- Hydrocarbons contribute, on average, 81% of central government revenues for Gulf sovereigns (GCC plus Iraq), and we expect the pace of economic diversification to remain gradual.
- Concentrated revenue streams and economic activity in the GCC have led to downward rating migration in the region in recent years, reflecting structurally lower oil prices.
- Our hypothetical long-run stress test of oil price declining to below $40 by 2040 suggests the average rating of Gulf sovereigns could fall by two notches from 'BBB+' to 'BBB-', although this is not our base-case scenario.
- The downward trajectory in the average rating highlights that, including an assumed policy response and static production, the current pace of economic and fiscal revenue diversification is not sufficient to counter a gradual decline in oil prices.
- Shifting investor appetite away from sectors and regions that generate high greenhouse gas emissions could pose a headwind to economic diversification. However, investors may see select green diversification projects within the GCC as compelling investment opportunities.
- The low cost of hydrocarbon production in the region provides GCC sovereigns some resilience to energy transition risk, helping buy time for economic diversification.
The hydrocarbon-exporting economies of the Middle East will remain reliant on oil and gas as the primary source of economic activity well into the next decade, in our view. In this context, one of the most frequently asked questions we receive from investors is what will be the longer-term impact for Gulf Cooperation Council (GCC) countries of the global transition towards a lower-carbon world economy, and to what extent do our ratings on these sovereigns account for this risk? These questions extend to our ratings on banks, insurers, and nonfinancial corporates in the region.
As global investors get to grips with the implications of climate change for their portfolios, they are likely to reappraise their appetite for investment in sectors and regions they perceive as most at risk from decarbonization initiatives. These stem to a large extent from the 2016 Paris Agreement goal to maintain global warming below 2 degrees Celsius. Climate change is also driving political backing for more public investment in alternative energy across Europe, Asia, and the Americas. The economic and political incentives for large hydrocarbon importers to find a sustainable substitute for oil have never been greater.
Still Hooked On Hydrocarbons
One gauge of a country's exposure to energy transition risk is the contribution to GDP from sectors related to oil and gas activity (upstream and downstream). The hydrocarbon sector contributes on average about 40% to the GDP of the six hydrocarbon-producing GCC countries plus Iraq (see chart 1). This data primarily relates to upstream activities (oil and gas extraction). Adding downstream activity, such as petrochemical refining and other sectors indirectly dependent on hydrocarbon revenues, the contribution is even higher. A similar narrative emerges, with even higher concentrations, when measured in terms of the contribution of hydrocarbons to revenues. At the general government level, hydrocarbons on average for the peer group contributed an estimated 70% of revenue (or 81% of central government revenue, which excludes our estimates of investment income earned on assets). A similarly high concentration exists in the peer group's external accounts, with hydrocarbons contributing 60% of current account receipts (CARs) on average.
The region's significant hydrocarbon-related activity also results in a high carbon footprint from greenhouse gas (GHG) emissions. Using a production-based carbon accounting approach, Trucost, part of S&P Global, estimates the GCC countries together generated approximately 1.5 billion tons of absolute GHG emissions in 2017, while Iraq generated 194 million metric tons (for further details of Trucost's methodology, see Related Research below).
On a per capita basis, GCC greenhouse gas emissions are among the highest globally, at 27.2 tons per capita (see chart 2). This compares with the 7.6 tons average for the EU (including the U.K.), 5.9 tons for the 15 largest economies in APAC, and above the 16.3 tons per capita average for the North America (U.S., Mexico and Canada). Production-based carbon accounting includes all emissions generated from domestic consumption and products and services-exported, but excludes emissions generated from imports. Using a consumption-based approach, which includes local consumption as well as imports but excludes exports, the GCC remains higher than other regions at 23.5 metric tons per capita.
An alternative approach of looking at GHG emissions per dollar of GDP (according to Global Carbon Atlas) indicates that although the GCC is better placed than major economies such as China, Russia, and South Africa, the region operates with emissions at the higher end of the spectrum of major economies. Many GCC countries have made commitments under the Paris Agreement via nationally determined contributions (NDCs). Yet, even if they meet these NDCs, their emissions could still rise very significantly compared with 2015 levels. (See for example the Climate Action Tracker For Saudi Arabia https://climateactiontracker.org/countries/saudi-arabia/pledges-and-targets/).
