OREANDA-NEWS. Fitch Ratings has assigned Corral Petroleum Holdings AB (CPH) an expected Long-term Foreign-Currency Issuer Default Rating (IDR) of 'B+' with Stable Outlook. Fitch has also assigned Corral's proposed payment-in-kind toggle notes (PIK) issue an expected rating of 'B(EXP)'. The final ratings will be contingent on successful issuance of PIK notes and the receipt of final documents conforming to information already received.

The ratings are supported by the high complexity of CPH's refinery in Lysekil, increasing biodiesel sales, and strong liquidity. The ratings are constrained by the inherent volatility of the refining earnings, weaker business diversification than peers, and high leverage.

CPH is a holding company, and owns Preem AB, a medium-sized, Sweden-based refining company that operates two refineries (89% of EBITDA) and a retail network (11% of EBITDA). CPH accounts for 80% and 29% of Swedish and Nordic refining capacity, respectively. The marketing segment includes 341 Preem-branded stations and 165 diesel truck stops. CPH's ultimate shareholder is Mohammed Al-Amoudi, who acquired the company in 1994.

KEY RATING DRIVERS
Good-Quality Assets
Preem operates two refineries, the 220,000 barrel per day (bpd) Preemraff Lysekil plant and the 125,000 bpd Premraff Gothenburg site. Lysekil is a hydrocracking refinery with a Nelson complexity index (NCI) of 10 using mainly sour crude (81% of total feedstock). The Gothenburg refinery operates as a hydroskimming plant with an NCI of 7.1, processing primarily (91%) sweet crude. The average NCIs in Europe and North America were 9 and 11.7, respectively, in 2014.

We view the high complexity of the Lysekil refinery positively, as it allows the company to benefit from higher yield of light and middle distillates (diesel and gasoline account for 74% of output) and the ability to process lower-quality crude blends such as Urals.

Hydroskimming margins were on average USD5.1/bbl lower than hydrocracking margins in 2011-2015 in northwest Europe, which limits the profitability of the Gothenburg site. However, use of renewable feedstock and large storage capacity, coupled with coastal location and access to a variety of crude oil blends allowed CPH to reach gross margins at Gothenburg that were USD3.1/bbl higher in 2011-2015 than the average for hydroskimming refineries in northwest Europe.

We view Preem's overall asset quality as good. Its coastal location allows it to use short-term possibilities for crude oil supply and shipping products to external customers, but also exposes Preem to significant global competition, where trade in oil products is increasing.

Focus on Refining
CPH's retail network accounts for about 11% of EBITDA, which is positive for the credit profile because of the greater stability of marketing earnings than refining margins. However, the concentration of earnings on supply and trading of refined products means CPH's business diversification is weaker than for peers such as Polski Koncern Naftowy ORLEN S.A. (BBB-/Stable) or MOL Hungarian Oil and Gas Company Plc (BBB-/Stable), which also own petrochemical and upstream assets and have strong retail networks.

CPH's closest peer is Turkiye Petrol Rafinerileri A.S. (BBB-/Stable), which is also predominantly focused on supply and trading of oil products. Its ratings are supported by the growing Turkish fuel market and lower leverage on a through-the-cycle basis.

Biofuel Supports Results
CPH is the largest supplier of ultra-low-sulphur diesel fuel in Sweden, with a sulphur content of less than 5 parts per million, significantly below the Euro 4 requirement of 50 parts per million. CPH's biofuel, which qualifies as Swedish Environmental Class 1 diesel, attracts tax incentives from the Swedish Tax Agency of about EUR0.60 per litre. CPH produces 160,000 cubic metres of the biofuel, which translates into an annual tax incentive of SEK900m.

The current Swedish regulation will remain until 2018 and is then likely to be replaced with a new permanent system. Although there is a risk that tax incentives will be lower after 2018, we assume the difference would not be material due to European government's support for environmentally friendly policies. CPH also plans to increase biofuel output, which may help offset potential negative tax changes.

Volatile Cash Flows and Credit Metrics
Comparability of results between periods is hindered by inventory effects. Fuel prices tend to lag behind oil prices. Therefore when oil prices fall, as in 2014, fuel prices at the time of sale reflect lower crude oil prices than the price at the time of refining. This reduces gross profit. The impact on cash flow from operations and free cash flow is typically offset by working capital inflows.

Nevertheless, the inherent volatility of refining margins coupled with the inventory effect has resulted in significant swings in CPH's historical leverage metrics. FFO net adjusted leverage was 5.0x in 2015 and we expect the ratio to be 3.6x-4.6x in 2016-2018. Our forecasts, prepared on a current cost of supply basis assuming hydrocracking margins in northwest Europe of around USD5/bbl and Fitch's oil price deck (USD35/bbl in 2016, USD45/bbl in 2017 and USD55/bbl in 2018), show much more stable cash flows. However, a period with low refining margins and more volatile oil prices may result in high inventory effects and working capital swings affecting CPH's credit metrics. The volatility is largely offset by deleveraging plans and good liquidity.

Manageable Capex Requirements
Annual capex requirements total around SEK1bn. Spending in 2016 and 2017 will be higher, between SEK1.5bn and SEK2.4bn, mainly due to turnaround at the Gothenburg refinery and investment in vacuum distillation equipment at Lysekil, planned to be completed in 4Q18 (expected payback period of 3 years). CPH also plans to further increase its retail network in the medium term. The next turnaround at Lysekil will be in 2019.

