IMPLICATIONS OF ECONOMIC TURMOIL TO EMERGING MARKET PROJECT FINANCE TRANSACTIONS—A RATING AGENCY PERSPECTIVE

• Jurisdiction: Derecho Internacional

Oil and Gas Development in Latin America
(Mar 1999)
CHAPTER 19E
IMPLICATIONS OF ECONOMIC TURMOIL TO EMERGING MARKET PROJECT FINANCE TRANSACTIONS—A RATING AGENCY PERSPECTIVE
Curtis A. Spillers, CFA, Vice President
Duff & Phelps Credit Rating Co.
Chicago, Illinois

SPECIAL REPORT

GLOBAL PROJECT FINANCE

Branch Rickey, the Brooklyn Dodgers general manager who signed Jackie Robinson, often remarked: "Luck is the residue of design."

Since project finance transactions are specifically structured to minimize potential sovereign risks, will they be lucky enough to avoid the current financial turmoil surrounding many emerging markets? Only time will tell, but investors holding this paper certainly hope so! Generally, Duff & Phelps Credit Rating Co. (DCR) believes most projects in emerging markets can withstand this turmoil. Most project assets are long lived and thus must be structured to withstand changing economic and political environments.

Nevertheless, current economic turbulence engulfing many foreign markets is adding stress to many projects for the first time. Sponsors and lenders alike are watching and waiting to see if these structures work as advertised. In the meantime, new projects must show very compelling economics in order to obtain financing. Weaker or more dubious projects are being mothballed due to lack of financing. This natural weeding out process should be good for investors and the market in general. Over the longer term, a potential reduced supply of many commodity products could lead to higher prices and upward pressure on inflation.

How are current market conditions changing the way sponsors, investors and lenders look at project finance? First, future deals may have higher levels of equity than the 10-30% levels seen in the past. Currently, DCR is rating a project that has 60% equity and subordinated debt against 40% senior debt. This adds a much higher degree of protection to senior lenders. Second, more deals brought to the 144A or private placement markets are likely to have "belts and suspenders." A greater involvement of ECA's and multilaterals are an example of this.

The largest risk being assumed by investors in most project finance transactions is commodity price risk. Production capacity of most projects are sold under long term contracts at market prices to buyers identified in advance. Currently, most commodity prices are at or near historical lows, including oil, gold and copper. For those companies with the financial wherewithal, now may be a good time to build additional capacity in anticipation of higher prices when these projects are completed. Future project financings may see sponsors assume part of this price risk instead of passing it completely on to lenders. DCR is currently rating a domestic newsprint project that eliminates 70% of the volatile price risk of newsprint via a fixed and floor pricing structure with the buyers. Thus, most of the commodity price risk is assumed by the buyers of the project output, not bondholders. A tracking mechanism minimizes risk for the buyer, who

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pays a floor price when prices fall below the floor, but continues to pay the floor price when prices rise above the floor until credits earned in the tracking account are eliminated.

Construction risk in projects have been assumed by both sponsors and lenders. When lenders have assumed this risk, protection has typically been in the form of a fixed-price, lump-sum, date certain EPC contract with substantial...