Project financing knits parts of costly LNG supply chain

Qatargas LNG plant, State of Qatar (photo by Charles Crowell, 1996).

For a grassroots project, substantial investments may be necessary for each link in the supply chain: field development; liquefaction plant and storage; ports and utilities; ships; receiving terminal and related facilities; and end-user facilities such as power stations or a gas distribution network.

The huge sums required for these projects make their financeability critical to implementation.

Early LNG projects were financed on a government-to-government basis or with heavy consuming-country government support. Alternatively, oil companies and other foreign shareholders raised a large part of the financing with general corporate debt.

More recently, commercial banks and government export credit agencies (ECAs) have been willing to lend funds to these projects on a limited or nonrecourse basis. That is, lenders may only look to project cash flows or assets for repayment.

(Limited or nonrecourse financing will be referred to hereafter as "project financing.")

In financing for the Ras Laffan LNG Co. (Rasgas) project, which closed in December 1996, bond investors participated in an LNG project financing for the first time.

Lenders have become increasingly comfortable with LNG as a business and now have achieved a better understanding of the risks associated with it. Raising debt financing for many future LNG projects, however, will present new and increasingly difficult challenges.

Instead of selling to AA and AAA-rated LNG purchasers from major industrial countries, many future projects will involve sales to emerging-market buyers with higher credit risks or to independent power projects (IPPs) with no credit standing whatsoever.

The challenge of financing these projects will be formidable: political instability, economic uncertainty, and local currency volatility will have to be recognized and mitigated.

Development and implementation of new and creative financing will be of paramount importance to maximize leverage and maintain favorable financing terms.

Described here is the evolution of financing LNG projects, including the Rasgas LNG project financing which broke new ground in this area.

The challenges that lie ahead for sponsors seeking to finance future projects selling LNG to emerging markets are also discussed.

And the views of leading experts from the field of project finance, specifically solicited for this article, address major issues that must be resolved for successful financing of these projects.

Growing comfort levels

Most of the early LNG projects were equity financed or relied on significant government support, often from the financially stronger importing country. Japan, for example, imports more than 65% of the world's LNG and has used its economic and financial strength to enable LNG projects to be financed.

A combination of loans and guarantees by Japanese government agencies and commercial banks supported many of the early Indonesian LNG projects and as late as 1995 helped finance the downstream facilities of the Qatargas project.

Japanese government support was necessary to help implement the government's strategy to diversify its energy sources and to improve the environment by emphasizing natural gas as a significant segment of its energy portfolio.

Recently, financing of LNG projects such as Qatargas and Rasgas has been done on a limited-recourse basis; generally, however, the debt will remain a liability to the sponsors until completion of construction.

Lenders have now become comfortable with the LNG business, because the projects to date have had:

• An unblemished record of performance
• Long steady utility-type cash flows with minimal foreign exchange risks
• Investment-grade purchasers who agree to long-term (up to 25 years) sales and purchase agreements with take-or-pay provisions.

If he has a strong credit rating, lenders will be more comfortable that payments can and will be made.

Rasgas financing

The recent financing of the Rasgas LNG project established many precedents likely to have a major impact on the financing strategy of future LNG projects.

The Rasgas LNG project is being developed by the State of Qatar through its national oil company, Qatar General Petroleum Corp., and by Mobil QM Gas Inc., a wholly owned subsidiary of Mobil Corp.

These sponsors knew the financing was going to be especially challenging since negotiations with the lenders were concurrent with the financing of the Qatargas LNG project, another LNG project in Qatar. This project raised $2.6 billion in separate downstream and upstream financings from a combination of Japanese government agencies, commercial banks, and ECAs.

The Rasgas sponsors were concerned about the capacity in the financial markets to raise an additional $2.5 billion of debt for another Middle East LNG project.

A finance plan was developed that would allow Rasgas to raise funds through a variety of available funding sources. In addition to ECAs and commercial banks, the sponsors decided to try to raise funds from the capital markets.

They knew this would be a challenge because this approach had never been tried on an LNG project. A capital markets tranche was appealing to the sponsors because it potentially accessed another source of capital.

Furthermore, a capital market offering enabled the sponsors to select a debt repayment period that provided an amortization profile that better matched the project's cash flow profile.

The sponsors effectively educated the credit-rating agencies about the State of Qatar, the LNG business, and the Rasgas project itself. The financial standing and commitment of the sponsors to the project and its strategic importance to both the State of Qatar and Mobil were emphasized.

Their endeavors paid off when the Rasgas project received investment grade ratings from both Moody's (A3) and Standard and Poor's (BBB+). The subsequent marketing of the Rasgas bonds benefited from the strong ratings and the soundness of the project.

