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Rating Action:

MOODY'S DOWNGRADES ENERGEN CORP.'S DEBT RATINGS (TO Baa2 SR. UNS.) AND CONFIRMS ALABAMA GAS CO.'S (A1 SR. UNS.), BOTH WITH STABLE OUTLOOKS

27 Sep 2004
MOODY'S DOWNGRADES ENERGEN CORP.'S DEBT RATINGS (TO Baa2 SR. UNS.) AND CONFIRMS ALABAMA GAS CO.'S (A1 SR. UNS.), BOTH WITH STABLE OUTLOOKS

Approximately $560 Million of Debt Securities Affected

New York, September 27, 2004 -- Moody's Investors Service downgraded the debt ratings of Energen Corporation (Holdco) to Baa2 senior unsecured/(P)Baa2 senior unsecured shelf from Baa1/(P)Baa1 and confirmed those of its utility subsidiary Alabama Gas Company (Alagasco, the utility) at A1 senior unsecured. Energen's ratings are downgraded to reflect greater exposure to E&P activities, notably the mounting execution risk in continuing to grow its E&P business so as to meet its stated long-term earnings growth targets. The confirmation of Alagasco's ratings at a rating level four notches above Energen's reflect our view that the utility's credit profile remains unaffected by its parent or Energen Resources (Resources, Energen's E&P subsidiary), and that there is a measure of protection provided by regulatory oversight.

The rating outlook is stable for both entities, acknowledging management's financially conservative and steadfast approach to its business model and a proven track record in its "acquire & exploit" E&P strategy. These rating actions end a rating review prompted by Energen's recent debt-financed $263 million acquisition of natural gas reserves in the San Juan Basin by Resources and a re-assessment of Alagasco's relationship with Energen and Resources.

These rating actions tie Energen's rating more closely to the business risk profile of Resources' E&P business -- less to that of Alagasco -- and better reflect Energen's role as the financing vehicle for Resources. Resources has steadily developed over time to comprise roughly 70% of Energen's capitalization, earnings, and cash flow. Given the critical mass that it has accrued, Resources faces a rising hurdle in continuing to grow at a pace that will enable Energen to meet its target average EPS growth of 7-8% a year. Given the natural declines in its existing reserve base, Resources will be challenged to make periodic sizable acquisitions. This execution risk is magnified by higher than historical capital outlays that Resources would need to make amidst rising reserve acquisition multiples, which reflect high commodity prices and declining production in mature North America basins. Indeed, in the five-year period ending 2008, Energen budgets $1 billion of reserve acquisitions -- about the same amount it has spent over the course of the past nine years and increasing the level of execution risk per acquisition.

The four-notch rating differential between Energen and Alagasco reflects the distinct financial positions that the company maintains for each of its two sole lines of business. There is no operational integration between the two. The fact that Alagasco is a SEC registrant separate from Energen highlights its discrete, self-financing nature. Alagasco enjoys no explicit ring-fencing provisions from regulatory or financing agreements other than broad restrictions under an Alabama state statute. Nevertheless, the requirement for Alagasco to get regulatory approval before any financing helps to prevent a debt-financed distribution of such a size that would weaken Alagasco's credit quality. Moody's believes that such a scenario is highly unlikely given Energen's conservative management and the relative strength of Resources. Alagasco generates little if any excess cash flow that could be swept to Holdco or to support Resources.

The stable rating outlooks anticipate Energen's continuing to execute on its long-held "acquire & exploit" E&P strategy with consistent results, including realizing expected levels of incremental production from the newly-acquired San Juan properties over the next two years. In addition, we assume that Energen maintains its conservative financial policies. The outlook incorporates periodic gas reserve acquisitions to the extent that they are in keeping with Energen's well-articulated five-year plan, acquisition criteria, and financial policies. The ratings anticipate acquisitions of a size that more than offset natural declines in Resources' existing reserves so as to manage Energen's business mix at near current levels over time (assets and earnings derived from E&P no higher than in the 70% range; the balance from Alagasco), while maintaining F&D costs at around its current historic levels and continuing its record of organic reserve replacement. A rating downgrade could result if an acquisition veers significantly from the company's long-held parameters (e.g., long-lived North American onshore gas reserves with exploitation potential, expected production mostly hedged), is unduly debt-financed, or produces results significantly below expectations.

