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Rating Action:

MOODY'S LOWERS KERR-MCGEE'S DEBT RATINGS TO Ba3 FROM Baa3. OUTLOOK IS STABLE.

14 Apr 2005
MOODY'S LOWERS KERR-MCGEE'S DEBT RATINGS TO Ba3 FROM Baa3. OUTLOOK IS STABLE.

Approximately $3.2 billion of Debt Securities Affected

New York, April 14, 2005 -- Moody's Investors Service lowered the long-term and short-term debt ratings of Kerr-McGee Corporation (KMG) to below investment grade. Moody's assigned a Ba3 Senior Implied and lowered KMG's Senior Unsecured notes to Ba3 from Baa3. Moody's expects that KMG's existing notes will be secured equally and ratably with new secured term loans that the company has arranged. The company's short-term ratings were lowered to Not Prime from Prime-3. This action concludes the review begun March 4 that had reflected "material event risk" resulting from a more activist shareholder base. The outlook is stable.

The downgrade of Kerr-McGee's ratings to below investment grade reflects the material shift in the company's risk profile as reflected by its share repurchase announcement and the corresponding increase in leverage. KMG announced a "Dutch Auction" tender for up to $4 billion of its common stock in a price range of $85-92 per share. KMG's proposed stock buyback represents 27-29% of its outstanding shares and will increase its balance sheet debt outstanding about two and one-quarter times to over $7.2 billion. KMG's higher leverage exacerbates its weak fundamental operating performance and portfolio durability as shown by inconsistent organic reserves replacement and correspondingly high finding and development (F&D) costs over the past three years. The downgrade further reflects the time necessary over the medium term for KMG to transform its portfolio from a higher risk predominantly exploration focus to a lower risk balance of exploitation and exploration.

In its analysis of KMG, Moody's considered the company's reserves and production characteristics, including size, scale and diversification, as well as proved developed (PD) reserve life; its reinvestment risk reflected in reserves replacement and finding and development (F&D) costs; KMG's operating and capital efficiency as shown by full-cycle costs and leveraged full-cycle ratio; its leverage as measured by debt per PD boe and debt plus future development costs to total boe; and other factors including execution risk of its proposed asset sales and deleveraging strategy, and uncertainty regarding the disposition of the chemicals business and resolution of environmental liabilities.

Reserves Characterization

Kerr-McGee's ratings are supported by the scale and diversification of its predominantly US oil and gas asset base, with 1.2 billion boe of proved reserves at the end of 2004, and the strength of its near term production. However, KMG's PD reserve life, based on year end PD reserves divided by annualized fourth quarter production, was only 5.8 years at the end of 2004. This metric was two years shorter than the median of the Ba3 exploration and production (E&P) companies. KMG's shorter reserve life exacerbates its higher leverage.

Leverage

Kerr-McGee's leverage, as measured by adjusted debt per proved developed barrel of oil equivalent (debt per PD boe), will be about $9.80 per PD boe immediately after the stock buyback. This leverage level is higher than any E&P company that we rate. However, KMG expects to reduce leverage over the near term through proceeds from the sale of its chemicals business and the sale of E&P properties representing 10-15% of proved reserves. Free cash flow (after capex and dividends), supported by a significant level of commodity price hedging, lower capital spending and a reduction of its dividend, will also contribute to debt repayment.

In March, KMG announced its intention to sell its chemicals business and the additional E&P asset sales could result in total proceeds of $2.5 - 3 billion in the near term. KMG has hedged its commodity price exposure on 75% of its expected 2005 and 2006 production reflecting today's high commodity price environment. The company expects a reduction in its capital expenditure program over time and is reducing its dividend from $1.80 per share to $0.20, saving about $270 million per year (pro forma for the buyback). The combination of commodity hedging, lower capex and dividends should result in free cash flow on the order of $1 billion per year in each of 2005 and 2006.

KMG's deleveraging plan is supported by the proposed terms of its new senior secured debt, which contemplates that asset sale proceeds and a portion of excess cash flow will be used for debt repayment. Through asset sales proceeds and free cash flow, Moody's expects KMG to reduce its leverage to under $8 per PD boe in 2005, with further reductions in 2006 to below $7. While this is an improvement over the leverage immediately after the buyback, these leverage levels are still high.

Portfolio Durability

KMG's rating also reflects the company's weak portfolio durability in terms of reserves replacement, percent PD reserves and F&D costs. KMG's all-sources reserves replacement for the three years ending 2004 was 124%; however, this was dominated by the Westport Resources acquisition in 2004. Looking at drilling only (ignoring revisions), KMG replaced only 51% of its production during these three years. Looking forward, KMG expects to add 205 million boe to proved reserves in 2005 in its base plan, which would replace 155% of expected production. There is reasonable visibility around 40 million boe from exploitation in the Rockies and another 40 million boe from projects under way, including offshore Gulf of Mexico (GOM) projects Blind Faith and Tahiti that should be sanctioned this year. Further down the risk spectrum are appraisal of 2004 discoveries, including Alaska, Brazil and China, which could add from nothing to 80 million boe with a likely outcome around 40 million. These three categories could combine to add 120 million boe, or about 90% of 2005 production. Anything beyond this would come from exploration success, which is both difficult to predict and challenging for debt holders to ascribe value given KMG's inconsistent results in recent years.

In addition to uncertainty around the absolute volume of reserves added, another concern is the mix of proved developed and proved undeveloped (PUD) reserves. KMG's asset sales program will be dominated by PD reserves, while the company's reserves additions will be primarily PUD reserves. Moody's estimates the percentage of PD reserves will drop from 65% at the end of 2004 to the mid to high 50% range in 2005, which will negatively impact metrics that use PD reserves like reserve life and leverage.

Moody's recognizes the portfolio management benefits of the proposed asset sales program, including reduced capital intensity of its remaining assets, lengthening reserve life and lower operating cost structure. We also appreciate the value of improved portfolio focus as a result of selling the chemicals business and reduction of the environmental liability overhang.

Ratings Outlook

The stable outlook reflects the expectation that Kerr-McGee will successfully execute its asset sales and deleveraging strategy, including reducing leverage to below $8 per PD boe in 2005. The stable outlook also considers that KMG's credit metrics, including percent PD reserves, PD reserve life, reserves replacement, F&D costs, leveraged full-cycle ratio and leverage, will improve over the near term. The company needs to demonstrate significant improvement along these key credit metrics to move its outlook to positive, including replacing substantially more than 100% of its production at competitive F&D costs (~$10/boe). Stronger cash margins and improving F&D costs, leading to a leveraged full-cycle ratio consistently above 2x, are also needed. Moody's will continue to monitor KMG's performance to ensure it is on track to meet its plan. A combination of reserves replacement less than two-thirds of production, higher F&D costs (~$15), weaker leveraged full-cycle ratio (< 1.5x) or leverage that remains above $8 could result in a negative outlook.

Ratings affected include those of Kerr-McGee Corporation and all of its rated subsidiaries.

Kerr-McGee Corporation, headquartered in Oklahoma City, Oklahoma, is an independent exploration and production company with primary operations in the US and the UK North Sea. Kerr-McGee also manufactures and markets inorganic chemicals.

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

New York
Steven Wood
Vice President - Senior Analyst
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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