Fitch Ratings has assigned a 'B+'/'RR4' rating to 3R Lux S.a.r.l's (3R Lux) proposed notes of up to USD500 million due 2031.

The notes will be senior secured and guaranteed by 3R Petroleum Oleo e Gas S.A. (3R) and some of its subsidiaries. The net proceeds will mainly be used to fully repay 3R's term loan facility of USD500 million. Fitch has also published 3R's 'B+' Long-Term Foreign Currency (FC) and Local Currency (LC) Issuer Default Ratings (IDRs), both with a Stable Rating Outlook. 3R's Long-term National Scale Rating is 'A(bra)' with a Stable Outlook.

3R's IDRs are limited by its modest scale in the volatile oil and gas (O&G) market. Its production and proven reserves (1P) are less than 75 thousand barrels of oil equivalent per day (kboe/d) and 400 million boe, respectively, although distributed across a balanced asset base. Fitch expects strong production growth in the coming years, as the company tackles infrastructure bottlenecks and advances on recovery projects. Operational efficiency should also increase, reflecting scale gains, better commercialization terms and operational synergies. Production volatility should reduce as of 2025, after significant maintenance investments in recently acquired assets. Fitch expects 3R to maintain a conservative financial profile, with EBITDA net leverage around 2.0x in 2024 and below that as of 2025.

Key Rating Drivers

Limited Scale: 3R's production should approach 50kboe/d in 2024, on average, from 34kboe/d in 2023 (or 43 kboe/d, pro forma for the Potiguar acquisition), growing towards 75kboe/d up to 2026. This strong growth is supported by intense revitalization activity and the elimination of limitations on facilities, especially in offshore Papa Terra. The Potiguar and Papa Terra clusters should represent around 55% and 25% of 3R's production through 2026, respectively. Natural gas will likely represent around 16% of production and 10% of net revenues from upstream in 2023-2026, adding to revenue diversification and predictability. Any delays in production associated with environmental licensing would be compensated by capex postponement.

Improving Cost Profile: Production ramp-up and operational synergies, especially from the recently acquired Potiguar cluster, should contribute to diluting high fixed costs and reducing lifting cost to around USD22/boe in 2024 and USD18/boe in 2025, compared to USD24/boe estimated for the fiscal year ended in 2023. The reduction of heavy maintenance activities and insourcing of key supplies also support efficiency gains. Half-cycle costs (operating costs plus interest payments) are expected to reach around USD40/boe in 2023-2024 on average, falling to USD30/boe in 2025-2026. Full cycle costs (which include royalties, leases and investments) are estimated at USD50/boe in 2023-2024. Onshore production represents around 80% of expected production over the rating horizon, leading to high capex flexibility.

Robust Reserves: 3R's credit profile benefits from low exploration risk, considering its proven reserves of over 360 million boe, although they fall slightly short of the 'BB' category (400 million boe). 3R should maintain a comfortable useful life of 1P reserves, of around 13 years through 2027, already considering the production ramp-up over this horizon and assuming no replacement of reserves (or 15 years, with full replacement). This long useful life brings high flexibility to cut investments during downward market cycles. Around 70% of proved reserves are already developed, which benefits capex predictability. Fitch estimates costs to develop 1P reserves at around USD6/boe.

Better Prices to Benefit Cash Flows: 3R has been successful in renegotiating contracts and accessing new markets, which has improved its oil and gas prices. The ability to export 90% of its oil production, after the acquisition of Potiguar and the expansion of the offloading capacity in Papa Terra further contribute in this regard. For oil sales, Fitch estimates an average discount on Brent of USD7/boe in 2023 and USD5/boe in 2024, compared to USD11/boe in 2022. Fitch estimates EBITDA at BRL1.9 billion in 2023 and BRL3.6 billion in 2024 and expects cash flow (FCF) to turn slightly positive for the first time in 2024.

The refining business should contribute less than 10% of the company's EBITDA, with gasoline and diesel production being highly dependent on imports of fuels. Projections consider average crack spreads around USD11/bbl. For bunker fuel, the refinery's main product, spread is estimated at USD1.0/bbl.

Declining Leverage: Fitch believes that 3R will maintain a conservative financial profile, with debt/1P reserves ratio close to USD5/boe until 2025. EBITDA leverage is estimated at 3.0x for the fiscal year ended in 2023 and 2.3x for 2024, from 2.7x at the end of September 2023, on a pro forma basis for the acquisition of the Potiguar cluster (deal closed in June 2023).

Debt projections include M&A obligations due to Petrobras (BRL1.9 billion in September 2023). Fitch estimates net leverage at 2.2x for 2023 and 2.0x for 2024, from 2.3x in September 2023. For the purpose of calculating leverage ratios, Fitch deducts from debt derivatives held by 3R Lux, valued at BRL2.5 billion at the end of the third quarter 2023. 3R's above-average interest cost is partially offset by high tax efficiency associated with regional tax benefits.

