M Filippich - 1 - 27-1-11 FUTURE TRENDS IN LNG PROJECT FINANCE By Michael Filippich I INTRODUCTION Liquefied Natural Gas (LNG) developments are amongst the most capital intensive and complex projects in the world. In the 1970’s and 1980’s LNG was considered to be a niche fuel produced by a select group of International Oil Companies (IOCs) 1 and sold under long term contracts with state backed utilities. These ventures were typically funded by the participants themselves using a combination of cash reserves and corporate debt. Over the last two decades the global LNG industry has developed significantly. The number of producers and buyers has increased and more LNG cargos are being sold under short term contracts or on the spot market. The majority of new LNG plants are being constructed in developing countries such as Peru, Yemen, Angola and Papua New Guinea with cargos being sold to buyers from emergent markets such as India and China. As more participants enter the LNG market, project sponsors are becoming increasingly reliant on project finance as an alternative to corporate finance. Project financiers have in turn developed more sophisticated financing structures to meet the needs of project sponsors and mitigate the risks that arise along the LNG value chain. This paper provides an overview of the techniques used to project finance LNG and highlights recent trends that have the potential to change the way future projects are funded. Particular attention shall be paid to the role of Export Credit Agencies in 1 Traditional LNG producers include ConocoPhillips, ExxonMobil, Shell and Total.
Transcript
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FUTURE TRENDS IN LNG PROJECT FINANCE By Michael Filippich
I INTRODUCTION
Liquefied Natural Gas (LNG) developments are amongst the most capital
intensive and complex projects in the world. In the 1970’s and 1980’s LNG was
considered to be a niche fuel produced by a select group of International Oil Companies
(IOCs)1 and sold under long term contracts with state backed utilities. These ventures
were typically funded by the participants themselves using a combination of cash
reserves and corporate debt. Over the last two decades the global LNG industry has
developed significantly. The number of producers and buyers has increased and more
LNG cargos are being sold under short term contracts or on the spot market. The
majority of new LNG plants are being constructed in developing countries such as Peru,
Yemen, Angola and Papua New Guinea with cargos being sold to buyers from emergent
markets such as India and China. As more participants enter the LNG market, project
sponsors are becoming increasingly reliant on project finance as an alternative to
corporate finance. Project financiers have in turn developed more sophisticated financing
structures to meet the needs of project sponsors and mitigate the risks that arise along the
LNG value chain.
This paper provides an overview of the techniques used to project finance LNG
and highlights recent trends that have the potential to change the way future projects are
funded. Particular attention shall be paid to the role of Export Credit Agencies in
1 Traditional LNG producers include ConocoPhillips, ExxonMobil, Shell and Total.
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providing debt capacity for large LNG projects and the impact of the LNG spot market
on financing terms and conditions. The paper will also address the finance risks
associated with new technologies such as LNG from unconventional gas and Floating
LNG (FLNG).
II THE LNG VALUE CHAIN
A distinguishing feature of LNG projects is that they are developed as a complex
value chain with the purpose of bringing low cost gas from countries with abundant
reserves to remote markets with insufficient or no domestic supply. The LNG value
chain consists of four essential elements:
� An upstream gas supply including onshore and offshore wells, production
facilities (e.g. gas processing plants) and gas pipelines.
� A liquefaction plant, LNG storage tank and export terminal which is
designed to receive gas from the upstream supply and cool it down to
-160 oC so that it can be economically transported as a liquid. Liquefying
the gas reduces its volume by a factor of 600 and allows it to be stored at
atmospheric pressure. Each liquefaction unit is referred to as a train and
typically ranges in size from 3 to 5 million tonnes per annum (mtpa).
Trains as large as 7.8 mtpa have recently been constructed in Qatar. If
additional gas reserves and or customers are found, the liquefaction plant
can be expanded by installing additional trains at a cost of between $2 to
$4 Billion USD per train.
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� Specialised ships called LNG carriers which are used to transport LNG to
overseas markets.
� A LNG import facility consisting of a port, storage tank and
re-gasification unit which vapourises the LNG so that it can be introduced
into the domestic pipeline network for transmission to end users.
The capital breakdown for a single train LNG development is approximately 20% for the
upstream component, 50% for the liquefaction facility, 15% for transport and 15% for re-
gasification. The overall success of an LNG development is dependent on the
performance of each individual link in the value chain. Often the upstream, liquefaction,
shipping and re-gasification terminal are integrated through a combination of joint
ownership and contracts to create a single multi-jurisdictional business venture on a scale
not seen in any other industry.
III LNG PROJECT FINANCE
The term project finance is used to describe a financing structure where the third
party institutions that provide debt for a project have limited or no recourse against the
project’s shareholders.2 The project’s debt capacity and ability to service the debt is
instead determined by the revenue that the project is able to generate. Unlike corporate
finance, where lenders can have recourse to all of the borrower’s assets and revenues,
project financiers can only look to the assets and revenues of the project to recover any
2 Stuart Salt, Financing LNG Projects Globe Law and Business
http://www.globelawandbusiness.com/LNG/sample.pdf at 10 December 2010.
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debt that may be owing to them. To mitigate the risk of default, project finance
arrangements require complex legal structures and lengthy due diligence periods. Project
finance is generally more costly than corporate finance due to the higher risk premium
and advisor fees.
