SAN FRANCISCO--(BUSINESS WIRE)--Fitch Ratings has assigned an 'AA' rating to the following North Slope Borough, AK bonds:
--$73.4 million general obligation (GO) bonds series 2016B (general purpose);
--$16.4 million GO bonds series 2016C (schools).
In addition, Fitch affirms the following ratings:
--Issuer Default Rating (IDR) at 'AA';
--$255.3 million outstanding GO.
Bond proceeds will fund the borough's ongoing capital improvement program and pay cost of issuance. The bonds are scheduled to sell via negotiation on or about October 13.
The bonds are payable from an unlimited ad valorem property tax levy on all taxable property within the borough.
KEY RATING DRIVERS
The 'AA' IDR reflects the borough's very strong financial position and moderate liabilities balanced against a very concentrated and unusually vulnerable economic resource base. The revenue and expenditure framework assessments are weighed down by Fitch's expectation of a period of weakness in revenue and tax base performance due to low oil prices.
Economic Resource Base
North Slope Borough is home to the U.S.'s largest conventional oil field at Prudhoe Bay as well as smaller but significant oil and natural gas resources. The borough's oil and gas reserves are non-renewable and naturally declining resources, but new investments and improved technology have repeatedly pushed out the estimated lifespan of the oil fields. The near-term outlook for the tax base, revenue and employment growth are weak due to low oil prices. Fitch expects a significant level of energy extraction activity to continue well past the life of the bonds.
Revenue Framework: 'a' factor assessment
Fitch expects revenue growth to slow with the economy, but the borough has a substantial independent legal ability to raise revenues.
Expenditure Framework: 'a' factor assessment
The natural pace of spending growth is likely to exceed the level of revenue growth as the economy weakens, but the borough has adequate ability to adjust spending.
Long-Term Liability Burden: 'aa' factor assessment
Liabilities are moderate relative to the economic resource base.
Operating Performance: 'aaa' factor assessment
The borough is well positioned to withstand a period of economic stress with very high reserves and midrange inherent budget flexibility. Budget management in times of recovery is very strong with significant resources dedicated to long-term financial needs via a massive borough permanent fund.
DOWNSIDE TRANSITION RISK: The risk of rating transition is weighted to the downside. The rating could come under downward pressure if low oil prices led to a sustained and significant decline in assessed values (AVs) and revenues. The rating is unlikely to move higher due to the concentration of the economic resource base.
The borough is located on the north coast of Alaska, encompassing a vast 94,877 square miles, an area slightly larger than the United Kingdom. The borough's modest population of 9,730 swells to more than 20,000 after including energy-sector workers.
The borough has a large, energy-dominated economy. The borough produced about 465,000 barrels of oil per day in 2015, down 3% from 2014. Production has fallen from a peak of 2 million barrels per day in the 1980s but still makes up more than 5% of U.S. production. Estimates of total recoverable reserves have increased over the years with improvements in technology and the exploration of areas farther from the first fields developed at Prudhoe Bay in the 1960s and 1970s.
Continued exploration of oil fields across the borough and large gas reserves in the North Slope suggest that energy extraction activity will continue at a significant level for the foreseeable future despite near-term weakness. The borough's harsh Arctic environment is likely to support only a very limited economy in the time after energy production, but the borough is actively building its permanent fund to prepare for the post-oil era.
The $21.4 billion tax base is highly concentrated with 90.7% of 2016 AV related to the top 10 taxpayers, all energy companies. The top two taxpayers, BP PLC (IDR 'A'/Stable Outlook) and ConocoPhillips Co. (IDR 'A-'/Negative Outlook), account for about 60% of fiscal 2016 AV.
The borough's revenues are dominated by property taxes with the vast majority of taxes paid by large oil and gas producers or oilfield services firms.
Underlying revenue growth prospects are weak - absent policy action to adjust tax rates - despite very strong performance during the most recent period of very high oil prices and reinvestment in borough oil fields. The borough's 10-year compound annual growth rate of general fund revenues is particularly strong at 7% in the decade ended 2015. But growth prospects have shifted lower with a sustained period of weakness in oil prices now in its third year.
Borough revenues are driven by changes in AV of oil industry capital investments in the borough. Revenues are much less volatile than energy prices and only react to sustained changes in prices. AV is based on the depreciated replacement cost value of the capital stock, not the economic value of oil infrastructure or mineral resources in the ground. AV fluctuates as investment rises and falls, but changes are driven by gradual depreciation and the degree to which depreciation is offset by new investment (or extension of field life in periods of higher oil prices). Investment decisions are driven by long-term energy price expectations and only appear in AV data with a significant lag. AV growth has slowed but remained positive with a 2.5% increase in fiscal 2016.
Fitch expects a period of weakness to emerge, reflecting the current, extended period of low energy prices. The borough has seen some oilfield investments deferred, including Royal Dutch Shell PLC's 2015 decision to abandon most of its efforts to develop major fields in the Chukchi Sea. Fitch's baseline forecast is for a gradual rise in oil prices (See 'Corporate Oil Price Assumption Raised for 2016: Slow Recovery From Here', published July 27, 2016). Oil market forecasts are inherently uncertain, as are second-order effects on the borough's tax base and revenues. The borough rating conservatively assumes a period of stagnation in AV is likely absent sustained and unexpectedly strong improvements in the oil price environment or changes in tax rates. The borough has experienced sustained periods of declining revenues during past episodes of low oil prices such as the late 1990s. The borough is also likely to experience near-term reductions in intergovernmental revenues due to budget cuts, such as reductions in debt service reimbursements for school bonds, from the oil-dependent state. The rating could come under downward pressure if the borough experiences large revenue declines, particularly if they are accompanied by unexpected further weakening in the global oil markets and long-term expectations for the market.
