U.S. coal producers are going deeper into export markets to offset the decline of domestic thermal coal volumes, which have dropped about 24% since 2015. S&P Global Ratings assumes that U.S producers will export about 60 million short tons of thermal coal in 2018 and that without those exports volume would have declined 33% since 2015. Exports have proven critical to coal producers as domestic power plants, which increasingly use natural gas for fuel, have sharply cut their coal purchases, leading to deteriorating credit metrics, disappearing profits, and in some cases bankruptcy for coal companies over the past few years. Even though credit quality is stabilizing due to conservative financial policies post restructuring and growth in export sales, access to capital is waning, particularly for thermal producers.
Power companies switching to natural gas and the retirement of coal-fired power plants are the key reasons for the decline in domestic coal consumption. We believe that the domestic energy portfolio will continue to migrate toward natural gas and renewables given scheduled coal plant retirements and the growing state and local preference for green power production. We see this happening even as we acknowledge that coal, although declining in use, will remain the second-largest source of electricity.
We anticipate the average adjusted debt will continue to decline in 2018 and 2019 for our U.S. rated companies, largely because they are using some of the cash flows generated in the export market to repay debt. We also assume a 40% hike in average capital spending in 2018, as U.S.-based issuers resume key replacement and rebuild programs that were put on hold in 2017. Financial policies are conservative and focused on shareholder returns in the form of dividends and share repurchases. The coal producers in the best position to benefit from exporting will be those with the most high-quality in-demand types of coal, prudent financial policies that manage foreign currency risk, and strong transport options to get their coal from domestic mines to foreign markets. Moreover, despite the growth of natural gas and renewable sources for power plants both domestically and internationally, we expect that traditional export markets for thermal and metallurgical (met) coal in Europe and Latin America will remain strong over the next 12 months, while coal exports to Asian markets, including India, will increase slightly.
Total shipments for our rated U.S. coal producers increased to 647 million short tons in 2017, a 5% bump from weak conditions in 2016, partly because companies resumed operations after restructuring and bankruptcy in 2015 and 2016. We assume total shipments in 2018 to decline by about 4% to 621 million short tons due to continued declining domestic demand and coal plant retirements. Indeed, we anticipate domestic thermal coal shipments, which account for approximately 76% of total coal shipments, will decline by about 6% in 2018 (see chart 1).
Less coal-fired power
The U.S. Energy Information Administration (EIA) says that natural gas and renewables will dominate power capacity additions in the next five years, likely adding 82,000 megawatts (MW) of new capacity (see chart 2). By contrast, no coal plant additions are planned in the next five years, after approximately 75,000 MW of retired coal-fired capacity in the past 10 years (see chart 3).
We rate four coal companies (see table 1) with operations in regions with both high natural gas and renewables capacity; Alliance Resource Partners L.P., Arch Coal Inc., Peabody Energy Corp., and Murray Energy Corp..
The Northeast, Southeast, Gulf, Central, and Midwest regions have accounted for about 84% of all retired coal capacity in the past 10 years. These regions also are expected to house almost all of the planned natural gas additions (46,000 MWs) in the next five years, and that will more than offset the retired natural gas capacity in past 10 years (35,960 MW).
Similarly, EIA data suggest that renewables will be playing a bigger role in the generation mix, adding about 35,000 MWs of new capacity in the next five years across all regions. The Northern, Western, Gulf, Central, and Midwest regions have the highest renewable capacity additions as a percentage of the existing renewable capacity.
The declining coal demand in the recent years for some of these companies demonstrates the displacement of coal-fired capacity by natural gas and renewables generation. For example, as of year-end 2017 Murray's domestic sales volumes declined by almost 17% versus 2015. In 2018, we assume domestic sales volumes will recover moderately growing by 12% versus 2017; however the growth is associated with export sales. Similarly, we anticipate Arch Coal and Peabody Energy thermal coal volumes will be 30% and 21% lower in 2018 than in 2014, respectively, driven primarily by oversupply and decline in demand in the Powder River Basin (PRB) and Western regions. We do not forecast material improvements in thermal sales volumes beyond 2018 for Murray, Arch and Peabody.
