An Alaska North Slope natural gas pipeline is projected to be a mega project — and financing that will require a mega financing.
Frederic Rich, who runs the project finance group at Sullivan and Cromwell, says the Alaska gas pipeline project will take the project financing market into new territory. It would be a quantum leap, a multiple of the largest financing done to date, a market-setting project.
That makes it both easier and harder, he said. Because it’s a high-profile strategic project some things will be easier, but other things will be harder.
The project finance market is global and oil and gas projects are a small sliver, Rich told House Finance April 25 (see part 1 of this story in the May 6 issue of Petroleum News). The total size of the market changes dramatically — varying by a factor of four between high and low.
Process complicatedA three-country Caspian crude oil line required 11,000 signatures and 17,000 documents and took four to five years, Rich said: Arrangements for mega projects are difficult and expensive.
The general advice is to start early and think about financing when you do government and commercial agreements.
The cost of delay on a mega project is huge, he said, so financing needs to be started early so it doesn’t delay the start of construction.
Rich said he didn’t mean to be “unduly negative.”
Oil and gas and pipeline projects are a relatively popular segment with lenders because past experience has been good. The resources are known, generally the technologies are well proven and with a few exceptions financings have been paid.
Price risk is the main risk in the oil and gas business, but it’s a risk lenders think they can understand and price. And lenders like big oil because it’s highly creditworthy and has a conservative culture.
And the buzz word today is strategic and the markets are interested in strategic projects.
Mega financings take timeWith small projects you can get from start to completion of financing in maybe six months, Rich said, but with mega projects it can take three years and up, so you have no idea what the market will look like when you are ready to finance. Today’s markets couldn’t be more favorable, he said, with a huge liquidity bubble which means credit standards are low.
And the market is global: Of the value of the 2006 market, only 15.7 percent was U.S. domestic.
An Alaska project will probably be done with bond financing, he said, since the bank market is basically 10 years and this project is expected to have a longer-lived debt. The disadvantage with the bond market is that it is very volatile and there will be times when bond markets may not be available.
How do people deal with this? By doing multi-track finance plans, just as they deal with the possibility that the market will be at either trough or peak by making market-neutral decisions, he said.
How are big projects done?Outside of North America a lot of midstream developments are completely integrated with the upstream, Rich said. A lot of projects are also developed separately but with the resource owners as owners of the midstream. The projects were separate so there was no recourse but the upstream producers were shareholders.
And some projects have been entirely separate: producers or utilities not shareholders in the midstream at all.
Lenders do look at the links into the upstream. The assumption here is that transportation commitments from producers are expected, although downstream utilities may also be shippers. Rich said downstream shipping commitments are analyzed differently and add another layer of credit risk because lenders still have the risk of reserves and the ultimate downstream market, and are now adding the risk of the utility.
The nature of the transportation commitment is also considered, with firm transportation commitments the norm although overseas projects have been done without them.
And the pressures for integration come from both sides. The producers worry about timeliness, control of construction and operating costs and reliability. That’s why overseas so many projects are done on an integrated basis, he said, with midstream and upstream developed as a single project or producers playing a large role in the midstream.
Lenders have similar concerns, he said. They are utterly dependent on the upstream and reserves for payment of the debt and they focus on the link between upstream and midstream. If the only link is the transportation contracts, then they bear all of that weight.
Additional debt, shareholder completion testRich said one of the hardest-fought covenants in any project financing is additional debt. The lender is willing to take credit risk but additional debt adds a burden the lender didn’t expect. The norm, he said, is lender consent for additional debt. For U.S. domestic pipelines the typical formula is that the maturity of the additional debt can’t be shorter than the original debt. And someone independent has to run all of the data through a model to demonstrate that even with expansion debt the original lender still gets paid.
Another hard-fought part of the financial plan is the completion test. An independent engineer checks that the project was built as proposed and that it passes operating tests.
There is also financial verification: Are those who signed contracts still creditworthy? At the moment when the shareholder guarantee is being taken away, lenders want to know that everything is in place as expected.
Completion support highly negotiatedThe form of shareholder completion support is also highly negotiated, Rich said. Ten years ago if there was a well-known sponsor group lenders didn’t worry but in the last five years with unexpected price blowouts on pipeline projects the market focus on completion risk is “absolutely extraordinary,” he said. The Alliance Pipeline has overrun guarantees limited to 30 percent of costs — Rich said he doesn’t think that deal would be possible today.
The federal statute requires the Department of Energy to get completion support and guarantees.
Rich said it’s usually one or another — you guarantee all debt until completion is met or you guarantee a certain amount of overruns. It’s very rare to do both, he said, but the statute seems to require it.
He said he hopes that when DOE does regulations they can be persuaded that completion support, as in the Alliance Pipeline, would be acceptable. At the Alliance rate of 30 percent of the base case capital costs that would be more than the capitalization of most players in this market that develop pipelines, Rich said.
It’s the ability to deal with completion support requirements that separate good projects that get built from those that don’t, he said.
Rich said the pre-completion margin paid on the loan reflects the credit of the person giving the guarantee.
Post-completion the rate is higher because the lender is then taking all of the project risks.
As far as the federal loan goes, Rich said hawks on fiscal probity might argue the statute requires completion support and that the federal guarantee would only kick in after completion. The other possibility is that the federal guarantee would be in place from day one — the lenders would not bear the pre-completion risk, but guarantee would be required from pipeline company shareholders.
Order of cash use controlled by lendersOnce the project goes into operation, lenders have recourse only to the project.
Because cash flow is the means of repaying the loan, lenders prescribe the order in which cash can be used: It goes first to pay operating costs and taxes, then to debt payment and only then are profits — if any — distributed to the project owners.
Rich said lenders do downside scenarios. They ask their lawyers and engineers and advisors what could go wrong and then they look at what the cash flows would be if everything went wrong.
Interruptions and curtailment in pipelines are big issues, he said: There is zero cash flow in interruptions. Lenders protect themselves by requiring funded cash reserves based on worst-case scenarios.
With a long-term project lenders will also look at the underlying market, he said. Lenders remember that in the 1970s there were 20- to 30-year contracts for liquefied natural gas but when the market completely turned against them people just walked away from the contracts.
Dual project riskWhen the upstream and midstream are separately constituted there is a dual project risk, Rich said. The crux of the issue is that the midstream lenders are exposed to the upstream risk without control.
While dual project risk doesn’t make financing impossible it has to be managed and dealt with, he said.
The firm transportation commitment may be from an affiliate of a super major, but unless there is a guarantee the lender doesn’t have a hook into that corporate credit. The credit behind the firm transportation contract is a company whose sole assets consist of reserves and it can only meet its obligations as it monetizes reserves.
Firm transportation contracts are the beginning of the story, not the end, Rich said. Sometimes there is pressure for credit enhancement especially if the upstream and midstream are totally greenfield. He said Alaska’s upstream isn’t exactly greenfield because of existing infrastructure, but the lender will ask, if the gas market tanks and there is 20 years left on the debt and netback is below zero, will the companies pay on the debt for 20 years when they’re not producing gas?
Lenders look at two things — the name behind the contracts and underlying market conditions.
If there is a super major behind the company making the firm transportation agreement, lenders know super major integrated oil and gas companies aren’t in the habit of letting affiliates fail. On the market side lenders will ask how likely is it that over the period of the loan it will be economic for the contract to be performed. History teaches that contracts get performed and debt repaid when the market works. If the netback is positive and the producers are shipping then the loan will be repaid.
While lenders look at legal recourse, they also look at how likely it will be that debt will be repaid voluntarily because the project is economically feasible.