DBRS Confirms Penn Virginia Resource Partners, L.P. at BBB (low)

DBRS has today confirmed the rating for Penn Virginia Resource Partners, L.P. (PVR or the Company) at BBB (low) with a Stable trend. The Company’s business profile and financial profile are still acceptable for the rating despite the aggressive leverage and the changing business profile.

The recent increase in investment in the natural gas midstream sector has raised the risk in the Company’s business profile. Prior to 2005, PVR’s core business was managing and leasing coal properties. Accordingly, the principal business risk for PVR is the matching of operators to its properties such that production and hence royalty revenue are maximized. The Company has a strong track record in this area, with a minimal occurrence of lease disruptions. In March 2005, PVR’s business profile was diversified through the acquisition of natural gas midstream assets. The natural gas midstream segment is growing rapidly; this segment generated 42% of total operating profit in 2007 compared with 29% in 2006 and 20% in 2005. This growth in the natural gas midstream segment has led to increased risk in the business profile, since the Company must now manage significant operational risk. However, the risk is still acceptable for the rating.

In 2007, PVR’s financial performance was weaker than expected. Net earnings were negatively impacted by a $37 million increase in derivatives expense year-over-year (YoY). This was due to changes in the valuation of unrealized derivatives positions used in hedging natural gas midstream production. Despite the fact that earnings were lower in 2007 than in 2006, operating income was 15% higher YoY due to improved natural gas midstream revenues, although this increase was partially offset by the decline in coal royalty revenues.

Coal royalty revenues were impacted by a change in sales mix (increased production of lower-priced coal from the Illinois Basin versus lower production of higher-priced coal from Central Appalachia). Revenues were positively impacted by higher gas and coal prices as well as by higher production volumes for the midstream segment.

DBRS expects revenues to increase in the near to medium term due to expected strong gas prices and increased production in the natural gas midstream market (due to acquisition and organic growth). Coal prices are escalating due to increased worldwide demand and supply constraints. Despite the fact that most of PVR’s production is sold through long-term contracts, the Company will benefit from the hike in coal prices as contracts roll over in the coming year. As well, the Company made significant acquisitions during the course of 2007 and should realize the benefit of this in the near to medium term.

These 2007 acquisitions, which included coal reserves, forestland and oil and gas royalty interests, cost approximately $176 million and were financed with cash and debt, causing the gross debt in capital structure to increase to 53% at the end of 2007, up from 35% in 2006. In addition, unlike in previous years, PVR generated negative net free cash flow in 2007 (the Company was unable to cover both maintenance and expansion capex as well as distributions with internally generated cash flow). The Company funded the shortfall with debt, thereby pressuring the leverage metric even further. However, PVR 2008 guidance has indicated that capex will be reduced by half and this, coupled with increased earnings, should result in positive net free cash flow in the near term (although this would be contingent on the level of distributions made by PVR).

Despite the fact that current leverage is highly aggressive for the rating, PVR’s coverage ratios are at the high end of the rating range: cash flow-to-debt is at 0.32 times and EBITDA interest coverage is at 9.2 times (as at December 31, 2007). The Company has demonstrated discipline in returning leverage ratios to acceptable levels (well within the parameters of the rating) through equity issuances in 2005 and 2006 (i.e., leverage was at 54% at the end of Q306, the Company subsequently reduced debt levels to 35% through an equity issuance in December 2006). As such, DBRS expects that the Company will remain committed to reducing its leverage to a level acceptable for the rating (below 45%) within the next 12 months.

Note:
All figures are in U.S. dollars unless otherwise noted.