Financing Upstream Oil and Gas Projects in the CIS
By Nabil L. Khodadad
There are many ways to raise financing for oil and gas projects in the CIS, the region that used to make up the Soviet Union. This article discusses five: pre-payment contracts, supplier financing, structured trade financing, project financing and bonds. Two case studies are presented to illustrate how these methods are used to finance a project, often in combination.
Before delving into the different types of financing and the case studies, it is important to spell out some issues that are common to all projects in the CIS and will affect the terms of whatever type of financing a project seeks.
The project may be subject to restrictions on whether it can assign rights in a license to a lender.
In Russia, one cannot take an assignment over a license. In Kazakhstan, one can take an assignment over a subsoil contract, but such assignment must be registered by the Ministry of Energy and Mineral Resources. There is uncertainty as to whether the assignee can take or transfer to a third party the subsoil use rights without the consent of the Ministry of Energy. In Azerbaijan, this is less of an issue because most projects are evidenced by a production sharing agreement and usually it permits assignment, but assignment is typically always subject to the consent of the State Oil Company of the Azerbaijan Republic, called SOCAR.
Foreign exchange and offshore banking restrictions affect all CIS projects.
Many lenders insist that their borrowers establish offshore bank accounts so that they can take an assignment or charge over such accounts. However, it is very difficult for a Russian company to get approval to open an offshore bank account. Often the companies resort to back-to-back arrangements as a way of getting around some of these issues. Under such an arrangement, an offshore affiliate of a Russian producer borrows from the lender and opens an offshore account which it assigns or charges to the lender. The offshore affiliate then enters into a contract with an offtaker (such as Glencore or Vitol) and instructs the offtaker to remit payment directly to the offshore account. In Kazakhstan, it is much easier to obtain approval to open offshore bank accounts. In Azerbaijan this issue is typically dealt with in the production sharing agreement.
Repatriation requirements may affect lending arrangements as well. For example, in Russia, all proceeds from exports must be repatriated. Plus, 25% of foreign currency proceeds must be converted into rubles.
Export restrictions are also very important to financing arrangements.
There are many practical restraints on the export of crude oil and gas because pipeline capacity is limited. Russia sets quotas on exports, and a Russian producer is unable to export more than 35% of its production of crude oil by pipeline. In Kazakhstan there are no formal restrictions, but informally there is a lot of pressure to sell in the domestic market. However, some of the domestically sold crude oil actually ends up being exported. In Azerbaijan this is really less of an issue; most production sharing agreements provide that production can be freely exported.
Taxes and duties can be another significant issue.
Throughout the CIS, withholding tax is imposed on interest and management fees paid offshore. The withholding rates for interest are 15%, 15% and 10% in Russia, Kazakhstan and Azerbaijan, respectively. Tax relief can often be obtained by taking advantage of a bilateral tax treaty. For example, Russia has very favorable tax treaties with the Netherlands and Cyprus.
A project in the CIS will likely be affected by either excise taxes or customs duties, or both. In Russia there are no excise taxes; however, there are duties. As of October 1, 2003, the applicable duty is $33.80 per ton of crude oil. On January 1, 2004, the Kazakh government is scheduled to introduce a new oil export tax that would vary according to the price of oil, with higher oil prices attracting higher tax rates. Azerbaijan has no export taxes or duties, but it imposes a charge called a “mandatory payment to the budget” that operates just like a tax. Under this mandatory payment, a producer is required to pay 25% of the difference between the export price and the domestic price. The domestic price for crude oil in Azerbaijan is much lower than the export price, so this mandatory payment effectively operates like a tax. Fortunately, producers who entered into production sharing agreements before the mandatory payment was introduced should be exempted.
Sources of Financing
With these issues in mind, there are several sources of financing that may be attractive to an oil or gas project in the CIS.
One source of financing is the prepayment contract.
This arrangement essentially involves the prepayment for future deliveries of petroleum. This can be an attractive form of financing for a producing company that does not have much of a track record. Usually the offtaker will focus on the producer’s current levels of production. There are some disadvantages, perhaps the biggest of which is the fact that that there is a high implicit rate of interest because the offtaker usually demands a steep pricing discount — and that is, effectively, a hidden form of interest.
Another problem is that this sort of financing is usually available for only very short periods of time. In certain transactions the offtaker will also try to obtain equity-type rights. Although there are some disadvantages, it can be useful for companies that do not have a lot of history or production, and for them it may be the only source of financing.
Another type of financing is supplier financing.
Essentially a field service supplier, like a Baker Hughes or a Schlumberger, provides field services in exchange for a share of production. It is similar to a production sharing arrangement.