Oil companies have traditionally avoided project finance on the basis that it is
more time consuming and expensive than funding a project using cash reserves or
conventional debt backed by corporate balance sheets.3 By funding projects themselves,
sponsors retain more control over the use of funds and the manner in which the project is
developed and operated. In contrast, project finance agreements typically place
restrictions on spending and often grant the lenders security over not only the project
company’s assets, but also the supply and offtake agreements. Many oil companies are
unwilling to grant this level of security over their prized upstream assets. In recent years
the benefits of using project finance to keep project debt off corporate balance sheets
have also been minismised by changes to legislation and accounting rules in many
jurisdictions.4
Despite these limitations, project finance has become the primary source of
funding for LNG projects over the last two decades. As of 2010, $95 Billion USD had
been raised to project finance LNG developments worldwide, of which approximately
3 Rob Morrison, Gas and the Attractions of Project Finance International Gas Union
http://www.igu.org/knowledge/publications/mag/april08/mag-apr08-p144_173.pdf at 10 December 2010
4 See above n 1.
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$60 Billion USD has been committed to upstream assets and liquefaction plants.5 The
widespread use of project finance in the LNG industry can be attributed to the following
factors: 6
� LNG projects are highly capital intensive with most new projects costing between
$10 to $20 Billion USD. Projects also require substantial up front capital for
equipment and materials which is beyond the credit limitations of all but a few
International Oil Companies. Even those companies that are able to fund an LNG
facility using their corporate balance sheet may prefer to commit their financial
resources to other more profitable projects in their portfolio or fund exploration
activities that have the strategic advantage of extending the company’s reserve
base.
� Many LNG projects are developed as joint ventures between a stated owned
National Oil Company and one or more International Oil Companies. Project
finance structures are well suited to joint venture arrangements and limited
recourse financing has the advantage of insulating the individual project sponsors
from the project’s debt and risk of failure. Often National Oil Companies will use
project finance as a way of keeping project costs off sovereign balance sheets and
maintaining foreign currency reserves. It is also possible for a well structured
LNG project to achieve a higher credit rating than its host country which
improves financing opportunities.
5 Anselmi JJ, Baker R and Rich F C, ‘The future of LNG finance’ (2010) March Petroleum Economist. 6 See above n 1.
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� LNG projects have a number of features that enable lenders to offer attractive
finance packages containing competitive interest rates and flexible terms. These
features include the industry’s impressive track record for supply and offtake
security, a steady state business model based on long term sales contracts with
revenues paid to US dollar offshore accounts, proven technology and increasing
global demand. Another factor that provides comfort to financiers is that LNG
projects are normally of state significance and will often receive express support
from the governments involved.
IV SOURCES OF LNG PROJECT FINANCE
The substantial growth in the LNG industry over the last two decades has meant
that project sponsors have had to access a number of different funding sources to fulfill
their project finance requirements. Project sponsors will normally try to leverage a
project to the maximum extent possible in order to minimise their equity contributions.
Commercial banks have long been a major contributor to LNG projects worldwide. Bank
loans are provided on an uncovered basis or under the umbrella protection of an Export
Credit Agency or Multi-Lateral Agency guarantee. Following the Global Financial
Crisis, loan periods offered to LNG projects typically range from 7 to 15 years. Interest
on these loans is usually charged at a margin over London Interbank Offered Rate
(LIBOR). Commercial bank loans are often classified as senior debt meaning that loan
repayments take priority over the re-payment of subordinate debt or dividends to equity
investors. Senior debt also ranks highest in the event of bankruptcy or default.
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Export Credit Agencies (ECA) and Multi-Lateral Agencies (MLA) are another
important source of funds for LNG projects. ECAs are government agencies that
facilitate project finance to further the commercial or policy interests of their country.
MLAs operate in a similar fashion to ECAs but are made up of members from multiple
countries. The primary goal of MLAs is to encourage investment in developing countries
in accordance with certain policy criteria. ECAs and MLAs will either loan directly to
the project or provide guarantees or insurance policies for private sector funding. The
guarantees provided by an ECA may protect the bank from any act of default by the
borrower or be limited to political risk only.
Traditionally ECA support was tied to the export of goods or services for the
project. For example the Export Import Bank of Korea (KEXIM) will often provide
loans to projects purchasing LNG carriers built in Korean shipyards. Similarly the Italian
Export Credit Agency SACE provides financial support to LNG projects using Italian
equipment or construction contractors. There is also a growing trend for ECAs to
provide funds to projects as a way of securing long term energy supplies for the country.
The Japanese Export Import Bank has allocated a large portion of its available funds to
LNG projects supplying gas to Japan and four of the top five private lenders to the LNG
industry are Japanese commercial banks that receive ECA support.7 The important role
played by ECAs in LNG project finance is discussed in more detail in Section VI of this
paper.
7 See above n 3.
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The third source of LNG project finance is the global capital market. Over the
last 15 years project sponsors have been able to raise funds through the issue of project
bonds. The main advantage of bonds is that they have a longer maturity than bank loans
which results in a lower net present value for financing costs even though the bond
interest rate is slightly higher. Bonds also have less restrictive financing terms than bank
loans, reflecting the fact that bond purchasers are typically unconcerned with the day to
day operation of a project. Bonds normally have the same seniority as bank debt and are
treated on a pari passu8 basis.
The rapid expansion of the LNG industry in Qatar is perhaps the best example of
the use of bonds to finance LNG projects.9 In 1996 a joint venture between the Qatari
national oil company Qatar Petroleum and ExxonMobil raised $1.2 Billion USD on the
back of BBB+ rated bonds for Phase 1 of the Ras Laffan LNG project. A further $2.25
Billion USD of A rated bonds were subsequently issued for the expansion phase of the
project. In 2005 Qatar Petroleum and ExxonMobil were once again able to raise $2.25
billion to help fund Phase II of the Qatar Gas LNG project. These bonds were given an
A+ rating by international rating agency Standard & Poor and priced at 1.3% and 0.97%
over treasuries for a 15 and 22 year issue. Although the project bond market temporarily
closed as a result of the Global Financial Crisis (GFC), it is still considered possible for
investment grade LNG projects to raise funds through a bond issue. In 2009 at the height
of the GFC, ExxonMobil engaged three credit rating agencies to make the necessary
8 Latin term used in finance agreements that literally means “equal footing”. 9 Peter Rigby, LNG Project Finance: Clearing the Investment Grade Hurdle Standard & Poors http://www2.standardandpoors.com/spf/pdf/fixedincome/project_finance_2005_13.pdf at 10 December 2010.
