Fitch Rates $18MM Oklahoma ODFA Bonds 'AA'; Outlook Negative
--$18.48 million Oklahoma state system of higher education, master real property lease revenue bond bonds series 2016G (subject to annual appropriation).
The bonds are expected to sell via negotiation on or about Oct. 18 and 19, 2016.
The Rating Outlook is Negative.
SECURITY
The bonds are limited special obligations of the ODFA secured by annual appropriations of the state of Oklahoma. The intended source of repayment on the bonds is annual allocations to the state Board of Regents for higher education on behalf of certain Oklahoma colleges and universities.
KEY RATING DRIVERS
State Appropriation: The rating on the bonds, secured by annual appropriations from the state's general fund, is one notch below Oklahoma's 'AA+' Issuer Default Rating (IDR), reflecting the state's general credit standing, sound lease structure, and statutory authorization for these types of bonds. The Negative Outlook reflects the state's challenge in achieving structurally sustainable solutions over the medium term given the sizable economic concentration in natural resource development and subdued growth prospects for revenues.
Economic Resource Base
One-third of the state's gross state product is attributable to the drilling, production, and economic multiplier effects of the oil and natural gas sectors. After consistently outperforming national growth trends coming out of the last recession, the state's economy has weakened and employment has shown recent, steady declines as the slumping natural resources sector has led to shuttered rigs, production declines, and layoffs. The unemployment rate moved closer to the national average (80% in 2015 compared to 65% in 2012) while the continuing drag in 2016 boosted the rate above that of the U. S.; August's rate was 5.1% compared to a 4.9% U. S. rate. Population growth continues above the national pace.
Revenue Framework: 'aa' factor assessment
Fitch expects Oklahoma's revenues, which are supported by broad-based sources, to continue to reflect economic volatility tied to the extensive natural resources sector. The current economic slowdown is expected to extend over the medium term and will continue to challenge revenue growth. The state has complete control over its revenues, with an unlimited independent legal ability to raise operating revenues as needed, although a supermajority vote of the legislature or voter approval for tax rate increases limits flexibility.
Expenditure Framework: 'aaa' factor assessment
The state maintains ample expenditure flexibility with a low burden of carrying costs for liabilities and the broad expense-cutting ability common to most U. S. states. A policy of appropriating only 95% of expected revenues provides a cushion for revenue variability. As with most states, Medicaid remains a key expense driver but one that Fitch expects to remain manageable.
Long-Term Liability Burden: 'aaa' factor assessment
Debt levels are low. On a combined basis, the state's net tax-supported debt and unfunded pension obligations is at the median for U. S. states as a percentage of personal income and a low burden on resources. Other post-employment benefit (OPEB) obligations are small.
Operating Performance: 'aa' factor assessment
The state's strong management of its financial operations has historically offset volatility in its revenue sources; however, the state has been especially challenged by the current economic slowdown and prolonged period of low natural resource prices. The state's financial operations benefit from the maintenance of a separate rainy day fund (RDF; the constitutional reserve) and cash flow reserve funds although the state drew on its reserves to cover gaps in fiscal 2016 and further applied reserves in the enacted budget for fiscal 2017. There is a consistent history of rebuilding reserves as the economy strengthens; however, a likely prolonged low oil price environment will continue to subdue the economy over the medium term and rebuilding of reserves may prove difficult.
RATING SENSITIVITIES
The rating on the state's appropriation-backed bonds is sensitive to shifts in the state's IDR to which it is linked.
The Negative Outlook on the IDR reflects Fitch's concern that the state will be challenged in providing a durable response to its current economic and financial challenges, diluting its future financial flexibility.
CREDIT PROFILE
The ODFA bonds currently offered are secured by lease rental payments by the State Regents from state general fund revenues, subject to annual legislative appropriation. ODFA is one of the principal financing agencies of the state. Both the state constitution and enabling statutes provide for appropriation of lease payments in support of the master real property program. Additionally, the master leasing structure on behalf of the State Regents has been validated by the Oklahoma's Supreme Court.
The terms of the leases extend through the life of the bonds; the maximum lease term permitted by the ODFA under the master real property lease program is 30 years and lease payments are not abatable. The current offering will fund construction of a new building at Oklahoma State University's Stillwater Campus and refund outstanding bond issues for three separate colleges.
