Piercing The Sovereign Ceiling: Issues In Oil And Gas Project Financing

Thomas S. Coleman
Moody's Investors Service
New York

Shown is Ras Laffan industrial city in Qatar, site of the Qatargas LNG export facilities and future development of the Ras Laffan LNG Co. Ltd. export project. Ras Laffan is one example of an oil and gas project whose credit rating "pierced" the sovereign ceiling. Photo courtesy of Qatargas.

Comparing soverign risk in two key petroleum projects [18,458 bytes]

Author's note

This analysis was written before financial and economic turmoil prompted downgrades of key sovereign foreign currency ratings in Asia. Since that time, the long-term debt rating of Ras Laffan Liquefied Natural Gas Co. Ltd. has been downgraded from A3, as referenced in the article, to Baa2. It remains under review for further rating action. The downgrade reflects a decline in South Korea's foreign currency ceiling during that period from A1 to Ba1; as noted, a key factor in the initial A3 project rating was the credit quality of South Korea and Korea Gas Corp., as the project's contractual offtaker. Despite the change in the project rating, the basic issues around rating projects above a country's foreign currency ceiling remain valid. Capital markets in the 1990s have witnessed the emergence of large, cross-border project financings and structured transactions to support infrastructure and energy projects around the world, often in high-growth developing countries.

In many of these locales, major infrastructure and energy needs, coupled with low savings rates and immature domestic capital markets, have opened up significant cross-border financing opportunities to providers of capital. Factors supporting this growth include the globalization of trade flows, capital markets, and technology; political liberalization and privatization; and other regulatory reforms aimed at opening up traditional monopolies and financial markets to competition.

In the oil and gas sector, corporations and governments face huge capital spending requirements in order to transform large resource discoveries into producing, cash-generating assets. These needs can be met only partly from internal cash flow. The balance must come from equity participations, usually from foreign partners, and from the banking sector and capital markets. A significant portion of this funding is expected to be done on a "project finance" basis, where bank lenders or bond investors take a secured position in financing a discrete project, with the expectation of being paid back by the cash flows from that project after completion.

This trend is increasing demand for crediting rating services to provide credit ratings for these project financings. A key challenge is to analyze and rate credit-worthy projects in countries that have relatively low foreign currency sovereign ceilings due to economic, political, and financial risks. In most cases, the credit ratings for projects financed in currencies outside the host country are "capped" at the country's foreign currency ceiling. However, in a few instances, mainly in the oil and gas sector, Moody's has "pierced" the foreign currency ceiling, or rated certain projects above the sovereign ratings of the countries where they are domiciled.

The purpose of this article is to briefly explain some of the qualitative factors and considerations that have allowed Moody's to pierce the ceiling in the oil and gas sector, with a focus on two recent and noteworthy projects: Ras Laffan Liquefied Natural Gas in Qatar (rated A3, sovereign ceiling Baa2) and Petrozuata in Venezuela (rated Baa1, sovereign ceiling Ba2).

Project finance essentiadegreesls

It is important to first remember that any well-structured project should exhibit certain characteristics, before even addressing sovereign issues. These characteristics include:

Sound, stand-alone economic returns.
Creditworthy sponsors that have equity at risk and clear motivations to see a project through to completion.
Guarantees or supports such that precompletion risk is not borne by debt holders or is minor and commensurate with the rating assigned.
Competitive feedstock and energy supplies.
An experienced and reputable project operator, post-completion.
A strong offtake obligation (if project sponsors and offtakers are affiliates, so much the better).
Offtake pricing mechanisms that generate good debt service coverage under stress scenarios.
A debt structure and tenor commensurate with the resources being financed.

The above are all preconditions to a credit-worthy project but would not be sufficient reason to rate a cross-border project above the foreign currency ceiling.

Foreign currency ceiling

In cross-border project financing, the foreign-currency ceiling becomes a fundamental consideration in establishing a project credit rating.

The foreign currency ceiling is the measure of a government's ability and willingness to make foreign exchange available to service cross-border debt, including the government's own debt. Within any country, access to foreign currency is subject to government control, generally through the central bank. During a financial crisis, a sovereign may choose to limit or cut off access to foreign exchange for entities subject to its legal jurisdiction. The foreign currency ceiling will "cap" the ratings of almost all cross-border obligations, because the sovereign's ultimate power could prevent even the most credit-worthy borrowers from making timely debt-service payments. For a debt obligation to be rated above the sovereign ceiling, it must be judged to have a lower probability of default than the government's own senior bonds, which would generally carry the lowest default risk in a country.