Slow Progress On Economic Diversification
Since 2012, GCC economies have made some progress in diversifying away from oil. Despite the challenges of measuring oil versus nonoil GDP, we estimate that the nonoil private sector's share in Gulf economies' real GDP will reach an average of 36.8% by 2022, up from 29.2% in 2012 (see chart 3). This represents an increase of 7.6 percentage points (ppt), or 0.8ppt per year on average.
Partly, the percentage increase in nonhydrocarbon private sector economic activity reflects lower oil prices. Qatar's efforts to move away from gas production appear to have yielded the most among the peer group. We expect Qatar's nongas share of real GDP will have nearly doubled to 33% of GDP in 2022, compared with 18% in 2012. We also anticipate that Oman's share will have increased by 13ppt, and that Bahrain, which is already comparatively diversified among GCC countries, will have seen its share advance by nearly 11ppt of GDP (see private sector in chart 3).
Over the same period, GCC governments have also begun to diversify public revenue away from a near total reliance on oil. Average central government revenue (excluding investment income estimates) at the end of 2018 was about 25% below 2012 levels, reflecting a 36% decline in oil prices. Over the same period, nonoil revenues increased by 81% on average, largely reflecting the introduction of value-added tax (in Saudi Arabia and to a lesser extent Bahrain) and other indirect taxes in 2018.
Still, in spite of some progress, we expect revenue-side hydrocarbon concentration to remain a determining characteristic of GCC countries' fiscal accounts. At the central government level, which excludes our estimates of investment returns on assets, oil accounted for approximately 81% of total revenue on average for the peer group in 2018, from 88% in 2012. On the external side, hydrocarbons account for approximately 60% of CARs, down from 70% in 2012, with total CARs remaining about 20% lower than they were in 2012.
Further, given the concentration of oil rents in GCC economies, it is difficult to disentangle hydrocarbon GDP from nonhydrocarbon GDP (see footnote of chart 3). The source of financing for nonenergy investment generally comes from oil wealth. Sectors included in nonoil GDP, such as construction and nongovernment services, are indirectly highly dependent upon hydrocarbon wealth. A material proportion of diversification away from hydrocarbons is also likely to be into sectors that themselves rely on hydrocarbon feedstock and are carbon-emitting, particularly downstream petrochemicals. Aside from infrastructure projects, public sector diversification efforts are frequently away from hydrocarbon production, but into hydrocarbon processing, potentially adding to overall carbon emissions.
The move from a lucrative carbon-emitting industry toward still nascent and expensive-to-develop carbon-neutral sectors is core to carbon transition in the region. Based on what we know today, global hydrocarbon demand is yet to peak and GCC governments have many decades of reserves. Nevertheless, alternative scenarios could put hydrocarbon demand on a steeper downward trajectory, placing pressure on oil prices. As oil is much more entrenched in the global economy, we expect the energy transition and electrification trend to be more gradual than for instance the more abrupt downside risk for coal. Coal demand is experiencing a continued falloff in the OECD as renewable generation increasingly offers a competitive alternative. Notably, though, after three years of decline, global coal demand increased in 2018 on the back of recovering demand in China and India.
Although GCC governments' diversification efforts have picked up pace, economic diversification takes time. Creating new industries and educating a suitable workforce requires decades to implement. Further moves into industries that build on the GCC's comparative advantage will likely yield benefits faster and with more certainty than the creation of new ones, and we do not expect this equation to structurally change. Following a recovery of oil and gas to today's prices from 2014, and given the very low cost of production enjoyed by GCC states, the incentive to forego further hydrocarbon development remains mixed, at best. This is in spite of a substantial weakening of public finances across the region.
