OREANDA-NEWS. Fitch Ratings has assigned OMV AG's proposed subordinated fixed-to-reset rate euro-denominated notes an expected rating of 'BBB(EXP)'. The securities qualify for 50% equity credit. The final rating is contingent on the receipt of final documents conforming materially to the preliminary documentation.

The expected rating for the proposed hybrid capital securities reflects the highly subordinated nature of the notes, which are considered to have lower recovery prospects in a liquidation or bankruptcy scenario than senior debt. The equity credit reflects the structural equity-like characteristics of the instruments including subordination, maturity in excess of five years and deferrable interest coupon payments. Equity credit is limited to 50% given the securities' cumulative interest coupon, a feature considered more debt-like in nature.

The notes' rating and assignment of equity credit are based on Fitch's hybrid methodology, dated 25 November 2014 ("Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis" available on www.fitchratings.com).

KEY RATING DRIVERS FOR THE NOTES
Ratings Reflect Deep Subordination
The proposed notes have been notched down by two notches from OMV's Long-term Issuer Default Rating (IDR) given their deep subordination and consequently, the lower recovery prospects in a liquidation or bankruptcy scenario relative to the senior obligations of the issuer. The bonds rank pari passu with OMV's fixed-to-floating EUR750m notes issued in 2011, also rated 'BBB' with 50% equity credit.

Equity Treatment
The proposed securities qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, remaining effective maturity of at least five years, full discretion to defer coupons for at least five years and limited events of default. These are key equity-like characteristics, affording OMV greater financial flexibility.

Effective Maturity Date
While the proposed notes are perpetual, Fitch deems the effective, remaining maturity as 2026 for the short tranche (NC6) due to the notes' 100bps coupon step-up from year 10 and the lack of replacement language. According to Fitch's criteria, the equity credit of 50% will change to 0% five years before the effective remaining maturity date.

The long tranche (NC10) includes replacement language, and we therefore do not apply a time limit for equity credit. The issuer has the option to redeem the notes on the first and second call dates in 2021 and 2026, respectively (for 6-year non-call bond) or 2025 (for 10-year non-call bond) and on any coupon payment date thereafter.

Cumulative Coupon Limits Equity Treatment
The interest coupon deferrals are cumulative, which results in 50% equity treatment and 50% debt treatment of the hybrid notes by Fitch. The company will be obliged to make a mandatory settlement of deferred interest payments under certain circumstances, including the declaration of a cash dividend. This is a feature similar to debt-like securities and reduces the company's financial flexibility.

KEY RATING DRIVERS FOR OMV
Flat Upstream, Targets Revised
In 1H15, OMV posted a 0.3% increase in total hydrocarbon output yoy to 305kboepd, most of which was achieved in 2Q15. We view this as a positive result as additional production volumes from Norway's Gudrun platform launched in 2014 (OMV's share: 24%) and New Zealand's Maari field offset shut-ins in Libya and Yemen. During 1H15, OMV Petrom, the group's 51% subsidiary in Romania, accounted for all of the group's upstream clean EBIT (excluding one-off items and inventory holding gains/losses), on production of 182kboepd or 60% of the group's total.

OMV's upstream operating costs per barrel of oil equivalent fell 19% yoy in 1H15 to USD13.8/bbl, reflecting a stronger US dollar and cost-cutting measures that OMV is currently implementing to combat the oil price decline. We view this achievement as positive given that OMV operates in relatively high-cost areas such as the North Sea and central and eastern Europe.

While OMV continues spending on upstream exploration and development, it has abandoned its upstream production target of 400kboepd by 2016, given the currently unfavourable oil prices. We conservatively forecast OMV will achieve oil and gas production of no more than 315kboedpd in 2018 on lower contribution from the North Sea than expected by management and lower production in Libya and Yemen due to political uncertainty.

Downstream Saves Performance
In 1H15 OMV reported a 13% fall yoy in clean EBIT to EUR1.9bn, mainly due to sharply lower revenues (down 40% yoy) on lower oil prices. Downstream accounted for 46% of clean EBITD, compared with 22% in 1H14. This was mainly the result of favourable refining margins that averaged USD7.6 per barrel (bbl) in 1H15, compared with USD1.8/bbl in 1H14, and 92% refinery utilisation, up from 87% during the same period.

OMV attributed its significantly higher refining margins to lower costs for own crude consumption, firmer product spreads and improved yields in Petrobrazi following the completion of refinery upgrades. OMV's three refineries in Austria, southern Germany and Romania have a combined capacity of 17.8mt p.a. In 1H15, OMV refining input volumes were down 1.4m tons or 14% yoy at 8.7m tons. With refinery portfolio optimisation and EUR1bn downstream disposals completed by end-2014, OMV has significantly reduced its exposure to downstream.

In our forecasts, we expect OMV's downstream (refining and marketing) margins to return to USD5/bbl - USD6/bbl in 2016-2018 from current highs, as Europe has persistent refining overcapacity. These margins incorporate OMV's improved refining asset mix due to retention of better performing or recently upgraded assets eg, modernised Petrobrazi in Romania, in the company's portfolio.

Weakening Cash Flows
OMV's cash flows from operations in 1H15 were down EUR322m or 20% yoy to EUR1.3bn, which was partially offset by a reduction in capex of EUR409m or 23% yoy to EUR1.4bn. Most capex cuts were in downstream - EUR268m or by 59% yoy, while upstream was down only by EUR135m or 10% yoy. OMV continues to invest in fields in the development stage, eg, Norway's Gullfaks, Aasta Hansteen, Edvard Grieg and Gudrun; Romania's field redevelopments; Tunisia's Nawara, and the UK's Schiehallion.

OMV expects to spend between EUR7.5bn to EUR9bn on capex in total over 2015-2017, of which roughly 80% is to be allocated to upstream. We believe that to offset weak oil prices OMV may cut upstream capex further in 2015-2018. As we expect oil prices to recover to USD65/bbl in 2016 and USD75/bbl in 2017, we view this upstream capex reduction as a temporary cash-saving measure. However, if this trend persists, it may change our view on the company's future upstream profile, as OMV's current upstream production is commensurate with the 'BBB' rating category.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Fitch's latest Brent price deck of USD55/bbl in 2015, USD65/bbl in 2016, USD75/bbl in 2017 and USD80/bbl in 2018
- Upstream production of between 300kboepd and 315kboepd in 2015-2018
- Capex of EUR2.7bn in 2015 and EUR2.5bn-EUR3bn in 2016-2018
- Dividend payout ratio of 30% in 2015-2018
- Planned hybrid bond qualifying for 50% equity credit

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Funds from operations (FFO) adjusted net leverage above 2x and FFO fixed charge cover below 10x on a sustained basis.
- Failure to meet oil and gas production targets, higher-than-expected expenditure or delays in delivering upstream projects in the North Sea or significant adverse changes in taxation, licensing and regulatory regimes in OMV's main markets.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Positive rating action is unlikely given OMV's limited business profile and smaller size relative to its larger and more diversified 'A' category rated European peers.

LIQUIDITY
At 30 June 15, OMV had EUR558m in cash and cash equivalents versus EUR1.5bn in short-term debt. In 1H15, OMV's free cash flow (FCF) after dividends and disposals was down EUR522m yoy to negative EUR962m. For 2015, we expect that the company will post slightly negative FCF after nearly EUR3.3bn in capex and dividends.

Historically, OMV has enjoyed good access to capital markets. We expect that the company will be able to tap capital markets to refinance upcoming maturities. Furthermore, at end-June 2015, OMV had undrawn committed credit lines of EUR3.6bn.