An eerie quiet has settled over Brazilian issuance in the Eurobond markets, with not one borrower from the country selling debt in December and January.

“Investors know how to look at sovereign and corporate credit risk, but how do you price this scandal?” asks one senior DCM banker in New York pointing to the avalanche of disclosures that has sidelined not just Petrobras, but threatens to take down creditors, suppliers, and bankers as well. “People don’t know what companies are and aren’t linked to Petrobras. They don’t know how far the scandal can go.”

Ramifications of the Petrobras scandal continue to roil Latin America’s largest nation. At broader risk are Brazil’s capital markets and construction activity.

Indeed, as investors turn skittish and credit agencies slap downgrades on Brazilian debt, the whole economy must deal with the impact of this “painful” affair, as Maria das Graças Foster, the company’s former chief executive, termed it late last year.

Claims over the past year include commissions of up to 3% on contracts involving more than $20 billion, with funds siphoned off to political parties and individuals. “The payment of kickbacks in large contracts… was endemic and commonplace in the supply, services, and international directorates,” the federal prosecutor’s office has said as part of its investigations into Petrobras. Those directorates were firmly in the hands of the Workers’ Party, in power since 2003, although the prosecutors allege other parties benefitted, too.

The scandal shows how ill-suited state-owned resource companies are for technically complex projects, and how prone they are to graft, says Daniel Freifeld, founder and principal of emerging markets specialist Callaway Capital Management. The recent decline in oil prices exacerbates the situation. “There was some confusion about it at the peak of the commodities boom, but [Petrobras] is showing how brittle these companies are,” he says.

In the first weeks of 2015, it remained difficult to gauge the sheer depth of the Petrobras crisis, even after the company issued an unaudited balance sheet for its third quarter results in late January. The report had been delayed since mid-November when the external auditor, PricewaterhouseCoopers, refused to sign off.

Even after releasing the results, Foster admitted it was “impracticable” to put a reliable figure on asset depreciation due to graft. Still, the company’s initial estimates assumed overpayments at around 61 billion reais ($23 billion), or about 10% of Petrobras’ fixed assets.

Battered and bruised

For Petrobras itself, once the flagship of natural resource nationalism in Brazil with 86,000 staff, the scandal has had a devastating effect.

The company has lost some 80% of market value since its 2008 peak, and its worth fell 40% in the final weeks of 2014 alone. Numerous class actions have been launched by US law firms. Petrobras is also being investigated by the US SEC and Department of Justice.

Late last year, Aurelius Capital, a US-based distressed debt investor, called on creditors to use debt covenants stipulating the release of quarterly results within 90 days to declare the company in default. “If Petrobras still has not released its third-quarter financials by early March,” said an Aurelius Capital report, “the underlying causes of the delay may be considerably worse than is understood today.”

Already, Petrobras’ leverage is rising, and its ratings are under threat. Standard & Poor’s cut its stand-alone ratings to junk (BB) in mid-December. In late February, following Petrobras’ release of unaudited results in late January, Moody’s downgraded the company’s senior debt rating to Ba2 with a negative outlook.

“This corruption issue has reached an unimaginable scale when people start talking about [write-downs of] 80 to 100 billion reais,” says William Eid, coordinator of the finance department at the Getulio Vargas Foundation, a business school in São Paulo. “No credit rating agency will leave Petrobras at investment-grade level.”

“Debt refinancing will become more difficult, especially as the companies’ ratings are being revised,” says Francisco Petros, at law firm Fernandes, Figueiredo Advogados and former president of the Brazilian Association of Analysts and Capital Markets Investment Professionals.

The situation may get worse, he says, as oil prices sink and the dollar strengthens. Between the second and third quarters of 2014, Petrobras’ leverage increased from 3.9 to 4.6 times debt-to-Ebitda, way above the 2.5 times target of previous years. In January, Deutsche Bank forecast that in 2015 Petrobras’ leverage could reach 7.9 times debt-to-Ebitda in a bear scenario, depending on oil prices and the exchange rate.

Petrobras may be able to access funding from Brazil’s state development bank, BNDES, says Fitch Ratings. Yet it will remain cut off from international capital markets until it can release an audited balance sheet.

And Petrobras will likely have to return to the market soon: its borrowing needs for the year are between $15 billion and $25 billion, according to Fitch.

Former chief financial officer Almir Barbassa said in November that the company was strong enough to finance itself for six months. Daniel Sensel, corporate analyst at JPMorgan, suspects Petrobras can last a year without tapping bond investors. But he warns that “things will get nasty” after 2015 if Petrobras still has no access to foreign capital markets.

The most pressing concern now is to restore a sense of normality.

Petrobras brought in a suite of new management in February after Foster and five executive directors resigned. Aldemir Bendine and Ivan de Souza Monteiro, Banco do Brasil’s chief executive and chief financial officer, were hired in the same roles at the oil company.

Even before their arrival, Petrobras announced measures to save cash including reducing operating costs and capital expenditures. Foster said in January that projected 2015 investments would be cut by 30% to less than $33 billion. The company also stopped work on two refineries in northeast Brazil, even though it had already invested more than $1 billion in the projects.