Derivation Summary

3R's rating is equivalent to Origem Energia S.A.'s (Origem, A(bra)/Stable). Origem's cash flows are more predictable, as gas production, usually sold via long-term take-or-pay contracts, with partial exposure to Brent, represents three quarters of its production. 3R partially mitigates exposure to Brent by contracting short to medium term hedging for around a third of its production. 3R benefits from larger scale and asset diversification than Origem, whose proven reserves of 164 million boe and current production of 11 kboe/d are highly concentrated in a single asset (Alagoas cluster). EBITDA margins are close, as is cash generation per boe produced (before and after investments), although projections of EBITDA net leverage are lower for Origem (1.6x in 2023-2026, on average) than for 3R (2.4x).

3R's robust reserves is a key differentiation factor in comparison with Sierracol Energy Limited (SierraCol, B+/Stable) and Geopark Limited (Geopark, B+/Negative). 3R's 1P reserve life of 13 years through 2026, on average, is above estimates for these peers (four to seven years). On the other hand, SierraCol and GeoPark operate more efficiently, with mid-cycle costs close to USD14/boe and USD22/boe, respectively, benefiting from lower debt costs. Fitch's projections for SierraCol's lifting costs are similar to 3R's, but SierraCol pays more royalties (around USD20/boe). GeoPark operates with lower lifting costs, although its oil pricing is less favorable. SierraCol and GeoPark's average production is estimated at 33kboe/d and 42kboe/d in 2023-2026, respectively, below the estimate for 3R (55kboe/d).

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer Rating Include

Average Brent prices from 2024 to 2026 (USD/bbl): 80; 70; 65;

Average daily production from 2023 to 2026 (kboe/d): 34; 50; 64; 75;

Oil sales consider discount to Brent of USD7/bbl in 2023 and USD5/bbl as of 2024, and existing hedging contracts;

Lifting cost from 2023 to 2026 (USD/boe): 24, 22, 18, 16;

Annual capex averaging BRL2.2 billion in 2023-2026, with no significant investments in midstream & downstream;

Effective tax rate around 27%;

No dividends until 2026, with payout ratio of 25% onwards;

Recovery assumptions include a going concern EBITDA of BRL1.6 billion and 5.0x EV multiple.

Recovery Analysis

Going Concern Approach: The recovery analysis assumes 3R would be reorganized on a going concern basis, rather than liquidated. 3R's going concern EBITDA is BRL1.6 billion, assuming Brent flat at USD45/bbl throughout the projection horizon. The going concern EBITDA estimate reflects Fitch's view of a sustainable level of post-reorganization EBITDA, on which the company's valuation is based. The applied enterprise value (EV)/EBITDA multiple is 5.0x and administrative claims are estimated at 10%.

Fitch applies an analysis to the post-default EV cascade, based on debt claims in the capital structure. These targets resulted in a recovery rate for secured notes in the 'RR3' range, which would be commensurate with 'BB-' rating. However, due to Brazil's soft cap of 'RR4', 3R's secured notes are rated 'B+'/'RR4'.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Achieving and maintaining 1P reserves of at least 400 million boe;

Increasing production to more than 75kboe/d, while maintaining 1P reserve life of at least 10 years, consistently;

Reducing lifting cost to USD13/boe or full cycle costs to USD30/boe.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Significant increase in debt/EBITDA and net debt/EBITDA ratios to more than 3.0x or 2.0x, respectively;

Weakening of the liquidity profile;

Major operational disruptions at key assets, resulting in a significant reduction in production.

Liquidity and Debt Structure

Comfortable Liquidity: The USD500 million proposed noted due 2031 will lengthen 3R's debt maturity schedule and enhance its liquidity profile. The company also has a firm placement guarantee for issuing at least BRL900 million debentures in 2024, with a five-year term and a two-year grace period, whose proceeds are to be used for liability management. Fitch expects that additional debt issuance in 2024, if occurs, will have this same purpose, and that 3R will maintain cash balance above short-term debt.

The company ended the third quarter of 2023 with BRL796 million in cash, disregarding reserve account balances of BRL221 million. Short term debt was BRL1.4 billion, including BRL809 million in obligations related to acquisitions. In November 2023, 3R issued BRL1.0 billion in debentures for funding capex, with 10-years maturity and 5-years grace period for principal payment.

Issuer Profile

3R is an independent oil and gas producer focused on revitalizing mature onshore and offshore fields in Brazil. It acquired assets from Petrobras in recent years and plans to significantly expand its production to about 75kboe/d by 2026 (based on proved reserves).

Summary of Financial Adjustments

Obligations related to acquisitions were incorporated into debt; restricted cash was incorporated into cash; derivatives pledged as guarantee for debt payment were excluded from debt.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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