There are not that many examples of this type of financing in the CIS. For certain producers it may be the only sort of financing that they can obtain. There are some disadvantages. One disadvantage is that this type of financing effectively dilutes the interest of the equity investors because they are parting with some of their upside. If oil prices go up, they are in effect getting less of the cash flow because they are paying the producer in kind instead of in cash. Also, it is very important to draft the mechanism by which the operator recovers costs carefully to make sure that the field service company has the right incentives to mitigate operating expenses and capital expenditures.
A third type of financing is structured trade financing.
Essentially this is financing that is secured by an offtake contract. Typically the proceeds from the offtake contract will be placed in an offshore bank account. The contract will be assigned to the lender; the offshore bank account will be charged and assigned to the lender as well. This can be a very attractive form of financing. Structured trade financings tend to have lower interest rates and longer maturities than the type of financing that domestic banks are willing to offer. While a structured trade financing tends to have a longer term than a prepayment contract, it usually has a shorter term than a project financing, which is discussed in the next section.
There have been a lot of interesting developments in the field of structured trade finance. A couple of banks have been able to arrange structured trade financings for long periods of time. Approximately a year ago, Société Générale arranged a structured trade financing that was secured by export receivables. It was broken up into several tranches and the longest tranche had a tenure of six years, which is quite long.
In the press, there have been reports that Citibank and ABN Amro are considering a $500 million loan to Lukoil backed by oil receivables. This apparently is going to be broken up into different tranches, one of five years and another of seven years. The terms of these tranches are quite long for a structured trade financing.
As one would expect, the lenders in a structured trade financing focus on reserves. They look very carefully at existing levels of production and at the creditworthiness of the offtaker, because they are relying on the offtake contract for the repayment of their loans.
The terms and conditions typically found in a structured trade financing include a life-of-loan coverage ratio, which looks at projected net cash flow from proven reserves over the life of the loan in relation to long-term debt, and a life-of-field coverage ratio, which looks at projected net cash flow from proven reserves over the life of the field (a longer period than the term of the loan) in relation to long-term debt. The deal may also include a “top-up” covenant. This is a requirement that if oil prices fall, the producer must pledge or assign more production to the lenders. Usually a lot of time is spent negotiating this covenant.
Hedging is another issue in structured trade financing arrangements. Sometimes lenders want their borrowers to hedge against the risk that oil prices will fall. Sometimes hedging is not required at the outset of the loan, but is required if subsequent decreases in oil prices trigger a fall in coverage ratios below a certain agreed level.
A lender may also ask its borrower to grant a “negative pledge.” A producer may not be assigning all of its production to the lenders, but the lender may want to be comfortable that no other future lender has access to production, particularly if oil prices fall. The first lender will want to make sure that the borrower is not assigning production to other lenders. If the borrower does, then it may be hard for the borrower to comply with the top-up covenant.
A fourth type of financing is project financing.
It is limited-recourse financing that is predicated on the merits of the project. There are longer loan maturities for a project financing than there are for a structured trade financing. Lenders are more sensitive in a project financing to all the risks associated with the project — for example, reserve risk, completion risk, operating risk, market risk, price risk, political risk, legal risk, environmental risk and force majeure risk.
In a structured trade financing, the lenders focus more on the offtake contract. In a project financing, the lenders have to get a lot more comfortable with the entire project. That requires more due diligence. Also, lenders in a project financing will try to take security over everything. That is not true in a structured trade financing, where the lenders’ security is typically limited to an assignment or charge over the receivables, the offtake contract and the offshore bank account.
In a project financing, the lenders typically receive a guarantee from the sponsor that covers completion risk. Usually the most heavily negotiated issue in the deal is how to define “completion.” This is an important issue because prior to completion, the sponsor guarantees the debt of the borrower. When completion is achieved, the guarantee disappears and the lenders can only look to the borrower for repayment of their loans. Usually the borrower’s only asset is the project. Thus if the project fails, the lenders will probably not be repaid in full.
Finally, another financing option to consider is Eurobonds.
There has been an improvement in the creditworthiness of Russian and Kazakh issuers. This has been mirrored by the fact that sovereign credits for both Russia and Kazakhstan have improved. Russia and Kazakhstan are now investment grade. That makes the capital markets a lot more attractive to local producers than they otherwise would be.
There are certain advantages to Eurobonds. They are unsecured — the issuer does not have to pledge any security. The covenants and events of default also tend to be a lot less onerous than a structured trade facility or a project finance facility.