|Coal Company Operations in High Substitute Fuel Capacity Additions|
|Operating in regions with high natural gas capacity additions||Operating in regions with high renewables capacity additions|
|Alliance Resource Partners L.P||Yes||Yes|
|Arch Coal Inc.||Yes||Yes|
|Peabody Energy Corp.||Yes||Yes|
|Murray Energy Corp.||Yes||Yes|
|Contura Energy Inc.||Yes||No|
|Consol Energy Inc.||Yes||No|
|Foresight Energy L.P.||Yes||No|
|Cloud Peak Energy Resources LLC||No||Yes|
|Wolverine Fuels LLC*||No||Yes|
|Drummond Co. Inc.§||No||No|
|Source: Company financial statements, EIA June 2018 Generator Report. *Wolverine Fuels LLC is formerly known as Bowie Holdings, LLC. §Drummond’s thermal coal operations are based in Colombia.|
Our Stress Scenario: Strong U.S. Dollar and Declining Domestic Demand
As U.S. coal companies dive deeper into exports, they add more currency risk to their sales. In addition, we believe that weaker domestic thermal demand remains a key risk for U.S.-based producers facing competition from natural gas and renewables.
We performed a stress scenario of 11 rated coal companies, taking our 2018 and 2019 assumptions as a starting point. Then, we assumed that a combination of interest rate hikes and other economic policies will cause an increase in the U.S. Dollar Index beginning 2019. At the same time, we assumed a steady domestic thermal decline beginning 2019. Specifically, our assumptions in the stress scenario were:
- The U.S. dollar strengthens by 10% in 2019 and 5% annually in the next two years. Because we assume an inverse relationship between the price of the U.S. dollar and coal exports, we lowered the company's realized or expected index price in 2019-2021 by the same percentage as the U.S. dollar.
- Domestic thermal volumes will decline 3% annually from 2019 through 2021.
- Cash costs, capital spending, and selling, general and administrative expenses would remain constant.
The result of our stress test showed that thermal coal producers in the PRB region, such as Peabody, Arch, and Cloud Peak, are most sensitive to declining domestic demand. In addition, met coal players such as Peabody, Coronado Group LLC, and Contura Energy Inc. are most vulnerable to price shock due to a stronger U.S. dollar because of their sizable met coal exports.
We assume Peabody will sell approximately 11 million tons of met coal on the export market in 2018. Companies' sizable met coal sales could swing margins by 370 basis points (bps) under our stress scenario versus our base assumption in 2019. In addition, the thinner margins of the PRB coal, which makes up a large part of thermal coal Peabody sells domestically, contributes to the falling margins when domestic demand falls.
Similar to Peabody, Arch is largely concentrated in the PRB region, with more than 80% of the expected sales coming from there, but, in contrast, has smaller met coal sales. Arch is therefore more sensitive to a steady domestic thermal decline given its concentration in less profitable PRB region. Arch's adjusted EBITDA margin dropped by nearly 300 bps and leverage increased by less than a turn to 3.4x versus our base case in 2019.
Cloud Peak has been trying to offset some of the domestic decline by increasing export sales. However, its price realization in the export market is limited by the lower heat content of its PRB coal, longer distance to ports relative to other U.S. export players, and increasing cash costs. After the stress scenario, we saw Cloud Peak's margins drop by about 230 bps versus our base case in 2019.
Coronado is highly sensitive to a strong U.S. dollar because the company exports more than 60% of its coal to the Asia-Pacific region. With the strengthening dollar, we observe a steep drop in EBITDA margins to less than 18% from about 26% under our base case in 2019. This is because the company produces lower quality met coal that sells at a discount to the benchmark as well as higher operating costs.
Pro forma for the merger with Alpha Natural Resources, met coal will make up about 48% of total coal sales for Contura, with the rest being Appalachian thermal coal. Under the stress scenario, higher domestic production costs relative to peers, coupled with lower grade met coal, contribute to a drop in adjusted EBITDA margins to about 17% from 22% under our base case scenario in 2019.
The Pivot To Thermal Coal Exports
International thermal and met coal markets, however, have been a major outlet for domestic volumes over the past 12 months. With the Newcastle index price reaching a new high of $120/ton in July 2018 (more than 30% higher than a year earlier) and recently modestly lower at $110/ton, all domestic producers pivoted their sales to the export market to offset domestic decline (Chart 4).
Peabody Energy Corp., Coronado Group LLC, Foresight Energy LLC, Murray Energy Corp., and Alliance Recourse Partners, are well-positioned to service the export market because of their access to multiple ports, proximity to rail and river barge transportation (see table 2). The largest privately held coal company Murray Energy, including Foresight, has access by far to the most diverse transportation network with five Class I rail networks, six U.S. ports, and three international ports. While Peabody, Coronado, and Alliance have access to two Class 1 rail networks domestically, Alliance can utilize three additional Class 2 and 3 rail networks in the U.S., and Coronado and Peabody's operations in Australia are served by Aurizon and Pacific National rail networks.