Favourable Refining Environment
CPH's net refining margins in 2015 increased to USD6.62bbl (USD4.12/bbl in 2014), in line with the improved European refining environment. Fitch expects refining margins to moderate in 2016 from the highs of 2015, but they are unlikely to revisit the lows of 2H13 and 1H14, due to depressed oil prices supporting demand for fuel and lower cost of oil for refineries' own consumption.

Oversupply in Europe to Return
The longer-term outlook for Europe's refining sector is more uncertain. Excess refining capacity, structural decline in fuel consumption because of growing engine efficiency and environmental policies, and stronger competition from new refineries in the Middle East are likely to put pressure on the European refining sector in the medium to long term. CPH supplies fuel mainly to mature markets such as the UK, Sweden and the Netherlands (35%, 16% and 14% of total supply and trading revenue, respectively), where we expect demand to shrink due to structural factors such as improved energy efficiency and greater use of renewable energy.

Competition in Crude to Benefit European Refiners
The lifting of the US ban on oil exports in December 2015 resulted in the Brent-WTI differential collapsing, which improved the competitiveness of European refining companies compared with their US peers. We expect the Brent-WTI differential to remain nil on average over the rating horizon, although with significant volatility.

The discount of Urals crude oil to Brent widened in 4Q15 and exceeded USD3.5/bbl in late October and November 2015, compared with the average of USD1.3/bbl in 2012-2014. The widening gap reflected higher availability of Russian crude in the Baltic Sea region as production in Russia reached post-Soviet highs. Saudi crude oil deliveries to PKN and Preem in early November might have also contributed to the widening Urals discount. This is positive for the refinery in Lysekil, which mainly uses Russian crude oil.

Consolidated Rating Approach
Preem has a USD1.5bn borrowing base and revolving credit facility, which contains a cross-default provision. CPH's subordinated PIK toggle notes contain a cross-payment default provision. The senior lenders at Preem level will negotiate in good faith before opting to accelerate, but once that happens all the debt becomes due and payable. Fitch has therefore ascribed a Long-term IDR to the restricted group comprising the issuer and its subsidiaries, the most important of which is Preem. The shareholder loans were excluded from the debt amount, as they are structured to have equity-like characteristics.

High Recoveries
In an enforcement scenario all or most of the exposure at Preem level can be satisfied through collection of receivables and marketing of crude and inventories. Although the banks are over-collateralised and may enforce against the refinery and other assets, if necessary, recovery analysis indicates that the creditors at CPH level should be able to comfortably achieve RR5 recoveries, even in a distressed scenario.

The subordinated PIK toggle notes make up a much higher proportion of permanent debt, effectively financing long-term assets, than for leveraged finance transactions rated in the 'B' category, where the second lien or mezzanine debt layer normally only accounts for 15%-25% of long-term debt. These proportions result in better recoveries for Corral, as a large part of the proceeds from fixed assets should be available for distribution among the subordinated PIK toggle note holders.

KEY ASSUMPTIONS
Fitch's key assumptions within its rating case for the issuer include:
- Brent price of USD35/bbl in 2016, USD45/bbl in 2017, USD55/bbl in 2018 and USD65/bbl in 2019
- North-west Europe hydrocracking margin of USD5.5/bbl in 2016, USD5/bbl in 2017-2019
- US dollar/Swedish kroner exchange rate of 8.9 in 2016, 8.2 in 2017, 7.5 thereafter
- Capital expenditure of SEK1.5bn in 2016, SEK2.4bn in 2017 and SEK1.1bn in 2018

RATING SENSITIVITIES
Positive: Developments that may, individually or collectively, lead to positive rating action include:
- Reduction in gross debt (revolving credit facility and PIK toggle notes)
- Higher business diversification leading to less volatile cash flows
- FFO-adjusted net leverage sustained below 3.5x
- Quicker-than-expected refining capacity reduction in Europe leading to improved outlook for margins

Negative: Developments that may lead to negative rating action include:
- Failure to maintain refining margins at the Gothenburg refinery above benchmark
- Unfavourable changes in regulation for biofuels
- FFO-adjusted net leverage sustained above 5.5x

LIQUIDITY
CPH plans to reduce its gross leverage. In 2016 the company expects to make a final payment under the USD650m term loan entered into in 2011 (outstanding balance at end-September 2015 of USD133m). CPH can amortise 10% of the PIK notes annually from 2017. At end-2015 utilisation under the credit facility at Preem was around USD0.8bn. The borrowing base of the loan corresponds to the balance of receivables and inventory and the limit can be increased to USD1.65bn and then further to USD1.8bn if the oil price rises above USD100/bbl.

SUMMARY OF FINANCIAL STATEMENT ADJUSTMENTS

Fitch has adjusted the balance sheet debt by capitalising the annual operating lease of SEK50m using the standard 8x multiple. As a result the debt increased by SEK400m.

Additionally, Fitch has decreased the balance sheet debt by excluding the shareholder loan and subordinated notes, amounting to SEK6,025m, due to their equity-like characteristics.