Introduction
In the competitive business environment where companies are constantly looking to do bigger projects there is a consistent hurdle that must be overcome: Accessing finance. This is especially true where the size of the project is significantly larger than what the company can finance through traditional methods.
In these instances, project finance is particularly appealing for sponsors that want to take on big projects but their access to capital is restricted or constrained (e.g. small firms with small balance sheets to borrow against). This unique form of financing not only allows sponsors to raise significantly more debt than would otherwise be possible, it also allows for that debt to be repaid solely from the proceeds of the financed project[1].
To make the project a safe bet for the lender, significant attention is given to the risk mitigation structures put in place for the project. This paper centres on the five techniques used to reduce any risk a project encounters and by extension make the project more bankable.
This article has three sections: (1) Overview of project financing (2) Risk Mitigation Techniques (3) Project Risks. If you are already familiar with the nature of project financing, skip section 1.
Overview of project financing
Project finance has been defined as a form of financing for the development of assets (usually natural resources), where the bulk of the financing is to be provided by way of debt and is to be repaid principally from the cashflows of the assets being financed[2].
It is primarily used for capital intensive projects. It features high debt to equity ratios, is long term in nature and collateral for the loan is limited to the project assets.
This form of financing requires a special purpose vehicle (SPV) company be set up, this SPV will have no other obligations or functions other than the project at hand[3]. It will be owned by the sponsors through a corporate entity which restricts the recourse banks can have against sponsors because of the corporate veil[4]. However, lender controls over the SPV is common and all material contracts will be assignable to the lender.
Following this, a range of contracts (construction contracts, purchase agreements, insurance contracts etc.) with various partner stakeholder will be entered into in order to create certainty of the project, its cash flows, operations and efficient execution. This almost ‘turn-key’ project is presented to lenders for financing [For more information on how lenders go about raising financing through syndication, I’ve written another article on that topic here].
The planning of these projects matches the finance structure with the project risks and economics. Every measure is taken to protect the project because, provided the financing is non-recourse, sponsors have no obligation to repay the debt or interest should the project fail to produce the projected cash flows[5].
In order to execute this efficiently a range of risks within the project must be identified and then mitigation techniques must be put in place before the project even begins. All these techniques have one overarching aim: protecting the project cash flows.
Risks Mitigation Techniques[6]
Broadly, there are five methods to mitigate project risks:
Controlling the risk with a contract. Here the parties can explicitly agree to take on certain risks or address scenarios in a particular manner, as stipulated in the contract.
Transfer the risk from one party to another by means of a trigger. When a particular event happens (the trigger), the risk is moved to the party best able to carry it.
Financing the risk by use of mechanisms such as insurance or a standby loan.
Conducting a study of the risk to gain a clearer picture and thus considering the risk reduced.
Avoiding the risk altogether.
The easiest way to understand these mitigation structures is to apply them to a risk. Completion risk provides an opportunity to apply most of these structures.
Completion risk[7]
In the event that the lender agrees to finance the construction of the operation, they are committing money to a project that does not exist (‘is not complete’) yet. Completion encapsulates the risk of cost overruns and the risk that the project will not be constructed in accordance with the economic metrics and projections upon which the financing was provided. An objective completion test is used and if satisfied, the pre-completion supports are released and the project continues on a limited recourse basis. Until that point, the sponsor must meet any cost overruns[8].
Contract structures
Completion undertaking – The sponsors undertake to put forward whatever amount of cash is necessary for the project meet the objective completion test.
Turn-key construction contract – This contracts states that the contractor will deliver a fully functional facility to the sponsors and it transfers most of the construction risk to the contractor. The banks will also insist on there being no limit to the liability of the contractor[9] and as a result, most turnkey contracts incorporate testing periods to allow time to ensure completion.
2. Trigger structures
Equity and debt subscription – in the event of a cost overrun, all parties agree to put up additional funds in agreed proportions to meet the cost overrun, with a ceiling on the banks’ exposure.
Default agreement – This can be thought of a completion guarantee (discussed below) except it is specific for ‘standstill’ periods after all base financing has been provided.
Delay in Start-up insurance – Delay in Start-up insurance policies. This is useful in covering the capitalization of interest caused by the delay.
3. Finance structures
Completion guarantee – This requires the loan to be repaid by the sponsor if the project is not completed by a certain date.
Overrun undertaking – The sponsor agrees to pay for the overrun amounts above the agreed financing.
Standby facility – This may be a contingent underwriting facility or money in an escrow bank account, provided to cover cost overruns.
Deficiency agreement – An agreed amount of sponsor support is available to meet debt service if cash flows are unable to do so. These agreements are for an agreed amount and for an agreed period.
4. Avoided
Post-completion implementation – The project finance is not put into place until after completion. In other words, the project completion is paid for entirely in equity up-front.
These risk mitigation techniques are common in any project financing and are applied to the various other risks. Below is a list of the various project risks which must all be mitigated through some of the aforementioned techniques. The list is contextualised to oil and gas projects.
Project Risks[10]
Reserve – If the reservoir information is unclear this impacts the economics of the entire project and certainty at reserve level is crucial. Reserve classification into proved, probable and possible are used to estimate reserves. These estimates, however, are subject to fluctuation and the estimates are only completely certain once all petroleum has been produced[11]
Operating: technical risk – This revolves around the technical aspects of extracting the oil. The nature of the wells, their completion and special consideration regarding unconventional plays. Uncertainty around technology is a major factor here.
Operating: cost risk – The fluctuating cost of operations passes through and impacts the ultimate debt service, parties will want to keep their costs of operations manageable.
Operating: Management risk – This speaks to the expertise of the individuals running the operations. Inexperienced professionals without a track record pose a risk.