The borough has substantial independent legal ability to raise revenues, giving policymakers the power to offset transitory cyclical variations in revenues by raising property taxes. The borough has flexibility to raise both property taxes and permanent fund transfers, providing enough to offset typical cyclical revenue declines.
Policymakers may legally transfer up to 8% of the borough's massive permanent fund ($579.8 million at the end of fiscal 2015) to the general fund to support operations annually. The borough is not currently making transfers, so it retains the full flexibility. Fitch believes a sustainable level of transfers from the fund is lower and closer to the borough's prior practice of transferring 4% of the principal balance to the general fund annually, but the on-going gap-closing capacity provided by sustainable use of the permanent fund is a meaningful credit strength.
The borough also has some flexibility to adjust its operating tax levy. The borough's tax rate is limited by state law that sets property taxes on oil infrastructure at 20 mills. The borough generally levies 18.5 mills with the final 1.5 mills of capacity collected by the state. Under a complex tax limitation formula, the borough can increase its operating levy significantly if it reduces its overall tax rate below 18 mills. The total revenue take would be lower, leaving a larger proportion of the standard 20 mill levy for the state, but the borough could increase its operating levy by 25% if policymakers reduced the overall rate below 18 mills. With debt that amortizes rapidly, policymakers have the flexibility to take advantage of these provisions by not issuing new GO bonds when bonds mature each year. However, policymakers can access the capacity only gradually. Given current amortization rates, the borough could access the full 25% increase in property tax revenues over a four-year period with a pause in debt issuance.
The borough is a full-service general government providing most of the services provided by cities and counties, including public safety, social services and basic infrastructure. The borough also provides a significant proportion of funding for a politically independent school district. The borough is the main employer and economic driver in villages outside of the oil patch around Prudhoe Bay, and services tend to be more expensive to deliver than in other jurisdictions because of the climate and vast area of the borough.
The natural pace of spending growth is likely to be above the level of revenue growth in the near term if revenue growth slows as Fitch expects. In addition to typical inflationary increases in general costs, the borough faces pressure to backfill state reductions in school funding for its component unit school district.
The borough has adequate expenditure flexibility. Like most local governments, the borough's largest expense is labor. The borough's workforce is not unionized, allowing strong control over compensation costs. The relatively fixed carrying costs of debt service and post-employment liabilities was high at 30.3% of governmental funds in 2015; however, the metric reflects very fast amortization of outstanding bonds with the majority of debt paid off within three years of issuance. The borough has ample ability to structure new bond sales to reduced near-term carrying costs during periods of weakness. The borough assembly also retains the legal authority to reduce services, which are currently well above minimal levels provided in other Alaska communities.
Long-Term Liability Burden
The long-term liability burden is moderate relative to the economic resource base. While the burden is very high relative to Fitch's estimate of personal incomes at 71.8%, Fitch believes personal income fails to capture the significant wealth of the borough's unusual tax base and that the borough's economic resource base is best measured by the AV of the oil infrastructure that provides the tax base for both bond and operating levies. Combined debt and net pension liabilities (assuming Fitch's standard 7% pension rate of return assumption) are moderate at 2.1% of current AV and about 93% of 2015 total governmental funds revenues.
The borough provides pensions and other post-employment benefits through the Alaska Public Employees' Retirement System, a cost-sharing multi-employer pension plan that is closed to new entrants. The state of Alaska provides significant support for local pensions in the state and has historically absorbed most of the risk of the plan's unfunded liabilities. The borough's payments to the plan are capped at 22% of payrolls under current state law. Unfunded pension liabilities equal about $95 million of the borough's long-term liability burden at Fitch's standard 7% rate of return assumption. Fitch's debt ratios reflect this liability, but the state has thus far taken responsibility for paying off the liability, making large recent payments, and may make more unscheduled payments via state pension obligation bond issues.
The borough's direct debt burden is dominated by fully amortizing, fixed-rate unlimited tax GO bonds. Amortization is very strong with 75.6% of principal repaid in five years and 100% repaid in 10 years. Indeed, the majority of debt is repaid in three years, providing very strong budgeting flexibility in the face of potential medium-term weakness in the tax base. The borough is a regular issuer, but generally issues less debt than it amortizes. Debt has been declining in recent years and is well below prior peak levels. Fitch expects the debt burden and unfunded pension liabilities to continue to decline.
The borough is extraordinarily well positioned for the current period of economic weakness, having built up large reserves in anticipation of cyclical downturns and an eventual decline in oil production. Fitch expects the borough to take a balanced approach to gap closing, using reserves, spending cuts and revenue increases to withstand stress periods, while maintaining reserves solidly above the level necessary to maintain the 'aaa' financial resilience assessment. Inherent budget flexibility is judged to be midrange, reflecting a substantial degree of revenue raising flexibility and adequate expenditure flexibility.
The borough's $579.8 million permanent fund provides an extraordinary buffer against cyclical revenue volatility. The borough may use up to 8% of the fund each year. The borough also maintains solid unrestricted general fund balances, ending fiscal 2015 with an unrestricted general fund balance of 29.1% of spending. Unrestricted fund balance is likely to fall somewhat in 2016 due to an agreement to restrict $43 million for debt service as part of a settlement with the state over a tax dispute. Fitch expects unrestricted reserves to remain solidly above 20%, more than four times the approximately 5% decline in revenues that the Fitch Analytical Sensitivity Tool (FAST) suggests the borough may experience in a moderate economic downturn.
Budget management in times of recovery is strong. The borough budgets conservatively without undue reliance on one-time gap closing measures, and pension funding practices are typical for Alaska and strong. The borough has made extraordinary efforts to save for the period after oil production declines, creating a permanent fund that is quite unusual among U.S. local governments.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
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