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«Deutsches Institut für Wirtschaftsforschung 2015 Financing LNG Projects and the Role of Long-Term Sales-and-Purchase Agreements Sophia Ruester ...»

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Discussion

Papers

Deutsches Institut für Wirtschaftsforschung 2015

Financing LNG Projects and the Role

of Long-Term Sales-and-Purchase

Agreements

Sophia Ruester

Opinions expressed in this paper are those of the author(s) and do not necessarily reflect views of the institute.

IMPRESSUM

© DIW Berlin, 2015

DIW Berlin

German Institute for Economic Research

Mohrenstr. 58

10117 Berlin

Tel. +49 (30) 897 89-0

Fax +49 (30) 897 89-200 http://www.diw.de ISSN electronic edition 1619-4535

Papers can be downloaded free of charge from the DIW Berlin website:

http://www.diw.de/discussionpapers

Discussion Papers of DIW Berlin are indexed in RePEc and SSRN:

http://ideas.repec.org/s/diw/diwwpp.html http://www.ssrn.com/link/DIW-Berlin-German-Inst-Econ-Res.html Financing LNG Projects and the Role of Long-Term Sales- and-Purchase Agreements Sophia Ruester 1 Last update: January 2015

ABSTRACT

The financing of infrastructures is a major topic in recent energy policy debates. Project finance, as a specialized form of debt finance, thereby has become a well-established financing tool. This paper contributes a qualitative and quantitative analysis of the determinants of the debt ratio in project finance, using data on 26 liquefied natural gas (LNG) export and import projects. We argue that lenders will make their decision on how much to lend dependent on the risk profile of the project. In this vein, a project’s off-take agreements serve as a security for financial contracts. We empirically show that the debt ratio of an LNG project decreases with increasing risks associated to future cash flows. Estimation results confirm that leverage increases with higher shares of a project’s capacity sold under long-term sales-and-purchase agreements, with a lower capital outlay of the project, and with a lower risk index of the country where the project is located.

KEYWORDS

Project finance, debt ratio, long-term contracts, liquefied natural gas

JEL CLASSIFICATION

C21, G32, L22, L95 1

German Institute for Economic Research (DIW Berlin), Mohrenstrasse 58, 10117 Berlin, Germany. Contact:

sruester@diw.de.

Acknowledgements: The author thanks Aleksandar Zaklan, Sebastian Schwenen, Seabron Adamson, Anne Neumann, Christian von Hirschhausen and participants of a Brown Bag Seminar at DIW Berlin for helpful comments and suggestions. Special thanks also go to Anne Neumann for providing a substantial part of the database on long-term sales and purchase agreements in the LNG industry. The usual disclaimer applies.

1. Introduction The financing of infrastructure projects is a major topic in recent energy policy debates as the transition towards a decarbonized economy requires substantial investments, including investments into low-carbon technologies and renewable projects, but also investments into related infrastructures such as electricity grid expansions or natural gas supply assets. During the 1990s, project finance, as a specialized form of debt finance which involves the creation of a legally independent project company by one or more sponsoring firms, and where debt is secured by the project’s cash flows, has seen a rise in applications (see e.g. Brealey et al., 1996). It has become a well-established financing tool – especially for capital-intensive assets with a particular purpose such as power plants, oil and gas exploration & production sites, or pipelines. At the same time also the sources of project finance broadened to include the capital markets (Davis, 2003).

This development initiated considerable research effort encompassing the many interdisciplinary aspects related to this financing tool – from firms’ capital structure decisions and debt financing, over project management and organizational behavior, to contractual arrangements surrounding a company and firm governance. See Gatti (2013) for a comprehensive overview on project finance in theory and practice. Kayser (2013) summarizes methodological aspects of the instrument and implementation challenges for specific applications.