The Efficacy Of Diversification Investment Activity Is Declining
Stocks of foreign direct investment (FDI) and portfolio investment in the GCC are among the lowest globally (see chart 4). Diversification efforts in the region stem from, and are almost always at least partially funded by government and other public sector investments, for example by national oil companies (see chart 3 footnote on definition of private sector).
But the cost of creating and maintaining this new economic activity is becoming more expensive for governments. When estimating how much investment it takes to generate one percentage point of economic growth (the incremental capital output ratio, or ICOR), it seems that the productivity of investment is declining. Using a five-year rolling average ICOR to smooth out fluctuations, investment effectiveness appears to have fallen: in the five years to 2013 it took 6% of GDP in investment spending to generate one percentage point of real output growth. Over the five years to 2018, this had climbed to 11% (see chart 5).
Lower real GDP growth related to lower oil production between 2014 and 2018 offers a partial explanation for higher ICORs. They also indicate that investing outside of the oil and gas sectors, for example in infrastructure projects, is not as effective as investing within it. An increase in investment into projects that don't immediately yield equivalent additional value because of their ancillary nature, such as roads and sewerage networks, or because the sectors of investment are already saturated, such as real estate, offer further explanation for the higher ICORs.
Attracting foreign investment and reducing the cost burden of nonoil growth is, therefore, a stated target of regional diversification plans. Without such investment, governments could incur higher expenditures and greater fiscal strain to diversify. Changing global sentiment away from "brown" investments could reduce the attractiveness of the region and potentially risk the pace at which new economic sectors develop. This also risks reinforcing carbon-emitting activity as the most effective deployment of domestic capital.
Investment In Renewables Could Be A Growth-Enhancing Alternative
GCC nations have started to view renewables, particularly solar, as a significant opportunity to pursue green diversification that is also growth-accretive.
The International Renewable Energy Agency (IRENA) believes that if GCC nations can achieve their various renewable deployment targets by 2030 they can save 354 million barrels of oil-equivalent (BoE) in fossil fuel consumption in the power sector, reduce emissions by 136 million tons of carbon dioxide, while creating over 220,000 jobs in the process. GCC countries have very high solar radiation levels and a large number of sunlight hours throughout the year--two factors crucial for efficient and economically viable solar electricity generation. According to IRENA, close to 60% of the GCC's land surface area has excellent suitability for solar photovoltaic deployment. Still, even if these targets are met and domestic consumption of fossil fuels in the region reduces, we expect hydrocarbon exports will remain very material and the main source of funding for regional investment. Currently the biggest share of installed renewable energy capacity in the GCC is in the United Arab Emirates (68%), followed by Saudi Arabia (16%) (Source: IRENA 2019 Report; see related research).
Downward Rating Migration Is Partly Due To Single-Sector Concentration
Assuming that the pace of economic diversification will be gradual, with the region remaining largely reliant on hydrocarbons, the key question that follows is this: Do we adequately reflect this concentration on a single sector in our sovereign ratings. Some GCC sovereign ratings--namely Bahrain, Oman, and Saudi Arabia--have migrated downward since the decline in oil prices in 2014 (see chart 6). The migration for these sovereigns has been particularly steep, owing to their governments' propensity to pursue pro-cyclical fiscal policies and support the domestic economy in a world of structurally lower oil prices. This resulted in weaker external positions, particularly for Oman and Bahrain, and weaker fiscal positions on a flow basis. Aside from Bahrain, general government net debt levels (stock) will remain relatively low in the region. Our ratings on Kuwait, Abu Dhabi, and Qatar remain resilient due to very strong external asset buffers.
Our hypothetical stress-test analysis
We have considered the effect of a hypothetical oil price stress scenario on Gulf sovereign ratings, which we emphasize is not our base case. We do not expect any shift in investor appetite away from "brown assets" to directly affect the demand for Middle East oil for reasons explained later in the article. Furthermore, changing supply-demand dynamics for hydrocarbons, for example, as outlined by the International Energy Agency under different global warming scenarios could result in an increase in oil prices. We expect global demand for oil to continue to grow until 2035. We do not consider the implications for the stand-alone credit profiles of national oil companies in this stress test exercise.
