Fitch Ratings has maintained KMG International's (KMGI) 'B+' Long-Term Foreign Currency Issuer Default Rating (IDR) on Rating Watch Negative.

The maintained RWN follows KMGI's announcement that JSC National Company KazMunayGas (NC KMG, BBB-/Stable) has agreed to sell China Energy Company Limited (CEFC) a 51% stake in KMGI. The RWN also captures the litigation brought forward in May by Romania's Directorate for Combating Organized Crime and Terrorism (DIICOT), where KMGI, Oilfield Exploration Business Solutions and Rompetrol Rafinare were summoned as civil liability parties in a case under investigation with DIICOT. The investigation may have significant negative financial consequences for KMGI. Fitch will resolve the RWN following the ownership change and clarification of potential consequences resulting from the investigation by DIICOT.

KEY RATING DRIVERS

Deal with CEFC Rating Negative

NC KMG and CEFC entered into a share purchase agreement in April 2016. Pursuant to the agreement, CEFC will become a 51% shareholder in KMGI. The parties are currently discussing details of the agreement following DIICOT's announcement in May. Should the deal be closed, we will probably rate KMGI on a standalone basis, resulting in a downgrade. We will reassess KMGI's standalone profile from the current 'CCC' to take into account potential contingent liabilities and leverage. If the investigation by DIICOT is concluded with no significant negative consequences for KMGI and the hybrid loan provided by NC KMG is converted into equity, leading to a significant decrease in leverage, we may view KMGI's IDR as commensurate with a rating in the low 'B' category.

Ratings Driven by Parental Support

Until the ownership change, KMGI's rating is based on a bottom-up approach in line with Fitch's parent and subsidiary rating linkage methodology. The rating reflects a three-notch uplift from the company's standalone credit profile, assessed at 'CCC' due to a weak financial profile (end-2015: funds from operations (FFO) adjusted net leverage of 12.9x), for parental support from NC KMG.

Fitch currently assesses the strategic and legal ties between KMGI and NC KMG as moderate to strong, which supports the three-notch uplift to KMGI's standalone rating. If the deal to sell the majority interest to CEFC is not completed, Fitch will consider whether this notching should be maintained or reduced on the basis of information available at the time. The present legal ties between KMGI and NC KMG include a direct guarantee of KMGI's debt (USD200m) and a cross-default provision in the documentation for NC KMG's USD7.5bn global medium-term note programme, which also relates to KMGI's debt. Historical financial support has taken the form of a USD1.1bn cash injection as capital increase, and shareholder loans (USD0.9bn) converted into a 51-year hybrid loan. Fitch expects that KMGI will no longer qualify as a material subsidiary under NC KMG's bond documentation once the sale of the majority stake to CEFC is finalised and hence NC KMG's debt will not be subject to a cross-default provision with KMGI's borrowings.

DIICOT Investigation

On 9 May 2016 DIICOT announced that it had launched an investigation against 14 people in connection with the privatisation of the Petromidia refinery. KMGI, Oilfield Exploration Business Solutions (the former Rompetrol SA) and Rompetrol Rafinare are parties in the investigation. DIICOT also seized KMGI's assets of RON3bn (USD770m) including KMGI's key asset - Petromidia refinery. We understand that the seizure has no immediate impact on KMGI's day-to-day operations. KMGI is preparing a vigorous legal defence on the case, to challenge on merit the allegations in Romanian courts and, if necessary, in international arbitration courts. Importantly, the seizure of the refinery initiated in 2010 is still ongoing.

Share Buyback Plans

KMGI's repurchase of 27% of Rompetrol Rafinare S. A.'s (RRC) shares from the government for USD200m has not yet taken place as envisaged in the Memorandum of Understanding (MoU) between KMGI and the government in 2014. The repurchase was intended to close a dispute with the government regarding conversion of KMGI's bonds into shares. Fitch expected that transaction would be financed by KMGI's parent. Due to lack of progress in implementing the 2014 MoU and the ongoing DIICOT investigation, we do not expect the dispute between KMGI and the Romanian government relating to the conversion of bonds to equity will be cleared based on the MoU.

Stronger Standalone Performance

Strong refining margins in Europe in 2015 allowed KMGI to improve its standalone performance. The company's Fitch-calculated EBITDA increased to USD148m (USD113m in 2014). FFO net leverage, including the 51-year hybrid loan of USD920m from NC KMG, remained elevated (12.9x). Excluding the loan, net leverage amounted to 5.2x. The lower cost of crude for own consumption, more optimistic outlook for European and global fuel demand under lower oil prices, collapse of WTI-Brent spread limiting the competitive advantage of US refiners over their European peers to some extent offset overcapacity in the European downstream market. KMGI's Petromidia plant benefits from a relatively high refining complexity (Nelson complexity index of 10.5). In addition, KMGI's EBITDA has historically been supported by relatively stable retail and marketing operations.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- Gross refining margins of USD5.5/bbl in 2016 and USD5/bbl thereafter.

- Stable EBITDA generation of the retail and marketing segment.

- Annual EBITDA averaging USD160m in 2016-2019.

- Improved leverage metrics on the back of higher cash flow generation.

- Support from NC KMG for repurchase of RRC shares.

- Average 2016-2019 capex equal to USD87m annually.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- Weaker ties with NC KMG leading to a reassessment of the three-notch uplift to the standalone IDR for parental support.

Positive: Future developments that may, individually or collectively, lead to positive rating action including an affirmation are:

- Unchanged strategic, legal and operational ties between KMGI and NC KMG.

LIQUIDITY

At end-2015, KMGI's short-term debt was USD285m against an unrestricted cash balance of USD92m. The company's end-2015 liquidity was supported by USD83m of undrawn credit lines that mature in more than one year, of which USD25m was committed. KMGI plans to roll over around USD230m of short-term credit facilities in 2016. Fitch does not expect the company to experience problems with liquidity as KMGI has a record of successful short-term debt extension.

KMGI's debt excluding the hybrid loan from NC KMG was USD680m as of 31 December 2015, down from USD761m at end-2014. The decline in debt is largely related to the sale of 51% stake in Rompetrol France SAS, a company engaged in fuel trading and marketing in France and Spain, which was deconsolidated in 2015.