But, low oil prices are not catastrophic, says Petros. The government has allowed Petrobras to maintain retail gas prices despite lower costs on its imports for domestic distribution. That helps it claw back some of the billions of dollars lost from gas subsidies over the past three years, when prices were higher. Over the longer term, however, lower oil prices could jeopardize the feasibility of its higher-cost production projects.

Curbing capital expenditure will help, says Petros. Another option, as Petrobras’ debt nears $140 billion, would be to convert the share of debt held by state-controlled banks into equity. “This would help prevent a sharp downgrade of the company’s rating,” he says.

Spill over

Meanwhile, the crisis is hitting Petrobras’ contractors: 23 companies have been temporarily excluded from public bids, and executives of some of the country’s biggest building firms have been arrested since November. Some companies have run into financial difficulty. OAS, a large engineering firm, has already missed interest payments.

Marcela Nagib, who covers corporates at JPMorgan, says the investigation has created an immediate “reputation risk” for Petrobras contractors, impacting their ability to roll over short-term credit from banks. Aside from not being able to do new business with Petrobras (and potentially other public-sector entities), these firms could have a harder time accessing funding from state banks, she says. “More problems will come as the investigations progress,” says Nagib, warning of fines and contracts renegotiated at less favorable terms.

The bigger engineering and construction companies are sufficiently diversified both internationally and domestically to cope with a temporary shutoff from Petrobras contracts. Odebrecht, in particular, does only around a third of its business in Brazil. Partly thanks to a strong cash position, Nagib says, Odebrecht could even benefit from the scandal and win market share if it was found free of any wrongdoing.

But companies such as Galvão and Mendes Junior that have greater proportional exposure to Brazilian state clients are more at risk, argues Alexandre Garcia, a Fitch associate director in São Paulo. “The situation has deteriorated faster than we anticipated,” he says. Banks “are more reticent to roll over debt if the client is regarded as deeply involved [in corruption].”

Itaú Unibanco’s investor relations director Marcelo Kopel said in January the bank may increase provisions due to the Petrobras scandal. To avoid being pulled into Petrobras’ quicksand, banks need to be “quite conservative”, says Eduardo Ribas, director of financial institutions at Fitch in São Paulo. The scandals bring the potential for more bad debts, provisioning, and restructuring, especially at the state-owned banks.

International contractors could eke one positive from the scandal: the squeeze on local construction and engineering firms could force open the large Brazilian market for contracts in state-led investment projects, especially in oil and gas. “[The investigation] could trigger a lot of operational problems at Petrobras’ investment projects, which are very dependent on local suppliers,” says Petros.

Collateral damage

Meanwhile, the crisis is endangering the Brazilian economy as a whole. The oil and gas sector accounts for 13% of GDP and 5% of total investment. Brazil’s investment rate is already low at around 17% of GDP, according to government figures covering the third quarter of 2014, and may now decline further. Petros reckons that the fall may be as great as 1.5 percentage points of GDP. The biggest concern: that the crisis spills over to infrastructure tenders vital for economic growth as the country tries to rebalance current spending after the election.

New projects are in the pipeline, but public-sector concessions have ground to a halt since November as officials become increasingly skittish. “You do not want to carry out a project if you only have one bidder,” says Garcia. “You do not want to invite in people who are under investigation. You would rather wait to see who is investigated [and what is the outcome]. Naturally it will take more time to get [the concessions] up and running.”

Graham Stock, head of emerging market sovereign research at BlueBay Asset Management in London, says investors are not yet betting that the sovereign’s creditworthiness will come under pressure over a bailout of Petrobras. But if a sovereign downgrade ensues, corporates in the country will have even more difficulty raising financing at attractive terms, especially as US rates rise.

“[The scandal] is contributing to very low business confidence in Brazil,” says Stock. “Investment is clearly being depressed by the revelations.”

While it may still be early to say that the worst is behind Petrobras, optimists see some positive political fall-out. “Contracting will have to be more transparent and professional,” says Fitch’s Garcia.

Petrobras appointed João Adalberto Elek Junior, a former Citibank and Fibria Celulose chief financial officer, to head its new department of corporate governance, risk, and compliance in January. Ellen Gracie Northfleet, a respected former head of the Supreme Court, and Andreas Pohlmann, a German lawyer specialized in compliance and internal control, also joined the company’s special governance committee in late December.

Paolo Valle, managing director and senior portfolio manager at Manulife Asset Management, says the investigation is just “one of the many changes that Brazil has to go through”. In the longer term, “we see Brazil as a glass half-full rather than half-empty,” he says.

“We think the Petrobras scandal is going to be positive for Brazil, whatever the outcome of this investigation. It is going to bring changes to the way business is done. It is going to lead to a cleaner investment environment.”

Investors with shorter-term time horizons may take more convincing. Yields on Brazilian oil and gas credits have shot up as a result of the scandal. But even yields of up to 9% for names that would have yielded less than 5% a few months ago may not be high enough, given the lack of visibility over individual companies’ involvement and potential write-downs.

“There are other areas of the world — like Mexico or Colombia — where you can play the oil price without being exposed to this kind of corruption risk,” says AJ Mediratta, co-president of New York distressed debt investor Greylock Capital. LF

Additional reporting by Dominic O’Neill