Originally the sponsors hoped that $200 million could be raised from the capital markets. The final offering raised $1.2 billion at a significantly lower all-in cost than the bank and ECA loans to the Rasgas project.

Rasgas became the largest international project bond issue of any kind and marked the first time that:

• An LNG project had used the capital markets to raise debt
• A capital-markets issue was integrated into and closed simultaneously with a bank/ECA financing
• A bond offering had been done in a Middle Eastern, Persian Gulf country.
• The success of the Rasgas bond offering likely will result in capital-market offerings being integrated into the finance plan of most future LNG project financings.
• Changing players

LNG is likely to continue to be the fuel of choice for the incremental energy needs in such traditional markets as Japan, Korea, and Taiwan and the financing of LNG projects selling to strong creditworthy electric utilities and gas companies in those countries should become easier.

There will be greater participation by commercial banks and the capital markets and less reliance on ECAs and multilateral agencies (MLAs) who tend to be more expensive sources of debt and require more complex loan and security documentation.

Emerging markets

However, many of the next wave of LNG projects will require creative and innovative financing because they will not always have strong creditworthy LNG purchasers.

Much of the projected growth in LNG demand will likely come from customers in developing countries such as China, India, Pakistan, and Turkey.

The ability of LNG suppliers to capture this demand will depend on their ability to finance projects which may rely on noninvestment-grade buyers or third parties like IPPs with no credit history for all or a significant portion of a project 's cash flow.

While sponsors can take comfort knowing that lenders now better understand the LNG business and its risks, LNG sales to emerging markets may layer a new set of risks upon LNG business risks with which lenders have just begun to develop some degree of comfort.

Sponsors will need to develop well-structured transactions to provide sufficient comfort to potential lenders that principal and interest on the loans will be paid.

Without substantial lender participation, project sponsors alone will be unable to make progress in satisfying the energy needs of the emerging economies.

Most sponsors cannot raise the vast amounts of capital required to implement these projects without seriously impairing their balance sheets.

A collaborative effort of project sponsors, buyers, and lenders along with a strong commitment by governments of both exporting and importing countries will be necessary to raise the capital required for the entire chain of investments from the well head to the end user.

Successful project financing will result in acceptable and economic allocation of risk among all these participants. Unfortunately, there are no easy solutions.

Experts in project finance from the financial advisors in the banking institutions to the senior officers of ECAs and MLAs, however, agree that well-structured projects should be able to arrange adequate financing.

Sponsors seeking to finance LNG projects selling to emerging markets will need to do a number of things to attract participation of lenders.

Banks and other sources of financing first will need to be convinced that the long-term fundamentals of the LNG business are sound and that LNG will be cost competitive with alternative fuels in any particular country.

Lenders also must believe the project possesses strong fundamentals (for example, economics, cash flows, and structure).

Each project will present different challenges depending on the political environment of the exporting and consuming countries, the amount of support and commitment of the governments of the affected countries, the quality of the purchasers, and the strategic importance of the project to the sponsors.

Following are some of the major issues that will need to be resolved to finance emerging market LNG projects. These issues are addressed by some of the leading authorities in the field of project finance.

LNG vs. other fuels

It is important that lenders believe in the long-term viability of LNG as a fuel. Particularly in emerging-market economies, it will be important for LNG to be cost competitive with alternative fuel supplies.

It is unlikely that LNG or any other clean-burning fuel will be able to obtain an "environmental" price premium. As markets continue to become more deregulated and high-cost suppliers are supplanted, IPPs and other energy providers' survival will depend on their being competitive on price.

"As long as LNG is an important fuel for the supply of the country's energy balance, you should be able to finance the project," says Adebayo Ogunlesi of Credit Suisse First Boston.

He also believes that the more attractive LNG is as a cost-effective fuel, the greater the likelihood that payments for the product will be made. "An emerging-market country or buyer is more likely to miss or delay a loan payment than a payment for a low-cost supply of energy," he says.

The technological advancements in the LNG industry, which continue to improve plant efficiency and reduce development and operating costs, should ensure that LNG will be able to compete effectively on price with other fuels in many countries.

Governments' support

It will be important to demonstrate appropriate commitment to the LNG project by the governments of both the exporting and consuming countries.

The tax, legal, and regulatory framework of both countries must be conducive to foreign investment, and there must be assurances that these governments will not promulgate changes that could damage the project cash flows or the abilities of the parties to perform.

Many of the emerging-market countries will likely need the government to assist in restructuring the legal and regulatory framework to facilitate infrastructure development and import commodity transactions.

