Head, Investment Banking, FBNQuest Merchant Bank
This paper provides a broad overview of the financing issues to be taken into consideration for those seeking to develop a Liquefied Natural Gas (“LNG”) supply business and the concurrent development of gas fields. It is written on the basis of a greenfield transaction that seeks to utilise project financing as the basis for its fund raising. It is not intended to be exhaustive and we welcome the opportunity to discuss the contents of this paper in further detail.
THE LNG SUPPLY CHAIN
In establishing an LNG supply chain, a number of major capital intensive activities need to be integrated and delivered effectively. The entire value chain, from field development, gas treatment, transportation of extracted gas, liquefaction of the gas, transportation of the LNG to the end buyer’s market, regasification at the point of unloading and transportation of the gas to the end users. Note – the entire value chain from field development through to the end-users need to demonstrate a robust fully funded financing plan and be de-risked to attract funding. This paper addresses the business from the point of view of the LNG exporter, and thus we concentrate on the financing of the field development costs, the transportation of gas to the liquefaction facilities, and the liquefaction facilities themselves.
Although we do not specifically discuss the financing of the transportation to the buyer (typically by LNG tankers) or of the receiving facilities, the successful completion of these are an integral part of the financing of the exporter’s own facilities and various assurances or direct undertakings by the purchaser of the LNG will typically be required by those financing the exporter’s infrastructure.
The cost of building the exporting infrastructure will depend heavily upon, among other things, the state of development of the gas fields and location of the fields relative to the point of export. The liquefaction equipment cost will not vary considerably between facilities of a similar size but the cost of developing the gas fields and transporting the gas obviously will vary from project to project.
Although it is therefore difficult to generalise, as an indication of the cost involved, by way of illustration, the Ras Laffan project in Qatar, which was financed in 1996 had an all-in development cost of US$2.4 billion for facilities to export 5.2 million tonnes per annum. For this project, which financed both field development and export infrastructure, field development accounted for approximately 25% of the overall total project cost.
Given the huge capital costs / investments involved, LNG projects are not undertaken on a speculative basis, such is more common in the petrochemicals industry for example, although well-structured petrochemicals projects “bolt-on” credible off-takers to reduce the unknown contents. Before such investments are made, the export of LNG will need to be backed through the establishment of long term (usually 15 years or more) Sales and Purchase Agreements (‘SPA’) with one or more credible LNG purchasers. However, given the evolution of LNG projects over the last 20 years, an increasing component of LNG sales are now being done on a much shorter basis, but overall, lenders have significantly less appetite for such short term contracts.
The SPA provides the core “building-block” of the financing structure as it defines the nature and quantum of the revenues to be received over the life of the financing of the investment and therefore banks place their spotlight / attention in this direction as it drives the transaction’s debt capacity. SPAs will specify both the volumes to be delivered and also the price of the gas. Volumes will typically be fixed with some limited deferral options and in the absence of a spot LNG market, pricing will typically be linked to a proxy such as the price of crude oil which as a competing fuel source gives some indication of the monetary energy value of LNG.
We have seen LNG project financing structures develop incrementally over the last two decades. In the 1980s borrowers such as Sonatrach or ADGAS raised bank debt either on a corporate basis or with the guarantee of their shareholders. In the 1990s project finance structures first came into use with, broadly speaking, two project finance models being adopted. The first, of which the Qatargas LNG project is an example, separates the development of the gas fields from the remaining infrastructure including LNG Liquefaction. The second, such as Ras Laffan, treats all elements as a single transaction and provides a single financing package – the trend globally has gravitated towards the foregoing.
The first model of adopting two financings was the first to be seen in the market. Whilst it can be argued that this properly reflects the fact that gas field development and an LNG export facility are two separate businesses, the fact that the former is being developed as a dedicated source for the latter ensures that the financing structures for the two are heavily interlinked – this of course presumes common shareholders. For example, the pricing of gas supply from the gas field project (revenues high enough to support its debt) and the LNG project (gas supply costs low enough to ensure sufficient cash is generated from the SPAs). Not only is this relationship between the two project entities critical but the relationship between the two sets of lenders is equally sensitive.
These complexities have led to the adoption of an integrated approach whereby the gas field development and LNG infrastructure are financed as one integrated package. By pooling the financing of the two elements, a more simplified structure can be achieved which will reduce the cost, time and “runaway risks” involved in concluding a successful financing. In terms of arranging debt, a simpler and interconnected structure will also aid the raising of debt from the bond and or bank markets, and may also assist in securing better terms from export credit agencies (‘ECAs’).
Historically, it has been the case that debt providers are willing to finance up to 75% to 80% of the costs for such development projects. The balance being financed by equity from the project owner(s), typically in the form of share capital but possibly also in combinations with quasi-equity such as shareholder debt subordinated to the main commercial debt providers. The choice will normally be dictated by the adequacy of funds for capital and taxation considerations. Higher equity proportions may be needed for projects having SPAs with weaker credit countries or corporates.
In addition to providing a proportion of the financing requirement through equity or quasi-equity, the shareholders would normally be expected to provide guarantees to the debt providers in respect of the completion of the project. This would usually include undertakings to complete the project within a fixed time schedule and to repay the debt providers in full in case such deadline is missed by more than an agreed extension period.
The finance providers would also generally insist on restrictions being placed on shareholder dividend distributions subject to an agreed list of financial and technical metrics – i.e. a minimum percentage of the debt having been amortized and also the project demonstrating acceptable cover ratios as a minimum over a continuous period of time.