While the constraint of the foreign currency ceiling still applies in most cases, Moody's has found instances where it made good sense to reexamine the ceiling relative to certain project financings and structured transactions. To rate a cross-border security above its country ceiling, a basic question must be answered: "During a severe balance-of-payments or financial crisis, when a government is not paying its own cross-border bond obligations and has imposed foreign exchange controls, why would this issuer (or project) be allowed to pay investors on a timely basis, as specified in the original debt instrument?"

A project would be expected to generate ample foreign exchange for debt service and be exempted from currency restrictions. Properly structured offshore accounts and strong legal deterrents to interference would have to be in place, but a credit rating service would also have to reasonably conclude that other political or economic motivations give a high likelihood to the obligations being paid timely.

To answer the question, we must make reasoned suppositions beyond legal structures or protections, because, in most crisis scenarios, a sovereign government has already decided to override such protections. The following factors can provide some framework for answering the question.

Strategic importance to the sovereign

The more a country depends on an industry or the more strategic a project, the less risk of government interference or interruption.

To rate above the foreign currency ceiling, an industry must be strategic and generate a dominant share of the country's tax revenues, exports, and foreign exchange. The sponsor or the project in question must be key to its industry and/or the country's economic health, development, and public welfare. Of course, these characteristics raise the visibility, political sensitivity, and scrutiny that an industry or project attracts (this has always been the fate of the petroleum industry), but they also argue against government interference or tampering with operations or exports, which could hurt financial flows.

Any government would be well aware of that critical importance, and one would have to conclude there is negligible risk of government interference, which would depend on legal structures and, to some extent, on history and precedent. This analysis could not be easily transferred to a country with a highly diversified economy in which an industry or commodity, even one as important as petroleum, is only one component of the national wealth and economic growth. It would also be difficult to apply in cases where a commodity or product is more fungible (e.g., light, sweet crude oil vs. LNG shipments or synthetic crude) or plays a less critical role in the world economy.

In terms of importance to world trade, economic development, and financial flows, petroleum may be the strategic commodity and unique industry par excellence. Oil is a highly fungible commodity in demand worldwide, it generates U.S. dollars, and it is the leading engine of economic development in many oil-producing countries. While a government might be in a precarious enough financial position to want to interfere with the industry to capture more revenues, it would have very little incentive to actually disrupt the operations and trade flows to obtain foreign exchange.

In assessing the risk of government interference, it is important to look at a country's history, legal structures, and government precedents in dealings with its own corporations and cross-border creditors. This would include the country's record on expropriation and on defaults and foreign currency controls during periods of economic crisis or a change in government. Another way to look at it is whether a sector (e.g., petroleum) has any record of being singled out for preferential access or treatment in a time of national financial crisis.

Petrozuata

Venezuela is an interesting case and one that will continue to be highly unusual, as reflected in the recent rating of the Petrozuata project.

Moody's rated Petrozuata's senior debt Baa1, well above Venezuela's Ba2 foreign currency ceiling. The key to the government's treatment of the oil sector is that Petroleos deVenezuela SA (Pdvsa), the state oil company, generates the bulk of the country's exports and foreign exchange and a large share of the government's tax revenues and dividends. While that certainly results in a high degree of industry visibility, a number of factors indicate a low risk of government interference in the company's operations or payment flows.

The state oil company's legal underpinnings include agreements that require the Central Bank to make foreign exchange available to Pdvsa on a priority basis before all other entities, including the Republic of Venezuela. The dollars are available for debt service, operations, and capital spending. The Venezuelan Congress also specifically authorizes Pdvsa to maintain a U.S. dollar account offshore (a $600 million rotating fund), which is always fully funded before dollar funds are remitted to the Central Bank. Both Pdvsa's operations and the offshore account have functioned unimpeded during periods of economic stress, including the 1995 crisis in the banking sector. Pdvsa has never delayed payment or defaulted on any of its debt.

Petrozuata, a 49%-owned project finance, is likewise a key asset to the state. It is the first of five or more upgrading projects designed to find markets for and monetize the country's vast, low-value extra heavy oil reserves. The Petrozuata concession alone involves about 22 billion bbl of extra heavy crude on a resource estimated at 500 billion bbl. Its operational success and unimpeded financial flows will be important to Pdvsa's future ability to attract foreign oil companies to Venezuela's oil sector and to invest in heavy oil development.

Ras Laffan

Qatar's Baa2 foreign currency ceiling reflects a lower risk of default or government interference in debt service than Venezuela's.

