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Rating Action:

MOODY'S ASSIGNS B3 TO HARVEST OPERATIONS CORP. SR. UNSECURED NOTES; B2 SENIOR IMPLIED RATING; SGL-3 LIQUIDITY RATING; STABLE OUTLOOK

04 Oct 2004
MOODY'S ASSIGNS B3 TO HARVEST OPERATIONS CORP. SR. UNSECURED NOTES; B2 SENIOR IMPLIED RATING; SGL-3 LIQUIDITY RATING; STABLE OUTLOOK

First Time Rating - Approximately US$200 Million of Debt Securities Affected

New York, October 04, 2004 -- Moody's assigned a B2 senior implied rating to Harvest Operations Corp. (HOC), a B3 rating to its pending US$200 million of 7-year senior unsecured notes, and an SGL-3 liquidity rating. Harvest Energy Trust (HTE) wholly-owns HOC. The notes and HOC's C$370 million of secured bank facilities receive guarantees from HTE, HOC subsidiaries (except Red Earth Partnership which holds 13% of reserves), and HOC's sister affiliate Harvest Sask. Energy Trust (HSET). HTE's assets consist mainly of indirect net profits interests in oil and gas reserves held by HOC, HSET, and their subsidiaries. Proceeds will refund C$182.5 million of secured bank debt and a C$70 million bridge loan, incurred as partial funding for the Storm Energy (C$189 million) and Encana reserve (C$526 million) acquisitions.

As a point of clarification, per the Canadian convention, HTE reports its gross reserves and production before royalties paid to its government. Per U.S. GAAP and FAS 69 reserve accounting, HTE holds a lower 69.1 mmboe of net proven reserves (of which 62.1 mmboe is net proven developed or PD reserves) generating 32,725 boe/day of net production. HTE's reserves were calculated using forecasted prices and costs rather than flat prices and costs as used in FAS 69 and SEC reporting. Year-end 2004 reserves will provide an opportunity to reconcile the U.S. and Canadian methods and update capital productivity measures.

The ratings are restrained by HTE's: comparatively small size; short intra-year duration of ownership of much of the property base; very mature nature and high water cut for most of its properties; modest pro-forma unit cash flow cover (roughly 140%) of its C$13.85/boe in net reserve replacement costs (elevated by recent acquisitions); high leverage of C$8.74/boe of net PD reserves (US$6.82/boe net PD reserves); relatively short reserve life of 5.2 years on net PD reserves; potential leveraged acquisitions and need to accommodate a growth-by-acquisition strategy; high cash flow payout inherent to its unit trust structure, coupled with the depleting nature of oil and gas reserves; and modest potential for HET's properties to generate full organic reserve replacement.

The ratings benefit from: adequate liquidity and cash flow support from an expected supportive price environment; a substantially strengthened property base from recent acquisitions that added diversification (bulk of production is spread across 10 fields), greater scale, and exploitation opportunity; a high proportion of reserves in well-known regions with long production histories (though many generate very high water cuts); incremental exploitation potential on the high 90% of properties operated by HTE; a high degree of ownership (21%) by the Chairman and his demonstrated willingness and capacity to invest new second secured funding for acquisitions; the Chairman's prior participation in building and successfully selling an exploration and production company; and downside support from 49% of 2005 production being hedged with puts and calls.

The notes are one rating notch below the senior implied rating due to substantial existing and expected effective subordination to senior secured bank debt. However, asset coverage is also cushioned to a degree by C$105 million of subordinated debt junior to the rated notes. We expect growth to be driven by acquisitions funded by HTE's C$370 million of committed secured bank revolver maturing June 29, 2005. Moody's believes that roughly C$210 million of the revolver will be available and undrawn after placement of the notes.

The SGL-3 liquidity rating reflects: adequate cash flow coverage of full-cycle costs, financial obligations, capital spending needs, and significant distributions of free cash flow to unit holders, cushioned by HTE's option during cash flow weakness to reduce substantial cash distributions to unit holders. HTE also exhibits: adequate undrawn external liquidity, sensitized for the risk of elevated acquisition borrowings followed by negative borrowing base revisions during weak prices; good covenant coverage; but weak alternative liquidity since HTE's assets are already pledged to its banks.

