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LNG financeFollowing the supply chain

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Financing needs in the LNG sector are huge.

Extraction and gathering pipelines

Liquefaction, storage and loading

Transportation (tanker)

Receiving terminal; regasification, storage

Transportation (pipeline)

Power plant

Utility / Local Distribution Company

At 1 billion cubic feet of gas/day, construction cost of US$ 500 million to US$ 1 billion.

Five to ten vessels needed, at over US$ 150 million each (costs have almost halved in the past ten years).

US$ 2 to 10 billion, depending on size and location. Costs have gone down sharply over the past decade.

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LNG producers

Receiving terminal; regasification, storage

Power plant

Mitigates risk by using toll-based contracts, with capacity reserved under long-term contracts

PipelineMitigates risk by having powerplants agree to throughput guarantees, under long-term contracts

Increased willingness to bear risk, by selling LNG at netback prices

Practices are changing

LNG vesselOff-balance sheet leasing finance, with long-term charter contracts.

And in Asia, many of the long-term contracts are expiring from 2005 onwards.

Increasing investments upstream and in transport

?

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LNG producers

Receiving terminal; regasification, storage

Power plant

Pipeline

LNG vessel

Financing schemes

Corporate finance, esp. for initial trains in «risky» countries, project finance otherwise

Shift towards project finance, underpinned by long-term charter agreements.

Growth of stand-alone schemes (SPVs), relying on project finance backed by tolling contracts

Project finance with take-or-pay throughput contracts

Growth of merchant plants, using project finance

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LNG project

Very long lead times, and expensive – around 250 US$ per tonne of installed liquifaction capacity.

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LNG project Typically, a project finance structure

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Local (state) company may have to be a shareholder. Problem: they may be much weaker (in management and financing capacity) than the other shareholders. Project structuring should be such that this difference does not create problems.

A risk is that shareholders may change in the course of the project. Are new shareholders sufficiently committed to the project, do they have the capacity to manage it, and would they agree to the project finance structure?

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EPC contract(s) with liquidated damages. Usual problems of project finance, with perhaps a somewhat greater importance of timing-related risks (because of the supply-chain links created for the project). Who will cover these?

One practical issue is when the construction is deemed complete – only when a LNG cargo has been successfully produced. This will be done only if there is a buyer. But can the LNG producer trigger the start of a supply contract? What will happen if it turns out that the plant does not perform satisfactorily?

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Note that there is a move away from turnkey contracts with one general contractor (who then takes responsibility for sub-contractors), there are now often multiple contracts with different contractors.

Problem: if there is a problem, they may try to shift the blame. The project company (and its banks) needs to ensure that

- the liquidated damages clauses of the various contracts fit together

- and that the timing and completion tests of the various components are well synchronized.

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It is common to use operations & maintenance contracts, with liquidated damages in case of non-performance.

But are all risks properly covered?

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If the gas is associated to oil production, normally no large problems (except for practicalities of building the pipeline from the fields to the LNG plant – obtaining rights of way, government licenses etc.).

But if a separate gas project, possible complications when the gas project is not fully equity financed. If banks are involved in financing the gas field, there can be complicated intercreditor negotiations.

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Risks both before and during the project:

- delays in the government granting licenses/concessions, and unwillingness/ inability to pass proper legislation

- during the project, political risk: government reneges on commitment, starts (creeping) nationalization, etc.

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Financiers generally insist on forward sales of much of the LNG that is expected to be produced, to creditworthy buyers. The term of these sales has to exceed the tenor of the financing by several years, to enable financiers to recuperate eventual payment delays. Financiers would also like a high degree on certitude with respect to the prices to be received.

LNG producers may want more flexibility, to enable them to react to favourable spot market conditions; and may also want to respond positively to buyers’ requests for more flexible pricing arrangements. For projects with large equity finance, this may be feasible.