The risk factors weighted into Qatar's Baa2 ceiling are also different from Venezuela's. Qatar's rating encompasses a host of regional political concerns that constrain the degree to which Ras Laffan's A3 project rating can be "elevated." Risks such as war and physical proximity to conflict in the Middle East, Qatar's location inside the Straits of Hormuz (the only exit for Persian Gulf LNG exports), and questions of political succession in a small country, all loom large in the analysis.

Nevertheless, Ras Laffan's strategic importance to Qatar cannot be overstated, and any motivation to interfere with operations or cash flow of the project for short term gain would be remote. Qatar's North field is one of the world's largest natural gas fields, a resource estimated at 370 tcf, with no contiguous gas markets or pipeline routes for its gas. The government has identified natural gas as the key to Qatar's economic development, and more than 80% of the country's capital investment is tied to export projects, mainly LNG. Massive investments in port facilities and a similarly sized LNG project, Qatargas, pre-dated the $3.8 billion Ras Laffan project. LNG will thus be the backbone of the country's future wealth and status as a world class supplier of LNG.

Limited asset carve-out

In project financings, it is also important to look at the size of the project assets and revenues carved out for creditors.

This becomes a question of scale, and has two dimensions: the amount of carve-out relative to the project and resource being financed, and, from a larger government perspective, the carve-out relative to a country's total export base.

At the project level, it encompasses the leveraging of the project and the risk that insufficient equity returns could increase scrutiny and potential interference by the sovereign/shareholder.

At the national level, it is based on a view that a country needs access to export earnings and may interfere with private transactions to obtain sufficient cash flows to meet its own debt obligations. Too large an export carve-out would increase the risk of government intervention during a financial crisis.

While both Ras Laffan and Petrozuata are substantial projects, both have good equity bases and are sufficiently robust such that, even under fairly stressed scenarios, they should generate cash back to the sponsors after debt service. In addition, neither project represents a disproportionate carve-out of its country's export flows.

Offshore product, payment flows

A project must generate adequate U.S. dollar revenues outside the sovereign's geographic boundaries, and the funds must be captured and retained offshore in accounts to first benefit the debt holders, both for debt service and collateral protection.

This issue partly relates to a project's status as a strategic asset that will generate foreign currency and mitigate foreign exchange and devaluation risks. However, it also encompasses legal protections that can strengthen a project structure and insulate it from the actions of a sovereign. These arrangements would include offshore accounts in legal jurisdictions that have satisfactory risks and protections for creditors; irrevocable payment instructions directed to those accounts; and properly structured collateral that gives creditors the ability to attach assets, seek remedies, and enforce judgments in the event of default.

The mere existence of a transaction with offshore financial flows is not sufficient to rate a project above the foreign currency ceiling. Identifiable physical goods must be exported and traceable to an off-taker and a market-with assets and cash flows pledged or assigned to the trustee for the benefit of debt holders. A security interest in identifiable cash flows and assets (e.g., non-fungible upgraded syncrude or LNG shipments) will make its easier for creditors to attach assets and enforce claims in the event of default or diversion actions. Conversely, it will become more costly and difficult for a sovereign to interrupt such flows.

Petrozuata provides a good model. More than 95% of the project's revenues will be generated offshore in U.S. dollars. Petrozuata has specific congressional authorization to collect and maintain dollars offshore (this is separate from Pdvsa's rotating fund), and the accounts are not directly subject to Venezuelan law. An offshore trustee controls the offshore accounts, which are pledged for the benefit of senior lenders. The accounts under trustee control include loan drawdown accounts, operating and insurance accounts, partner loans, and a debt-service reserve.

Most importantly, all of Petrozuata's future export proceeds must be deposited to the account under irrevocable payment instructions, whether generated by sales to affiliate Conoco or to third-party buyers. (A limited amount of onshore bolivar funds fall outside this arrangement.) All distributions to partners are subject to debt service and maintenance of the debt-service reserve.

Likewise, Ras Laffan's offshore dollar revenues make up nearly all that project's revenues, and the offshore accounts and security arrangements are similarly well-structured.

Low diversion risk

An important issue that partly relates to properly structured offshore accounts and collateral is diversion risk.

Diversion risk refers to the degree to which a sovereign (or a company under the direction of its government) can physically divert products or related payment flows in a time of financial crisis to capture export revenues. Diversion sidesteps the legal claims and interests of debt holders and customers. A related question in assessing diversion is the severity of the economic penalties attached to diversion. The real risk relates to the sovereign, since in most cases, a sponsor (or project) could be assumed to have every reason to honor debt obligations in a timely manner.