All higher education appropriations to the State Regents are consolidated, with the State Regents authorized to allocate funds first to payment of lease rentals of each participating institution. The State Regents covenant to include a budget request for lease payments sufficient to pay debt service for all bonds. The enacted fiscal 2017 operating fund appropriation for the State Regents is $810 million; this is a reduction of almost 16% from the enacted fiscal 2016 budget and down 7.7% from the revised fiscal 2016 budget following two rounds of mid-year cuts. Despite the appropriation reductions, Fitch believes the state retains ample financial resources to fund debt service requirements for higher education debt obligations, particularly as the majority of debt service is funded by student tuition and campus fees.
The bonds are rated one notch below the state's IDR, reflecting the slightly higher degree of optionality associated with payment of appropriation debt.
Revenue Framework
Sales taxes and personal income taxes (PIT) provide almost equal support of the General Revenue Fund (GRF), totaling about 75% of fiscal 2016 revenues, with additional revenue flowing from corporate income and severance taxes. The state is directed by state statute to deposit portions of tax revenues to several of its pension systems for funding of the actuarially required contribution (ARC). Dedicated revenues include insurance premium taxes, driver's license taxes, and motor vehicle inspection fees; a sizable 5% of revenues from sales and use taxes, PIT, corporate income taxes, and lottery proceeds are dedicated to funding the annual contribution to the teachers' pension system.
Historical growth in the state's revenues, after adjusting for the estimated impact of tax policy changes, was slightly below the pace of national GDP growth over the 10 years through 2014, with solid growth in most years more than compensating for recessionary declines. A key input to the solid growth trend has been natural resource development; however, the current slump in these commodities required state action to close a sizable forecast budget gap in fiscal 2017. Fitch expects this slow revenue trend will continue over the medium term as crude oil and natural gas prices are expected to remain subdued.
The state has unlimited legal ability to raise revenues, although rate increases require either a supermajority vote of the legislature or a majority vote of the people.
Expenditure Framework
As in most states, education and health and human services spending are Oklahoma's largest operating expenses. Education is the larger line item, as the state provides significant funding for local school districts and the public university and college system. Health and human services spending is the second largest area of spending, with Medicaid being the primary driver.
Fitch expects that spending growth, absent policy actions, will be ahead of natural revenue growth, driven primarily by Medicaid, and require regular budget adjustments to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U. S. states and the nature of the program as well as federal government rules limit the states' options in managing the pace of spending growth. In other major areas of spending such as education, Oklahoma is able to more easily adjust the trajectory of growth.
Overall, Oklahoma retains ample ability to adjust expenditures to meet changing fiscal circumstances. While Medicaid remains a notable cost pressure, spending requirements for debt service, pension, and other post - employment expense (OPEB) are manageable; carrying costs accounted for 8% of expenditures in fiscal 2015. Pension contributions over the past several years have been significantly above the ARC as the state dedicates certain portions of various taxes to pension liabilities and these contributions benefited from the robust revenue growth coming out of the national recession prior to fiscal 2015. Fitch does not expect this ratio to change significantly; but, commensurate declines in both dedicated revenues and operating expenditures are expected as the state tackles its current financial difficulties.
Long-Term Liability Burden
As of June 15, 2016, the state's debt burden at 0.8% of 2015 personal income is very modest and remains a low burden on resources. Per Fitch's October 2015 State Pension Update report, the state's total net tax-supported debt and unfunded pension liabilities represented a low 5.8% of 2014 personal income, equal to the 50-state median. The state has consistently overfunded its actuarial contribution for the pension systems in recent years due to allocation of specific tax receipts into various systems, and Fitch expects annual contributions in upcoming years to move closer to the ARC due to the constrained revenue situation. The state's OPEB obligations are modest, and the state made 63% of the actuarially calculated ARC payment for OPEB in fiscal 2015.
The state is a frequent issuer of debt although overall levels remain modest; most debt issuance is backed by annual appropriations from the state legislature. As of June 15, 2016, there was $122 million in outstanding general obligation debt out of a total of $2.1 billion outstanding. The remainder of obligations is fairly evenly split between the Development Finance Authority, largely for projects related to the state's system of higher education with a large proportion self-supported by tuition and campus fees, and the Capital Improvement Authority, for capital projects related to various state agencies, including the Department of Transportation.
