The subprime mortgage-related credit crunch already has led to a significant slowdown in energy project finance, and its effects likely will be felt through 2008, according to energy consultants with Washington, DC-based Pace Global Energy Services.
To navigate around any possible problems, Pace Executive Vice President Rutherford “Bo” Poats said the “credit squeeze can be dealt with via prudent project and capital structuring and careful selection of capital sources.”
According to Poats, the power sector has been particularly affected by the credit crunch, “set against a looming power project finance requirement in excess of 120 GW over the next 10 years.” However, “coupled with a booming midstream gas and upstream oil and gas market, Pace expects capital markets to be challenged, and capital sources to remain tight.”
A veteran energy attorney in the Pacific Northwest underscored these same sentiments about the power sector in co-chairing a two day energy conference in Seattle in mid-January, saying the nation’s need to replace nearly half of its current electric generation fleet during the next 20 years may be short-circuited by the continuing fallout on Wall Street from the subprime mortgage crisis.
The impact is likely to be “very, very severe, regardless of whether we have a full-blown recession or not,” said Laurence Cable, a Portland, OR-based attorney at the Law Seminars International conference, “Buying and Selling Electric Power in the West.”
“Whether it leads to a recession or not is unknown, but I think it is already having quite a dramatic effect on the availability of capital to build new generation plants,” said Cable, a principal in Cable Huston Benedict Haagenen & Lloyd LLP, which represents various energy organizations in the Pacific Northwest.
The market for capital, Poats said, “is expected to remain selective, driven by stricter project quality requirements, and adjusted default-risk pricing within credit committees.” Banks positioned to underwrite projects will be in strong demand and standards for bank group syndications will be more rigorous in the near term, he stated.
Hedge funds had the “most immediate impact” from the initial credit squeeze, Poats said, because they took “large positions in energy assets, often with aggressive pricing terms in Term B and other sub-debt positions.” Sub-investment grade projects “led many funds and banks to freeze investment activity in late summer, as Term B markets effectively closed.”
Sub-investment grade loans are now cautiously returning, said Poats, but at “conservative pricing levels,” which reflects an adjusted default risk.
“There is a delicate balance between the optimism of traditional project finance desks, balanced by the continued concerns about the final impact of the subprime crisis,” said Poats. “The final tally of defaults is not yet in and could worsen significantly as rates are reset, especially if the economy falls into a recession.
“Of significant interest are forward fixed-rate LIBOR [London Inter-Bank Offer Rate] swaps. Four- and five-year swaps are currently trading approximately 100 basis points lower than front (three) month floating-rate LIBOR, which is signaling an eminent economic slowdown.” LIBOR is the interest rate that the banks charge each other for loans.
“The credit situation will make it more difficult for project finance lenders to obtain credit approval in 2008,” Poats said. “Terms will continue to tighten, unless the market improves, and credit committees will decline higher-risk transactions. Deals will need to be cleaner with larger equity commitments at the table until the market is confident that the crisis has passed. The need for energy project investment, however, is expected to create a robust supply of project finance opportunities, which will assist in correcting the market, especially if the economy can avoid a significant downturn in 2008.”
Investment banks, hedge funds and insurance companies clearly see much more uncertainty in the capital markets as a result of the mortgage problems, said Cable, citing discussions he had on Wall Street last month while attempting to close a power plant sale for a client. It pointed up for Cable the fact that there is what he called “a competing situation” ongoing in the power generation sector that has been created by the push for electricity from renewable energy sources.
Cable said Wall Street blue chip investment banks and hedge funds have been earmarking specific portions of their available capital for investment in renewables because there are lots of opportunities and the returns are so good.
“They are setting aside a given amount [in billions of dollars] because they think it is going to be mandated, and because it is going to be very profitable,” he said. “They all want to advance money for this purpose.”
How long is it going to last? “No one really knows, but it won’t be months, and it could certainly be a matter of years, according to the experts,” said Cable, noting that prompted his law firm to do a short analysis of the attraction of public-private financing.
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