DUBAI, May 12 (Reuters) - Standard & Poor's cut Oman's credit rating to junk on Friday, saying low oil prices had eroded the country's external reserves to the point they could no longer offset the threat of low oil prices.
The downgrade made Oman the second of the Gulf's wealthy oil-exporting states to drop below investment-grade because of cheap crude. Bahrain was last year cut to junk status by all three of the major credit ratings agencies.
S&P said on Friday that it was lowering Oman's sovereign rating by one notch to BB+ from BBB- with a negative outlook, meaning there was a substantial chance of a further downgrade.
"The negative outlook reflects the potential for Oman’s income level to weaken and for its fiscal and external positions to deteriorate," S&P said.
The other two major ratings agencies have higher assessments of Oman than S&P. Moody's Investors Service rates the country Baa1 with a stable outlook, three notches above S&P, while Fitch Ratings has a BBB rating with a stable outlook, two notches above.
Many analysts and traders of Omani debt, however, have been preparing for the possibility of downgrades. Its financial and hydrocarbon reserves are much smaller than those of neighbours such as Saudi Arabia, giving it less room to cope with large state budget deficits caused by cheap oil.
S&P said it expected Oman to continue running sizeable current account deficits, making it a net external debtor by 2020. It also said the country might suffer a "disruptive period of uncertainty" if the royal family did not quickly agree on a successor to Omani leader Sultan Qaboos, who is 76.
Despite the weakening of its finances, Oman has shown it is still able to borrow large sums from international markets. In March the government sold $5 billion of bonds, and this month banking sources said it was seeking a $3.6 billion loan from Chinese banks.
But Bank of America Merrill Lynch (BofA) said in a report last month that the Omani rial's peg to the U.S. dollar was under threat from the country's large deficits.
Official data suggests Oman's net foreign reserves are around $11 billion, excluding $5.5 billion in three-year sovereign deposits from Iran and $2 billion placed with the Omani central bank by Oman's top sovereign wealth fund, BofA said.
"We expect the Iranian deposits to be fully redeemed over the coming years, thus likely increasing external financing needs," it added.
Reacting to S&P's downgrade, Oman-based United Securities said recent austerity measures by the government were likely to cut the budget deficit more than expected.
It also said S&P was too pessimistic in not expecting major inflows of foreign direct investment through 2020. Development of a huge industrial zone at Duqm, on the country's southern coast, is soon likely to attract sizeable investment, it said. (Reporting by Andrew Torchia, editing by G Crosse)