|Coal Company Transportation Capability|
|Domestic railway accesssScore§||Trucks||River||Number of domestically accessible ports||Number of internationally accessible ports|
|Peabody Energy Corp.*||2||Yes||Yes||3||5|
|Coronado Group LLC||2||Yes||Yes||4||2|
|Murray Energy Corp.||3||Yes||Yes||5||3|
|Foresight Energy L.P.||3||Yes||Yes||3||0|
|Wolverine Fuels LLC||2||Yes||No||2||0|
|Alliance Resource Partners L.P||3||Yes||Yes||2||0|
|Arch Coal Inc.||3||Yes||Yes||2||0|
|Consol Energy Inc.||2||Yes||Yes||2||0|
|Contura Energy Inc.||2||Yes||Yes||1||0|
|Warrior Met Coal Inc.||1||Yes||Yes||3||0|
|Cloud Peak Energy Resources LLC||2||Yes||No||0||1|
|Drummond Co Inc.||*||Yes||Yes||*||1|
|Source: Company reports. * Peabody Agreed to Acquire Drummond's Shoal Creek Mine in September 2018. §1--Company has access to one domestic rail network. 2--Company has access to two domestic rail networks. 3--Company has access to three or more domestic rail networks.|
In addition to the ability to get their product to market, coal companies access to overseas buyers is a function of asset quality—the type of coal they mine. We assess the relative attractiveness of coal assets by the breadth of product, and the coal's grade (thermal or met), volatility, and sulfur content. High-heat and low-sulfur coal is better quality than low-heat and high-sulfur coal. High-sulfur coal sells at a discount and often needs to be blended with lower-sulfur coal to meet product qualification standards. That can increase production costs. Each of the coal-producing basins has unique product characteristics. In the PRB, where Peabody, Arch, and Cloud Peak have most of their operations, coal has the lowest-heat and lowest-sulfur content. A combination of lower international price, a greater distance from ports, and more limited transportation options relative to Eastern regions results in the lowest export volumes anticipated from these companies in 2018 (see table 2).
Conversely, Illinois and Appalachian Basin coal have high-heat and high-sulfur content that corresponds to a higher international price, even with a hefty sulfur penalty. Companies that have most of their operations in these coal regions, such as Alliance, Consol, Foresight and Murray, and Contura benefit from proximity to ports and greater transportation and port options. Not surprisingly, we estimate thermal exports from these companies will make up 77% of our assumed exports in 2018.
Low volatility hard coking coal, or high-grade met coal, tends be more price resilient for its quality and because of a lack of substitutes when used to produce pig iron, from which steel is made. Peabody and Warrior Met Coal produce the most low-volatility met coal as a percentage of total met coal volumes (about 28%), followed by Arch, Coronado, and Contura. The rest of the met coal these companies produce is lower-grade met coal, such as mid and high volatility, as well as semisoft coking coal and pulverized coal injection (PCI).
Alliance Resource Partners
This producer resumed exports this year and we anticipate it will export about 11 million tons in 2018. Alliance also plans to reopen idled capacity at the Gipson North mine, enabling it to export another 2 million tons in 2019. Alliance, however, has some of the highest grade Btu (British thermal units) thermal coal (in the Northern Appalachian and Illinois Basin regions) with relatively high sulfur content. That might require the company to blend it with lower-sulfur coal to meet certain coal specifications. In addition, we estimate that the company can weather a moderate decline in domestic demand and foreign currency shock due to its low cost operations.
Drummond Co. Inc. is the only thermal producer with most of its production in the Republic of Colombia. This provides Drummond with unique advantages in the export market. It exports essentially all of its thermal coal (36 million short tons) to South America and Asia. Unlike its U.S. peers, the company is not exposed to the domestic thermal decline. Drummond offers a similar Btu content as the Illinois Basin thermal coal (~11,000 Btu/lb.), but with one of the lowest sulfur content of about 0.6% versus 2.5% or more for Appalachian or Illinois Basin coal. These qualities are sought after by countries such as Korea and Japan that have stringent sulfur content requirements. We assume the company will generate strong operating cash flow in 2018 due to the elevated international coal prices.
Murray Energy and Foresight
Murray and Foresight are making a massive shift into export markets (Chart 5), partially offsetting the domestic thermal decline. Cash flow for these two companies is growing, and we estimate that they will have consolidated adjusted EBITDA margins of 25%-30% for the full year 2018. Their mines are in the Northern Appalachia (NAPP), Illinois Basin (ILB), and Uinta Basin (UB) areas, which are near rail and river transportation. The consolidated company also has access to six domestic ports on the East Coast and the Gulf of Mexico, and three international ports in the Republic of Colombia and Mexico. The increased shipments of nearly 28 million short tons in 2018 should allow the company to negotiate volume discounts on rail transportation and port shipments.
