Fitch Ratings has upgraded Civitas Resources, Inc.'s (Civitas) Long-Term Issuer Default Rating (IDR) to 'BB' from 'BB-' following the close of the Hibernia and Tap Rock acquisitions.

Fitch has also upgraded the Reserve Based Loan (RBL) credit facility to 'BBB-'/'RR1' from 'BB+'/'RR1' and its senior unsecured notes to 'BB'/'RR4' from 'BB-'/'RR4'. Fitch has removed Civitas' ratings from Rating Watch Positive and assigned a Positive Outlook.

The upgrade reflects the closing of the previously announced Hibernia Resources III LLC (Hibernia) and Tap Rock Resources LLC (Tap Rock) acquisitions, which materially increase production size and proved reserves base, provide diversification outside of the DJ Basin, and support strong post-dividend FCF. Although the transaction significantly increases gross debt and leverage, the company will maintain clear headroom under Fitch's leverage sensitivity with leverage projected to remain at or below 1.5x throughout the forecast.

The Positive Rating Outlook could be resolved before the 12 to 18 month timeframe if Civitas makes material progress in reducing post-close RBL borrowings and demonstrates a successful track record as an operator in the Permian Basin.

Key Rating Drivers

Scale and Diversification Enhancing Acquisitions: Fitch believes the announced acquisitions of Hibernia and Tap Rock are transformational to Civitas' operating profile. The transactions diversify Civitas' asset profile and add material scale through approximately 68,000 net acres in the Permian Basin, 100 Mboepd of liquids-weighted production and 800 highly economic drilling locations. Fitch views the entry into the Permian favorably as it is a more regulatory-friendly basin to operate in compared to the DJ Basin, and regulation risk in Colorado has historically been a constraint on the rating.

Gross Debt Increases; Leverage Remains Low: Although the transaction is leveraging in the near term through the addition of approximately $3.45 billion of debt to the company's balance sheet, Fitch forecasts mid-cycle EBITDA leverage to remain at or below 1.5x. Fitch expects that FCF will be allocated toward paying back RBL borrowings. The company has a goal to return to below 1x net leverage by YE 2024 and achieve a long-term net leverage target of 0.75x.

FCF Prioritized Over Drill Bit Growth: Civitas aims to keep organic production flat to benefit FCF generation. Hibernia and Tap Rock are currently operating with three and four rigs, respectively, and Civitas plans to drop both locations to two rigs moving forward in order to prioritize FCF generation. Fitch expects 50% of the company's FCF, gross of working capital changes, will be distributed to shareholders through a variable dividend on top of a quarterly fixed dividend of $0.50/share.

Under Fitch's base case, Civitas is forecast to generate over $300 million of post dividend FCF in 2023 through 2025, which will provide Civitas with funding for debt reduction, potential cash supported M&A, development activities or further shareholder activities. Civitas' strong pro forma FCF is underpinned by its scale and improved liquids mix, which are expected to support strong unhedged cash netbacks.

Near Two Years of Permits in Hand: Citivas has 100% of the 2023 development plan permitted and over 80% of 2024 permits progressing or in hand with a goal of getting permits 12-18 months in advance. Civitas' permitting status consists of approximately 600 wells in various stages of progress on top of 132 locations that were approved in 2022.

Civitas balances its two-rig program in the DJ Basin with drilling rig allocations between its Southern position (e.g. Adams county, Arapahoe county) where it has large blocky inventory positions that are oilier and more rural, its rural Eastern position (e.g. eastern Weld county and acquired Bison Oil & Gas acreage) and its Western position (e.g. Broomfield county and western portion of Weld county), which is more developed, but is more likely to experience permitting challenges.

PDP-Focused Hedging Policy: Civitas' hedging strategy is expected to change post-close as the company plans to hedge a substantial portion of target oil volumes through 2024 in order to maintain leverage and liquidity throughout a $40 oil price scenario. Fitch views this shift positively as it will meaningfully reduce near-term pricing risk and will support FCF generation and reduction of the RBL borrowings. At 2Q23, Civitas had approximately 30% and 15% of its expected 2023 and 2024 oil production hedged and 10% and 5% of its expected 2023 and 2024 natural gas production hedged, respectively.