Operating Performance
Oklahoma's ability to respond to cyclical downturns rests with its superior budget flexibility. While the state fared better than the nation through the most recent recession, operating revenues nevertheless experienced two years of significant declines. To achieve budgetary balance, the state reduced expenditures and applied balances in its RDF, a similar approach to that taken by the state in closing the recent, significant budget gaps created by the extensive softening in the oil and natural gas industries and the PIT rate cut enacted prior to the fall in resource prices. The state's reliance on spending cuts and reserve draw-downs to achieve balance in downturns partially reflects the requirement of a supermajority vote of the legislature or an affirmative vote of the electorate for revenue expansions, which limits the state's practical ability to use this tool.
Financial operations are supported by largely conservative fiscal policies, including a provision in the state constitution that limits appropriations to 95% of anticipated revenues in the forthcoming fiscal year. The state closely tracks revenue collections during the year and forecasts are updated three times each fiscal year.
The state's monthly revenue monitoring and forecast updates are an important tool that the state applies to ensure budgetary balance. Additionally, state agency spending is overseen by the state's secretary of finance and administration who is granted the authority to enact across-the-board agency reductions should revenues fall below expectations. These practices are critical to maintaining balance as the volatile natural resource industry has an oversized impact on the state's economy and finances and operations also respond quickly to national economic trends.
The state's steady recovery following the most recent recession, largely tied to vibrant growth in the oil and natural gas industries, allowed the state to rebuild its RDF to 9.3% of GRF revenues in fiscal 2015. The enactment of a two-step PIT rate cut in 2014, with the first reduction taking effect in 2016, did not consider the potential for a significant retraction in this sector that would slash the state's operating revenues. The rate cut contributed to a very large structural budget gap identified for fiscal 2017, leading to the allocation of $65.8 million from the RDF. The appropriation from the RDF for fiscal 2017 follows total appropriations from the fund of $228.6 million in fiscal 2016, bringing the expected RDF balance at the close of fiscal 2017 to $240.8 million or 4.6% of GRF revenues. Fitch believes the continued appropriations from the RDF highlight the difficulty in achieving structural solutions to the currently underperforming revenue sources and have reduced the state's financial flexibility.
Current Developments of Interest
The underperformance in state revenue sources caused by significant softening in the oil and natural gas industries strained fiscal 2016 financial operations; revenue performance for the year came in 9.4% below enacted budget expectations. PIT collections came in at 1.3% less than forecast, sales tax collections fell short by over 11% (incorporating a decline in mining-related equipment purchases), gross production tax collections underperformed forecasts by 67%, and motor vehicle tax collections missed expectations by 6%.
For fiscal 2016, the state instituted a 7% mandatory midyear funding cut to balance the budget following the declaration of a revenue failure. However, final revenue collections beat expectations, allowing the state to distribute $140.8 million in fiscal 2017 equally among all agencies receiving GRF allocations. The $140.8 million was not eligible to be deposited in the RDF, as the funds are not considered surplus funds under state statute.
Fitch believes financial operations will continue to face challenges in the context of the suppressed natural resource price environment. Fitch currently forecasts an oil price per barrel (bbl) of $42 in calendar year 2016 and $45 in 2017; the state's forecast incorporates a price expectation of $40.29/bbl in fiscal 2017.
The enacted $6.8 billion operating budget for fiscal 2017, not inclusive of the $78.6 million supplemental appropriation for fiscal 2016 from the RDF, closed an anticipated $1.3 billion budget gap (equal to 19% of appropriations in fiscal 2016). The gap resulted from continued low natural resource prices, a weak economic forecast and an enacted PIT rate cut that predates the energy price slump. State actions to address the gap included various fund transfers and sweeps, additional allocations from the cash flow reserve fund, reforms to the PIT, a shift to bonding for transportation capital projects rather than pay-as-you-go funding and a further appropriation from the RDF. Fitch believes the sizable number of one-time measures to close the gap leaves the state exposed to further budgetary imbalance and reduced reserves, absent revenue stabilization, all of which is reflected in the Negative Rating Outlook. Further, under current statute, a second PIT tax cut, to 4.85%, will take effect no earlier than two years after the enactment of the first rate cut under the established trigger guidelines. However, Fitch believes the tax cut will not be triggered in the near term.
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