Overview -- U.S. power plant Sandy Creek Energy faces construction delays and low electric power prices. -- We are lowering the rating on the project's $735 million first-lien senior secured facility to 'B+' from 'BB-'. The '3' recovery rating remains unchanged. -- The negative outlook reflects uncertainties relating to the length of the construction delay, as well as expected lower gross margins for the merchant portion of the project after it begins operations due to low wholesale power prices in the ERCOT market. Rating Action On Aug. 20, 2012, Standard & Poor's Ratings Services lowered its rating on Sandy Creek Energy Associates L.P.'s (SCEA) $735 million first-lien senior secured facility to 'B+' from 'BB-'. We left the recovery rating at '3', indicating our expectation of a meaningful (50% to 70%) recovery if a default occurs. The outlook is negative. Rationale Sandy Creek Energy Associates L.P. represents 575 MW (64%) of the 900 megawatt (MW) Sandy Creek coal plant currently under construction in Riesel, Texas. The expected commercial operation date is Spring 2013. Of the 575 MW, 251 MW (44%) is under 30-year power purchase agreements (PPA) with credit-worthy Texas wholesale power providers Brazos Electric Power Cooperative Inc. (Brazos: A-/Positive) (150 MW or 26%)and the Lower Colorado River Authority (LCRA: A/Stable)(100 MW or 17%). The remaining 324 MW (56%) is hedged only under short-term agreements. The downgrade reflects increased refinancing risk in 2015 due to recent low electricity prices in the North Electric Reliability Council of Texas (ERCOT) region. The downgrade also reflects uncertainty regarding the length of the construction delay and the amount of debt that the project must refinance in 2015, including the senior term loan and swap termination payments. The project's debt in 2015 will include the first-lien term loan which we expect to have a balance of about $655 million to $670 million at maturity on Aug. 29, 2015. Senior debt also includes $100 million of variable-rate tax-exempt bonds that mature in 2042 and 2043 and whose interest rate is currently under 1%. The project also has five forward-starting swaps with a total notional amount of $300 million and fixed rates ranging from 5.2% to 5.6% from 2015-2039 that must be terminated and settled in August 2015. The Dec. 31, 2011 audit estimated the market value of these swaps to be about negative $69 million, but the 2015 value will depend on the forward swap market at the time. The project will likely have to issue debt to fund the termination payment. In total, we expect the project to have outstanding about $834 million of senior-lien debt at term loan and swap maturity in August 2015, or about $1,411 per kilowatt. From the commercial operation date until the 2015 debt maturity, we forecast debt service coverage to range from about 2x in 2013-2014 to about 1.5x in 2015. Our forecast of debt that Sandy Creek must refinance does not include subordinate holding company debt. Sandy Creek Holdings LLC, which owns the project through intermediate holding companies that have no debt themselves, issued $170 million of subordinate debt in 2007 with a pay-in-kind option. The subordinate debt accreted to about $217 million at March 31, 2012, up modestly from $214 million at Dec. 31, 2011. The subordinate debt matures Feb. 29, 2016. Under the terms of the subordinate credit agreement, the subordinate lenders may not accelerate their loans so long as the loans are held by a project sponsor or their affiliate. The sponsors have no plans at this time to transfer the loans. On Oct. 17, 2011, during test-firing the plant with coal, a number of tubes overheated that badly damaged the boiler, delaying commercial operations that had been expected to begin in June 2012 to an estimated date of commercial operation of about spring 2013. The PPAs allow one year of force majeure delay after July 3, 2012, before the project must pay a small amount of liquidated damages. If commercial operations do not begin by July 2014, then Brazos and LCRA may terminate the PPAs. A consortium consisting of Zachry Construction Corp., Overland Contracting Inc. (a Black & Veatch subsidiary), and Gilbert Central Corp. (a Kiewit Construction Co. subsidiary) is building the project jointly and severally under a fixed-price, date-certain turnkey engineering, procurement, and construction (EPC) contract. Although we do not rate the guarantors under the EPC agreement, Standard & Poor's has confidentially reviewed Kiewit and is comfortable that its creditworthiness does not limit the project's rating. The Brazos and LCRA PPAs are an important credit strength and allow Sandy Creek to pass through actual fixed and variable operating and maintenance costs, fixed fuel expenses and emission allowance expenses. The