Both MEC and FELP also benefit from having high Btu product. However, these companies are also penalized with a sulfur discount on exports due to the high sulfur content (2.5%-3%) of their coal. Despite that, Murray has sufficient headroom for prices to drop more than 35% from current levels before the company breaks even on its exports, and Foresight could see prices fall by more than 45% before breakeven thanks to one of the lowest cost mining operations in the U.S.
We assume Contura Energy, Inc. will have the highest percentage of exports among total sales volumes in 2018, but thermal sales volumes accounting for about 33% of exports and the rest being met coal. The company maintains about 14 million tons of thermal production from mines in Appalachia. Because production costs of this coal are high, we believe it has fewer export options than its lower cost thermal peers when international prices are low, despite the high heat content of its coal. Our EBITDA margin forecast of about 22% in 2019 ranks Contura in the average range of our rated coal companies, and we estimate that the company will be more sensitive to moderate currency shocks, as almost half of its coal sales will be met exports, pro-forma for the combination with Alpha Natural Resources.
Cloud Peak Energy Resources LLC has not been able to capitalize on the favorable export opportunity due to port capacity limitation at the Westshore Terminal, which is capped at 5.5 million tons in 2018. We do not assume Cloud Peak will be able to offset the domestic decline and we estimate its adjusted EBITDA will decline about 25% in 2018 from 2017. The demand for the company's 8,400 Btu per pound product has dropped nearly 50% since 2015 due to lower demand. Cloud Peak benefits from one of the lowest sulfur content (0.3%) coals, but its coal has a low Btu that limits the the price it can get overseas.
Another Western producer, Wolverine Fuels, LLC, has had limited participation in the export market because most of its production is committed through long-term supply contracts with domestic utilities. This provides stability of earnings. With about 11 million tons of annual capacity, we assume the company will export about 3 million short tons to the Asian market in 2018 by purchasing 65% of its export coal from third-party producers, typically at a higher price than Wolverine's production cost. That could lower the company's margins. Nevertheless, we forecast Wolverine's 2018 EBITDA will increase about 35% versus 2017 because of higher export tonnage on top of stable cash flows from the long-term contracts. Wolverine's coal has medium Btu and low sulfur content, which provides the company with moderate cushion during international price decline.
Met Coal Exports Feed A Tight Global Market
Similar to the thermal export market, the metallurgical (met) coal export market has been marked with increased export activity from U.S. coal producers. Even with hard coking coal index price (HCC) moderating to about $215/ton from a high of $260/ton at the beginning of 2018 (see chart 6), U.S. producers have an attractive opportunity with renewed supply setbacks from Australia, including weather delays and mine production issues, as well as the Aurizon rail dispute, all of which are contributing to tight global supply conditions.
Of the 93 million short tons of exports we forecast in 2018, about 33 million short tons, or 36% will be met coal shipments. We anticipate most U.S. met coal will be exported to the traditional export markets such as Europe and South America, but an increasing amount of shipments will reach Asian countries including Japan, South Korea, India and China. We assume less than 5% of metallurgical and thermal coal will be shipped to China in 2018 and 2019, and that the impact of Chinese coal tariffs on earnings will be minimal. Nevertheless, Asia accounts for roughly three quarters of the met coal imports. This high demand for met coal is spurred by increased global demand for steel and infrastructure investment growth in Asia Pacific Region.
We rate two pure play met coal exporters, Coronado Group LLC and Warrior Met Coal, Inc., and four more diversified players, Peabody, Arch, Contura, and Consol Mining.
We assume strong demand for Warrior's premium low-volatility (low-vol) HCC on the international market. Warrior's premium low-vol and mid vol HCC is ideally suited for steel making because of its high coke strength after reaction (CSR). Because of its high coal quality, Warrior can achieve some of the highest HCC price realizations that are either in line with or at a slight discount to the Australian HCC index price. (Warrior realized 100% of index price in the second quarter of 2018). We have a high level of confidence that the company will be able to ramp up production to an annual run rate of eight million short tons by the end of 2018. The company exports essentially all of its production to Asia through the Port of Mobile in Alabama. We anticipate Warrior's premium high-CSR coal, coupled with their highly flexible cost structure, will enable the company to continue generating some of the highest EBITDA margins (41% as of June 30 on rolling 12 month basis) and strong cash flows through the cycle.
