DBRS Morningstar Confirms Ratings of Source Energy Services Canada LP and Source Energy Services Canada Holdings Ltd. at CCC, Stable Trends

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating and the Senior Secured First Lien Notes Due 2025 (the Senior Notes) rating of Source Energy Services Canada LP and Source Energy Services Canada Holdings Ltd. at CCC. Both trends are Stable. The Recovery Rating on the Senior Notes remains unchanged at RR4. DBRS Morningstar has based its analysis on the consolidated financial statements of the ultimate holding company, Source Energy Services Limited (Source or the Company). The ratings are underpinned by Source’s integrated operations, storage, and logistics infrastructure that provide the Company with a competitive advantage in the Western Canadian Sedimentary Basin (WCSB). However, the ratings are constrained by the Company’s weak financial risk profile due to its high financial leverage. The Stable trends reflect DBRS Morningstar's expectation that Source's earnings and cash flow will increase in 2022 as stronger oil and gas (O&G) prices are likely to spur higher drilling and completion activity.

Source’s sand sales volumes improved materially in the first nine months of 2021 (9M 2021) as activity levels in the WCSB recovered after the pandemic-induced collapse in 2020. Source maintained its position as the leading supplier of northern white sand in the basin and added three new customers and secured contract extensions with two major customers. Source continued to benefit from cost reduction measures implemented in 2020; however, the Company also started to experience inflationary pressures on labour and fuel costs in 2021. Improved earnings along with a reduction in ongoing lease payments and the ability to Pay Interest-in-Kind (PIK) on the Senior Notes enabled the Company to generate a free cash flow (FCF; cash flow after capital expenditure, dividends, and lease payments) surplus during 9M 2021 that was used to reduce borrowings under its asset-backed credit facility (the Credit Facility). Nonetheless, overall debt levels at September 30, 2021, remained relatively unchanged compared with year-end 2020 as the reduction in the debt drawn on the Credit Facility was offset by an increase in Senior Notes due to the exercise of the PIK option.

DBRS Morningstar expects activity levels in the WCSB to improve modestly in 2022 despite strong commodity prices as O&G producers continue to focus on maintaining capital discipline, deleveraging, and returning capital to shareholders. DBRS Morningstar also expects the Company's earnings and cash flow to improve in 2022 and the Company to generate adequate FCF surplus to meet its scheduled debt repayment obligations ($7.5 million) despite the resumption of cash interest payments on the Senior Notes. While it is improving, Source’s overall financial risk profile is anticipated to remain weak with lease-adjusted debt-to-cash flow ratio above 6.0 times (x) in 2022.

Source remains dependent on activity levels improving in the WCSB and has limited flexibility to withstand market volatility given its high leverage. The primary source of the Company's liquidity is its Credit Facility and there is limited headroom under some of the Credit Facility covenants. If earnings and cash flow do not improve in line with DBRS Morningstar’s base-case assumptions or the Company’s liquidity profile deteriorates materially and/or financial covenants are breached, a negative rating action is possible. Alternatively, DBRS Morningstar may consider a positive rating action if the Company maintains satisfactory liquidity and the lease-adjusted debt-to-cash flow ratio improves sustainably to 6.0x or less.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodologies are Rating Companies in the Oil and Gas and Oilfield Services Industries (August 16, 2021; https://www.dbrsmorningstar.com/research/383104), DBRS Morningstar Criteria: Recovery Ratings for Non-Investment-Grade Corporate Issuers (August 19, 2021; https://www.dbrsmorningstar.com/research/383238), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (May 31, 2021; https://www.dbrsmorningstar.com/research/379424), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at [email protected].

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

DBRS Morningstar will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving the report, contact us at [email protected].

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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