LCRA PPA provides pass-through of actual coal costs, while the Brazos PPA reimburses the project for coal at a heat rate above the 8,850 Btu per kilowatt-hour rate that is guaranteed under the EPC contract. The PPAs also include payments to the project for replacement energy. The ratings reflect the following risks: -- The project faces refinancing risk in August 2015 for its first-lien term loan and forward-starting swaps. -- The project faces around-the-clock merchant power prices for about 56% of its capacity starting in 2015 following a two-year restructured hedge period. -- The project is exposed to commodity and transportation contracts for Powder River Basin coal. The following credit strengths temper the risks: -- The long-term PPAs with LCRA and Brazos provide contractual payments for about 44% of capacity. -- The ERCOT North power market could face higher electricity prices in the future due to decreasing capacity margin, particularly if economic growth and load demand were to increase. -- A 2008 lawsuit with the Sierra Club and other groups regarding alleged violations of the Clean Air Act has been settled. Liquidity We forecast that the project will have sufficient liquidity to pay senior-lien debt service and operating and maintenance expenses through spring 2013 and multiple months beyond, if necessary. Sources of liquidity include sponsor equity commitments that are backed by letters of credit, delay-in-start-up insurance and liquidated damages for construction delays under the EPC contract. The project held about $3.2 million of restricted cash at March 31, 2012, similar to $3.6 million at Dec. 31, 2011. Debt is fully drawn, with $740 million of long-term senior debt and $100 million of tax-exempt bonds outstanding. The project currently expects commercial operations to begin in spring 2013. The EPC contract guaranteed a completion date of June 2012. Interest payments are payable at the end of March, June, September, and December beginning September 2007. Principal payments (1% annual amortization) begin after substantial completion, the date the construction loan converts to the term loan, and are payable on the same dates. The project has a revolving working capital letter of credit of $20 million that it uses for credit support obligations. Before commercial operations begin, the project will raise a separate credit facility not to exceed $75 million, to cover debt service reserve and liquidity needs. A $100 million letter of credit supports the variable-rate tax-exempt bonds. Credit Suisse provides the letters of credit. The debt service reserve is funded after the term loan conversion. Recovery analysis Our default scenario assumes default in 2015 as a result of refinancing risk. We assume that the Brazos and LCRA PPAs remain in place because they contain the provision that the foreclosure by a lender does not constitute an event of default. We assume 30 years of cash flows following default, through 2045, using our merchant assumptions for the unhedged portion of the plant. We reduce enterprise value by administrative costs of 5%, resulting in an enterprise value of $560 million. We assume that the project pays $69 million to terminate its forward swaps in 2015, which was the market value estimated at Dec. 31, 2011. We also assume that a $40 million letter of credit is drawn and we increase outstanding debt by six-months of pre-prepetition interest, resulting in total debt outstanding of $890 million. This results in a recovery rating of '3', indicating our expectation of a meaningful (50% to 70%) recovery if a default occurs. Outlook The negative outlook on the ratings reflects uncertainty regarding the length of the construction delay and the amount of insurance proceeds and other liquidity that could be needed until operations begin. The outlook also reflects long-term concerns about the possibility of low power prices in the ERCOT market, which increases refinancing risk when the project's term loan matures in August 2015. In addition, the size of the termination payment that the project will pay on its forward starting swaps in 2015 is uncertain. We assume that the termination payment will be funded with debt, increasing refinancing risk. We could lower ratings if construction issues persist or if additional costs of complying with environmental rules appear likely. We would likely return the outlook to stable following successful commercial operations. A rating upgrade is not contemplated prior to commercial operation. Related Criteria and Research Updated Project Finance Summary Debt Rating Criteria, Sept. 18, 2007 Ratings List Rating Lowered To From Sandy Creek Energy Associates L.P. $735 mil first-lien sr secd debt B+/Negative BB-/Negative Recovery rating 3 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.