On the edge of a fiscal cliff

Low oil prices and poor fiscal judgement have pushed Newfoundland and Labrador into a recession. With the looming threat of credit rating downgrades that could cripple the economy, Finance Minister Cathy Bennett doesn’t have much room — or time — to make some tough decisions.

The Province of Newfoundland and Labrador has collected $20 billion in royalties since the first barrel of offshore oil was produced in 1997, but it has not put any of it away for a rainy day. Now, according to Finance Minister Cathy Bennett, “It’s raining.”

Oil prices are falling. Offshore production is falling. Provincial government revenues are falling. According to Premier Dwight Ball, this constitutes a “perfect storm”. And it’s a storm that threatens to wash away gains that have taken decades to achieve, like “have” status.

Last March Memorial University (MUN) economist Wade Locke said there was a “zero chance” the province could slip back into “have-not” status. Last month a former senior member of the province’s finance department, speaking on condition of anonymity, said it’s “entirely possible,” while a New Brunswick-based economist told CBC that “bankruptcy is absolutely a possibility” for the province.

The fiscal numbers facing the new government are sobering, as is a close reading of the most recent reviews by the province’s credit rating agencies. Travis Shaw, the Dominion Bond Rating Service’s (DBRS) lead analyst for Newfoundland and Labrador, describes the province’s fiscal gap and its “extent of deterioration” as “concerning”.

The extent of Shaw’s concern was reflected by a DBRS modification in the province’s credit rating last month and a warning that “without a material improvement in the fiscal and debt outlook supported by a credible multi-year fiscal plan a one-notch downgrade is likely.”

A credit downgrade would likely be accompanied by an increase in the cost of borrowing, representing an additional expense for a province whose expenses already exceed its revenues.

The former senior member of the provincial Department of Finance says the key word in the analyst’s warning is “credible”.

The former Progressive Conservative government forecast a 2014-15 fiscal year budget deficit of $538 million. According to the provincial Auditor General’s recently released audit the 2014-15 budget deficit was $986 million making it the “highest deficit in history”.

Last April former PC Finance Minister Ross Wiseman forecast a 2015-16 election year budget deficit of $1.093 billion, which would set a new record. The actual scale of the 2015-16 deficit, however, was only apparent when within weeks of winning the Nov. 30 provincial election the new Liberal government announced it was almost $2 billion.

According to Shaw an early measure of of Bennett’s credibility will be whether she sets targets and hits them or misses them. Bennett’s deficit forecast is based on an assumption of the price of oil at $51 a barrel next year. In contrast, the DBRS review notes forward prices for Brent crude range between $34 a barrel for year-end 2016 and $36 a barrel for the year end 2017.

The January DBRS review cautions that failing to produce a “credible multi-year” plan is “likely” to lead to a credit downgrade, which, according to economist and former Toronto Star economics columnist David Crane, means “certain institutions can no longer buy the provincial debt.

“This reduces the potential market for Newfoundland debt and means Newfoundland must pay a higher interest rate.”

Crane says the metric to watch is provincial debt as a share of the province’s GDP.

Newfoundland and Labrador’s bond rating track record

The DBRS and other bond rating agencies use rating scales to express their opinion about risk. At the top of the DBRS scale is an ‘AAA’ rating for borrowers with the highest credit quality. Next is ‘AA’ for those with superior credit quality, followed by ‘A’ for those with good credit quality. ‘BBB’ means adequate credit quality, and below that rating is ‘BB’ for speculative credit quality.

Additionally, DBRS modifies each rating on the scale with indicators of ‘high’ or ‘positive’, ‘stable’, and ‘low’ or ‘negative’ to indicate whether their opinion of a borrower’s credit worthiness is improving or deteriorating.

 “Without a material improvement in the fiscal and debt outlook supported by a credible multi-year fiscal plan, a one-notch downgrade is likely.” — DBRS

Following the closure of the cod fishery in 1992 Newfoundland and Labrador’s debt-to-GDP ratio peaked at 83 percent and its DBRS credit rating was BBB (low) — barely investment grade and only one step above a speculative rating. By 2004/2005, as oil revenues began to flow, the province reduced its debt-to-GDP ratio to 59 percent and its DBRS credit rating climbed to BBB (high).

A year later, buoyed by a $2 billion Atlantic Accord payment, the province’s debt-to-GDP ratio dropped to 43 percent and its credit rating was upgraded to A (low). Then, in October 2008, buoyed by a $1.3 billion budget surplus in the previous year, the debt ratio fell to 34 percent and the province’s credit rating climbed to A — still below AA or AAA, but A none the less.

In 2014-15 the province’s debt-to-GDP ratio was 31 percent but the 2015-16 deficit is expected to drive that number up. Last November Shaw estimated a provincial debt-to-GDP ratio of 42 percent, or “even higher if fiscal targets are missed.”

In it’s January review two months later, DBRS estimated Newfoundland and Labrador’s debt-to-GDP rate could exceed 55 percent early in 2016-17. As a consequence DBRS modified the province’s ‘A’ rating by revising the trend from “Stable” to “Negative” — still ‘A’, but a weaker ‘A’ and the last stop on the DBRS’ rating scale on the way back to BBB.

Moody’s and Standard and Poor’s, the other two provincial bond rating agencies, have followed DBRS and also reduced the outlook for Newfoundland and Labrador bonds.

The province, as economist Wade Locke noted last year, has no influence on the international price of oil, and as a result does not fully control its revenue stream. However, in its November ratings report DBRS says it “expects that additional fiscal measures will likely be required to limit the deterioration in key financial matters.”

Doug May, an economist at MUN, says what DBRS means by “additional fiscal measures” are spending cuts, and he predicts they will “cut right across the province and have multiple repercussions.”

The unknowns

As Bennett tries to weather perfect storm, May says the finance minister also has to contemplate unknowns, including the status of the Hebron oil field development and the province’s equity stake in it.

In 2008 then-Premier Danny Williams committed the province to buying a 4.9 percent stake in Hebron. At the time of the announcement the government projected oil prices at $87 barrel. The price of the province’s stake in the Hebron project was $110 million and Williams forecast a return to the province of $20 billion.

The economics have since changed and the province’s anticipated profit may turn into a loss. The capital cost of the project—which is scheduled to come into production in 2017—has escalated.

In 2014 the lead partner in the project, Exxon Mobil, forecast capital costs at $14 billion. The arithmetic is simple. If the field has reserves of 700 million barrels, as estimated, and the capital cost is $14 billion, then the capital cost per barrel is $20. Add production, transportation and a discount because of the viscosity of the lower quality oil, then the province may lose money on every barrel of oil produced.

According to May the worry for analysts like Shaw is that the economics of the Hebron project is just one unknown. Another is the economics of the Muskrat Falls hydro project in Labrador, already over budget and behind schedule. According to some critics the project could increase the province’s gross debt by 50 percent.

Though only sworn in as finance minister on Dec. 14, Bennett immediately faces tough decisions. According to Shaw there is “clearly a need for action.”

Unlike some of her predecessors, Bennett does not have the benefit of “getting on the roller coaster when it was stopped at the station,” says May. “She has had to jump on while it is moving.”

In a Jan. 29 press release responding to Standard and Poor’s credit downgrade, Bennett acknowledged the province is in a “serious” and “tremendously difficult” situation.

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