Industry Looks to 2004: A Credit Perspective

Global Finance, Dec 2003 by Chew, William

Project debt remains a challenge in many markets after two of the worst years in memory. For many institutional and bank lenders, project debt continues to cany a Biblical mark reflecting its role in some of the more extreme recent credit meltdowns.

There remain some important exceptions:

* Contract-backed projects with off-takers manifestly distant from any visible credit problem;

* Projects in sectors with strong credit fundamentals, such as oil and gas; and

* Projects favored, and in some cases supported, by current governmental policy trends, such as power from renewable resources, carbon-sequestration projects and other environmentally oriented projects.

And some current financial market trends will likely favor project finance in various forms. The return to favor of the high-yield bond market in the United States, and record liquidity in the bank-loan market in particular, have helped to open the way for well-structured projects free of any exposure to current or potential credit problems. But even as the project finance market begins, at least selectively, to show some signs of life, it will remain important that projects address some of the key credit challenges that have demonstrated the potential to bring projects down, such as the collapse of tenor, or severe margin squeezes.

As credit pressure has risen, lenders have reacted by reducing tenor. For many lenders, especially lead banks, this became a preferred approach to managing rising credit risk. Banks have long held that by reducing tenor, they increase their ability to actively manage a borrower's credit standing. But experience shows that for the power sector in particular this approach also has the potential to cause concentration of near-term maturities that can, in the aggregate as well as for individual companies, become a negative credit factor in and of itself.

Under more normal market conditions, this risk could be assumed to be immaterial, but the sharp contraction of both the bank and bond markets in 2002 leaves the potential that refinancing may again become an issue, particularly for higher-risk credits, which may face a challenge even under less-stressed market conditions.

For projects, credit strength often depends on the match of revenues and expenses at levels not possible in many other areas. This capacity stems in part from regulated monopolies, especially utilities and their ability to pass through costs to end-users. It also reflects markets' ability to match key components in revenue and expenses, such as by hedging between power and fuel prices.

Optimistic assumptions about deregulated markets have led some borrowers to depart from basic matching practices on the assumption that, like financial markets, input and output markets offer relatively continuous opportunities to roll over hedges. But recent experience shows that, just as financial market assumptions on continuity became overly optimistic, many assumptions about the continuing ability to roll over or extend project-level hedges proved to be unrealistic.

In power, in particular, many borrowers missed the extent to which power and key fuel-input prices not only could de-link but also, in the case of gas-fired generation, could rapidly put projects into severe margin squeezes. Some of these squeezes may abate as declining power prices, driven by factors well beyond fuel markets, may force cancellation and deferral of gas units. But failure to match long-term revenue with expenses will continue to be one of the key factors marking weaker, as opposed to stronger, credits for some time.

Credit strength, a hallmark of well-structured projects, has remained an issue for both borrowers and lenders in 2003. For individual credits, and even more for overall credit trends, positive developments were few and hard to find. But there are some encouraging signs. Above all, the focus on credit, intermittent at best during the credit expansion, returned with a vengeance across most areas of project and infrastructure finance. The continuing issue for lenders and borrowers has become how long this focus will last.

By William Chew, managing director, corporate and government ratings, Standard & Poor's, New York City