A Eurobond also allows the issuer to increase the potential universe of investors. With a structured trade financing or a project financing, a project is basically looking to commercial banks and bilateral and multilateral credit agencies. With a Eurobond, an issuer can look to other investors as well. A Eurobond offering is also a public relations exercise. It is a way for a company to advertise itself and to bring its credit to the attention of a much larger group of investors.
Probably the main disadvantage to a Eurobond, and there are others, is that it is very difficult to amend or waive covenants or events of default once the bonds have been issued. This is much easier to do for a syndicated loan facility.
Spreads for energy bonds have fluctuated over the last couple of years, but the trend is down. There are some significant issuers in Central and Eastern Europe; for example, Gazprom has about $4.2 billion of bonds outstanding, Sibneft $900 million, TNK $00 million and Lukoil $50 million. Those are big numbers. But the Central and Eastern European energy bond market is really just a small fraction of the energy bond market in Western Europe. In Western Europe the energy bond market is about one-quarter of a trillion US dollars, and in Central and Eastern Europe it is only about $9.2 billion.
To put this all in perspective, it is helpful to look at a case study on the financing of Karazhanbasmunai. Karazhanbasmunai has rights to a field called Karazhanbas. It is in the western part of Kazakhstan, very close to the North Buzachi field.
Karazhanbasmunai is a company that was set up during Soviet times and privatized in 1997. A Canadian independent energy company called Nations Energy acquired all the equity in Karazhanbasmunai. Between 2000 and 2003, Karazhanbasmunai was able to raise about $148 million of debt from a variety of sources.
Karazhanbasmunai is the borrower and has all of the rights to the Karazhanbas oil field. It entered into an offtake contract under which it has agreed to deliver 15,000 barrels per day to Glencore International. The bank syndicate has taken an assignment over the contract. All of the proceeds from the offtake contract are deposited into an offshore bank account in London, and that account is pledged to KBC Bank and a syndicate of lenders. In addition, there are a couple of other key assets that are assigned or pledged to the lenders as security. KBC and the syndicate have lent $80 million to Karazhanbasmunai.
In addition to the structured trade financing, there are other layers of financing as well. Karazhanbasmunai has borrowed about $40 million from three different Kazakh banks. Generally the terms of those loans are not quite as favorable; the interest rates are higher on the domestic loans because the Kazakh banks have a higher cost of funding. Karazhanbasmunai has also issued about $20 million in bonds to a number of Kazakh pension funds.
It is interesting to note that as production has increased over time, more and different types of financing became available to Karazhanbasmunai. For example, initially the only type of finance that was available to Karazhanbasmunai was pre-export finance. Then after production increased to 20,000 barrels per day, it was able to access the local capital markets, the domestic bank market and the domestic bond market. As production increased further, Karazhanbasmunai was able to access funds under a structured trade financing from a syndicate of European banks.
Karachaganak is a condensate, oil and gas field located in western Kazakhstan. This field has been producing since Soviet times (1984). The field covers a vast area of 200 square miles and benefits from a 40-year production sharing agreement with the Kazakh government. It is a large and important project.
There have been three very large projects in Kazakhstan to date — Kashagan, which is still being looked at, Tengiz and Karachaganak. Karachaganak is the largest project to obtain financing on a limited-recourse basis. There are immense recoverable reserves: liquids of about 2.53 billion barrels and gas of 18.4 trillion cubic feet.
There are various members in the project consortium — British Gas, Agip, ChevronTexaco and Lukoil. The financing just concerned Lukoil. It did not concern the financing of the other three companies’ interests in the project.
The project included the financing of a pipeline from Karachaganak to Atyrau. At Atyrau this pipeline connects with the CPC pipeline. Before this pipeline was built, oil was actually going to Orenburg. The consortium was not receiving world prices for its oil. It is now able to access the international markets. Today, the first oil is being shipped through the CPC pipeline. It may not look like a very big pipeline, but the Karachaganak/Atyrau segment of the pipeline is 600 kilometers long.
Financing was extended by the International Finance Corporation and a group of commercial banks under the IFC’s A/B loan program. Basically, IFC is the lender of record on the A and the B loans, but it participates out the B loans to a syndicate of commercial banks. The split of the $150 million loan was roughly $75 million A loan: $75 million B loan; in other words, the IFC held on to about $75 million and through the B loan program it participated out another $75 million. The borrower is Lukoil Karachaganak, which holds a 15% interest in the Karachaganak field, and the ultimate parent is Lukoil JSC.
There was a completion guarantee. Prior to completion, Lukoil JSC is on the hook. If the loan is not paid after project completion, the lenders can only look to Lukoil Karachaganak for repayment of their loan.