72/boe in 2008) suggest recent improvement in performance. However, the Company’s inconsistent reserve replacement results will remain a key challenge due to its large-project growth strategy, although this could be partly mitigated in the future by shorter-cycle projects such as development of the Horn River shale gas play.

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

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

This is a Corporate (Energy) rating.