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 metrics will improve as a result of successful execution of its announced March 2011 plan to reduce its total debt by approximately $1.5 billion by late 2011 or early 2012 (from approximately $5.1 billion at year-end 2010), which should reduce its total debt-to-cash flow ratio to below two times, more in line with the current ratings. Total debt was $4.264 billion at March 31, 2011 (pro forma the US$500 million ($534 million) bonds redeemed in April 2011).

Nexen’s financial profile remains aggressive relative to its peers, partly due to the slower than expected production ramp-up of its 65%-owned and operated Long Lake in-situ oil sands project (Long Lake) in Alberta, as demonstrated by its weak credit metrics in a lower crude oil price environment in 2009. Nexen has since used asset sale proceeds to repay debt and reduce its net debt-to-capital ratio to 29.6% at March 31, 2011 from 42.1% at year-end 2009 and its net debt-to-cash flow ratio to 1.64 times in the 12 months ending March 31, 2011 (LTM March 2011) from 3.23 times in 2009. Nexen’s total debt-to-cash flow ratio of 2.32 times (2.05 times pro forma the April 2011 bond redemption) in LTM March 2011 remains relatively high given current strong crude oil pricing and is expected to improve as noted above. Nexen’s $2.4 billion to $2.7 billion capital program for 2011 should be fully funded by cash flow, based on strong crude oil prices despite production at, or potentially marginally below, the low end of the November (Nov.) 2010 guidance range (see below).

Nexen maintains strong liquidity, with cash of $0.8 billion (net of the bond redemption) and availability under committed credit facilities of $2.6 billion at March 31, 2011, and minimal refinancing needs until 2019.

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 production ramp-up, and has the highest netbacks among the regions in which the Company operates. The U.K. North Sea accounted for 51% of total production and 69% of total E&P EBIT before depreciation, exploration and amortization (DE&A – EBITDEA) in 2010.

Production ramp-up of Long Lake has been much 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 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. The Company’s 2011 Long Lake production guidance range in Nov. 2010 was 38,000 b/d to 45,000 b/d (25,000 b/d to 29,000 b/d net to Nexen). However, in order to reach the low end of the range, production would have to average 42,200 b/d (27,800 b/d net to Nexen) over Q2 2011 to Q4 2011, or 50% higher than the Q4 2010 peak, which is unlikely.

In June 2011, OPTI Canada Inc. (OPTI, 35% interest in Long Lake) announced that it would not pay the interest due on certain of its outstanding long-term debt on June 15, 2011. OPTI has a 30-day grace period following which it would be in default of its obligations. DBRS does not expect any negative consequences for Nexen in that event, as the Company is well protected by its Long Lake operating agreement with OPTI.

In May 2011, Nexen indicated that it expected 2011 production to be at the low end of the Nov. 2010 net guidance range of 210,000 boe/d to 240,000 boe/d for 2010 (compared with 220,100 boe/d in 2010) following recent downtime at Buzzard (U.K. North Sea) and Yemen. Total production in Q1 2011 was 207,200 boe/d, or 6.4% below Q1 2010 production (1.1% excluding the Canadian heavy oil assets sold in July 2010). DBRS expects 2011 net income (before extras) to be modestly higher than 2010 levels, based on strong crude oil prices (average of US$111 per barrel Brent and US$98 per barrel WTI to date) despite production at, or potentially marginally below, the low end of the Nov. 2010 guidance range. DBRS expects the impact of the recent U.K. tax increase to be partly mitigated by Nexen’s intention to reinvest capital in the country.

Medium-term production growth is expected to come from projects in Canada (e.g., the Long Lake ramp-up, its Phase 2 (Kinosis) expansion and the Horn River shale gas play), the U.S. deepwater Gulf Of Mexico (GOM) (although delayed subject to delays given the very slow ramp-up after the 2010 suspension of drilling by the U.S. government), the U.K. North Sea (Golden Eagle and other tie-backs) and offshore West Africa (Usan field offshore Nigeria). In Yemen, Nexen (52% working interest, operator) is negotiating a five-year extension of the Masila Production Sharing Agreement (PSA), although it may not be in place by the December 17, 2011, expiry date.

Nexen’s production and reserve mix is highly weighted to crude oil (81% and 92%, respectively, in 2010), although this has been partly hedged in 2011. Nexen has price protection in place (through put options) on 100,000 b/d of its 2011 crude oil production (48% of its 2011 low-point Nov. 2010 guidance) at monthly WTI floor prices of between US$50 per barrel and US$63 per barrel while maintaining the upside of higher crude oil prices. The Company’s large exposure to crude oil prices, while a positive factor at current high crude oil and low natural gas prices, results in greater cash flow volatility compared with companies with more balanced production profiles.

Nexen has had high reserve replacement costs in recent years. Nexen’s three-year average conventional reserve replacement costs (including Long Lake) of $28.46 per barrel of oil equivalent (boe) from 2008 to 2010 (excluding the 2009 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 (including cost overruns at Long Lake) and subsequent delays prior to proved reserve additions. Nexen’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.