OREANDA-NEWS. Pressure will mount on states like Alaska and West Virginia to diversify their economies beyond the energy sector if energy prices remain range bound into the mid-term, Fitch Ratings says. These states will also be pushed to expand stringent measures to maintain fiscal balance, including tight management of expenses and prudent use of rainy day funds (RDFs).

Fitch forecasts average prices for Brent and WTI of $45/b in 2017 and $55/b in 2018 respectively. This slow, steady recovery will do little to address state revenue declines caused by the steep drop in crude oil and natural gas prices that began in 2014 and the sharp drop in West Virginia coal production over the past two years. These negative trends hit state tax revenues as lower production, job losses and declines in the construction and manufacturing sectors reduced severance taxes, which are collected when non-renewable natural resources are extracted and economically-sensitive taxes such as personal income and sales taxes.

The challenged natural resource markets add to the pressures on both states to diversify their industries. Approximately one-third of Alaska's gross state product is attributable to the crude oil and natural gas industries. We believe this is a primary vulnerability for the state's revenues as Alaska largely bases its revenue structure on taxing its energy sector. West Virginia's economy has been severely hampered by the steep decline in the domestic and international demand for coal. While development of West Virginia's crude oil and natural gas reserves has accelerated in recent years, it has been unable to compensate for this loss.

Managing both states' expenditures will be challenging in this tepid revenue environment. The states' main expense driver is Medicaid and education expense is also a large part of their budgets. Fitch believes these cost pressures will continue to challenge fiscal accounts as declining revenue trends push the natural pace of spending growth above revenues and require adjustments to maintain balance.

Alaska has traditionally managed revenue shortfalls by using its sizable reserves. However, fiscal 2016 was the state's fourth straight year with an operating deficit and reserves are sharply declining. We expect fiscal 2017 to record a sizable deficit unless revenues recover and/or the state slashes expenditures. In fiscal 2016, the contribution of West Virginia's revenues to its general revenue fund (GRF) lagged the budget by 9.9%. The state cut expenditures, revised appropriations, and made an intra-year appropriation from its RDF in addition to an initial appropriation to help fund the budget.

The prudent use of RDFs will be important for both states as energy prices recover slowly. West Virginia's fiscal 2017 budget estimates its RDF balance at 16.4% of GRF revenues. Alaska's reserves at the end of fiscal 2017 are expected to total a still substantial 2.4x the undesignated general fund budget but the state's rate of spend is concerning as other means to achieve fiscal balance have not been authorized.

Fitch rates Alaska 'AA+' and West Virginia 'AA'; both states have Negative Outlooks on their Issuer Default Ratings.