S&P Global Ratings' working oil price assumptions are $60 per barrel (bbl) in 2020 and $55 bbl from 2021. However, if we assume that the global shift to less carbon-intensive sources of energy will over time result in lower oil prices, a point-of-time scenario analysis can help inform the degree of headroom at current rating levels. This helps to indicate if the current speed of diversification is sufficient to offset a decline in prices, assuming future policy responses will reflect previous decisions.
The assumptions in our hypothetical stress scenario are:
- Fiscal and current account revenues and GDP are exposed to a stylized $1 per barrel per year reduction in the price of oil.
- Nonoil economic, fiscal and external revenue growth expands at the same rate as it has on average over 2012-2022, a proxy for each sovereign's "diversification rate" (0.8ppt per year on average).
- Production remains at 2020 assumptions, aside from in Qatar, where we include a 50% increase in production between 2025 and 2030 (see Related Research).
- Population growth continues at the past 10-year average.
- All central government deficits are entirely financed by debt.
- A fiscal expenditure-side response based on a regression between our forecast government expenditure and nominal GDP growth.
Under this scenario, we would expect the average rating of Gulf sovereigns to fall by two notches from the current level of 'BBB+' to 'BBB-' by 2040. A downgrade is indicated for all sovereigns in our sample (see chart 7). The analysis showed limited change to external indicators, given the region's large external asset positions, but vulnerable economic and fiscal metrics (see table 1).
The downward trajectory in the average rating highlights that, including an assumed policy response and static production, the current pace of economic and fiscal revenue diversification is not sufficient to counter a gradual decline in oil prices.
In 2027, under our hypothetical stress scenario, our expected average rating of Gulf sovereigns falls to 'BBB' from 'BBB+'. The initial fall in ratings for individual sovereigns is, on average, driven by changes in their fiscal positions. The revenues of all Gulf sovereigns depend to a significant degree on oil and gas sales. The gradual fall in oil prices affects fiscal flows first, but continues to erode the net stock of assets, pushing some sovereigns from a net creditor to a net debtor position. On average, however, the net asset position of the group declines only slightly, which reflects the continued accumulation of assets held in sovereign wealth funds of the higher-rated sovereigns. Change in net general government debt to GDP deteriorates from about 0.3% on average in 2020 to almost 3% on average by 2040.
As expected, countries with large net asset positions on average fare better under our exercise. We see this as indicative of those governments having the fiscal space to implement diversification strategies at a slower pace, if desired, without seeing a substantial deterioration in ratings.
In the outer years of our exercise we again see a fall in the average rating to 'BBB-', this time explained by weaker macroeconomic fundamentals. Declining GDP per capita against our expectation of positive global growth largely drives this second deterioration. As the price of oil continues to decline, the concentrated economies of the Gulf shrink commensurately, highlighting the inherent risks of commodity dependence.
|Key Sovereign Indicators Under Our Hypothetical Stress Scenario (Average For GCC + Iraq)|
|GDP per capita ($)||38,000||34,603||37,746||26,262||22,477|
|Annual change in net general government debt/GDP (%)||0.30||0.50||0.60||1.70||2.80|
|General government interest paid/GG revenues (%)||6.70||9.90||14.00||19.10||25.00|
|Oil price per barrel ($)||60||52||47||42||37|
More than 40% of the corporate and infrastructure issuers we rate in the GCC are government-related entities (GREs), where the issuer ratings are closely linked to the ratings on the relevant sovereigns. We would expect any sovereign rating actions would also affect the credit ratings on most associated GREs. The stronger an entity's link to, and role for the government, according to our GRE criteria, the more likely the ratings would follow that on the sovereign.
