Corporates 

Energy (Oil & Gas)  Global  Sector­Specific  Rating Criteria 

Rating Oil and Gas Exploration and Production Companies 
Sector Credit Factors 
Summary 
Consistent with the master “Corporate Rating Methodology”, dated 24 November 2009, the rating of oil and gas producers reflects both qualitative and quantitative factors encompassing the business and financial risks of companies and their debt. However, oil and gas companies are differentiated from other corporate sectors in that they are significantly exposed to crude oil and natural gas commodity prices and the resulting volatility in cash flows associated with them. In addition, upstream companies have depleting asset bases which require substantial reinvestment to replace reserves. Because of these over‐arching issues, credit profiles are typically distinguished by lower levels of financial leverage in the sector than for an ‘average corporate’ across all rating categories. Additional financial metrics, including debt/barrel of oil equivalent (boe) of proven reserves and other cash flow‐based sector metrics, assist in the analysis of the overall financial leverage of companies in this sector. Operating metrics for the sector reflect reinvestment requirements to maintain the asset base, and the ability of the assets to generate positive free cash flows (FCF) to service debt. Key drivers evaluated for upstream companies include the level of debt relative to the asset base, and the cash flow generation ability of the company across a range of business and operating market conditions. In addition, Fitch Ratings examines an entity’s reserve size, location, diversity across fuel types, reserve life, and ability to replace reserves economically over time. Fitch examines the firm’s production profile, including size of production, production costs, and realisations (which are impacted by location, fuel mix, and taxation issues). Because of the commodity nature of the business, adequate cost control is an over‐riding concern. Full cycle costs, and the ability to generate sufficient cash flows to reinvest in the company’s asset base and sustain it over time, remain a primary focus of the analysis. This report defines and groups the ratings of companies operating in the sector into natural rating territories, based on Fitch’s view of the inherent risk profile of the industry or sector as a whole. For example, pure exploration and production companies would tend to have their ratings limited to, at best, the ‘A’ rating category, due to the sector‐specific risk profile in which these companies operate. By contrast, large and diversified integrated oil and gas companies could achieve more robust profiles and be rated up to the ‘AAA’ rating category. 

Analysts 
European Corporates Jeffrey Woodruff, CFA, FRM +44 20 7682 7322 jeffrey.woodruff@fitchratings.com Erwin Van Lumich, CFA +34 93 323 8403 erwin.vanlumich@fitchratings.com Andrew Steel +44 20 7682 7486 andrew.steel@fitchratings.com US Corporates Sean T. Sexton, CFA +1 312‐368‐3130 sean.sexton@fitchratings.com Mark Sadeghian, CFA +1 312‐368‐2090 mark.sadeghian@fitchratings.com Adam M. Miller +1 312‐368‐3113 adam.miller@fitchratings.com Asia/Pacific Corporates Steve Durose +61 2 8256 0307 steve.durose@fitchratings.com 

Related Research 
Applicable Criteria · Corporate Rating Methodology (November 2009) Other Research · US Exploration and Production ‐ Recovery Rating Methodology (March 2008) · Parent and Subsidiary Rating Linkage (June 2007) · Evaluating Corporate Governance (December 2007)

This report is an addendum to the overarching master “Corporate Rating Methodology”, dated 24 November 2009. The Corporate Rating Methodology describes the criteria applied by Fitch Ratings when assigning corporate ratings. This addendum provides a high‐ level overview of how those criteria are most frequently applied to companies in this sector. Users are referred to the Limitations section

Sector Risk Profile 
Oil and gas exploration companies, including both independents, pure upstream‐ focused companies, and integrated oil and gas companies, have a number of common risks associated with the industry, including: · · depleting asset bases and a need to continually reinvest in operations; cyclical earnings and cash flows stemming from: o o commodity price exposure; fluctuations in demand associated with the business cycle; 

on page 9 of this report.