Generally, the less opportunity for product or payment diversion and the more severe the economic penalties incurred, the better chance that a project can be rated above the ceiling. Diversion should be impractical, expensive, and time-consuming, with real economic (as well as legal) penalties or disincentives.

A project (or structured transaction) would be very difficult to rate above the ceiling if the offtake were highly fungible and readily delivered to other markets, or, for example, if there were no specific markets or contractually bound buyers and payment instructions. Part of this would be a cost/benefit analysis of the economic impact of diversion versus continuing to honor and pay a project as structured.

Both Ras Laffan and Petrozuata were judged to have limited diversion risk, based on economic and legal considerations.

For Ras Laffan, the long-term contracts that govern LNG trade, the infrastructure and vessel requirements, the importance of a reliable delivery record with customers (in this case, South Korea), and the lack of an active LNG spot market all add up to low diversion risk.

In the case of Petrozuata, the syncrude product has not been established as a preferred feedstock in existing markets. It also requires complex refineries, effectively limiting outlets to offtaker Conoco and to a finite group of large oil companies and independent refiners on the U.S. Gulf Coast. Even if sizable sales could be diverted to Europe or Asia, Petrozuata would incur large penalties of $3-5/bbl on quality and transportation differentials and would undercut the most logical geographic market outlets.

Legal and structural factors also mitigate diversion risk. In both projects, sales are subject to irrevocable payment instructions that must be acknowledged by the purchaser and that requires all payments to be made directly into trustee accounts for the benefit of debt holders. Deviation from the payment instructions would be an event of default, whether instigated by the government, seller, or buyer. Such actions would cut off the shareholders from entitlements to project distributions and fees, and could open the customers to claims by debt holders.

The likelihood is extremely remote that counterparties such as Korea Gas, Conoco, or a host of other major oil companies would willingly become embroiled in such actions or potential claims. Moreover, Conoco, the offtaker, is a sponsor with substantial equity at risk in a default.

Extra-territorial relationships

The existence of significant cross-border relationships involving governments, corporations, or customers could be a positive factor in rating a project above the foreign currency ceiling.

That necessitates a view that such relationships would be a strong deterrent to government interference in trade and payment flows. For example, a sovereign might have political links or commercial and trade ties with another country deemed so important that the government (as opposed to an issuer or sponsor) would be compelled to leave a project untouched, no matter how dire its own political or economic situation.

In the case of Ras Laffan, Qatar is forging trade ties and financial links with South Korea and, on the upstream side, with many of the major oil companies, among them Mobil Corp. These ties will be key to the country's ability to finance the development of its gas reserves and to find secure, long-term outlets in a market long on gas.

While opinions may vary as to Petrozuata's relative importance to Venezuela/U.S. relations, the project does become more critical if viewed in the context of Venezuela's larger oil development strategy. Venezuela is one of the top two crude oil suppliers to the U.S., recently outranking Saudi Arabia.

Over the next 10 years, Pdvsa plans to aggressively expand its production capacity. Its success will depend, in part, on attracting more than $11 billion of foreign capital to develop its reserves, and on selling most of that production into the premium U.S. market, the proximate and largest gasoline consuming nation in the world. Pdvsa is also forming strategic alliances with most of the major integrated oil, exploration, and oil service companies. These include upstream and chemical projects within Venezuela, and downstream ventures in the U.S. and Latin America.

While the government could lean on Pdvsa in a crisis, we believe all these factors (as well as historic precedent) would make the government circumspect about damaging trade flows or Pdvsa's independent status and existing debt service for short-term gain.

Sometimes, a concentration of offshore assets can be an important factor in assessing sovereign risk and the expected behavior of the government during a financial crisis. Pdvsa, for example, has a large capital investment and physical assets in the U.S. refining industry through its subsidiary, PDV America, as well as through a growing number of joint ventures. These will be financially and strategically important to Pdvsa as it seeks to develop markets for its crude oil and products. The scope of these assets and investments can be viewed as a strong indication of its intent to operate as a truly international oil company and to honor its international commitments. Also, the government, as sole shareholder, is well aware of the nature and importance of these investments to Pdvsa and the placement of Venezuelan crude.

Strong offtake relationships

In cases where these factors line up and Moody's can get comfortable about rating above a foreign currency ceiling, the participation of highly rated and committed offtakers outside the country can help elevate a project's credit quality closer to the offtakers' debt ratings.

