S&P Downgrades PetroQuest Energy (PQ) to 'CC'; Outlook Negative

S&P Global Ratings lowered its corporate credit rating on PetroQuest Energy Inc. to 'CC' from 'CCC'. The outlook is negative.

We also lowered the issue-level rating on the company's $145 million 10% senior secured second lien notes to 'CC' from 'CCC'. The recovery rating remains '3', indicating meaningful (higher end of the 50%-70% range) recovery in the event of default. The 'D' issue-level and '6' recovery ratings on the senior unsecured notes due September 2017 are unchanged. The '6' recovery rating indicates negligible (0%-10%) recovery in the event of default.

"The downgrade follows PetroQuest's announcement that it has launched an exchange offer to existing holders of its $145 million 10% senior secured second-lien notes and 10% senior unsecured notes for new senior secured second-lien notes due 2021 at par value," said S&P Global Ratings credit analyst Daniel Krauss. "The closing date is expected to occur by the middle of September 2016," he added.

We view the transaction as a distressed exchange because investors will receive less than what was promised on the original securities. While the exchange is being made at par, the timing of payments is slowed from a 10% cash interest rate to 1% cash interest and 9% payment-in-kind (PIK) rates for the first 18 months. Additionally, in our view, the offer is distressed, rather than purely opportunistic, given the current challenging operating environment, and significant upcoming debt maturities.

We assess PetroQuest's liquidity as less than adequate, based on our view that if the company does not raise additional external capital, liquidity sources will fall well below expected uses in 2017. In June, the company entered into an amendment under which it cannot incur any borrowings until it can satisfy the covenants under the credit agreement. These include debt/EBITDAX of less than 4x and EBITDAX interest coverage of at least 3x. Based on our current forecasts, we do not believe the company will have access to its revolver over the next few quarters. The company had a cash balance of $69 million on June 30, 2016. In addition, the company announced it has a commitment letter for a $50 million term loan, subject to certain conditions, including a successful exchange being completed.

The outlook is negative. Once the transaction has closed, we expect to lower the corporate credit rating to 'SD' (selective default) and the issue-level rating on the $145 million second-lien notes to 'D'. We would then review the ratings based on the new capital structure and consider an upgrade. We also expect to rate the new second-lien notes when there is more detailed information about the resulting capital structure. We could lower the ratings if the company does not meet its interest obligations.

We could raise the ratings if the transaction does not close.

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