www.fitchratings.com 

6 April 2010 

Focus on smaller legacy assets resulting in extreme cost management focus. Increased focus on growth in reserves and production driving higher levels of capital expenditures relative to operating cash flows and resulting in higher reserve replacement metrics. impact of extreme weather on production and shipment. Diverse operations across fuel mix. potential expropriations of assets. including: changing tax structures/regimes. Typically large operators with diverse upstream operations. the following summary of inherent risks for entities operating in the oil and gas sector indicates acceptable risk parameters commensurate with the following rating categories: Key Credit Factors · Type of entity and size · Reserve size and quality · Reserve replacement and reserve life · Full cycle and F&D costs · Production measures · Financial metrics. Strong full‐cycle economics and positive free cash flows. Increased use of hedges to mitigate cash flow volatility. Reserve development requires large initial capital investment. environmental policy exposure and resultant taxes/charges. through the cycle Oil & Gas Exploration & Production (E&P) Entities – typically ‘AAA’ to ‘AA’ Rating Categories · · · · · Typically large global operators with economies of scale.  Oil & Gas E&P Entities – typically ‘A’ to ‘BBB’ Rating Categories · · · · · · · · · · Oil & Gas E&P Entities – typically ‘BB’ to ‘B’ Rating Categories Rating Oil and Gas Exploration and Production Companies April 2010  2 . geographic locations. pipelines etc). Primarily upstream focus with more volatile (and often negative) cash flows. Minimal financial leverage throughout industry cycle. Small. Increased use of balance sheet to finance growth. demonstrating long‐term financial stability.Corporates · · · · geopolitical considerations. In addition to the common risk features impacting all firms in the sector. technological development enhancing the ability to exploit new and existing resources. chemical. Lacking diversity beyond upstream operations (not present across the entire value chain). liquid natural gas (LNG). Strategic importance of entities ‐ often evidenced by international (sovereign) negotiations on their behalf for long‐term projects. as these firms are heavily growth‐focused. and business lines (downstream. less diversified operators and potentially single asset risk. Strong full‐cycle economics and positive/neutral FCF across industry cycles. and exposure to man‐made disasters (war). and a clearly stated sovereign goal.

0 <1.  Certain sub­sectors  may contain a small number of observations; where no observations currently exist.7 36.0 1. guidelines for a category are extrapolated based on Fitch judgement.5 15 2.0 <1.7 15.  Rating Oil and Gas Exploration and Production Companies April 2010  3  .5 10 >5.0 25 2.500 A BBB Integrated players: benefit from diversity and spread of projects – smoothes out volatility Medium to Small 1.Corporates Building Blocks ‐ Oil & Gas Sector (Integrated Companies) Sector Risk Profile Company‐Specific Traits Financial Profile (Historical where relevant and forecast. Ratio levels refer to the mid­point of a through­the­cycle range; actual observations are likely to vary from these.0 <1.3 20 2. Additional factors will influence ratings. The factors give a high­level overview and are neither exhaustive  in scope nor uniformly applicable. mid points) FFO Lease‐ adjusted leverage (x) FFO Gross interest cover (x) Debt/ Proved reserves ($/boe) Size (Annual) EBITDA ‐ USDm) Other Factors Sub‐Sector  AAA · Essential global commodity · Depleting resource · Natural hedge to commodity price fluctuations from diversity across fuel types · Commodity price exposure · Significant cost focus due to commodity nature of industry · Cyclical industry Reserves Cost of production Production size Cycle ratio (x) CFO/Capex (x) AA <USD10/boe · Large · 60‐80% developed · FD&A Costs: <USD15/boe · Medium >USD10 ‐ <20/boe · 60% ‐ 80% developed · FD&A costs: >USD15 – <USD25/boe · Medium >USD10 ‐ <20/boe · <60% or >80% developed · FD&A costs: >USD15 – <USD25/boe · Small >USD20/boe · <60% developed · FD&A costs: >USD25/boe (as per BB) >USD20/boe Large 1.600 Medium 1.0 >3 1.0 – 5.000 Small >2.500 Cycle ratio: (CFO/boe) / (FD&A/boe) (x) Indicative factors observed or extrapolated for rated issuers in developed markets.500 BB B Very Small ‐‐ ‐‐ >5.0 4.0 1.3 9.0 – 5.0 >1 ‐ <3 1. particularly in emerging markets and where group relationships constrain or enhance a rating level.0 >1 ‐ <3 1.