The debt portion of the financing will usually comprise a mixture of “naked” commercial bank debt and other “covered” bank debt benefiting from political and commercial risk guarantees from export credit agencies supporting the contractors appointed to construct the infrastructure. The use of ECA guaranteed debt can provide competitively priced debt (on a fixed basis) at favourable repayments terms (i.e. long term facilities of up to 14 years or longer), can offer enhancement of returns for the commercial bank debt (assuming the ECA backed debt is packaged with the unguaranteed commercial bank debt), and also reduces the use of bank country limits (the ECA covered portion being allocated to the country limit of the home country of the ECA).
Not all commercial banks will be able to provide debt that matches the maturity of the ECA guarantees. Pricing will be on a floating basis although it is customary for the borrower to fix the rate at closing through the use of hedging instruments. However, interest rate hedging on a long term basis for project financings are yet taking-off in Nigeria.
The issuing of bonds can enable the borrower to achieve a much longer maturity than is available in the commercial bank market: typically, 20 years or more. Pricing will be determined by the rating assigned to the project bonds by the major rating agencies. The rating process is something that needs to be carefully managed and the rating will depend on both the structure of the financing but also the ratings of both the country where the project is located and also the rating of the purchaser under the SPA.
Whilst bond debt offers the opportunity to secure longer term financing it should be noted that in general terms, commercial bank debt is more flexible. This is particularly the case during the construction period of an LNG project when it is not uncommon for a host of changes to the project scope to be required which will require approval of the majority debt providers. With a commercial bank group, this process is relatively straightforward whereas with a bond typically being held by a dispersed group of bondholders (i.e. investors), many of whom have little or no project experience, securing approvals from bondholders can be difficult. On the other side, however, it is generally the case that bonds typically have less onerous requirements on the borrower in terms of covenants covering financial performance and project technical performance and reporting requirements.
In managing the entire process of financing such projects, borrowers usually appoint well experienced financial advisers to provide guidance throughout. The advice and experience of advisers are essential when considering the complexities of LNG project financings and can ensure that the process progresses as smoothly as possible. As to a timetable, from the point of appointing advisers to closing the debt finance can be expected to take in the region of up to 24 months (especially where ECAs are involved), however, well planned greenfield LNG projects have been able to achieve financial close within 9 to 12 months.
DEBT PROVIDER’S AREAS OF FOCUS
Whether debt is raised from the capital markets, commercial banks, ECA guaranteed debt, or a combination of these, the providers of such debt will by and large have the same concerns and will focus upon similar issues some of which are set out below.
- Adequacy of gas reserves: Given the long term nature of the LNG business, lenders need to be assured that the gas reserves to be exploited are sufficient to comfortably meet projected LNG sales. Typically, reserves (proven) should be significantly in excess of forecast sales which in turn will be applied towards debt service;
- Contractor / technology: The choice of the contractor and also the technology to be utilised (particularly the liquefaction technology) are of great importance to debt providers. The technology available for liquefaction is now well established and has a good track record, thus presenting relatively low technical risk. Notwithstanding, the track record of the contractor as an indicator of its ability to deliver the project on time and on budget remains important;
- Receiving Infrastructure: The receiving infrastructure comprises the LNG tanker transports, loading facilities, and regasification plant. As these will not be part of the exporters project package, undertakings from the off-taker as to the readiness and suitability of the receiving facilities is crucial, particularly as it is often the case that new infrastructure will be required to handle LNG supplied under the new SPA;
- Credit risk of off-taker: The off-taker will be undertaking not only to purchase the LNG over an extended period but also to ensure sufficient infrastructure is in place to receive and distribute the LNG. As such the ability of the off-taker to perform its obligations will be critical – this may also extend to the ability of the off-taker to fund any penalty payments due should it fail to meet its obligations in a timely manner. The off-taker’s credit standing and financial muscle is therefore critical;
- Political /economic stability: It has thus far been the case that off-takers have been companies owned and controlled by the governments of the importing countries. Although this has changed over the last decade as credit worthy corporates have gradually stepped-into this role. It will remain important that the importing country exhibits both political and economic stability in general given the long term nature of the commitments, but also has an established policy regarding the use of LNG as an energy source within the importing country. This stability is also important in determining the off-taker’s ability to access foreign currency to meet its US dollar (usually) payment obligations required under the SPAs;
- Financing structure: The overall structure of the financing needs to provide the debt providers with a “cast iron” level of security in terms of the projects revenue generation capacity, ability of the key / major project parties to carry out their pre and post completion obligations, project insurances and overall collateral in place. The foregoing will broadly comprise security interests in the payments under the SPA, reserve accounts, interests in the SPA itself, and where possible, interests in the project assets. The structure also needs to allow for sufficient control over any significant changes to the project proposed by the borrower and to monitor the progress of the project once operating;
- Other matters: lenders typically expect LLCR’s of at least 1.8x, commercial debt tenors of up to 16 years but ECA generally have appetite for much longer, project documents should ideally be on an arm’s length basis and have tenors longer than the project finance debt and EPC are preferred on a lump sum basis. Completion guarantees / support from sponsors are quite common and the Environmental and Social Impact Assessment and Environmental and Social Management will always a major focus area by debt providers;
The sponsors of already established LNG plants are however in a much stronger negotiating position when raising additional (i.e. expansion) financing. Such corporates are therefore able to negotiate much friendlier terms and conditions.