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Traditionally, in Asia LNG import contracts:

- are of a long-term nature (over 17 years)

- are of a take-or-pay kind (buyer will pay for a specified minimum amount, whether or not the quantity is taken)

- had prices linked to crude oil prices, but within an agreed band.

These specifications carried risks for the importers, but in the traditional

environment, they could manage these.

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LNG import contracts:

- of a long-term nature (over 17 years)

- of a take-or-pay kind

- prices linked to crude oil prices, but within an agreed band.

Demand was rising fast, so little risk of having to take « too much »

Importers were regulated utilities that could pass on fuel costs to consumers.

How are contracts likely to be affected by liberalization and privatization? Long-term take-or-pay commitments become risky where demand and competitive position are uncertain.

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LNG producers

But for new projects, will financiers accept that LNG producers take on more price risk?

Commercial risk

Political risk

mitigants

mitigants

+Total risk appetite is limited

Still, financiers have some flexibility. In the Nigeria LNG project (high political risk, but also much equity investment) they were willing to accept allocation of 12% of gas sales to non-investment grade offtakers, and 10% for short-term trade. If the buyer is a SPV, the bank may want parent company guarantees, and/or access to the SPV’s revenue stream.

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LNG producers may wish to build more security into a SPA by taking a first claim on the revenues that their buyer generates by selling the LNG or its product (e.g., electricity).

There are then intercreditor issues, with the financiers of the buyer. These normally do not have large problems with LNG producers taking a first claim, but only as long as business operates as normal. In case of default, they want first claim themselves.

LNG producers and importers may wish to build in some flexibility with respect to the start of the contract; e.g., the producer may have the right to deliver alternative fuels as substitute to its LNG delivery obligations.

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Financiers will want to see arrangements in place for the LNG to reach buyers. The LNG shipping market is very narrow (141 vessels in early 2003, expected to increase to close to 200 by the end of 2006), and most ships belong to LNG producers or importers, and are already committed. Constructing ships takes up to three years, and shipyard capacity is tight.

LNG producers thus have to decide whether to invest in their own ships, or, by signing long-term charter contracts, enable others to build them.

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A series of legal undertakings will be used to manage risk

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Financing a LNG regasification plant, with associated storage facilities and pipelines

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A LNG regasification plant could be financed with a similar structure as the LNG production trains… But the risks are larger, and clearly, legal agreements are not enough…

Dabhol Power

Metropolis Gas Corp.

LNG receiving and regasification plant and pipelines

ADGas

LNG

natural gas

MLNG Tiga (Petronas)

20 yrs SPAs

Ispat Energy

20 yrsOman LNG

LNG vessels were financed on the basis of long-term charter contracts.

Rashtriya Chemicals &

Fertilisers

PPA

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Two types of LNG regasification projects – is the plant a buyer, or not?

Regasification plant

Regasification plant

Offtaker (power, pipelines, desalination, etc.)

Offtaker

Offtaker

Offtaker

One owner (de facto)

Bundled projects Tolling projects

Local regulations on ownership of gas may make tolling approach necessary.

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From a financier’s perspective, the difference is large

Regasification plant

Offtaker (power,

desalination, etc.)

One owner

Bundled projects - what are the purchase agreements? (multiple suppliers or only one?)

- what are the sales arrangements?

- how are price risks dealt with?

- what is the risk of non-delivery by the LNG supplier?

- what is the risk of non-payment by the offtaker’s buyers (e.g., the local electricity board, captive gas buyers, water company)?

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Regasification plant

Offtaker (power, desalination, etc.)

One owner

Bundled projects In the supply contracts, security of supply is important:- credit rating of the supplier- force majeure clauses in the contract- contract default risk by importer (banks may wish

to ensure the importer pays the seller) - shipping arrangements

Also, the financiers will have a close look at the details of the sales contract. E.g., if these contain pricing clauses that directly link, say, the price that a local electricity board pays to the electricity production cost, will local political conditions in effect allow this? They may also want bank L/Cs, and local escrow accounts.

