Structuring LNG Export Projects
By Philip R. Weems, King & Spalding
Posted: 10th June 2014 09:15
LNG is not yet traded as a commodity in the way that oil is traded (with oil development and production preceding its marketing). Prior to the participants in an LNG export project agreeing to take FID to construct the necessary trains and associated facilities, all or a very high percentage of the train’s expected production will have to have been sold on a long-term basis (usually 20 years) to buyers of suitable creditworthiness. Thus, even if sufficient uncommitted reserves of gas are available, their production and sale is dependent on adequate market demand being present that generates advance sales to creditworthy buyers at a price expected to support development and construction costs and provide an acceptable return to the project sponsors.
Because of its size (both in terms of scope and cost), the interdependency of the links in the LNG chain, and the multitude of players and issues involved, an LNG project is one of the most complex of energy ventures. Each project is uniquely structured, as there is no one worldwide standard pattern of participation, gas supply, revenue sharing, financing, transfer pricing, etc., and a particular structure must satisfy the requirements of the project participants and their financiers. The extent to which the same participants are involved in the various components of the LNG export supply chain varies from project to project, and even in cases where there is a generally common ownership across the LNG export supply chain, the participants may often have a different equity share (and different commercial interests) in the various components. Some of the elements that project participants must consider in designing a project structure include:
- Governance – will the unincorporated joint venture structure widely utilised in the upstream international oil and gas business work or is an incorporated entity required for the complexities of the LNG project?
- Profit Centre Mechanism – will the LNG project be a part of an integrated (or partially integrated) project for monetising natural gas reserves or be a separate profit center; and, if a separate profit centre, will the LNG project be a merchant of LNG (buy-sell arrangements) or a service provider (tolling arrangements).
- Marketing Arrangement – will the LNG production be available to each project participants for separate marketing or will there be combined marketing of the LNG production by the project entity?
- Expansion/Operator – does the LNG project structure have enough flexibility to encourage expansion, while at the same time encouraging operating efficiencies?
Trends have developed over the life of the industry such that one of three forms is generally utilised for structuring the LNG exporter’s project: project company; tolling company; and unincorporated JV.
Under the “Project Company” structure, the participants become shareholders in a new company (usually incorporated in the country where the gas is located) that finances / funds and owns the LNG export plant. The project company purchases gas from upstream producers, liquefies the gas, and resells the LNG to third-party buyers. Thus, the project company is the entity that receives revenue from the LNG sale, and such LNG sales revenues are passed back to the participants through shareholder dividends. The owners of gas reserves may also profit from the separate sale of their feed gas, and such upstream profits are routinely taxed at a rate that varies from the Project Company’s overall tax rate. Royalty on produced gas may be based on the sale of the feed gas or on a netback of the LNG sale price which should take into consideration the value enhancement to the feed gas brought about through liquefaction. Because the assets and liabilities of the LNG project are confined to a separate entity to which the shareholders contribute significant equity, the Project Company structure is conducive to non-recourse project financing. Further, this vehicle has proved flexible, as parties are able to participate in parts of the LNG chain but not in others. However, from the viewpoint of the participants other than the host government, the Project Company structure has also had its drawbacks. Not all of the shareholders of the project company may own the gas reserves being purchased, creating conflicts of interest concerning whether the transfer price paid for feed gas should favor the upstream gas owners or the project company. Moreover, because a project company is established to own and supply a certain number of trains, future expansion plans typically are not addressed at the time of initial structuring. Negotiations for such expansions have often proven to be time consuming and distracting, resulting on occasion in the parties adopting a new structure for expansion. Nonetheless, when participants are relatively aligned and have anticipated expansions appropriately the success of expansions has been well demonstrated over the years.
An alternative structure that was first developed successfully in Indonesia is the “Tolling Company” structure. When the first LNG projects commenced in Indonesia in 1973, it was decided that the Indonesian government would finance and own the two LNG plants and that such plants would be operated on a non-profit basis. Although for obvious liability reasons separate companies (P.T. Badak and P.T. Arun) were incorporated to operate the two LNG plants and liquefy the gas, neither company purchases natural gas from upstream producers nor resells the LNG to third-party buyers. Instead, under the Indonesian version of the Tolling Company structure, the national oil company PERTAMINA and its production sharing contractors jointly market the LNG to buyers, with the final sale being solely in the name of PERTAMINA. Since the tolling company liquefying the gas does not make a profit, all revenues are generated to the Government of Indonesia and the international participants at the upstream level according to the equity sharing mechanism set forth in the relevant production sharing contracts.
Today, many of the proposed U.S. LNG export projects (e.g. Freeport, Cameron and Cove Point) are using a Tolling Company structure, where the tolling company provides liquefaction services to the gas owners for a negotiated fee. Both the Egypt LNG and Indonesian Bontang projects have successfully procured financing utilising the Tolling Company structure. From the gas producers’ perspective, the Tolling Company structure encourages exploration by maximising return to the upstream and permits the gas producers to separately market their own equity share of the LNG production. In contrast to the Project Company structure, future expansions can usually be more quickly developed under the Tolling Company structure. On the other hand, the fixed returns of a Tolling Company may be less attractive to shareholders than that of a Project Company.
Other projects have followed the “Non-Incorporated Joint Venture” structure approach. For example, each participant in the Northwest Shelf Project in Australia owns one sixth of the LNG plant, supplies one sixth of the LNG and is entitled to one sixth of the revenues. Woodside Petroleum, one of the participants in Northwest Shelf, was appointed the operator of the venture on behalf of the all participants. The NWS Shelf project did not chose to obtain third-party financing, and neither did the projects in Norway nor Alaska. On the other hand, the Papua New Guinea project adopted an adjoining offshore sales and financing vehicle in order to support its US$ 14+ billion financing arranged in 2009. The Non-Incorporated Joint Venture approach, which is common for upstream oil and gas ventures but less common globally for downstream ones, may be a suitable choice for projects in countries where the government does not take an active role (e.g. royalty or tax only).
Transportation has been handled in a variety of ways, depending in part on the desire of the importer’s government to support its shipbuilding industry, the availability and cost of non-dedicated LNG vessels in the world market, the willingness of importers and exporters to take maritime risks, the desire to make the transportation segment a separate “profit centre” and the need to control excess shipping capacity to make advantageous short-term (or spot) sales or purchases. More recently, the ability to divert cargoes of LNG to higher priced destinations has been a major consideration in determining how to handle the transportation facet of an LNG project. The general trend is recognition by participants throughout the LNG chain of the value in controlling LNG shipping.
Lastly, the structure may require the foundation support of special legislation or a foundational contract with the State. Nigeria and Russia adopted legislation which supports their LNG projects. Additionally, execution of a detailed “Project Agreement” or “Investment Contract” setting out the State’s support for the project and the participant’s right to implement the LNG project have proven critical to providing the necessary legal foundation for projects in Trinidad, Yemen, Angola, Papua New Guinea, Equatorial Guinea, Egypt, Indonesia and Peru, to name a few. Such legislation and contractual foundation in particular have often provided the necessary stability provisions required to obtain third party financing.