Energen's asset mix and business and financial model make a rating upgrade unlikely in the foreseeable future. Financial performance that varies significantly from our expectations will cause us to reassess Energen's ratings. Among those financial measures that we will monitor include, on a consolidated basis: adequate financial flexibility as measured by the ability to generate free cash flow after production replacement, earnings retention (dividend payouts expected in the 20% range), and capitalization (debt ratio expected in the 40% range). At Resources, key indicators include: full-cycle costs in the high teens/boe, drillbit F&D costs in the $5/boe range, and debt burden on proven developed reserves in the $2/boe range. For Alagasco, key metrics include: retained cash flow/debt at around 20%, dividend payouts in the 70% range, and debt/capital in the 40% range.

For Alagasco, we expect continued consistent results to be derived from the Rate Stabilization and Equalization mechanism (RSE, a self-adjusting rate formula which is in place at least through 1/1/08), weather normalization, a supportive regulatory environment, and a management committed to maintaining Alagasco's capital structure in line with allowed levels under the RSE (ROE a band of 13.15% to 13.65%, 60% equity/capital cap). These underpinnings should result in gradual, small increases in earnings over time from normal additions to rate base. We do not expect external growth at Alagasco. Given Alagasco's stability, any change in its rating could be a result of a currently unanticipated change in its regulatory framework or Energen's financing model that exposes Alagasco's credit more to those of Energen and Resources.

ANALYSIS OF RESOURCES' OPERATIONS

Over the past nine years since Energen initiated its E&P growth strategy, Resources' reserves have steadily grown 15-fold to roughly 230 million boe, solidifying its position among independent U.S. oil and gas producers. From its beginnings as a Black Warrior Basin coal bed methane Section 29 play in Energen's home base of Alabama, Resources has cumulated a credible operating track record and a more diversified portfolio of conventional and coal bed methane reserves in the San Juan Basin (56% of reserves, pro forma the latest acquisition), the Permian Basin (23%), the Black Warrior Basin (16%), and North Louisiana/East Texas (5%). Its reserves are durable: mostly proven developed (about 80%) with an above-average reserve life (proven developed R/P of 13 years).

Resources has increased its reserves steadily through acquisitions every other year or so to offset natural declines of about 8% a year, supplemented by internal additions from exploiting its existing non-producing and undeveloped reserves. It engages in nominal exploration activity. Resources' operating metrics are solid. The company has been successful in maintaining better than average reserve replacement and F&D costs (all-sources F&D costs of just under $5/boe) while improving cash-on-cash returns (leveraged full-cycle ratios recently in the 300% range). Resources has been conservatively financed ($2/boe of proven developed reserves and about $2 interest/boe produced). It continually hedges the majority of its expected production (over 80% of production hedged for the rest of 2004, about 60% hedged currently for 2005) in order to ensure meeting its earnings targets (7-8% average annual eps growth) and continuing its record of modest annual dividend increases.

In August, Energen paid $263 million to purchase 40 mmboe of San Juan reserves, half of which are behind pipe and undeveloped. In addition, it expects to spend $50 million in developing these properties. The consideration paid is about $102,800/boe current daily production, $122,400/boe based on all-in for future development costs. The full valuation reflects Energen's expectation of doubling production from these properties over the next two years and desire to intensify acreage in a core area. The valuation and 100% debt financing entailed in this acquisition place an onus on the company to realize expected incremental production over this time frame. This concern is mitigated by Resources' familiarity of the area (it has seven years of experience in the San Juan Basin, including acreage nearby), long experience in coal bed methane (mostly in the Black Warrior, and more recently the Fruitland coal in the San Juan where the new reserves are located) and approvals in hand to down-space locations in the acquired properties.

Headquartered in Birmingham, Alabama, Energen Corporation is a holding company whose subsidiaries engage in natural gas and crude oil production and natural gas distribution.

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

New York
Mihoko Manabe
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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