Competitiveness Is Key For The GCC Hydrocarbon Sector
As fossil fuel producers, Middle East and GCC national oil companies' (NOCs) have business models that are among the most exposed to the energy transition. Oil and gas prices and refining margins are extremely sensitive to medium- and long-term demand expectations. Nonetheless, as hydrocarbons are highly likely to remain necessary fuels to meet global--and growing--energy demand, NOCs in the Gulf look better placed than many to supply this oil and gas. They also look less exposed to potential stranded-assets risks--i.e., of capital being invested in developing reserves that ultimately won't produce--even if some resources remain undeveloped. We see low operating costs as a sustainable competitive advantage for these companies. Nonetheless, an NOC's credit profile also depends on other factors, including the fiscal regime and government actions. In a deteriorating oil price environment, a weaker sovereign can have a negative influence on its NOC. Furthermore, while we see a higher degree of operational resilience of Gulf NOCs to energy transition risk, the standalone creditworthiness of the NOCs will likely come under pressure if there is a sustained and structural decline in oil prices.
Over the next decade, we believe average oil demand will continue to expand (see chart 8). Over the longer term, oil production and prices will be more exposed. Industry projections from diverse sources typically foresee a decline in demand post 2035. According to many market projections, over the next two decades we will likely reach "peak oil", after which aggregate demand will start to decline. However, unlike coal, prolonged global supply-demand imbalances are mitigated by the significant natural decline of oil fields of 3% to 6% per year.
The speed of the transition away from carbon-based fuels is uncertain, but is beginning to accelerate. Disruptive external factors, such as worldwide governments' environmental policies and regulations on GHGs as well as long-term product substitution risks such as vehicle electrification, could weigh on overall industry credit quality. However, for NOCs in the GCC we see risks relating to license renewal and developing reserves as among the lowest for the sector.
The industry's transition challenges stem not just from the inherent GHG emissions of its products, but also from production activities. These can be a direct source of GHG, through methane leaks, gas flaring, or extraction methods. More broadly, other environment risks include spills and leaks, and increasingly water use and contamination risks.
We see many NOCs in the Gulf as well positioned compared with their industry peers in terms of production activities. Some have actively controlled flaring for many years and, where available, indicators for leaks and energy required in production compare favorably with peers outside the region. Critically, given the geological nature of their reserves and methods of production, both the investment needs and the average unit costs for NOCs in the region are among the lowest globally. This means that they can produce and sustain economic production at lower oil prices than competing suppliers.
We don't consider potential fossil-fuel funding constraints on banks and other investors--at present common for coal producers--as a likely challenge for NOCs given the often self-funding nature of their businesses. However, this is conditional on the fiscal terms remaining supportive. It is also conceivable that in the later stages of the transition, constraints on technology transfer to NOCs could impact their production efficiency and optimization.
Natural gas, largely methane, is another GHG when released, and has about 25x the impact of carbon dioxide. Although a fossil fuel, in general we consider natural gas production to be somewhat less exposed to environmental risks, at least for some time. This is because, when burned for power generation, gas is significantly less polluting than coal. Hence, gas is seen by many as a vital bridge fuel in the energy transition to systemic decarbonization. This should support demand over the next two decades, even under a two degrees warming scenario. Among gas producers and value chains, we note that total emissions arising from the liquefaction and delivery of liquefied natural gas (LNG) are higher than piped gas. Nonetheless, GCC gas producers, especially to the extent that they continue exporting large volumes as LNG, could see some advantages from this diversification away from oil. Qatar Petroleum stands out as best positioned in this respect.
Global Investor Appetite Is Rapidly Shifting As Climate-Change Risks Crystalize
In the years 2019 and 2020, global warming, carbon emissions, wild fires, and excessive plastic waste in oceans have hit the center stage of economic discourse. This year marks the beginning of what some are calling the decade of sustainability. The governments of the world's largest countries have pledged to undertake measures to meet these goals by reducing carbon emissions in their respective countries.
The European Green Deal (see "EU Green Deal: Greener Growth Doesn’t Necessarily Mean Lower Growth," published on Feb. 10 2020), published in December last year, calls for a decarbonizing of the EU's energy system as well as industrial sectors including steel and cement, the introduction of carbon pricing, fiscal incentives for green innovation, and large cuts in the use of byproducts from hydrocarbon refining (particularly plastics). This is one of many signs that not just investors but also end consumers are taking a harder line against climate change. This is leading to the introduction of legislation (such as the first European Climate Law to be legislated by March 2020) to mandate a change in patterns of energy consumption with the aim of climate neutrality. The risk is that time may be running out for GCC governments to diversify away from hydrocarbons. Rapidly changing preferences of global investors, regulators, and some energy consumers to shift away from emitting industries will continue to ramp up the pressure on GCC governments.