At first glance, the observed use of project finance seems to be incompatible with the classical theorem of Modigliani and Miller (1958), who argue that corporate financing decisions should not affect firm value. 2 In reality, however, firms actively choose among on-balance-sheet corporate finance and off-balance-sheet project finance, and show widely varying levels of debt. High leverage actually is interesting as interest rates are tax deductible, while dividends are not, lowering the total cost of financing. Moreover, as introduced by Jensen and Meckling (1976) and intensively discussed in the 1980s, the presence of risky debt in a firm’s capital base is known to lead to ex-post conflicts of interest between equity and debt holders. Project finance is one effective tool to reduce such agency costs (see e.g. Sha and Thakor, 1987; Berkovitch and Kim, 1990; Esty, 2003). Likewise, financing risky assets via a separate legal entity with non-recourse debt reduces the risk of underinvestment due to managerial risk aversion; it “allows firms to truncate large left-hand tail outcomes” (Esty, 2004).





Project finance moreover is interesting from the sponsors’ perspective, as first, the project is financed with limited recourse back to the sponsors, insulating corporate assets from project risk;

and second, a large amount of debt can be generated for the project company while at the same time preserving the parent company’s debt-to-equity ratio and thus protecting corporate borrowing capacity. A typical project company has a debt-to-total-capitalization ratio of about 70%, as compared to 35% for conventional corporate financing (Esty, 2004). Moreover, it allows the realization of projects being too big for one sponsor. On the other hand, project finance is interesting from the lenders’ perspective whenever future cash flows are well-predictable. Project credit risk can be considerably lower than a sponsor’s individual credit risk.

Literature related to the energy sector is quite limited. Pollio (1998) investigates the motivations of different types of sponsors to finance energy projects via project finance. He identifies risk 2 Underlying assumptions include a perfect capital market in equilibrium, a random walk market price process, as well as the absence of taxes, asymmetric information and agency costs.

1 management as well as higher fund-raising enabled through high leverage as key reasons to favor project- over corporate finance. Mills and Taylor (1994) and Lüdeke-Freund and Loock (2011) analyze renewable energy projects with a particular focus on risk factors relevant for lenders. Looking at renewable projects, too, Kann (2009) categorizes possible barriers to project finance, including regulatory risks and limited capital availability resulting from the recent global credit crisis. Davis (2003) adds to the literature a comprehensive qualitative discussion of case studies from various sectors, among them pipelines and refineries. Dailami and Hauswald (2000) analyze risk shifting as a consequence of contractual incompleteness and relate its sources to the price of risky debt in the context of project finance. Scannella (2012) examines the development of new financing models for large European energy infrastructure projects. He concludes that project bonds can be a useful longterm financial instrument to mobilize the necessary funding to meet the EU’s strategic energy infrastructure needs.

Empirical studies on project finance are rather scarce, last but not least due to the difficulty of data collection (Kayser, 2013). Our contribution to the literature is therefore a both qualitative and quantitative analysis of the determinants of the debt ratio in project-financed liquefied natural gas (LNG) projects. We build on Pierru et al. (2013) who examine the impact of country risk and selected project characteristics on ownership structure and debt ratio of gas pipeline as well as LNG projects.

We develop their reasoning further, arguing that (i) lenders will make their decision on how much to lend dependent on the risk profile of the project, and (ii) in this vein, the firm should be understood as a ‘nexus of contracts’ 3. Off-take contracts of a project, for instance, determine future cash flows and thus effectively serve as a security for financial contracts. In fact, the independent project companies are an attractive object of analysis for studying a particular financial structure because they provide a relatively clear picture on structural details and management decisions on various contractual arrangements.

The paper is organized as follows. Section 2 gives an overview on project finance in the LNG industry.

We discuss the determinants of the debt ratio in LNG project finance by identifying major risk factors which impact a project’s future cash flow stream and derive testable propositions. Section 3 introduces the dataset and methodology. We present and interpret estimation results in Section 4 before concluding in Section 5.

