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Rating Action:

Moody's assigns B1 rating to Forest Oil's $500 million senior unsecured notes; outlook now stable

31 May 2007
Moody's assigns B1 rating to Forest Oil's $500 million senior unsecured notes; outlook now stable

New York, May 31, 2007 -- Moody's Investors Service assigned a B1 (LGD 5; 72%) rating to Forest Oil's (FST) pending $500 million 12-year senior unsecured notes and affirmed its existing Ba3 corporate family, Ba3 (LGD 4; 50%) probability of default, existing Ba3 (LGD 5; 72%) senior unsecured note, and SGL-2 speculative grade liquidity ratings. The B1 (LGD 5; 72%) note ratings are assigned under Moody's Loss Given Default notching methodology. The outlook is moved from negative to stable.

Note proceeds would partially fund the $739 million cash portion of FST's now approximately $1.8 billion acquisition of Houston Exploration (THX). Remaining compensation consists of 23.8 million FST common shares exchanged for THX common and the assumption of approximately $100 million of THX debt. FST is paying a reasonable $49,750/boe of daily production and approximately $15.36/boe of proven reserves. FST also announced its pending sale of its Alaskan reserves for approximately $464 million of cash and stock, proceeds of which will repay a companion $380 million non-recourse term loan and somewhat over $60 million of parent secured bank revolver debt.

The move to a stable outlook reflects FST's relatively competitive 2006 reserve replacement cost trends, the substantial equity funded component of the THX acquisition cost; more moderate leverage pro-forma for THX and the Alaskan sale, and what Moody's believes are likely credit positive operational attributes of the THX acquisition. FST and THX have over-lapping core operating areas; an increased ability to high grade capital spending and drilling activity by curtailing activity at each firm's less attractive core areas to potentially reduce reserve replacement costs; greater production and prospect portfolio risk diversification; and the further high grading of the reserve base and debt reduction with divestitures.

FST reports an expected $900 million of 2007 capital spending pro-forma as if THX were owned the whole year, down from FST's and THX's combined $1.079 billion of 2006 spending. Pro-forma 2007 cash flow is currently on a trajectory to approach approximately $825 million to $900 million. Pro-forma total debt approximates $1.8 billion, including approximately $600 million of secured bank revolver debt. Pro-forma, FST will hold approximately 232 mmboe of PD reserves, 328 mmboe of total proven reserves, and generated approximately 82,000 Boe/day of first quarter 2007 production (roughly 30 mmboe per year).

To retain a stable outlook, FST will need to sustain favorable sequential quarter production trends (pro-forma for any debt reducing divestitures); reduce leverage on proven developed (PD) reserves, on total reserves, and on production; support further significant acquisitions with suitable equity funding; and continue to demonstrate successful reserve replacement trends at competitive costs. We note that FST's first quarter 2007 production was materially down from fourth quarter, reportedly partly due to shipping delays for Alaskan crude oil liftings, plus weather disruptions and transportation bottlenecks in the MidContinent.

Per Moody's Exploration and Production methodology, the combined FST and THX entity maps to a B1 rating category. This reflects the merged firm's Ba reserve and production scale and diversification, a Ba range leveraged full-cycle ratio (cash-on-cash returns), a Ba range cash flow coverage of debt after deducting sustaining capex from cash flow, and competitive reserve replacement cost trends. The Ba metrics are currently offset in the model by B rating range leverage on PD and total reserves, total full-cycle costs, and reserve replacement costs (though improving).

Combining the reserve replacement costs for FST and THX, FST has a pro-forma 3-year all sources cost of approximately $16.30/boe and a 3-year drillbit cost of approximately $17.90/boe. While historically high, we note that FST's 2006 reserve replacement costs were stronger than previous years, and competitive with sector 2006 costs. Total full-cycle costs are estimated to be in the low-mid $30/boe range. THX's lower production costs helping offset FST's slightly higher costs and resulting in a production cost of approximately $7.20/boe. G&A/boe is estimated to be approximately $5/boe and interest expense/boe to be approximately $4.15/boe.

Adjusted leverage of approximately $7.90/boe of PD reserves and $9.15/boe of total proven reserves (adding SFAS 69 future development costs to debt) remains high and maps to the B range. Though leverage may come down with further divestitures, we believe it will remain elevated relative to the current ratings. After closing the THX acquisition, FST will have approximately $600 million of secured debt under its $1 billion revolver and approximately $1.2 billion of senior unsecured notes. On a combined measure, future development costs were expected to be approximately $1.2 billion to $1.3 billion prior to the divestiture of the Alaskan reserves.

The acquisition takes place during long rationalization processes at FST and THX and a protracted period in which THX had been studying its strategic alternatives. Each firm had comparatively high organic reserve replacement costs, partially due to surging sector drilling and oil field services costs. While the merged firm would provide greater high grading opportunity in FST's allocation of larger pro-forma cash flows across a larger prospect base, it will need to demonstrate the ability to sustain competitive organic reserve replacement costs suitable to the expected price environment. The merger follows a transforming 2006 for both THX and FST in which each firm divested its high cost and very short lived Gulf of Mexico properties to increase the focus on-shore.

Forest Oil is an independent oil and gas exploration and production company headquartered in Denver, Colorado.

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

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