The SGL-3 rating reflects that pro-forma leveraged unit cash flow cover of reserve replacement capital spending is only adequate at 140%, considering the current up-cycle price environment. Reserve replacement costs have risen as HTE has acquired larger and higher operating margin properties. Also, in a low price environment and/or with higher reserve replacement costs, HTE's internal coverage of operating costs, interest expense, sustaining capital spending (Moody's measure is C$170 million), and significant cash distributions to unit holders may need to be supplemented by new units issues (equity) and/or secured revolver borrowings.

Committed back-up external liquidity is currently good, with roughly C$210 million undrawn and available under the secured revolver. However, revolver availability is governed by a borrowing base recalculated every 6 months and availability could be reduced during lower prices when cash flow cover of full-cycle costs is also diminished. HTE is also acquisitive so we anticipate significant borrowings under the revolver. To ensure ample back-up up liquidity, HTE will need to pro-actively fund acquisitions with adequate new units offerings.

Bank covenant coverage is good. There are only two principal bank loan covenants, including: EBITDA/Interest of 3.5x and a current ratio of 1.0:1. The company amply meets these covenants, though we would expect negative borrowing base revisions to have greater impact on borrowing capacity.

At HTE's current scale of operations, Moody's estimates that its full-cycle cost structure pro-forma's in the range of C$25.90/boe (US$20.20/net boe). HTE reports average pro-forma realized unit prices for the twelve months ended June 30, 2004 of C$31.72/boe of net production (US$24.75/boe), rendering modest cost coverage of 140% in spite of strong prices. However, realizations relative to benchmark prices were hurt partly by hedging losses, which should be reduced for 2005 as those hedges run off, and partly by heavy oil production (roughly 35% of pro-forma production) at a time when price differentials between light and heavy oil were particularly wide.

Moody's estimates pro-forma full-cycle costs of approximately C$25.90/net boe, including approximately: C$8.70/boe of production costs, C$0.80 of G&A expense, C$2.55/boe of interest expense, and C$13.85/boe of reserve replacement costs on net reserves. Thus, HET's pro-forma up-cycle unit cash flow coverage of unit interest expense is in the range of 8x to 9x, with post-interest unit cash flow cover of sustaining unit reserve replacement costs in the range of 140%.

Moody's estimates that HET's consolidated capital structure upon its September 2, 2004 closing of the Encana acquisition (pro-forma for the notes) includes C$160 million of senior secured bank debt, C$268 million-equivalent of the new US$200 million notes, C$105 million of convertible subordinated debentures (gradually converting to equity units), C$10 million of second secured parent company equity bridge notes due to Caribou Capital, and C$347 million of equity capital.

The stable rating outlook incorporates the expectation that prices will remain supportive of HTE's full-cycle costs and potential acquisitions will at least be adequately equity funded. Weakness in the rating outlook or ratings could result if: HTE is not able to sustain net production above 29,500/net boe to 31,500/net boe per day (34,700 boe/day to 37,000 boe/day gross) versus pro-forma second quarter 2004 production of 32,725 net boe/day; prices weaken sufficiently to materially affect HET's ability to internally fund sustaining capex; year-end 2004 reserve replacement costs are materially higher than expected; or if HTE executes materially leveraging acquisitions.

The outlook or ratings could improve if HTE materially reduces leverage on PD reserves and materially grows net reserves and net production at acceptable leveraged full-cycle costs, including net reserve replacement costs. This could be spurred by material acquisitions amply funded with equity to reduce leverage and support the relative price and execution risk within future acquisitions.

HTE went public in December 2002 as a Canadian unit investment trust. By definition, it makes substantial cash contributions to unit holders from defined free cash flow. Exploration and production (E&P) is a depleting asset business needing constant successful reinvestment of cash flow for reserve replacement. For the unit trust model to work for E&P firms, the new units market overall needs to be receptive, and individual E&P's in particular need consistent new issue access to fund acquisitions and capital spending and distributions in excess of free cash.

Harvest Energy Trust is headquarted in Calgary, Alberta, Canada.

New York
John Diaz
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Andrew Oram
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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