Infrastructure – This speaks to getting the petroleum from its source of production to its next destination. Remote or offshore project present problems in transportation as poor access to infrastructure can constrain the volume of crude oil sales[12].
Environmental – Oil spill and blowouts are always a major risk. Governments and institutions around the world have prioritised environmental compliance. Environmental damage can cause massive reputational damage to all parties involved and the damage to corporate brands can result in significant loss of value[13]. The Brent Spar scenario provides insights into the seriousness of the matter[14].
Market – Volume risk for crude oil is considered to be relatively low[15] but there is a decline of crude demand globally may impact the volume of oil that a project can sell, which ultimately impacts its cash flows.
Price – Crude oil prices are mainly influenced by supply, demand and geopolitics (in large oil producing or consuming countries), as well as by financial markets and spot markets[16]. The prices are volatile and this risk used to be absorbed by the banks but that has changed. Parties must be able to manage the volatility of the market price.
Political – The upstream petroleum industry is of national interest to many states. Dealing with sovereign power presents the risk of nationalization[17] and every country comes with its own set of risks e.g. civil war. The government exerts control in this sphere by (1) state ownership of resources which necessitates licensing or contractual arrangements, (2) regulatory regimes that require mandatory approvals for development plans or flaring and (3) taxation regimes that are subject to change[18].
Force Majeure – The risk that something entirely out of the hands of project sponsors and stakeholders derails the project. Floods, wars and market freezes are unlikely events that must be protected against.
Foreign exchange – Currency fluctuations do pose a threat. Although the fact that oil trades in US Dollars provides a natural hedge against this risk. However even small fluctuations must be protected against.
Interests – The floating interest rate that project financing is provided at can go fluctuate over time. Although this is necessary it does remove certainty from the project, uncertainty about the interest rate to be charged poses a financial risk to the sponsors.
Participant – The sponsors of a project can pose a risk to a project particularly where they are financially or technically weak. They will not be able to effectively manage times of crisis.
Engineering – This comes down to the design of the physical project. Over time a poorly constructed project may underperform or create cash flow problems[19].
Completion – This is the risk of the project being successfully constructed and commencing production. Construction is expensive and risky particularly with offshore development.
Legal – Operating within the legal framework and efficiently securing title to the acreage is the foundation of the project. Without the effective ownership rights over the underlying petroleum resources, project sponsors will encounter problems in raising 3rd party finance because of a lack of adequate security interests[20]. This issue only becomes particularly problematic in cross border operations where joint development zones are required.
Conclusion
Project risks come in various forms but each risk poses a significant threat and must be handled with care. If each risk is adequately addressed, the project will be bankable and should be appealing to several financial institutions. Resulting in sponsors to raising significantly more debt than would otherwise be possible.
END
About the Author
Zach Kauraisa holds an LLB, an LLM in International Oil and Gas Law and an MSc in Finance & Law. For inquiries, email: kauraisaz@gmail.com
References
[1] Clews, R. (2016). Project finance for the international petroleum industry. Academic Press. 250-255
[2] Dentons. 2018. A guide to project finance. Pg 2. Retrieved from https://www.dentons.com/en/insights/guides-reports-and-whitepapers/2013/april/1/a-guide-to-project-finance last accessed: 27/08/2020
[3] Kensinger, J.W., and Martin J. D.,. “Project Finance: Raising Money the Old-Fashioned Way,” in The New Corporate Finance: Where Theory Meets Practice (Chew, D., H., ed., New York: McGraw-Hill, 1993) p324.
[4] Wood, P., Project Finance, Subordinated Debt and State Loans, (London, UK: Sweet & Maxwell, 1995), at 23
[5] Hoffman, S., The Law and Business of International Project Finance, (2nd ed.), (The Hague, The Netherlands: Kluwer Law International, 2001), at 6-7.
[6] Tinsley, pg 4
[7] Tinsley at 9
[8] Saidu, B., “Oil Project Financing: How Can the Sponsor Mitigate Completion Risk?”, The Journal of Structured Finance, Vol. 12, No. 2, (2006) at 61-66.
[9] Vinter, G. D., & Price, G. (2006). Project finance: a legal guide. Sweet & Maxwell. 85-103
[10] Tinsley, C. (2000). Project finance : Project finance risks, structures and financeability (2nd ed., Euromoney-DC Gardner workbooks). London]: Euromoney. pg 11
[11] Clews, at 104
[12] Clews, at 106
[13] Clews, at 108
[14] Aggressive public campaigns resulted in Shell changing its decommissioning plans for a much more expensive alternative. EC Newsdesk. 2010. The controversial disposal of Shell’s Brent Spar oil platform changed the relationships between companies, activists and the public for ever, say Judy Kuszewski and Yasmin Crowther. Reuters. https://www.reutersevents.com/sustainability/business-strategy/brent-spar-battle-launched-modern-activism last accessed 19/09/2020
[15] Clews, at 106
[16] ‘What drives crude oil prices?’ Energy & Financial Market. Retrieved from https://www.eia.gov/finance/markets/crudeoil/ last accessed 20/09/2020.
[17] Venezuela nationalised Exxon Mobil’s assets. C,Pons. A, Ulmer. 2014. Venezuela ordered to pay Exxon $1.6 billion for nationalization. Reuters. Retrieved from https://www.reuters.com/article/us-venezuela-exxon-idUSKCN0HY20720141010 last accessed 19/09/2020
[18] Clews at 108-109
[19] Feo, E., et al., The Guide To Financing International Oil and Gas Projects, (London, UK: Euromoney, 1996), at 27-28.
[20] Clews at 109