A long-term sales contract strongly binds the supplier and offtaker, helping to ensure that expected volumes, pricing and payment mechanisms, and other key contract terms are honored in a timely manner. We analyze how critical the product is to the offtaker, as well as the nature of the offtake contract, including any "outs" available. Offtakers or their affiliates frequently are sponsors/equity investors in the same project, which further strengthens the commercial relationship and motivates all the participants to keep a project and its debt service on track. In such cases, the project rating would ultimately be limited by the offtaker's credit quality. In practice, we have seldom rated projects equivalent to the offtakers, largely due to the constraining effect of the foreign currency ceiling.

Both the Ras Laffan and Petrozuata projects have strong offtake contracts and incentives for the purchasers to take their product. South Korea is highly dependent on imported fuels and is looking for diversification of sources and for security of supply. Korea Gas Corp. entered into a 25-year take-or-pay contract for Ras Laffan's natural gas and recently doubled the volumes under the contract. Although Korea Gas is not guaranteed by South Korea-A1 foreign currency ceiling (see author's note, p. 43)-it is wholly government-owned and the sole importer of LNG into South Korea. There is little reason to believe it would fail to take delivery, which would have ramifications for the country's energy supply, the utilization of its large LNG infrastructure, and its ability to establish other offtake contracts in the future.

Conoco's offtake contract likewise is very strong. While Conoco does not depend on the Petrozuata semi-upgraded syncrude as an exclusive feedstock and could find substitute crudes for its refineries, it does have the Gulf Coast capacity suited to the offtake. It is also contractually bound as the taker of last resort on a base level of Petrozuata's output for the 35-year life of the association agreement. The intent is that ultimately the offtake will find third-party buyers at premium prices. In the meantime, Conoco will be there as purchaser in the event a market does not develop. Moreover, Conoco has substantial equity invested in Petrozuata and is developing other projects and investments with Pdvsa in Venezuela.

Conclusion

Many qualitative issues are factored into a decision as to whether an oil and gas project financing can pierce the foreign currency ceiling.

Before even considering this, however, a project is expected to exhibit certain characteristics: sound stand-alone economic fundamentals; motivated and creditworthy sponsors with meaningful equity at risk; substantial mitigation or elimination of pre-completion risk; experienced and reputable project operators; competitive feedstock and energy supplies; strong offtake obligation(s) from creditworthy parties; offtake pricing mechanisms that generate good debt service coverage under stress scenarios; and a sound debt structure and tenor.

There is no easy recipe or checklist to analyze whether a project can pierce the foreign currency ceiling. There are, however, certain characteristics common to projects that have been able to achieve this. Since every project is different, the weighting or relative importance of each factor, and the interactions among those factors, will vary from project to project.

Ultimately, sound analytical judgment will determine the relative effect of each of the factors. In addition, it is safe to assert that projects rated above the foreign-currency ceiling will continue to be exceptions that prove the rule.

Ecopetrol secures $290 million with oil production risk

COLOMBIAN STATE FIRM EMPRESA COLOMBIANA DE Petroleos (Ecopetrol) has raised $290 million through a unique deal involving notes secured through oil production risk.

Notes totaling $290 million were issued last year by Oil Purchase Co., a special-purpose firm based in the Cayman Islands. The notes were backed by rights to a quantity of oil from Colombia's giant Cusiana and Cupiagua oil fields.

The notes will be paid with revenues from export sales of the oil to Repsol Petroleo SA, a subsidiary of the Spanish oil company Repsol SA.

The notes

The notes have an expected final maturity of 4.5 years and an average life of about 2.7 years. The issue was distributed broadly in the U.S.

Moody's Investors Service has given the notes a Baa3 rating, while Standard & Poor's has given them a BBB rating, higher than Colombia's BBB-foreign currency rating.

"This transaction represents the first-ever asset-backed note offering from Colombia to have a rating higher than Colombia's foreign currency rating," said Salomon Bros. Inc., New York.

The transaction

Salomon Bros. and Chase Securities Inc. were joint lead managers on the transaction.

"This transaction represents a unique, innovative structure," said Salomon Bros., "which achieves a first-ever securitization of oil production risk while also incorporating key elements of an export-receivables securitization."

Ecopetrol Finance and Treasury Manager Diana Espinosa said, "We are very pleased with the success of this structure, which constitutes a valuable source of funding for the capital expenditure needs of our company. It also reflects the strength of a structure developed together by the finance team of Ecopetrol and our advisors and furthermore exemplifies the confidence of international investors in Colombia."

The Author

Thomas S. Coleman is a senior vice-president, energy, in the corporate finance department of Moody's Investors Service. He analyzes and monitors the credit quality of a portfolio of companies and project financings, including major integrated oil companies, refiners, independent exploration and production companies, and pipelines. Coleman holds a master's in international management from the American Graduate School of International Management and a BA from Duke University.