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preparations for a bond issue for their Papua New Guinea (PNG) LNG project.10
Although the project ultimately reached financial close without a bond issue, the
preparations made by ExxonMobil reflect the ongoing confidence of project sponsors in
the demand for investment grade LNG bonds.
In order for an LNG project to achieve an investment grade rating it must undergo
an in depth review by one or more internationally recognised rating agencies. The rating
agency evaluates the project’s ability to meet its existing and planned financial
commitments by taking into consideration factors such as the security of gas supply, the
strength of construction and offtake contracts, political and technological risks, the legal
and commercial structures established for the project and the creditworthiness of all
participants.11 The rating agency then assigns a credit rating to the project which reflects
the project’s ability to service its financial commitments. Standard & Poor’s rating scale
ranges from AAA which indicates an extremely strong capacity to service commitments,
down to D which indicates there has been a payment default. Any project with a credit
rating below BBB- is not considered to be investment grade and will find it difficult to
raise funds in the capital market.
Islamic finance is another important source of LNG project finance particularly
for projects located in the Middle East, Malaysia and Indonesia where it is used to
supplement more traditional sources of funding. Part of the finance package for Qatar
Gas II was comprised of a 15 year $530 million USD Islamic finance facility.12 Islamic
10 See above n 5. 11 See above n 9. 12 Ibid.
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finance is the broad term used to define financial structures that are compliant with Sharia
law. A key feature of Sharia law is that it forbids the charging of interest on monies
loaned. Capital returns are instead provided through profit sharing or leasing fees.
Islamic finance structures are usually asset backed and ownership is retained by the
investor.
A Sukuk, otherwise known as a Sharia compliant bond is one of the more
common Islamic finance instruments used to fund large capital projects. Sukuks are
issued as a trust note or certificate that represents a proportional ownership in the
underlying project assets. Each Sukuk entitles the holder to a percentage of the income
generated by the project and in this respect operates more like a share in a unit trust than
a conventional bond.13 Assets covered by the Sukuk are usually held in trust by a Special
Purpose Vehicle that also acts as the issuing entity. Secondary markets have been
established to allow Sukuks to be traded in a similar fashion as conventional bonds. The
use of Islamic finance has the advantage of encouraging regional participation and
increasing the debt capacity available to projects. As the Islamic banking systems
continues to develop the use of Islamic finance is likely to become more prevalent.
V MITIGATING RISKS IN LNG PROJECT FINANCE
LNG project finance relies on sophisticated commercial and legal structures to
enable multiple funding sources to work together to meet the project’s day to day
13 Richardson C F, ‘Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field’ (2005) 42 Texas International Law Journal, 119.
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financial requirements. The risk allocation of these structures must be carefully tailored
in order to attract different types of lenders and to preserve the bankability of each link in
the LNG value chain. LNG projects are exposed to a wide variety of risks including
technology risk, supply and offtake risk, financial risk, legal risk and political risk. The
allocation of these risks to the entity that is best equipped to manage them is essential for
attracting project finance.
Technology risk covers a wide range of factors affecting the design, construction
and ongoing operation of the plant. An investment grade LNG project must use field
proven liquefaction, transportation and re-gasification technology and apply robust,
industry standard operation and maintenance procedures. Failure to achieve performance
requirements or reliability targets will have a direct impact on LNG production and
therefore the project’s ability to service its debt. LNG project sponsors rely on
construction contractors that have a proven track record in delivering LNG plants.
Contracts are normally awarded on a lump sum turn key basis with a firm date for
practical completion. This transfers the cost and schedule risk for the design,
construction and startup of the plant or ships to the contractor who then “hands over the
keys” to the project sponsors once everything is up and running. Loan documents will
often stipulate that approval from the lending group is required to vary or increase the
contractor’s scope of work to ensure that costs are adequately controlled. Contracts will
also include liquidated damages for poor performance or delays however it is unlikely
that these will be sufficient to cover principal and interests payments. To prevent default
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the project sponsors are normally required to provide a completion guarantee to service
the debt until the project is fully operational and the non-recourse period can begin.
Another significant risk to LNG projects is the security of supply and offtake
agreements. Project financiers will need to be satisfied that the project has access to
sufficient and stable supplies of natural gas in order to maximise plant utilisation and
fulfill LNG sales commitments. For a stand alone liquefaction facility this is achieved
through firm gas sales agreements with one or more upstream suppliers. Integrated LNG
projects will need to engage an independent reserves analyst to certify that the volume of
gas available from upstream assets is sufficient to meet contractual requirements.14 The
reserves assessment will need to be periodically revised based on actual production and
reservoir data.
LNG offtake risks are managed by establishing comprehensive Sales Purchase
Agreements (SPAs) with creditworthy buyers. Traditionally, most if not all of the
available plant capacity was pre-sold under long term SPAs which provided guaranteed
revenues extending well beyond the scheduled maturity of the debt. Recently the rapid
growth of the LNG industry has seen a reduction in the number of cargoes sold under
long term SPAs. Most new LNG plants reserve a larger portion of plant capacity for sale
under shorter term SPAs or on the spot market. LNG SPAs are negotiated on a take or
pay basis to mitigate volume risk and will typically include a cargo deferral mechanism
to allow the buyer to delay the receipt of cargos from one year to the next or increase
their purchases from time to time. Most LNG SPAs tie the price of LNG to a set of 14 See above n 1.