Against this backdrop, the global fund management and investor community has also undertaken radical changes, with environmental factors becoming one of the key considerations in investment decisions. Over one-half of the global asset management industry now considers environmental issues before investing. Large, high-profile fund managers such as BlackRock have pledged to put sustainability at the heart of their future investment decisions. According to IEA research, in the five-years 2015-2019 climate-related shareholder resolutions for oil and gas companies increased to about 240, from 150 in the preceding five years. IEA analysis also indicates a rising trend in the cost of equity and debt capital for oil and gas companies since 2017.
Yet, despite this significant shift, global oil and hydrocarbon demand is likely to continue to rise over the next decade at least, on the back of GDP growth in emerging markets in particular, many of which still rely on GCC supplies. GCC suppliers will continue to benefit from their low-cost of production compared to other more expensive hydrocarbon producers. This will keep them in the hydrocarbon-producing and processing game long beyond others, and will help buy them time to diversify their economies away from it.
- EU Green Deal: Greener Growth Doesn’t Necessarily Mean Lower Growth, Feb. 10, 2020
- Credit FAQ: When GREs Raise Debt, What Are The Implications For Sovereign Ratings?, Nov. 19, 2018
- FAQ: How S&P Global Ratings Formulates, Uses, And Reviews Commodity Price Assumptions, Sept. 28, 2018
- Government Liquid Assets And Sovereign Ratings: Size Matters, Aug. 27, 2018
- Credit FAQ: How The Slump In Oil Prices Is Altering Standard & Poor's View Of Hydrocarbon Exporters' Sovereign Credit Ratings, March 2, 2016
- Gulf Governments Protect Investment Spending To Support Growth, Oct. 7, 2015
- Hooked On Hydrocarbons: How Susceptible Are Gulf Sovereigns To Concentration Risk?, June 30, 2014
- Jobs And Skills, Not Infrastructure, Are A Key To Overcoming Gulf Sovereigns' Oil Dependency, Nov. 17, 2014
- Summary: Qatar, Nov 8, 2019
- Research Update: Qatar Petroleum 'AA-' Ratings Affirmed; Outlook Stable, June 17, 2019
- Research Update: Saudi Arabia 'A-/A-2' Ratings Affirmed; Outlook Stable, Sept. 27, 2019
- Summary: Kuwait, Jan. 17, 2020
- Research Update: Bahrain Outlook Revised To Positive On Improving Fiscal Prospects; 'B+/B' Ratings Affirmed, Nov. 29, 2018
- Summary: Abu Dhabi (Emirate of), Nov. 29, 2019
- Research Update: Oman Ratings Affirmed At 'BB/B'; Outlook Negative, Oct. 18, 2019
- Renewable Energy Market Analysis: GCC 2019, International Renewable Energy Agency, January 2019
- Source for Trucost methodology available on its website upon registration: Accounting for Carbon: Sovereign Bonds, June 18, 2018 https://www.trucost.com/publication/accounting-for-carbon-sovereign-bonds/
- BP Statistical Review of World Energy 2019
- Gütschow, J. et al. (2018): The PRIMAP-hist national historical emissions time series (1850-2015). V. 1.2. GFZ Data Services. https://doi.org/10.5880/pik.2018.003
This report does not constitute a rating action.
|Primary Credit Analysts:||Benjamin J Young, Dubai (971) 4-372-7191;|
|Dhruv Roy, Dubai (971) 4-372-7169;|
|Max M McGraw, Dubai + 97143727168;|
|Timucin Engin, Dubai (971) 4-372-7152;|
|Simon Redmond, London (44) 20-7176-3683;|
|Secondary Contacts:||Ravi Bhatia, London (44) 20-7176-7113;|
|Gauthier Robinet, London 44-20-7176-0637;|
|Neesha-ann Longdon, London;|
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