Key risks in African oil & gas project financings
April 2018 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2018 Issue
Africa is home to five of the top 30 oil-producing countries in the world. Eighty percent of its oil is produced by Algeria, Angola and Nigeria, it has proven gas reserves of 502 trillion cubic feet, and 90 percent of its gas is produced by Algeria, Nigeria, Libya and Egypt. The past decade has seen a dramatic increase in project financing opportunities for oil & gas projects in Africa. Recent notable examples include the US$1.65bn multi-sourced financing of Vitol’s interest in the US$7bn oil & gas Offshore Cape Three Points (OCTP) project in Ghana and the US$4.7bn multi-sourced project financing for the Coral South FLNG project in Mozambique. These projects demonstrate that with the right sponsors and appropriate risk allocation among the project participants, it is possible to successfully finance large-scale oil & gas projects on a limited recourse basis in Africa.
The award-winning Vitol OCTP project financing comprised of four fully amortising debt facilities: a US$400m UK Export Finance (UKEF) facility, a US$300m International Finance Corporation (IFC) facility, a US$180m Multilateral Investment Guarantee Agency (MIGA) covered facility and a US$470m uncovered commercial bank facility. The financing represented a number of notable firsts, such as the first time a European export credit agency supported a financing structure of this kind and the first time UKEF provided a direct loan to an African nation. Its innovative structure combined aspects of a standard project financing, such as long-term tenors based on take-or-pay offtake contracts, reserve accounts and the grant of security over borrower’s rights, with aspects of a reserve-based lending model, such as annual borrowing base redeterminations.
In order to successfully achieve financial close on a project financing for a large scale African oil & gas project, the host government, sponsors, lenders and their advisers are all required to work closely together to identify, allocate and mitigate the multitude of complex risks that these projects face. Due to the large amounts of capital required to develop and construct these projects, which are often located in challenging jurisdictions, either geographically or geopolitically, sponsors will typically look to include export credit agencies (ECAs) and multilateral agencies as key elements of their financing plans. As these financial institutions find their roots in politics, rather than commerce, they possess a variety of tools that are not available to commercial entities alone. Among the most important of these tools is the ability to offer financial terms that are more generous than their commercial counterparts, as well as the ability to provide both ‘hard’ and ‘soft’ political protections for the projects in which they invest. These political protections create a ‘halo’ effect that is attractive to both the commercial banks that lend, alongside the ECAs and multilateral agencies, and also to the equity investors in the project.
An oil & gas project will share many of the same features that can be found in other types of project financings, but there are a number of risks that are specific to this sector. One such specific risk is commonly referred to as ‘reservoir risk’. Both equity investors and lenders to an oil & gas project will need to carefully diligence the quantity and the production profile of the project’s hydrocarbon reserves. The viability of the project financing at the outset will be determined by establishing that there are sufficient reserves that can be extracted to produce hydrocarbons for sale to generate sufficient revenues to repay the project debt and provide a return to the equity investors. Lenders to the project will employ an independent reserves consultant to conduct diligence and establish the level of proven reserves, probable reserves and possible reserves in the field. Lenders will typically seek to ensure that their loan will be repaid no later than the date when 25-30 percent of the proven reserves remain available; this percentage is commonly referred to as the ‘reserves tail’.
As with every project financing, lenders will be focused on the construction phase of the project, as during this phase the project’s cash flow is all outgoing, and the lenders’ first ranking security package over the project’s assets is of limited value before the project is completed. As the development and construction of an oil & gas project will typically involve a number of disparate technical components, such as the use of drilling equipment, the construction of production platforms, FPSOs, pipelines, liquefaction plants and potentially LNG tankers and regasification plants it has not, to date, been economically feasible, or practicable, for a single contractor to ‘wrap’ the entire construction risk and provide the project company with a single turnkey construction contract.
As lenders are typically unwilling to assume construction risk – the risk that the project will not be constructed on time, on budget or to the required specification – in the absence of the availability of a single turnkey wrapped EPC contract, lenders have traditionally required sponsors to provide completion support in the form of either a completion guarantee or a debt service undertaking. Either form of support will remain in place until the project can pass a ‘completion test’ – when the project has demonstrated to the satisfaction of the lenders that it can generate revenue on a reliable basis. A key element of the negotiation of the project financing package will typically focus on the terms of the completion-testing regime.
Oil & gas projects also differ from other large-scale infrastructure projects, such as power projects with long term take-or-pay power purchase agreements, in that the revenues that a project will generate will fluctuate over time. A project may benefit from a long term take-or-pay sales agreement in respect of its gas offtake, but typically lenders would be expected to take commodity price risk on the oil offtake, as the oil produced by the project is traded on international markets. In return for lenders agreeing to take this commodity price risk, they will often require a ‘cash sweep’ from the project accounts, which will take the form of a mandatory prepayment of the debt facilities using the proceeds of excess cash flow that might otherwise have been distributed to the shareholders. This mechanism is generally accepted by sponsors on the basis that such excess cash flows will only arise in a scenario when the price of oil or gas is advantageously high, and such mandatory prepayments will guard against any future down-cycles in the oil price, which could leave the project with insufficient revenues to make scheduled debt payments.
Oil & gas projects have their own unique commercial, contractual and regulatory framework, and project financings in Africa also have their own unique challenges. Understanding these frameworks and unique challenges is the key to achieving an optimal risk allocation and financing structure to enable the project financing of oil & gas projects in Africa.
Oliver Irwin is a senior associate at Milbank, Tweed, Hadley & McCloy. He can be contacted on +44 (0)20 7615 3006 or by email: email@example.com.
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