DBRS Rates Vermilion Energy at BB (low), Stable Trend

DBRS has today assigned an Issuer Rating of BB (low) with a Stable trend to Vermilion Energy Inc. (Vermilion or the Company). Pursuant to DBRS’s leveraged finance rating methodology, a recovery rating of RR3 has also been assigned to Vermilion’s proposed Unsecured Notes, with a corresponding provisional instrument rating of BB (low). The trends are Stable. The proposed unsecured notes, estimated at $200 million and supported by subsidiary guarantees, are structurally subordinated to Vermilion’s secured bank facility. Proceeds from these notes are expected to be primarily used to pay down the bank facility. The assigned ratings reflect the Company’s strong financial profile and diverse operations, with a considerable international presence (average of over 60% of production since 2005). Vermilion also benefits from lower royalties and higher netbacks in its international regions than in western Canada where most of its peers are focused.

Substantial growth prospects exist through organic expansion, as reaffirmed by the Company following its recent corporate conversion. While a departure from the Company’s previous acquisition-driven incremental expansions, DBRS expects that this growth target should be mostly achievable, underpinned by the natural gas project in Corrib offshore Ireland (Corrib - $137 million purchase cost in 2009) and stepped up Canadian developments (primarily the Cardium crude oil project).

Corrib is scheduled for first gas by late 2012, adding about 30% to current volumes for a total 50% growth target by 2015, or a 10% compound annual increase as indicated by the Company. The Corrib project is relatively low risk and includes the related infrastructure. Elsewhere, the Netherlands operations should add to production in 2011. Furthermore, despite its 60% oil-weighted operations, about 80% of the Company’s production is linked to oil prices, benefiting from current favourable prices, which will likely prevail in the near to medium term.

However, there are limiting factors to the assigned ratings. (1) During its growth phase, Vermilion’s balance sheet leverage will increase, with capex and dividends exceeding operating cash flow at least until Corrib commences. DBRS expects the Company to incur substantial capex over the next few years. Capital spending of $460 million (similar to 2010 levels) is planned in 2011 versus an annual average of about $310 million for capex/acquisitions for 2005 to 2009. About $110 million of 2011 capex is earmarked for Corrib. The Corrib purchase also includes a future payment expected at US$135 million, which DBRS anticipates will be mostly debt funded. (2) The Company’s plans to maintain stable distributions by way of dividends per share at $0.19 per month, unchanged since established in December 2007, will likely result in over 50% payout based on operating cash flow (56% for the 12 months ended September 30, 2010 (LTM)) for the next two to three years, requiring external funding for any potential funding shortfalls. However, the payout level is comparable with the levels seen among other recently converted E&P corporates. (3) The Company’s ability to grow gross production to the target levels of 45,000 boe/d to 50,000 boe/d is important in enhancing economies of scale through achieving critical mass levels. (4) Unlike its domestic operations, the Company’s international and offshore operations carry associated risks. It is noteworthy that all assets are located in France, the Netherlands, Australia and Ireland, all member states of the Organization for Economic Cooperation and Development (OECD), with low political risks. About one-third of current volumes and nearly 30% of proved reserves in 2009 were in western Canada. Canada will assume increasing importance, underscored by the Cardium oil and liquid rich gas drilling potential in Alberta; approximately $472 million, or 52%, of capex for 2010 and 2011 is projected for Canada. (5) All-in operating costs ($16.54/boe (net after royalties) for production and transportation in 9M 2010) and general & administration expenses are relatively high, partly due to the fairly self-sufficient international regions and the effective prepayment of transportation costs for Corrib.

Based on WTI of US$78/b, similar to the 2010 average, debt-to-cash flow could reach 1.9 times (0.74 times for LTM), which is acceptable for the assigned ratings. Should crude oil prices decline sharply from current levels (although this is not expected in the near term), DBRS estimates that this ratio would exceed 2.0 times, with debt-to-capital likely exceeding 40%. DBRS expects the Company to have sufficient flexibility in its capex and/or dividend distribution programs, in order to maintain its financial metrics within the parameters of the assigned ratings. Post-Corrib, the Company intends to maintain capex and dividends within cash flow as in the past, at a target level of 70% to 80%, which is more conservative than many of its peers. Management and directors continue to hold about 9% of shares, aligning their interest with the other stakeholders. Hedging is expected to remain part of the strategy to provide certain stability in earnings and cash flow during the accelerated growth phase (covering about 40% of 2011 planned volumes). In addition, the bulk of production should continue to be priced to crude oil, primarily, the Netherlands and Irish gas volumes. As Vermilion expands, DBRS expects the Company to focus on improving capital efficiency and its cost base. The dividend re-investment plan reinstated in early 2010 should provide incremental funding ($27.4 million in 9M 2010), supplementing cash flow going forward.

With fairly stable production volumes, France and Australia should continue to generate significant free cash flow to augment growth in other regions, principally developments in Canada and the advancement of Corrib. The Company also maintains sufficient liquidity through its secured credit facility with $635 million of borrowing base currently ($386 million available based on outstandings at September 30, 2010). Any bond issuance should extend the debt maturities beyond 2015.

Pursuant to our rating methodology for leveraged finance, DBRS has created a hypothetical default scenario for the Company, which includes estimating when and under what circumstances a default could occur. As part of the analysis, DBRS estimates the potential recovery value of the assets of the Company that would be available to satisfy the various claims of creditors under this scenario. The scenario assumes that the economy fails to recover and falls into a recession again in 2012 with a sharp drop in crude oil prices.

DBRS has determined the Company’s estimated value at default using both EBITDA multiples and per flowing barrel valuation approaches, as default would likely result in the restructuring of the Company or its acquisition by other industry participants, as opposed to the forced sale of its individual assets under a liquidation scenario. EBITDA multiples utilized are applied to cyclically normalized EBITDA discounted at 45% at default, incorporating the impact of lower crude oil prices and lower production due to theoretical operational problems. The per flowing barrel valuation approach applies a very conservative value of $35,000 per boe/d of production with the estimated volumes reduced 35% from year end projected levels. The respective valuation considers the payment priority of the specific debt instruments, and allocates proceeds accordingly. DBRS has estimated the economic value of the components of the enterprise at: (1) approximately $745 million using a 4.0 times (x) multiple of normalized EBITDA at a 45% discount, as mentioned above, and (2) approximately $750 million based on $35,000 per flowing barrel value. Therefore, the recovery for the Unsecured Notes is estimated in both cases to be between 50% and 70%, resulting in an assigned recovery rating of RR3. The provisional instrument rating of the Unsecured Notes is BB (low). Eliminating the notching of the instrument rating of the Unsecured Notes, instead of the customary one notch for an RR3 rating, largely reflects the potential upsizing of the secured debt as estimated by DBRS, in order to fund the accelerated growth to 2015, which ranks ahead of the unsecured notes and would likely have an impact on the future recovery prospects.

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

The applicable methodologies are Rating Oil and Gas Companies and Rating Methodology for Leveraged Finance, which can be found on our website under Methodologies