· Small · <60% production developed delays · FD&A costs: >USD25/boe Medium to Small 2.0 – 5.0 >1 ‐ <3 6.0 – 5.  Certain sub­sectors  may contain a small number of observations; where no observations currently exist.5 10 >5.0 1. mid‐points) FFO Lease‐ FFO Gross Debt/Proved adjusted Interest reserves leverage (x) cover (x) ($/boe) CFO/Capex (x) Cycle ratio (x) Size (Annual EBITDA ‐ USDm ) Other Factors Reserves AA A Upstream E&P · Medium companies – · 60% ‐ 80% more diverse developed projects.0 1. Additional factors will influence ratings.200 BBB BB · Medium >USD10 – · <60% or >80% <20/boe Upstream E&P developed companies – · FD&A costs: fewer projects.5 >1 ‐ <3 6.Corporates Building Blocks ‐ Oil & Gas Sector (E&P Upstream Companies) Sector Risk Profile Sub‐Sector AAA · Essential global commodity · Depleting resource · Natural hedge to commodity price fluctuations from diversity across fuel types · Commodity price exposure · Significant cost focus due to commodity nature of industry · Cyclical industry Company‐Specific Traits Cost of production Production size Financial Profile (Historical where relevant and forecast.100 Small >2. The factors give a high­level overview and are neither exhaustive  in scope nor uniformly applicable. particularly in emerging markets and where group relationships constrain or enhance a rating level. Rating Oil and Gas Exploration and Production Companies April 2010  4  . >USD20/boe cost overruns.0 15 2.5 20 2. >USD15 – vulnerable to <USD25/boe price volatility.0 <1 1. <USD25/boe but still subject to cost overruns and production delays >USD10 – <20/boe Medium 1.600 Cycle ratio: (CFO/boe) / (FD&A/boe) (x)  (x) Indicative factors observed or extrapolated for rated issuers in developed markets.0 <1. guidelines for a category are extrapolated based on Fitch judgement. less · FD&A costs: vulnerable to >USD15 – price volatility. Ratio levels refer to the mid­point of a through­the­cycle range; actual observations are likely to vary from these.

if the company is to continue to grow. taxes and debt service costs. Fitch views a constant proportion of 60%‐80% of developed reserves in the proven reserves base as an optimal level (see Table 2) as it signifies a balanced portfolio of assets. an entity may be rated investment‐grade despite having reserves below 1bn boe. production costs. For example. and often long time‐lags between licence acquisition and ultimate production. dealing with uncertain probabilities of discovering commercially viable reserves. Upstream companies operate in a high‐risk environment. enabling a company to generate ongoing cash flow (a factor which lends itself to a robust investment‐grade rating). including upstream realisations relative to finding. E&P companies can follow either an organic growth path or an acquisition‐driven expansion. Fitch divides a company’s proven reserve base into three categories: Table 1: Reserve Size Large Medium Small Source: Fitch Proven oil and gas reserves in billion barrels of equivalent oil (bn boe) More than 5 bn boe 1‐5 bn boe Less than 1 bn boe Observations ‘AA’/‘AAA’ rating categories ‘BBB’/‘A’ rating categories Less than ‘BBB’ rating categories Whilst the size of an oil and gas company does not necessary impact its ability to be efficient and profitable.Corporates Company­Specific Traits  A review of company‐specific traits encompasses the size and quality of the assets. undeveloped Less than 60% developed 60%‐80% developed More than 80% developed Description Leads to greater costs Optimal Possible difficulty finding new reserves Reserve Replacement and Reserve Life A distinctive characteristic of E&P companies is their depleting reserve base. often leading to a lower grade rating and Negative Outlook as the business contracts over time. Reserve Size and Quality Fitch considers an entity’s reserve base as its most important asset and one which will ultimately drive the other operating factors of the company. Quantitative measures that are examined include: the percentage of developed reserves. Undeveloped Reserves Observations Less than ‘A’ rating categories ‘AAA’ to ‘A’ rating categories Less than ‘A’ rating categories Source: Fitch Developed vs. Reserves. and therefore of future revenue and cash flow. and ratios related to the capital intensity of the reserve base. if asset economics remain intact. Table 2: Developed vs. together with the ability to extract them. development & acquisition (FD&A) costs. Rating Oil and Gas Exploration and Production Companies April 2010  5  . As Table 1 below demonstrates. and discerns features which lead to differences in the cash flow‐generating capabilities of the company throughout industry cycles. Fitch has positioned companies in certain rating categories to reflect their exposure and vulnerability to the market cycle. full‐cycle economics. are clearly an indicator of future production potential. reserve life. this is not however an absolute rule and exceptions can occur. A ratio of developed reserves below 60% may indicate future large capex and lead times to bring new projects on‐stream. meaning that they have to constantly invest in exploration and development to maintain or increase reserves and production life. a ratio of over 80% may signal low discovery rates and indicate declining future production potential.