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reference hydrocarbon prices such as the Japanese Custom Cleared price for crude oil or
the Henry Hub price for natural gas in the US. In the past LNG contracts had floor and
ceiling prices or S-curve pricing schedules to limit the buyer and seller’s exposure to
market volatility however these provisions are becoming increasingly rare.
Changes in LNG sales price is just one of the many financial risks that project
sponsors and lenders are exposed to. LNG projects are required to develop complex
financial models in order to demonstrate that the project is capable of servicing its debt
under a variety of different market conditions. The model must take into consideration
factors including variations in exchange rate, operating and capital costs, inflation risk,
interest rate fluctuations, LNG pricing volatility and taxes to calculate financial indicators
such as the Loan Life Cover Ratio and the Debt Service Cover Ratio.15 The Loan Life
Cover Ratio measures the ability of the project to produce enough cash flow to repay its
debt over the life of the loan. The Debt Service Cover Ratio or DSCR measures the
ability of the project to service its debt on one or more scheduled repayment dates and is
typically calculated by dividing the cash available to the project after all taxes and
operating expenses have been paid by the debt service requirement for that period.
Greenfield LNG projects typically have a DSCR of greater than 2.0 with
expansion projects such as Qatar Gas II having a DSCR as high as 5.17. 16 Even with a
high DSCR, sponsors will need to demonstrate that forecasts are robust enough to
withstand a variety of operational issues and that the financial modeling is accurate. The
15 Ibid. 16 See above n 9.
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DSCR generally operates as a short term health check on the project’s economics and is
used by the lending group to determine the overall debt capacity of the project. During
the lending period restrictions will be placed on the payment of dividends or subordinated
debt if DSCR thresholds are not achieved for a pre-determined historical and future
period. The DSCR can also be tied to the release of sponsor completion guarantees to
ensure that the LNG project is not only fully operational but also solvent before the no
recourse period of the financing begins.
A number of other techniques are used to mitigate financial risks in LNG projects.
Foreign exchange risk is minimised by selling LNG cargoes in US dollars. Payments are
made to offshore bank accounts in a zero risk jurisdiction where the money is held in
trust. The trustee then pays the project’s operating expenses and debt service costs before
releasing a portion of the remaining funds to the project sponsors. Financing agreements
often require the trust account to have a minimum balance or for additional amounts to be
transferred to a separate trust account where money is put aside for production problems,
regulatory compliance or major maintenance activities.
The creditworthiness of all participants in the LNG value chain is also an
important factor in managing financial risks. Lenders will want to ensure that buyers are
able meet the cost of their contractual commitments and that any devaluation of the local
currency will not affect their ability to make payments in US dollars. Even though LNG
project finance is provided on a limited or no recourse basis the financial and operating
strength of the sponsors will have enormous significance to lenders. A strong sponsor is
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able to bring in additional technical expertise, equity and subordinated debt to ensure that
the project it is completed on schedule if problems occur during the construction phase.
In some cases sponsors may even extend their own balance sheet to provide limited
recourse to the project if LNG prices fall below a level that is capable of servicing the
debt. As part of the finance arrangements for the Ras Gas project ExxonMobil provided
a $200 million USD revolving line of credit which can be accessed by the lending group
to make good any debt service shortfall if LNG prices drop below $10 per barrel of oil
equivalent.17
Lenders will also look to the legal structure of the LNG project as a way of
mitigating risk. Project sponsors will normally create a Special Purpose Vehicle (SPV)
or project company whose role is limited to owning the project’s assets, entering into
project related financial and contractual arrangements and carrying out the specific
business activities of the project. The SPV is structured to protect the lenders and project
if one or more sponsors become insolvent. It also acts as the sole source of principal and
interest repayments to the lending group. Loan agreements between the SPV and lenders
will typically prevent the SPV from: 18
� altering the risk profile of the project or agreed scope and operating
philosophy.
17 Mansoor Dailami and Robert Hauswald, Credit Spread Determinants and Interlocking Contracts: A Study of the Ras Gas Project LNGpedia http://www.lngpedia.com/wp-content/uploads/lng_project_financing_funding/Credit%20Spread%20Determinants%20and%20Interlocking%20Contracts%20of%20RasGas%20LNG%20Project%20-%20Robert%20Hauswald%20(American%20Univ).pdf at December 2010. 18 See above n 9.
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� taking on additional debt. The loan agreement may allow the SPV to take on
some additional debt however this will usually be subordinate to existing debt.
� reducing the project’s DSCR below a particular threshold.
� merging or consolidating with another entity without lender approval.
The SPV will also be required to provide a comprehensive security package to the
lenders to enable them to claim against the project’s assets should a default occur.
Security is generally held by a common security agent or trustee with proceeds paid to
senior lenders on a pro rata basis. Given that the lenders have no recourse against the
project’s sponsors post completion, the security package should be sufficient to enable
them to step in and continue the operation of the project (albeit via a third party) or
dispose of the project as a fully functioning entity. In addition to taking conventional
security over land and project assets, the lenders will also request first ranking charges
over gas supply and LNG sales contracts, permits, licenses, bank accounts and LNG in
storage and transit.19
The legal system of the host country may restrict the type of security provided.
Although most of the project’s financial documents choose to be governed by the law of
a major commercial centre such as England or New York, the project documents such as
leases and supply contracts are often governed by local law. Many countries will prevent
foreign companies from taking title over land or petroleum reserves or the transfer of
government approvals, petroleum leases and operating licenses. Some developing
countries simply lack the legal and business institutions necessary to enforce these 19 See above n 1.
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arrangements. Even in jurisdictions where these types of security arrangements are
enforceable the registration and transaction fees for transferring assets or permits can add
substantial cost to the project. Often project sponsors and lenders will need to reach a
compromise over the security package provided in order to fit the legal and political
system of the country in which the project is operated.
