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Providing coverage of Alaska and northern Canada's oil and gas industry
May 2007

Vol. 12, No. 18 Week of May 06, 2007

Rich on mega project financing: Alaska gas line would set record, federal loan guarantee may only be for 80% of 80%

Last year the Alaska Legislature got a workshop on building mega projects.

This year they got an introduction to what has to happen before a shovel hits the ground: megaproject financing.

Frederic Rich of the New York law firm of Sullivan and Cromwell said his firm developed the workshop for agencies working on the federal loan guarantee for the Alaska natural gas pipeline — the Department of Energy, the U.S. Treasury and the Office of Management and Budget — to provide an understanding of the context in which guarantees might be used.

Rich runs the project finance group at Sullivan and Cromwell, the only law firm where the average size of projects is more than a billion dollars. The firm has worked on half of the 10 largest oil and gas financings, either for the borrower or the lenders, he said, and has been engaged by the North Slope producer group over the last couple of years to advise them on finance issues.

But the opinions and views expressed, he told legislators attending a House Finance presentation on April 25, are solely his own, based on his 25-30 years of project work.

Alaska project will break new ground

Rich said the Alaska project will break new ground for financing oil and gas projects, where the largest financing has been well under $10 billion. And, he warned, what worked for other big project financings may not work for this one.

“Big important projects make their own market,” he said, but in general the commercial and economic robustness of a project determine what lenders will or won’t accept.

In project finance “we like to use a hairy dog metaphor,” Rich said: When there’s so much hair on the dog at some point lenders are going to balk. You don’t know what the balking point will be, he said, but you try to identify what’s described as hair on the dog.

Project finance, he said, is not corporate finance. It’s not based on a form — it’s tailored to the risk profile of the individual project.

It’s highly structured, requiring a lot of pieces.

The project is nondiversified — the debt gets paid in only one way. The project starts with reserves and the shipper pays the tariff, but where is your recourse? If you have a pipeline it is a separate entity from the downstream utility and the upstream fields. If I’m the lender, he said, the only thing I have recourse to is the pipeline and whether I get paid or not depends on other people, the shippers, who aren’t part of the pipeline.

The project is often greenfield — when you disperse the loan, there’s nothing there, no way to repay the loan.

In contrast to the Alaska gas pipeline, the great majority of the top 20 U.S. gas pipeline financings were expansion and acquisition financings, Rich said. And they were far smaller, with No. 20 on the list dropping to just $10 million.

A project financing is cash-flow-based credit usually backed by contractual commitments and it is limited recourse: The project entity is the only one that owes. After completion, the lenders agree to look only to the project entity for repayment.

What could go wrong?

As lenders design financing to reflect the economic profile of the project they look at projected cash flow from the project and they look at the risk to the cash flows: What could go wrong?

In the lending world, Rich said, the focus is on what could happen that results in the debt not getting paid. The whole project finance field, he said, is based on what could go wrong.

The first risk is will there be facilities and an enterprise to pay back the debt: Will the project get built on time, within budget — and will it work as promised.

Lenders don’t take this risk, Rich said.

If a project is built to the specifications and has contracts, then at completion the loans will be non-recourse. Before completion, however, the sponsor or shareholders of the project entity have to guarantee the debt.

And that is the main reason that good projects don’t happen, Rich said.

It’s why most juniors in mining farm-in majors: They may have a great discovery and lenders may be enthusiastic about a project once it is built, but the juniors don’t have the balance sheets to give completion support.

The federal loan guarantee legislation for the Alaska natural gas pipeline says if the federal government gives guarantees it will require completion support or guarantees.

Risk allocation and mitigation

And while some companies can finance completely with equity, then they take all the risk, which is why lenders are brought in — to share the risk. That way companies limit the first call on their equity.

Rich said that leverage is important to lenders, having skin in the game, because lenders want the owner of the project to be well motivated to fix things. Lenders want the owner to suffer before the lender does. And that is what equity is, Rich said, the first layer of loss in a project. If the project goes bad the equity suffers before the debt.

There is risk allocation within the debt portion, he said. You take all the things that could go wrong and make a list of who bears those risks proportionately. The markets like gas, but lenders won’t bear the risk naked and are going to demand that those with offtake contracts bear risk.

The tax and regulatory risk is quite a big deal in project financing, Rich said, and is often shifted to or borne by the host government, because for lenders one thing that could go wrong is that the tax burden is higher and the cash available for debt service is lower.

Completion risk

When considering completion risk, lenders look at the quality of the feasibility and budget work for a project: Who did it? What is the contracting strategy? Have any of the risks been laid off?

They look at what the quality of project execution is expected to be based on the track record of the shareholders and the size of the budget contingency. Sometimes they require pre-committed overrun financing.

All of these things can mitigate, but if they don’t work and there is a cost overrun, the lenders will not take the risk.

The sponsor bears that risk with completion support or guarantee from shareholders. The risk is allocated away from the lenders.

It all goes in a risk matrix, Rich said. You identify the risk and how each is mitigated and those risks need to be mitigated as part of commercial and governmental agreements negotiated before the project is financed.

—Kristen Nelson





How much will federal loan guarantee cover?

Frederic Rich of the New York law firm of Sullivan and Cromwell told an Alaska House of Representatives Finance Committee April 25 that the amount of the federal loan guarantee for an Alaska gas pipeline project is an issue.

The statute says the Department of Energy may guarantee up to 80 percent of the total project cost. If the project were 80 percent debt and 20 percent equity, that means the guarantee could cover 100 percent of the debt.

But, he said, standard practice in the U.S. government is 80 percent of 80 percent. That is the firmly held position of Treasury and the Office of Management and Budget: They want the lender to have skin in the game.

If the guarantee only covers 80 percent of the debt, the uncovered portion could be the largest oil and gas financing every done by itself.

In thinking about the markets there are a lot of different forks in the road, Rich said, and the 80 percent is one of the biggest.

If you have 100 percent of the debt guaranteed you’d be in one world and if it’s 80 percent you’re in a very different world.

The one good thing about this financing is that the construction period is lengthy, so you wouldn’t be looking to do all the financing at one time, Rich said.

Rich said the federal loan guarantee for the project is interesting.

When you have a guarantor, he said, all that means is that to the extent of guarantee that entity is the lender and has all the same requirements as the lender has. The federal government becomes in effect the worrier-in-chief, and that’s something the government takes very seriously, he said.

If the federal government guaranteed the loan and the project defaulted the federal government would pay the lender and then has all the same rights and remedies as the lender. The project still has to replay the money, but instead of having a private lender with discretion, the project now has the federal government, which by statute has to deal with assets in a responsible manner, Rich said.

Rich said the only benefit of a federal loan guarantee is that it lowers the cost of debt; there’s no other difference once the debt is dispersed.

—Kristen Nelson


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