Colorado Regulatory Risk: Fitch continues to assess regulatory risk within Colorado as high relative to other hydrocarbon-producing states. However, Fitch believes since the beginning of 2021 the risk has lessened following the overhaul of state laws that changed the Colorado Oil & Gas Conservation Commission's (COGCC) mission from fostering the development of oil and gas resources to regulating their development. The current rules, which established a single-permit process rather than the previous multistep process, have provided a tough but navigable framework that producers are learning to operate within.

Fitch anticipates knowledge gained from permit applications and continued collaboration with the COGCC and communities will help the permitting process become more efficient over time. Civitas' ESG investments to achieve a Scope 1 and Scope 2 carbon neutral position through a combination of operational improvements and emission offset credits also support its ability to continue to permit development plans.

Derivation Summary

Civitas is the largest producer within Fitch's 'BB' rating category with 2Q23 standalone production of 173mboepd. This compares to Permian Resources Corporation (BB-/Stable; 154mboepd as of Q1) and SM Energy (BB-/Stable; 154mboepd as of Q2). Pro forma the Hibernia and Tap Rock acquisitions, Civitas is expected to produce approximately 270-290mboepd, which is significantly larger than 'BB-' peers. Pro forma production is higher than Murphy Oil Corporation (BB+/Stable; 184mboepd as of Q2), but trails APA Corporation (BBB-/Stable; 394mboepd as of Q1) and Ovintiv, Inc. (BBB-/Stable; 573mboepd as of Q2).

Civitas' 2Q23 standalone Fitch-calculated unhedged cash netback of $29/boe compares favorably across Fitch's aggregate E&P portfolio due to its low-cost structure and oil percentage (49% in 2Q23).

Civitas has historically had the lowest leverage in the peer group (0.2x at YE22) due to the low amount of gross debt; however, pro forma the acquisitions and note issuances, Civitas' mid-cycle EBITDA leverage of 1.1x is more comparable to the peer group.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer Include

WTI (USD/bbl) of $75 in 2023, $70 in 2024, $65 in 2025 and $60 in 2026 and $57 thereafter;

Henry Hub (USD/mcf) of $3.00 in 2023, $3.50 in 2024, $3.00 in 2025 and $2.75 thereafter;

Base interest rates applicable to the company's outstanding variable rate debt obligations reflects current SOFR forward curve;

No organic production growth in DJ Basin;

Announced transaction close in 3Q23 under proposed terms;

$300 million in divestments of non-core assets by 2H24;

$500 million share repurchase program utilized by 2024;

Midstream operations in line with historical results;

Capex in line with management expectations;

Base portion of dividend does not increase through forecast, variable divided remains at 50% of post-base dividend FCF;

FCF applied to reduction of the RBL.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Strong FCF generation that is directed toward paying back RBL borrowings;

Successful track record as a new operator in the Permian Basin;

Continued increases in scale and/or diversification that helps mitigate overall regulatory and community opposition event risks;

Midcycle EBITDA leverage maintained at or below 1.5x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Change in financial policy leading to trend of gross debt increases and lower liquidity;

A regulatory change that affects permitting, unit economics, or visibility on future operations;

Sustained negative post-dividend FCF stressing liquidity or underinvestment in asset base;

Midcycle EBITDA Leverage sustained over 2.0x.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Sufficient Liquidity: At the closing of the Hibernia and Tap Rock acquisitions, Civitas has secured $850 million of incremental commitments from its lenders, which increases total elected commitments from $1.00 billion to $1.85 billion. The company has drawn $750 million on the RBL as of Aug. 2, and has approximately $1.1 billion of post-close liquidity. Fitch believes the liquidity profile will improve thereafter due to reduction of RBL borrowings via FCF generation.

Issuer Profile

Civitas Resources, Inc. is an oil and gas producer focused on developing and producing crude oil, natural gas and NGLs in Colorado's Denver Julesburg and Permian Basins.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Civitas Resources, Inc. has an ESG Relevance Score of '4' for Exposure to Social Impacts due to {DESCRIPTION OF ISSUE/RATIONALE}, which has a negative impact on the credit profile, and is relevant to the rating[s] in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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