2. Project finance in the LNG industry

2.1. Industry context and the role of project finance Converting natural gas to LNG for transportation by tanker has been utilized for 50 years now. Since the 1990s, investments in LNG infrastructure grew rapidly as worldwide natural gas demand increased, leading to the realization of substantial economies of scale throughout the value chain.

The industry achieved a remarkable level of global trade in the 2000s (see e.g. Ruester, 2013). Today, the Middle East accounts for more than 40% of worldwide proven natural gas reserves and has become the largest exporter of LNG (IEA, 2014). It is currently evolving to a swing producer;

deliveries to European and Asian markets and even to North America are feasible.

3 The understanding of a firm as a ‘nexus of contracts’ goes back to Ronald Coase’s seminal article on The Nature of the Firm (Coase, 1937), and has since then been developed continuously in economic literature.

2 Project finance is a common way to realize LNG projects – both upstream liquefaction (export) as well as downstream regasification (import) assets. During the first decade of the 2000s alone, about 100 mtpa of new LNG capacity 4 – out of about 240 mtpa of added capacity in total – have been developed based on such arrangements (Ledesma et al., 2013).

Project finance is an attractive financing tool for LNG projects for a number of reasons. First, LNG projects involve very capital-intensive upfront investments. These are in the range of 250mn to 1bn USD for import projects, and of 1bn up to even more than 20bn USD for export projects. Second, LNG projects have one, or a consortium of few, project sponsors. These involve mainly companies with commercial ties to the project, such as oil and gas majors, natural gas import and supply companies as well as some power utilities integrating upstream in order to secure fuel imports. Third, the technologies of natural gas liquefaction and regasification are well-known and established since decades, reducing technological risk substantially. 5 Fourth, cash flow generation relies on one major revenue stream, i.e. the natural gas throughput. 6 And finally, especially for national oil and gas companies, the use of project finance may lower the cost of debt as the resulting project credit risk in some cases is evaluated lower than the sponsor’s own credit risk.

Debt is provided by a syndicate of lenders (such as commercial banks, pension funds, investors in the public bond market, export credit agencies and government-backed lending institutions), who differ in terms of the amounts they lend, lending conditions as well as the ranking in the order of repayment. For institutional investors, project finance offers a way to diversify and earn acceptable (and uncorrelated) returns for the amount of risk taken.

Long-term sales-and-purchase agreements among LNG exporters and importers, linked to specific export and import infrastructures and determining respective capacity use, are usually signed ahead of financial contracts. They cover contract periods of about 15 to 25 years (Neumann et al., 2015), thus exceeding the typical loan duration which is in the range of seven to 15 years (de Saint Gerand, 2013). Prior to the completion of construction, shareholders in general have to provide financial guarantees to the lending institutions. Once the project enters successfully its operation phase, recourse back to sponsors ceases to apply.

2.2. Risk factors from the lenders’ perspective In order to attract the high level of funding required to realize an LNG project, a thorough understanding of the project itself as well as of possible project risks is essential. Lenders will make their decision on how much to lend dependent on the risk profile of the project. In this vein, and as has already been mentioned above, the firm has to be understood as a comprehensive set of interrelated contractual arrangements. Various contracts define business relationships among project sponsors and stakeholders, allocate risks – ideally to those best able to bear them, and thus

determine a project’s value and associated risks:

4 Million tons per year. A typical LNG export project has a capacity of 5 to 10 mtpa.

5 Project finance has proven to be less appropriate for projects that involve immature technologies, as evidenced e.g. by the failure of the UK government to secure project funding for R&D projects (see Brealey et al., 1996).

6 For liquefaction projects there might be some additional (though minor) revenues from the production of liquid petroleum gases.

3 Construction contracts govern engineering, procurement, and construction. So called “turnkey contracts” with construction guarantees and penalties for delays ensure that all risks related to the construction process are born by contracting partners and equipment manufacturers.

Operating contracts manage day-to-day operation and govern operating risks. The project operator typically is also one of the major sponsoring entities.

For a liquefaction project, in addition, natural gas supply contracts ensure commodity supply.



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