The most difficult type of LNG project risk to allocate is political (sovereign) risk.
Political risk covers a wide range of issues including:
� expropriation or nationalisation of project assets.
� wars, terrorism, blockades and embargoes in either the producing or
importing country.
� inability to convert or repatriate foreign currency.
� changes to regulatory requirements and taxation.
The effective mitigation and allocation of these risks is becoming increasingly important
with most new LNG projects planned for politically unstable or developing countries.
Even projects in politically safe jurisdictions such as Australia and Qatar can be exposed
to regulatory and taxation changes as was evidenced by the Australian Government’s
proposal for a Resource Super Profits Tax in 2010.
When planning a project in an area of high political risk sponsors need to gain
widespread government and public support for the project. This is achieved by ensuring
the local community is actively engaged in consultation and that any negotiations with
government are open and transparent to avoid any accusations of impropriety. The
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company may also choose (or be required) to take on a local or state owned partner to
develop the project. A comprehensive due diligence process should be followed when
determining the site location to minimize security risks and to ensure that culturally
sensitive areas are avoided. The project must also ensure that all permitting requirements
are met and that it follows industry best practices where local standards are inadequate or
non existent.
VI THE INCREASED ROLE OF ECAS IN LNG PROJECT FINANCE
Although some of the political risk can be mitigated by good planning and
corporate governance, projects in high risk countries will need to rely on Export Credit
Agencies and Multilateral Agencies to take on a major share of the political risk
exposure. ECAs and MLAs can provide either full or partial guarantees to commercial
lenders to cover debt service if the project sponsors default due to a political risk event.
They can also provide guarantees to project sponsors to cover their completion support
costs if a political risk event occurs before the no recourse period of the project financing
begins. Peru LNG is one example of a recent project that has relied heavily on ECA
support for political risk cover. The project’s $2 Billion USD in senior debt was supplied
directly from ECAs or through B- commercial bank loans covered by ECA guarantees.
ECAs are an important source of liquidity for projects in developing countries as they are
not entirely dependent on market conditions for funds and are also willing to take on
more risk than commercial lenders so long as the project benefits their home country.
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Providing political risk cover is just one of the ways that ECAs are able to
facilitate LNG project financing. Following the Global Financial Crisis, the aggregate
lending capacity of the top 30 commercial banks is estimated to be between $2 to $3
Billion USD for any one LNG project.20 With the cost of most new LNG developments
being in excess of $10 billion USD, project sponsors must look to ECAs to provide the
funding volumes needed to make up this shortfall. These funds are no longer tied to the
export of goods or services but are increasingly being used to secure gas supplies for the
future. This constitutes a major shift in the role of an ECA and is becoming a key
consideration when negotiating LNG Sales Purchase Agreements. It is now common for
projects to market to customers whose home country ECAs or banks have the ability to
assist with project finance requirements. ECAs in Japan and Korea have a long history of
lending to LNG projects that supply gas to their domestic markets. The Chinese
Government has also emerged as a major funding source for projects that dedicate a
substantial portion of their production to Chinese buyers.
ExxonMobil’s PNG LNG project is an example of a project that would not have
been possible without ECA support. The project is a complex, integrated LNG
development located in Papua New Guinea. In December 2009 the project was able to
raise $14 billion USD of debt commitments of which approximately $8.4 Billion USD
came from ECAs.21 In total six ECA loans were signed, three of which were based on
securing gas supplies for the ECA’s home country. The Japan Bank for International
20 See above n 5. 21 Steve Kane, PNG LNG Financing A Major Achievement PNG LNG http://www.pnglng.com/media/pdfs/speeches/PNG_LNG_Financing_Presentation___Steve_Kane_Dec_6_2010.pdf at 10 December 2010.
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Cooperation (JBIC) signed a loan agreement of $1.8 Billion USD to help secure future
LNG cargoes to offset a decline in supply from traditional sources such as Indonesia. As
global demand for LNG continues to grow competition for ECA funding will increase.
ECAs will need to increase the size of their financial commitments to support the rising
costs of large integrated LNG developments. Project sponsors will in turn need to
structure their projects in order to maximize opportunities for ECA participation.
VII THE LNG SPOT MARKET
Another factor that is affecting the way LNG is being marketed and sold is the
emergence of a global LNG spot market. LNG was traditionally sold on a point to point
basis under long term SPAs. Liquefaction trains, LNG carriers and re-gasification
terminals were specifically built for each project to cater for its entire production
capacity. The expansion of the global LNG market over the last twenty years has seen an
increase in the number of re-gasification terminals and ships available to accept spot
cargoes. This has coincided with a rise in the demand for natural gas as a clean burning
and more energy efficient alternative to other fossil fuels such as coal and oil. Many
countries, particularly those in Europe are constructing LNG receiving terminals as a way
of improving their energy security by reducing their dependence on pipeline gas from
politically unstable regions in Russia and North Africa.
Although a fully fledged commodity market for LNG is not yet viable due to
insufficient trading volumes, cargoes are being sold on a spot basis through open tenders
and brokered trades. In 2010 it was estimated that the spot market accounted for
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approximately 20% of all LNG cargoes sold. To take advantage of these opportunities
new liquefaction trains are allocating a larger portion of their production capacity to spot
market sales. Buyers are in turn requesting more flexibility for delivery terms and
commitment quotas when drafting long term SPAs. In 2007 12.5 billion cubic metres of
LNG (approximately 10 cargoes) was diverted from the Atlantic LNG market in Europe
and North America to the Pacific market in East Asia to capitalise on supply shortages in
that region.22 Crude oil based pricing formulas are also becoming less common with
many buyers insisting that cargoes be indexed against domestic or regional gas prices.
