International Debt Markets

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1 Bureau of Economic Geology, The University of Texas at Austin Why Discuss Debt Markets Access Requirements? Pemex The cost and availability of debt is key to its future investment program, especially if its tax burden continues at high levels. Pemex s future investment program is critical to achievement of the goals of reversing oil production declines and discovering new reserves. Potential Investors in Mexico They may have to access debt markets to invest in Mexico. They must consider potential Mexican investments impact on their credit rating, among other factors. Access to International Debt Markets: The Role of Corporate and Sovereign Credit Ratings Policy makers should be cognizant of the access and process requirements of international debt markets when designing investment frameworks. CEE-UT, 2 International Debt Markets Standard & Poor s Ratings Definitions US-type standards and institutions prevail in the major international debt and equity markets. US Securities and Exchange Commission (SEC) regulates public debt and equity issuers to ensure transparent markets and access to quality information. Credit rating agencies Standard & Poor s, Moody s, Fitch analyze the credit quality of corporate and sovereign debt issuers and assign ratings to specific debt issues The ratings assigned to debt issuers characterize issuers by their capacity to meet their financial The ratings influence the amount and cost of debt lenders provide. AAA AA Extremely strong capacity to meet financial Highest Rating. Very strong capacity to meet financial A Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances. BBB Adequate capacity to meet financial commitments, but more subject to adverse economic conditions. Mexico & Pemex with government support BBB- Considered lowest investment grade by market participants. BB+ Considered highest speculative grade by market participants. Pemex Stand Alone Credit Profile BB B CCC CC C D Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions. More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial Currently highly vulnerable. Currently highly vulnerable obligations and other defined circumstances. Payment default on financial Note: Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. CEE-UT, 3 CEE-UT, 4

2 Aaa Aa Moody s Ratings Definitions Extremely strong capacity to meet financial Highest Rating. Very strong capacity to meet financial A Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances. Baa Adequate capacity to meet financial commitments, but more subject to adverse economic conditions. Mexico & Pemex with government support BBB- Considered lowest investment grade by market participants. Ba BB B Caa CC C D Considered highest speculative grade by market participants. Pemex Stand Alone Credit Profile Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions. More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial Currently highly vulnerable. Currently highly vulnerable obligations and other defined circumstances. Payment default on financial Note: Ratings from Aaa to Caa may be modified with 1, 2 or 3 to show relative standing within categories. Role of Transparent Business and Financial Reporting Reporting of high quality, transparent and comparable business and financial information by issuers key to the effective and efficient functioning of debt markets Credit rating agencies require this information for their ratings analysis Financial reporting typically conforms to international accounting standards such as GAAP* and IFRS* with audits provided by recognized international auditing firms Oil and gas reserve reporting typically conforms to US Securities and Exchange Commission (SEC) standards with audits provided by recognized petroleum engineering firms *GAAP: Generally accepted accounted principles, mostly used in US *IFRS: International financial reporting standards, mostly used outside US but increasingly in US CEE-UT, 5 CEE-UT, 6 Credit Rating Methodologies Moody s Integrated Oil & Gas Industry Rated Companies Credit rating agencies have well-defined (and similar) analytical protocols for their ratings assessments. Analytical protocols vary by industry and issuer type (corporate vs. sovereign, for example) Credit ratings are more focused on ability to repay debt than a company s ability to grow equity markets more concerned with growth Our example is Moody s Global Integrated Oil & Gas Industry Rating Methodology dated November 2009 for corporate debt issuers (includes national oil companies) Ratings Universe Average rating of A2 for 22 companies Majors and super-majors rated Aaa- Aa; Smaller and/or more aggressively leveraged companies, with some regional concentration rated A-Baa; National oil companies or other regionally concentrated companies, often with significant scale and political position, but with ratings primarily driven by geopolitical or sovereign-linked factors CEE-UT, 7 CEE-UT, 8

3 Moody s: Global Integrated Oil & Gas Industry Key Rating Areas Factor 1: Reserves & Production Characteristics, 25% Reserve and production characteristics: 25% Re-investment risk: 10% Operating & capital efficiency: 10% Downstream rating factors: 15% Financial metrics: 40% Government fiscal dependence adjusts rating produced by the five weighted factors Ave. Daily Prod. Aaa 8% Proved Reserves Aaa 12% Proved Res. Life A 5% Reserves & production main source of cash flow Reserves & production provide a better measure of a company s size, scale and competitive position than financial metrics CEE-UT, 9 CEE-UT, 10 Factor 2: Re-investment Risk, 10% Factor 3: Operating & Capital Efficiency, 10% Reserve Replacement Caa 5% Finding & Development A Cost/BOE 5% An oil and gas company will eventually liquidate if it cannot consistently and successfully reinvest capital to discover new reserves and to replace and increase production profitably ROCE (consol.) Aaa 5% Leveraged full-cycle ratio (upstream) Aaa 5% The oil industry is capital intensive so strong returns on capital are critical to attracting low-cost debt & equity. The full cycle ratio measures how much cash a company generates in excess of its cost of replacing reserves, indicating sustainability.* *CEE comment: If a company is not fully replacing reserves, this measure is potentially misleading regarding sustainability of the enterprise. CEE-UT, 11 CEE-UT, 12