Financiers may ask for step-in rights

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From a financier’s perspective, the difference is large

Regasification plant

Offtaker

Offtaker

Offtaker

Tolling projects- are the tolling contracts sufficiently long-term?

- do they cover a sufficiently large part of capacity?

- is there a minimum monthly fee?

- how are force majeure events defined?

- how creditworthy are the tolling clients? If not good, then the financiers may want a) L/Cs; and b) to have greater control on actual LNG flows.

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Regasification plant

Offtaker

Offtaker

Offtaker

Tolling projects

Weather risk management?

The offtakers will normally reserve a certain processing capacity, and pay a price for this which is partly fixed (capacity charge), partly variable (cost-based).

The financier will normally look for the following:- offtakers guarantee to pay a minimum monthly processing fee irrespective of the quantity that has actually been processed (a « firm fee ».- in total, these firm fees are enough to cover debt service- the offtakers pay damages for non-performance; and maintain sufficient credit support.

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Vessel finance

LNG vessels are often purpose-built for specific needs and for specific routes. Transport costs account for a major part of the landed price of LNG (20-35%), so anything that can be done to make transport more efficient is useful.

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During the negotiations of the SPA, shipping arrangements need to be agreed on:- The buyer is responsible for transport, buying FOB (issue: this does not fit well with netback pricing arrangements, as the buyer may not deliver the LNG to the most valuable destination).

- The LNG is sold on a delivered basis, CIF (requires sophisticated logistics skills for the seller; and SPA contracts should ideally allow for cargo swaps; possible scheduling problems when buyer does not own regasification plant).

- Buyer and seller agree to use a third party.

The vessels (of over US$ 150 million each) are normally financed out of equity, or through a project financing structure. Islamic finance is also possible (Brunei gas). Banks tend to provide 10-12 year finance, while the economic life of a LNG vessel is more than 40 years.

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Shipping company

Shipyard

LNG buyers or

sellers

LNG vessels take 30 – 34 months to build. Risks of delays, which would compromise shipping company’s ability to meet charter obligations. Shipyard has to agree to liquidated damages for delays. Finance: only for 50-80%, unless if significant part of capacity is pre-sold under long-term charters.

Normally, long-term charters with fixed fee structures (fixed component, plus cost-based payment for operating & fuel expenses). Two major risks: default by contracting party (so banks may insist on investment-grade counterparts), and default by the shipping company on its charter obligations, which allows cancellation of contract.

Default by the shipping company can be the result of technical problems, or of the arrest of the ship under maritime law by unpaid crew or suppliers.

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In a project finance structure, the financiers will mitigate the risks in the usual systematic way of project finance.

Is the loading port a good one, and well-managed? What are the political risks? How creditworthy is the seller?

Is the shipping route safe (narrow straits, etc.)? How well will the vessels be managed?

Is the offloading port a good one, and well-managed? What are the political risks? How

creditworthy is the buyer?

What is the experience of the

ship-builders?

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If the underlying SPA is strong (note the risks, e.g., Dabhol), long-term charters will ensure a consistent cash flow. This makes it possible to provide non-recourse finance, with assignment of payments under long-term charter agreements. (Financiers may have to build in room must be built in for swap agreements and other methods to reduce costs).

Common structure once the vessel has been built:

Specialized leasing

company

Shipping company

ClientLease

paymentsTransport

fees

FinanciersMortgage

Finance for procurement

of vessels

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Protecting the charter contracts is important for the financiers.

They will, for example, build clauses into financings which are meant to reduce the risks that these charters are cancelled. E.g., ratios for the shipping company (minimum account of cash balance to be held; ratio of current assets to current liabilities; ratio of net debt(gross earnings), to ensure that if financial developments put the performance of the shipping company at risk (e.g., create problems for it to pay its bills), the financiers can accelarate loans, or stop lease contracts.

And if the shipping company gets into problems, the bank generally has step-in rights: the charter clients agree on the possibility of ownership on the vessel being transferred to another party – this is not a reason for cancellation of the charter contract.