From a project finance perspective these changes create a potential conflict
between large long term debt and small short term sales agreements. Loan documents
need to find a balance between allowing project sponsors to respond to market
opportunities and transferring too much price and volume risk to the lending group. An
aggregator or portfolio approach is one technique used to mitigate the risk of
uncommitted plant capacity to the lenders.23 This model involves one or more of the
project sponsors signing a take or pay agreement for the portion of the plant not sold
under long term SPAs. The sponsor taking the uncommitted cargoes must have access to
a large shipping fleet and a number of re-gasification terminals worldwide so that they
can deploy spot cargoes to the most profitable areas. An aggregator structure exposes the
sponsor to significant downside risk as well as upside potential and is usually only
adopted by International Oil Companies with considerable experience in the marketing
and distribution of LNG.
22 Rob Shepherd, Trends and Markets in Liquefied Natural Gas World Bank http://rru.worldbank.org/documents/publicpolicyjournal/182sheph.pdf at December 2010 23 Ibid.
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The LNG spot market has created an incentive for existing LNG developments to
expand in capacity. Once the infrastructure for a single LNG liquefaction train has been
established at a site additional trains can be added at a reduced cost. This is because
roads, power stations, jetties and pipelines are already in place for the original
development. The project sponsors are also able to avoid time consuming land owner
negotiations and government approvals as future trains are often considered as part of the
initial development plans. Expansion projects need careful consideration from a project
finance perspective. The threshold question is whether or not the expansion should form
part of the original project or whether it will be “ring fenced” as its own standalone
project financing.24
Incorporating the expansion into the existing financing structure is often the
simplest solution so long as it receives support from the lending group. Project sponsors
will need to demonstrate that the project economics and gas reserves justify an additional
liquefaction train. Difficulties can arise if new lenders need to be brought in for
additional debt capacity or if existing lenders do not want to participate. This raises a
number of issues particularly in relation to what security if any new lenders will take over
the original project assets and whether the revenue from the first phase of the project can
be used to support construction delays or cost overruns on the expansion project. As a
minimum new lenders will be expected to sign onto the existing common terms
agreement for the project financing. It is also customary for the project sponsors to
provide a separate completion guarantee for the expansion that is funded off their own
24 See above n 1.
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balance sheet and not the project’s revenues. In return the new lenders will expect that
their debt is equal to the existing debt in terms of security and seniority.
The alternative approach is to ring fence the expansion project and treat it as a
standalone project financing.25 This provides a number of advantages such as the
opportunity to redraft financing terms and engage new lenders. It also lessens the
involvement of the existing financiers in vetting the expansion project. Complications do
however arise in relation to the use of common assets. These are all constructed in the
first phase of the development but may need to be upgraded to support the expansion.
Depending on the security arrangements this could create a situation where the lenders to
one phase of a project could enforce against common assets used by another. To avoid
this situation and to protect the interest of all parties it is necessary for the new and
existing lenders to enter into an inter-creditor arrangement over common assets. The
lending community is starting to recognize the commercial benefits of expansion projects
and is willing to provide more flexible financing terms to help project sponsors grow
their business and achieve greater economies of scale.
As the volume of LNG traded on the spot market continues to increase many
analysts are now questioning whether or not a LNG liquefaction train could be project
financed as a “merchant plant” i.e. one that has little or no capacity committed through
long term contracts.26 The challenge of the merchant plant model is determining the
extent to which LNG sales revenue can be evaluated for financing purposes without the
25 Ibid. 26 Ibid.
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support of conventional offtake agreements. Project sponsors will also need to
demonstrate that they have guaranteed access to ships and re-gasification terminals to
service different markets and arbitrage pricing between them. Lenders will need to
decide whether they are willing to take a portfolio view on LNG sales to any number of
buyers with varying credit ratings and operational experience. At present it would seem
that there is a lack of liquidity in the LNG spot market to support the financial
assumptions necessary for a merchant plant. As LNG continues to evolve into a traded
commodity there will be greater transparency in global pricing and hence short term
supply and demand imbalances. This will enable market participants to take speculative
positions by purchasing cargoes from merchant plants which would improve the overall
bankability of the merchant plant model.
A major risk to the growing trade in LNG is competition from unconventional
supplies such as shale gas. As little as five years ago it was predicted that the US would
become a major importer of LNG due to a decline in its domestic gas reserves. A
number of new re-gasification terminals were constructed and LNG plants were
expanded in Qatar with cargoes planned for the US. By the time the expansion projects
were completed the US was already meeting its supply shortage by extracting gas trapped
in shale deposits. The production of shale gas has only recently become economic due to
advances in horizontal drilling technology and well completion techniques. Shale gas
can now be produced at a similar cost to imported LNG. It is predicted that the US will
be able to meet its domestic gas requirements through shale gas for at least the next 30
years and that LNG will only be a supporting player in a competitive spot market that
M Filippich - 25 - 27-1-11
could potentially include gas piped from Alaska. The impact of shale gas on LNG
imports in other regions is yet to be fully realised however countries such as Poland and
China also appear to have abundant reserves.
VIII FINANCING LNG DEVELOPMENTS USING UNCONVENTIONAL GAS
Project sponsors have been quick to exploit unconventional gas as a potential
feedstock for future LNG developments. In November 2010 the operators of the Freeport
LNG import terminal in Texas announced that they plan to install two liquefaction trains
on the existing site to export shale gas to overseas markets.27 Since it was commissioned
in 2008, the Freeport LNG terminal has been significantly under utilised due to the boom
in shale gas. The installation of two liquefaction trains will allow the terminal to operate
as a bi-directional facility and will make better use of existing LNG infrastructure such as
storage tanks and a jetty.