Coronado Group services both domestic and international met coal markets, selling its lower quality met coal to local steel producers and exporting its low vol HCC met coal to Europe, South America and Asia. The company increased its exposure to the Asian met market with the Curragh mine acquisition in Australia earlier in 2018. We assume the company's exposure to China to be immaterial for the expected earnings as there is strong customer demand from South Korea, Japan and India for the PCI product out of Australia. We anticipate any potential setback to the company's earning expectation could be caused by integration issues and productivity decline at the Curragh mine. We assume full integration to occur by the end of 2018 or early 2019 when the company reaches annual run rate production of about 14 million short tons in Australia. We also anticipate the company will maintain adjusted EBITDA margins above 30% in 2018.
For 2018 we assume Peabody to produce about 31 million met coal tons including all of the company's met coal in Australia. While this represents less than 20% of total production, the company is very sensitive to changes at the Australian operations because the average price of Australia produced coal is many times higher than the average price of the coal produced in the U.S. In our view, because participation in Seaborne markets is mostly limited to the Australian operations, we consider Peabody to be less exposed to shifts in trade policy between the U.S. and China as well as changes in freight rates, although foreign exchange rate movements could be a factor where cross border financing or distributions are involved.
Arch sells coal at Atlantic, Pacific, and Gulf of Mexico terminals. In 2017 the company exported about 8% of its total production (slightly under 8 million tons) and continues to benefit from seaborne met coal markets. However, Arch also sees an opportunity to expand thermal exports in particular given higher international realizations. For 2018 Arch is aiming for about 4.5 million tons in thermal exports, up more than 60% from 2017 levels.
Consol Energy Inc. has a diversified and flexible portfolio in the roughly 30% of total volumes it exports. In 2017 India accounted for over half of its thermal exports, with Europe constituting most of the rest. We estimate that metallurgical exports were less than 7% of total 2017 production, and these volumes went mostly to Asia and South America. The Consol Marine Terminal in Maryland and Hampton Roads Terminal in Virginia provide strategic access to the export market, and although we assume Consol will maintain a flat share of exports to total production volume for 2018, the company has grown its exports of coal from its Pennsylvania Mining Complex by more than 50% from 2015/2016 averages. Consol is somewhat unique in that it has recently secured new commitments domestically, including re-entering the domestic metallurgical coal market.
This company has also taken steps to further concentrate and secure its participation in the export markets. At the end of 2017 the company sold its PRB assets, which focused primarily on domestic customers. Then in April, 2018 the company merged with Alpha Natural Resources, assuring access to metallurgical coal destined for international markets. Pro forma for the combination with Alpha Natural Resources, Contura will be the largest met coal producer in the U.S., with approximately 12 million tons of annual met coal sales.
U.S. Coal's Last Best Hope?
The export markets will not be all that U.S. coal producers have in coming years, but it will be an increasingly important factor. In all probability, U.S. power producers will continue to close coal-fired plants and increase their reliance on gas and renewable energy sources. However, we are convinced that even in an environment of low natural gas prices, coal will continue to be a sizable, though diminishing, part of the fuel mix. Over the next five years we expect coal's share of domestic electricity generation to fall to less than 30% given our expectation of a natural gas price of $3.00 per million Btu and coal retirements. Coal will be here for many years to come and U.S. coal companies with best asset quality will continue to operate, although with less output. But we anticipate the international markets will remain ripe for exports in the next 12 months. We believe the better-positioned companies with quality assets, various transportation capabilities and strong operations can find pockets of growth and increase profitability.
|Coal Company Ratings And Outlooks|
|Alliance Resource Partners L.P||BB+||Stable|
|Arch Coal Inc.||BB-||Stable|
|Peabody Energy Corp.||BB-||Stable|
|Drummond Co. Inc.||BB||Stable|
|Consol Energy Inc.||B+||Stable|
|Warrior Met Coal Inc.||B+||Stable|
|Coronado Group LLC||B||Stable|
|Natural Resource Partners L.P.||B||Stable|
|Foresight Energy L.P.||B-||Stable|
|Cloud Peak Energy Resources LLC||B-||Stable|
|Murray Energy Corp.||B-||Stable|
|Contura Energy Inc.||B-||Positive|
|Wolverine Fuels LLC||CCC||Negative|
|Source: S&P Global Ratings.|
This report does not constitute a rating action.
|Primary Credit Analyst:||Vania Dimova, New York + 1 (212) 438 0447;|
|Secondary Contacts:||Donald Marleau, CFA, Toronto (1) 416-507-2526;|
|Chiza B Vitta, Dallas (1) 214-765-5864;|
|Research Assistants:||Pankajkumar P Nikhare, Pune|
|Shalaka Singh, Pune|
|Dan Daley, New York|
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