This measure over time is a good indication of the operational stability and sustainability of a company. Rating Oil and Gas Exploration and Production Companies April 2010  6  . F&D costs are the costs of adding proven reserves of oil and gas. a very long reserve life (in excess of 20‐30 years) is not necessarily an enhancement to the ratings. as it may indicate that a company is experiencing sustained declines in production. through exploration and development activities. upstream realisations (sales of the commodity) are important for ultimately determining margins. versus acquisition‐driven. Finding and Development (F&D) Costs Fitch uses F&D costs to measure a company’s performance regarding the efficient deployment of capex. have a limited ability to impact commodity prices ‐ cost control becomes an essential component of their financial policies. it is also important to evaluate the overall costs on a full‐cycle basis (in conjunction with realisations) as well as on a stand‐alone basis. extensions and discoveries) over a specified period of time. Likewise. Fitch also assesses the reserve life (a reserve‐to‐production ratio) of an entity. defined as the total volume of proven reserves divided by annual production (R/P). a declining ratio over time would tend to indicate falling future production potential and possibly the need for higher finding and development costs. and Fitch uses a number of measures to evaluate a company’s ability to find and produce reserves (with the ultimate goal of bringing the commodities to market to generate cash flows). High FD&A costs can be offset by such things as low production costs. which can impact who owns the reserves and the ultimate ability of the upstream company to realise full market value of the reserves. stable. Key drivers to realisations include fuel mix. Fitch focuses on the underlying reasons for the ratio level. The ratio should ideally be 100% or higher on average. hence. resulting in adequate margins. production and lifting costs. quality and/or additional processing required. if the scale of the company’s business is to be sustained at current levels. These costs are measured as a ratio of exploration and development expenditure to proven additions to reserves (including revisions. In addition. low FD&A costs associated with natural gas shale plays can be offset by low price realizations on the sale of the natural gas (as is currently being witnessed in the US). Finding and development (F&D) costs. Fitch also considers finding. Fuel mix. size of reserves and a host of other factors can influence the ultimate level of FD&A costs. While evaluating the reserve life. and expressed in years. distance to market. and geographical location. At the same time. Comparing F&D with FD&A‐related measures indicates the extent to which a company is reliant on organic. or declining) as it should reflect management policies in relation to the business profile of the company. Exploration and development is the most capital‐intensive part of an upstream business. high price realisations. in the case of oil. taxes and financing costs all impact the overall cost structure of a company.Corporates In Fitch’s view. A decline in reserve life to significantly lower than 10 years might be of concern. F&D costs are calculated as an average over a period of three years and on a per unit basis (USD per boe). Simply put. Full‐Cycle Costs As oil and gas companies primarily deal with globally traded commodities ‐ and as a single entity. growth. the reserve replacement ratio (RRR) indicates future production potential and sustainability of the business. development and acquisition (FD&A) costs (see Table 3). favourable tax regimes or. to demonstrate a stable or expanding business profile (although expansion is not necessarily a precondition to high credit quality). since it may indicate that the company faces very high production costs or difficulties relating to reserve extraction. The trend in reserve life over time is often seen as important (growing.