Coal seam gas (CSG) is another source of unconventional gas that is currently
being developed for LNG. In Australia, both British Gas (BG) and SANTOS have
received approval to construct a LNG plant on Curtis Island off the coast of Gladstone to
liquefy CSG from the central Queensland coal fields. A third project proposed by Origin
Energy and ConocoPhillips is currently awaiting environmental approval and final
investment decision. CSG is extracted from a large number of shallow wells drilled into
coal seams using techniques that were originally developed to drain methane gas and
27 LNG World News, Macquarie Energy and Freeport LNG Expansion LNG World News http://www.lngworldnews.com/usa-freeport-macquarie-to-build-lng-export-terminal-in-texas/ at December 2010.
M Filippich - 26 - 27-1-11
water from underground coal mines. After the well is drilled, water is pumped from the
coal seam causing trapped gas to be released as the coal dries out. The methane rich gas
is then gathered and processed in much the same way as gas from a conventional well.
A CSG well produces at a much lower pressure and volume than a conventional
gas well. It is estimated that approximately 1200 CSG wells will need to be drilled to
supply a single 4 MTPA LNG train whereas the same plant would normally be supplied
by 6 to 10 conventional wells.28 The life of a CSG well is also much shorter than a
conventional well meaning that drilling activities will need to continue throughout the life
of the plant. CSG fields need extended time to develop due to dewatering requirements
and once a well starts to flow gas it should not be shut it in for prolonged periods. This
issue is know in the industry as “ramp up” and means that wells will need to be brought
online even if there is nowhere to send the gas. Disposing of the large amounts of water
from the coal seam is also problematic due to its high salt content and other impurities.
Costly evaporation ponds or reverse osmosis plants are required to manage the water
from the wells. There are also a number of environmental concerns regarding the effect
of CSG dewatering on nearby aquifers. Despite these limitations, the shallow depth and
low cost of CSG wells results in a total upstream cost that is comparable to that of a
conventional offshore development making CSG an attractive option for investors.
28 Adrian Chiodo and John Schembri, Financing coal seam gas to LNG projects in Australia ALB Legal News http://au.legalbusinessonline.com/online-practice-area-editor/banking-and-finance/financing-coal-seam-gas-to-lng-projects-in-australia/46244 at 10 December 2010.
M Filippich - 27 - 27-1-11
Managing the technical risks associated with CSG LNG is essential from a project
financier’s perspective. Lenders will focus on the experience and creditworthiness of the
project sponsors. Due to the significant and ongoing nature of the drilling requirements it
is likely that sponsors will be expected to provide some form of long term completion
support or a revolving line of credit in case future drilling targets are not met. Robust
financial modeling will also be required to ensure that the project is able to withstand
increases to drilling costs and ramp up delays. One of the biggest disadvantages of CSG
wells is that unlike most conventional gas wells they don’t produce high value natural gas
liquids (NGLs) such as propane, butane or condensate (light oil). NGLs provide a
substantial revenue stream to the project sponsors during the startup phase of a project
which can also be used for completion support if necessary. CSG LNG sponsors will not
be able to rely on NGL revenues and will have to fund completion support entirely off
corporate balance sheets.
CSG LNG projects will also need to lock in long term take or pay arrangements
with credit worthy buyers as it may be difficult to sell CSG LNG on the global spot
market due to its lower heating value. The energy content of CSG LNG is approximately
10% less than that of conventional LNG due to its high percentage of methane. Given
that pricing is directly related to energy content, the value of a CSG LNG cargo will also
be less but will incur the same transportation and re-gasification costs. CSG LNG
doesn’t meet the minimum technical specifications for some domestic gas networks
limiting the markets in which it can be sold. One possible solution to this problem is to
install propane spiking equipment in the LNG plant to boost the energy content of CSG
M Filippich - 28 - 27-1-11
LNG so that it is equal to that of conventional LNG. This introduces some element of
technical risk and also increases the production costs.
Another significant issue that needs to be addressed by CSG LNG project
financiers is what assumptions should be made in terms of the nature, quality and
quantity of reserves. Conventional LNG plants are normally banked on 1P (proven)
reserves that are certified using data from appraisal or production wells. The drilling
program for a CSG LNG project will continue for the life of the facility and multiple
fields may eventually be developed to meet contractual requirements. Projects will
therefore need to be financed on the basis of 2P (proven and probable) or even 3P
(proven, probable and possible) reserves.29 To mitigate the reserve risk to lenders CSG
LNG projects may need to adopt a borrowing structure where the amount of debt
available under the loan facility varies accord to the project’s reserve base. The regime
would provide for reserves to be regularly certified by an independent consultant and
project sponsors would be required to pay back a portion of the debt if reserves estimates
fall below a predetermined threshold.30
IX FINANCING FLOATING LNG
The next technological advance planned for the LNG industry is Floating LNG
(FLNG). This involves the installation of a LNG liquefaction train on a large barge or
ship so that LNG can be produced and offloaded directly from an offshore gas field
29 Ibid. 30 See above n 1.
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without the need for costly subsea pipelines and onshore infrastructure. The FLNG
concept has a number of advantages including:31
� a significantly lower capital cost than onshore LNG. It is estimated that the cost
of FLNG is approximately $500 per tonne per annum of capacity compared with
an onshore cost of $1000 per tonne per annum. FLNG vessels can be constructed
in low cost overseas shipyards avoiding skilled labour shortages in countries such
as Australia. Onshore EPC costs have sky rocketed recently particularly in
isolated areas where materials must be transported over lengthy distances and
labour flown in and accommodated in construction camps.
� the ability to access “stranded gas’ which is the term used to describe gas
reservoirs that are either too small or too remote to justify the construction of a
subsea pipeline and onshore processing plant. FLNG vessels would be able to
travel from one pocket of stranded gas to the next to extract these reserves.