In some cases, lenders will need to be comfortable that the government of the consuming country demonstrates commitment to the project. This can be done in many ways.

The government could provide lenders with the comfort that there is a backstop to the payment and performance obligations of less credit-worthy LNG purchasers which in many cases will be government or quasi-government agencies.

In the case of IPPs, the portion of the payment by a state-owned electricity buyer relating to fuel costs could be guaranteed by the government.

Bill Voge of the project development and finance group at Latham & Watkins advises that many developing countries have come to realize that it is in their best interest to give only that level of government support absolutely necessary to allow private projects to reach financial closing.

"Legally binding guarantees are becoming increasingly difficult to obtain," Voge says.

"But it is still possible to receive lesser support such as comfort letters or letters of support, neither of which is legally binding. These give lenders certain assurances, particularly with respect to expropriation and currency risks, that the payment obligations of the purchaser will be satisfied."

Greg Randolph of Goldman Sachs believes the host government must provide lenders with the ability to receive payment in U.S. dollars or a similar tradable currency.

Convertibility may be a risk some lenders are willing to take in certain infrastructure projects, but it is usually unacceptable in an import project, Randolph says.

While lenders eventually should become comfortable with financing LNG projects with emerging-market purchasers with limited or no government support, some type of support may be necessary in the initial transactions.

Many MLAs such as the World Bank are currently unable to participate in a financing without government counter-guarantees.

Credit enhancement

Certain credit-enhancement techniques may need to be employed to give lenders comfort that the cash flow associated with an LNG purchaser's payments will materialize and enable repayment of the debt.

Various mechanisms can be explored. Rick Edwards of Chase Manhattan notes that one possibility may be to blend weaker and stronger credits of particular LNG purchasers.

"Structuring contracts with a portfolio of purchasers provides the ability to mix lesser credits with stronger credits and diminishes the risks associated with the weaker credits across the entire portfolio," he says.

The amounts of LNG at stake could be limited to the maximum capacity that the supplier can dedicate to a particular market without severely affecting the project's economics in the event of a disruption in that market.

Ramzi Al-Badr of the World Bank believes this is a reasonable approach because LNG demand in these emerging markets is still relatively undeveloped.

"The incremental approach also provides these governments with time to implement necessary reforms and can provide investors with a more accurate picture of long term supply-demand fundamentals in the country."

Edwards believes that if lenders understand the relationships between the purchaser and the end user, they are likely to gain greater comfort. "The ability to identify the purchaser's biggest receivables, and the possibility that the project could look to them for credit enhances the viability of the LNG sale and purchase agreement."

For example, an IPP could be structured so that an appropriate portion of the payments it receives from electricity buyers is convertible to hard currency and placed in foreign trust accounts which are directly accessible to the LNG project and its lenders.

Various other mechanisms could be employed to ensure direct access to payments by end users. The ability to link projects along the supply chain can enhance the creditworthiness of the project.

Dianne Rudo at the U.S. Export-Import Bank believes that lenders may be able to get comfortable with LNG sold into a developing country by examining the flow of the LNG from well head to burner tip.

While it is expected that the role of MLAs and ECAs will diminish in traditional market LNG projects, emerging-market projects are likely to require significant support from MLAs and ECAs at least initially.

Most MLAs are specifically mandated to provide financing for projects in emerging-market countries that the private sector alone would be unable to implement. The participation of ECAs and MLAs will provide a "halo" effect which will result in the participation of private sector lenders.

Rudo believes that ECA participation will be critical to the development of emerging market economies. "ECAs providing commercial and political risk cover are more likely to be comfortable with taking long-term exposure on credits in emerging markets than other types of lenders."

She expects that ECAs will have an important role in project financings involving the emerging markets.

As reforms and new policies are implemented in developing countries to encourage private investment, the capital markets will provide greater amounts of funding to these projects.

Ogunlesi believes a financing structure with a combination of commercial banks and capital markets and with political risk cover from ECAs will become the new approach to project financings in developing countries and will enable a project to capitalize on the strengths of each financing source.

Sponsor support

Project sponsors cannot realistically expect to lay off all incremental risks associated with emerging-market LNG projects.

Only a fraction of the infrastructure and energy-related projects required to satisfy the burgeoning demand in these developing economies will have any hope of being implemented, however, if sponsors are required to assume most of the risks.

Perhaps a higher portion of equity capital will be required to assuage lenders. In some cases, lenders may require sponsors to contribute their full equity obligations before receiving any loan amounts.

Project sponsors, however, will need to be resourceful in developing other ways to attract lenders which do not require additional equity infusions.