Fitch categorises upstream companies by scale. and capex requirements. results in lower costs per barrel.000 (boe pd) 500. with “the majors” capable of operating larger projects and enjoying economies of scale which. Fitch would expect larger and higher rated companies to display lower production costs due to their greater economies of scale. other things being equal. production costs as calculated by Fitch are the total costs arising from operating and maintaining the wells and their related equipment. Specifically. Table 5: Upstream Production Profile Small Medium Large Source: Fitch Oil and gas production by barrels of oil equivalent per day (boe pd) Less than 500. However. Table 4: Production Costs Observations ‘AAA’/‘AA’ rating categories ‘A’/‘BBB’ rating categories Less than ‘BBB’ rating categories Source: Fitch Production Costs (USD/boe) Less than 10 10‐20 More than 20 Production Size and Dynamics Oil and gas production dynamics are an essential indicator of a company’s scale and operating performance. transportation costs. this scale advantage can be outweighed by the geographical location of a company’s operations. In its assessment of production size. severance taxes.5 million (boe pd) Observations Less or equal to ‘BBB’ rating categories ‘A’ to ‘BBB’ rating categories ‘AAA’/‘AA’ rating categories Nevertheless. Industry‐specific quantitative measures that are examined include debt‐to‐reserve ratio. profitability per boe. Rating Oil and Gas Exploration and Production Companies April 2010  7  . These costs per boe include lifting costs (costs associated with bringing oil to the surface). measured per boe of oil and gas produced. general and administrative costs (related to the upstream portion of the business). These costs. while smaller and lower rated companies would tend to display higher production costs on average. workover costs. the size and geographic diversification of operations does provide some comfort in terms of a company’s overall stability and its ability to withstand operational disruptions.  Financial Profile  Fitch’s analysis of a company’s current and projected financial profile is critical to the process of narrowing down the range of rating possibilities. and other expenses. with some countries providing a relatively low‐cost environment. Table 5 shows how Fitch categorizes the size of production by rating category.5 million (boe pd) More than 2. vary significantly according to type of field and location of production (different cost dynamics in different countries/regions).000‐2. As Table 4 below shows. however.Corporates Table 3: FD&A‐Related Measures Observations ‘AAA’/‘AA’ rating categories ‘A’/‘BBB’ rating categories Less than ‘BBB’ rating categories Source: Fitch FD&A 3 yr average (USD/boe) Less than 15 15‐25 More than 25 Lifting and Production Costs A key cost control indicator used to compare a company to its peers is cost of production.