� less exposure to political risk by avoiding landowner and native title issues which
have the potential to cause significant delays to onshore LNG plants. Another
advantage of FLNG is that it can be moved to a safe location in the event of war
or civil unrest.
� a lower environmental impact than onshore LNG as there is no need for land
clearing or the construction of subsea pipelines through sensitive marine and
coastal environments. Site remediation costs are also avoided as the vessel can
simply sail away once the wells have been decommissioned.
31 Graham Hartnell and Iilmars Kerbers, A Breakthrough for Floating LNG La O’Hamutuk http://www.laohamutuk.org/Oil/Sunrise/PotenFLNGBreakthrough.pdf at 10 December 2010.
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� the ability to significantly reduce startup times as the vessel can be fully
commissioned whilst in the shipyard.
In 2010 Shell received approval from the Australian Government to use FLNG for the
development of the Prelude gas field off the coast of North West Australia. The project
is scheduled for completion in 2014 and is likely to be followed in quick succession by a
number of other FLNG projects that are currently planned for remote waters off Western
Australia and the Northern Territory.32
Financing FLNG presents a number of unique challenges. It is likely that the first
FLNG vessels will be wholly or substantially equity financed by project sponsors until
lenders can establish suitable precedents and risk parameters for the industry.33 Lenders
are traditionally reluctant to loan to new technologies. Although FLNG has yet to be
demonstrated in the field, it does combine a number of proven technologies. The floating
production, storage and offloading of crude oil has been used in the oil industry for
decades and gas liquefaction technology has a proven track record onshore. If FLNG is
project financed sponsors will most likely be required to fully guarantee the project
throughout the construction and start up phase and possibly during the first few years of
operation until it can be demonstrated that the technology works in a harsh offshore
environment.
32 Gervais Green, Briefing: Future Opportunities in the Global LNG Market Norton Rose http://www.nortonrose.com/knowledge/publications/2010/pub32012.aspx?lang=en-gb&page=all at 10 December 2010. 33 Ibid.
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Another issue that needs to be considered when financing FLNG is the loan life.
Onshore LNG plants typically have a loan life from 7 to 15 years with proven reserves
and sales agreements extending well beyond the tenor of the loan.34 It is unlikely that the
small stranded reserves accessed by some FLNG projects will cover the loan period. In
most cases multiple fields will need to be accessed over the life of the loan which creates
a redeployment risk for lenders. Relocating FLNG vessels may prove to be more
difficult than initially anticipated due to different gas compositions and pre-treatment
requirements. FLNG vessels may require substantial shipyard modifications prior to
redeployment which will have an impact on project revenues and the ability to service
debt. Given the reduced storage capacity of an FLNG vessel offtake risks will also need
to be carefully managed. In addition to the usual take or pay arrangements FLNG buyers
will need to agree to strict demurrage charges for offtake delays. It is also yet to be seen
how the marine insurance industry will deal with FLNG. At a cost of approximately $4
Billion USD the FLNG vessel currently being designed by Shell will be the largest and
most expensive ship in the world. It is unclear what approach lenders and insurers will
take to cover such a large investment in a single hull.35
The techniques used to project finance FLNG will no doubt improve once vessels
are put into service and the industry gains the operational experience necessary to
identify, assess and structure the relevant risks. This will enable lenders to reduce the
risk premium placed on FLNG project finance and increase the availability of funding.
34 See above n 31. 35 Ibid.
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Until such time FLNG will remain the domain of large International and National Oil
Companies that have the ability to fund these projects off corporate balance sheets.
X CONCLUSION
According to predictions from the International Energy Agency $250 Billion USD
will be required to project finance LNG over the next twenty years.36 Investment in
LNG is growing at an unprecedented rate. By 2012 international energy company Shell
expects to produce more gas than oil for the first time in its 100 year history.
Competitive pressures and economies of scale are driving up the size of LNG projects
and in turn the cost of each link in the value chain. Financing packages in excess of $10
billion USD have become the norm. At the same time LNG is losing its premium fuel
status and needs to remain competitive against other energy sources such as
unconventional gas and renewables. Project finance structures will continue to evolve in
order to meet these challenges. The ability to increase debt capacity, adapt to changing
markets and embrace new technology will be essential for sustaining growth. LNG will
no doubt continue to be one of the most dynamic and challenging fields in project finance
for many years to come.
36 See above n 1.
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BIBLIOGRAPHY
1. Articles / Books / Reports
Anselmi JJ, Baker R and Rich F C, ‘The future of LNG finance’ (2010) March Petroleum Economist. Richardson C F, ‘Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field’ (2005) 42 Texas International Law Journal, 119. 2. Other Sources
Adrian Chiodo and John Schembri, Financing coal seam gas to LNG projects in
Australia ALB Legal News http://au.legalbusinessonline.com/online-practice-area-
editor/banking-and-finance/financing-coal-seam-gas-to-lng-projects-in-australia/46244 at
10 December 2010.
Afonso Reise Sousa and William Clark, Financing strategies and principles throughout
the LNG value chain DocStoc http://www.docstoc.com/docs/3593364/LNG-FINANCE-
Financing-strategies-and-principles-throughout-the-LNG-value at 10 December 2010.
Ben Cobley, QGTC / Nakilat The Largest LNG Shipping Deal Ever Infrastructure
Journal Online http://www.ijonline.com/Pdf/IJ42/42-45_QGTCNakilat.pdf at 10
December 2010.
Graham Hartnell and Iilmars Kerbers, A Breakthrough for Floating LNG La O’Hamutuk
http://www.laohamutuk.org/Oil/Sunrise/PotenFLNGBreakthrough.pdf at 10 December
2010.
M Filippich - 34 - 27-1-11
HSBC Amanah, Introduction to Islamic Finance Kaz Forum