Several structural mechanisms are available which tend to strengthen the debt-service coverage ratios, and lenders will likely require the financing to be structured to provide them with the assurances that there will be adequate cashflow to satisfy all payment obligations including debt service.

Worenklein notes that lenders are likely to test the economics of the project under some prolonged low price scenarios.

"Lenders may require larger debt-service reserve accounts and possibly cashflow-deficiency support mechanisms but may be willing to allow structured amortization schedules that better match the project's cash flow profile," he says.

The lenders will take comfort in any completion guarantees provided by the sponsors and will see this as further demonstration of the strategic importance of the project to all stakeholders.

Another technique that sponsors could use in expansion cases is to provide lenders for expansion trains with additional security by giving them subordinated rights to revenues from existing LNG projects.

Rudo says that sponsor-support mechanisms during periods of low prices can benefit the transaction and allow lenders to be comfortable with the structure at all price scenarios.

Sponsors of future LNG projects should be able to preserve a higher level of debt if they can demonstrate to the lenders a stable and predictable stream of revenue taking into consideration the historical volatility of oil prices, according to Rudo.

The host government of the exporting/LNG country (which is often a project sponsor) can also play a vital role in determining both the economic viability and financeability of an LNG project.

Royalty payments on gas and condensate and taxes are one of the largest cost elements of an LNG venture. In a competitive buyers market, the host government can improve the marketability of LNG and make the project much more attractive to lenders by subordinating royalties to the lenders and by offering extended tax holidays to the LNG project.

These actions greatly enhance the cash flow of the project which also improves coverage ratios which lenders use as an indicator for sizing permissible debt.

"If you can demonstrate the strategic importance of the project to the sponsors, the host government, and to the developing country, the lenders will be more inclined to place less emphasis on the credit quality of the purchaser," says Ogunlesi.

The experts consulted agree, in sum, that financing an LNG project that depends on credit and cashflows from purchasers in developing countries will be achievable if well structured.

Sponsors should be able to attract lenders to projects that have strong economic fundamentals and that are strategically important to the sponsors and the exporting and consuming countries.

The large capital investment associated with these LNG projects will make it difficult for even the most financially sound sponsor to elect to place all of the necessary funds on his balance sheet.

Accordingly, both private sector and government-agency lenders will be called upon to assume some of these projects' political and economic risks in order to enable developing countries to satisfy their growing energy demands with an environmentally friendly fuel.

Sponsors will need to accept that the additional risks of these projects will likely result in a higher all-in cost of financing than recently financed projects that have sold into traditional LNG markets. n

Why project finance?

PROJECT FINANCING CAN BE EXPENSIVE AND TIME consuming.

Lenders typically charge more for the cost of funding than for corporate debt. The higher cost reflects the additional risk a lender is assuming by looking only to project cash flows and assets as a source of repayment.

The financing often is time consuming as lenders retain lawyers and technical consultants to analyze rigorously the various risks associated with the ability of the project cash flows to meet debt-service obligations.

The cost of the lenders' review and analysis is paid for by the borrowers.

But sponsors prefer project financing to alternative methods of corporate borrowing for several reasons:

• Project finance enables the sponsors to mitigate part of the commercial and political risks associated with many of these projects.
• Project finance provides certain balance-sheet and capital-budgeting benefits to some sponsors.
• Given most companies' limited budgets, project financing enables companies to diversify their investment portfolios and pursue and participate in multiple projects simultaneously.
• Sometimes there are tax incentives to project finance if the interest can be deducted for tax purposes by the project company.
• Project financing provides access to financing that otherwise may be unavailable to sponsors with weaker credit or to state-owned sponsors with no credit history. Or, if available, the financing may be at a lower cost than if the sponsors had attempted to borrow on their own.

The Authors

Robert J. Minyard is senior director of project finance for Mobil Corp., Fairfax, Va., responsible for Mobil's global project finance activities. He joined Mobil in 1978 and has been assistant general tax counsel, manager of financial planning and analysis, and manager for worldwide tax planning.

Minyard received a JD from Fordham Law School where he edited its Law Review and is a member of the New York and Virginia state bars.

Michael O. Strode is associate director for project finance for Mobil Corp. and involved with Mobil's project finance activities in Qatar. He joined Mobil in 1983 and, among various financial and technical positions, has been risk-management advisor for supply, trading, and transportation; analyst for crude supply and trading; planning associate for Middle East marine transportation; reservoir engineer; and operations engineer for exploration and producing.

Strode holds a BS in petroleum Engineering from Texas A&M University.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.