Additionally.0‐5. as well as long lead times to initial production. For example. In Fitch’s view. Cash Flow and Liquidity The agency’s analysis is focused on stability and sustainability of earnings and cash flow.0 More than 5. It is important to estimate the portion of discretionary capex.0 Fitch also considers reserve leverage ratios. and their exposure to volatile prices. their sustainability can come under pressure in a cyclical downturn.5 Observations ‘AAA’/‘AA’ rating categories ‘A’/‘BBB’ rating categories Less than ‘BBB’ rating categories Total debt / proven reserves (USD/boe) Less than 2. making year‐to‐year capital outlays less flexible (due to the operational issues created by Rating Oil and Gas Exploration and Production Companies April 2010  8  . these are generic for all corporates. as well as shareholder‐friendly actions (ie dividends and/or share buybacks). Fitch views positively those companies which maintain a conservative financial profile with moderate leverage throughout the cycle. as this reflects a company’s flexibility to scale down investment in the case of an industry downturn. In order to calculate forecast credit metrics and ratios. These are not forecasts of oil and gas prices per‐se. Cash flow from operations (CFO) is a more secure credit protection than external sources of capital. internationally‐focused projects or deepwater offshore projects often have multi‐year investment horizons. large. it is important to consider a company’s ability to finance capex with internally generated funds (see Table 7). which underpin a company’s ability to repay debt and finance operations. Capital Expenditure Upstream ventures are generally characterised by large initial capital investment needs and a high rate of capital investment throughout the life of an asset. which can lead to increased external borrowing. In addition to the analysis of an upstream company’s ability to generate cash inflows. as well as required and discretionary capex.0 2. These are good indicators of a company’s capacity for debt. Rather. and its ability to finance obligations compared with its oil and gas peers. these ratios are viewed relative to Fitch’s distressed asset recovery valuations of USD10/boe in developed markets. and FFO‐to‐gross debt).Corporates Leverage For financial leverage ‐ measuring a company’s long‐term creditworthiness and solvency ‐ Fitch analyses the dynamics of various leverage ratios (including the ratio of gross debt‐to‐EBITDA. Fitch also assesses actions related to cash outflows. Fitch analyses the flexibility of capex. whilst the implementation of intensive capex programmes on a fully‐ or partially debt‐financed basis can be feasible under favourable industry conditions. Because of the liquid market for asset sales. ie the breakdown between growth and maintenance. Fitch formulates mid‐cycle oil and gas price views (called Price Decks) and publishes these routinely throughout the year. Table 6: Leverage and Debt Ratios Observations ‘AA’/‘A’ rating categories ‘BBB’ rating category Less than ‘BBB’ rating categories Source: Fitch Gross leverage (x) Less than 1. Given the operating characteristics of oil and gas companies. Using CFO divided by production of hydrocarbons during the same period. due to the higher exposure to market price risk which their credit metrics will face when the cycle turns downwards. the Price Deck is the longer‐term average realized price oil companies are anticipated to achieve over the course of a complete business cycle. based on expectations of supply/ demand fundamentals in conjunction with marginal cost assumptions. nor are they expectations of market‐ related price movements. These include investment programmes.5‐2. Therefore. Fitch measures how much money is available for reinvestment per barrel after all cash costs have been paid.5 1. Entities whose leverage increases towards the peak of the cycle are viewed negatively. net debt‐to‐EBITDA. Factors impacting the scalability of capex include the operator of a specific project and its size/location.5 More than 2. such as gross debt‐to‐proven reserves. and gross debt‐to‐proven developed reserves. acquisitions.

Rating Oil and Gas Exploration and Production Companies April 2010  9  . or at any given rating category. their revenues ‐ and thus cash flows ‐ are exposed to volatile oil and gas prices. particularly in emerging markets and where group relationships constrain or enhance a rating level. As a result. Ratio levels refer to the mid‐point of a through‐the‐cycle range. Additional factors will influence ratings. large. less‐flexible capital expenditure profiles and therefore need to maintain greater financial flexibility to preserve a strong investment‐grade rating. In such instances ‐ eg where there is a cap on the price at which E&P businesses can sell their product to downstream businesses ‐ Fitch considers the impact of the price mechanism on revenue predictability and control over profitability on a case‐by‐case basis. throughout the cycle. Where no observations currently exist.Corporates repeatedly stopping/starting projects). guidelines for a category are extrapolated based on Fitch judgement.0 Revenue and Profitability Trends in revenue and profitability set a pattern for cash flow dynamics. The weighting of factors will vary substantially over time.3 1. both for a given issuer and between issuers. based on relative current significance agreed upon by the rating committee. a government may employ a market price mechanism which restricts E&P companies’ profits (usually via price setting or taxes).7 1.  Limitations  This report outlines indicative factors observed or extrapolated for rated issuers in developed markets. integrated companies will tend to have larger. The factors give a high‐level overview and are neither exhaustive in scope nor uniformly applicable. Table 7: Operating Cash Flow to Capital Expenditure Observations ‘AA’/‘A’ rating categories ‘BBB’ rating categories Less than ‘BBB’ rating categories Source: Fitch CFO/capex median ratio (x) 1. and actual observations may vary from these. Certain sub‐sectors may contain a small number of observations overall. In some countries however. Given that E&P companies lack business chain integration.

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