4 Factor 4: Downstream Rating Factors, 15% Factor 5: Financial Metrics, 40% Distillation Capacity A 5% # Large Refineries A 5% ROCE Caa 5% Downstream operations diversification, a hedge against oil price movements, economies of scale and the opportunity to capture the complete value chain through integration. Ret. Cash Flow/Net Debt Aaa 10% EBIT/Int. Expense A 10% Gross Debt/Proved Reserves Aaa 10% Gross Debt/Capital Caa 10% Financial metrics measures a company s capacity to incur additional debt, its balance sheet flexibility and its ability to generate cash to service its debt. CEE comment: If a company subsidizes downstream product prices, it loses its hedge against oil prices and value chain integration benefits. Its return on downstream capital suffers as in the case of Pemex. CEE-UT, 13 CEE-UT, 14 Factor 6: Government Fiscal Dependence Tax Revenue as Percent of GDP Brazil Argentina Uruguay Colombia Chile LATAM Avg Mexico Venezuela Tax revenue in Latin America Tax revenue in OECD 50 Sweden France 43 Czech Rep. 38 OECD Avg 36 Spain 35 Portugal 34 Ireland 30 United States 26 Pemex Rating: 6 Notch Decrease Overall Rating Impact: Based on first 5 factors, Pemex rating would be A2. Factor 6 reduces the rating to Ba2, a non-investment grade rating. A government is fiscally dependent on a company if its economy is not sufficiently diversified or tax collections from the non-oil sector are limited. This constrains the investment capability of the company Source: OECD Latin American Economic Outlook (forthcoming) based on ECLAC and OECD Revenue statistics databases (2007) Note: data are for (2004) and include social security contributions Source: Democratic Governance in Mexico, Javier Santiso, Chief Economist and Deputy Director, OECD Development Centre, June CEE-UT, 15 CEE-UT, 16

5 Rating Agency Comments on Pemex Stand Alone Rating Positive Large reserve base; central role in Mexican energy sector Profitable producing operations with competitive lifting costs Proximity to US markets Negative Significant financial risk profile. High tax burden results in debt funding of capital expenditures. Declining production and unfavorable reserve replacement rate compared with other investment grade peers Large unfunded pension obligations Impact of Sovereign Credit Ratings on Corporate Debt Issuers Countries issue debt and are assigned credit ratings according to a sovereign analytical protocol Mexico s foreign currency ratings August 2010: Standard & Poor s BBB/Stable/A-3; Moody s Baa1/Stable Mexico s investment grade ratings superior to Pemex stand alone noninvestment grade ratings (BB+ and Ba2) Pemex is considered a government-related entity due to its critical role in the energy sector; its provision of about 40% of public sector revenue, and government s heavy involvement in the company It is almost certain that the Mexican government would provide timely and sufficient extraordinary support to Pemex in the event of financial distress As a result, Pemex non-investment grade ratings raised to equivalency with Mexico sovereign ratings Historically Pemex s ratings one notch below Mexico sovereign ratings but Mexico rating reduced in December 2009 CEE-UT, 17 CEE-UT, 18 Standard & Poor s Assessment of Role of Government Support for National Oil Companies Implications of Government Support for NOCs A Mixed Blessing? Nine NOCs credit ratings benefit from indications that their governments would provide extraordinary support: CNOOC, PetroChina, Sinopec, KMG EP, Petronas, Pemex, Qatar Petroleum, PTT and PDVSA Additional six NOCs credit ratings benefit from indications that their governments would provide strong and almost certain support: Petrobras, Ecopetrol, GDF SUEZ, Statoil, Gazprom and Rosneft Government support usually accompanied by heavy government involvement in NOC strategies, investment programs and management Presence of substantial government safety nets could dampen innovation, risk taking and technical and managerial competence Government support for NOCs usually highest in oil and gas dependent economies and/or economies with major energy security issues - Country fiscal dependence on NOC can reduce a NOC s stand alone credit rating CEE-UT, 19 CEE-UT, 20