Coal to liquids : The new black gold?

Coal to liquids : The new black gold?

January 01, 2006 | By Todd Alexander in New York

The prospect that oil prices might remain high for the foreseeable future is forcing both governments and the private sector to explore other sources of transportation fuels besides oil.

Two alternatives — converting corn into ethanol and soybeans into biodiesel — have been around for many years, but have only recently gained market acceptance.

Another alternative — converting coal to liquids, or “CTL” — is experiencing rapid growth overseas and renewed interest in the US.  There are new federal incentives for such projects and new stringent environmental regulations that should also help make them economic.  However, the projects face daunting challenges.

Potential Market

CTL projects typically, although not always, use a two-step process for converting coal into a liquid synthetic fuel.  In the first step of the process, coal is exposed to steam and oxygen at very high pressures, yielding hydrogen and carbon monoxide.  This step is called “gasification.” It is the same process that is used in integrated gas combined cycle, or “IGCC,” power plants.

Step two is application of the Fischer-Tropsch process, which converts the gas produced in step one into a synthetic fuel that can be processed into a cleaner version of diesel fuel and several co-products.

The Fischer-Tropsch process was used by Germany during World War II to make fuel for motor vehicles.  Germany had ample amounts of coal but negligible petroleum. The process was originally invented by Franz Fischer and Hans Tropsch in Germany in the 1920s.  By 1944, Germany was producing synthetic fuel at the rate of more than 45 million barrels a year.

South Africa is the only other country to have employed CTL on a large scale.  South Africa was driven to use of the process by trade embargoes during the apartheid era.  Like Germany during World War II, it had abundant coal and little to no petroleum.

One consequence of extended use of CTL by South Africa is that SASOL, a South African energy and chemical firm, helped improve the technology.  SASOL has produced more than 1.5 billion barrels of synthetic fuel from 800 million tons of coal in the past 50 years.  It currently supplies about a quarter of South Africa’s fuel needs through coal.

Despite the enormous potential of CTL technology, its use has been limited to date to situations when political necessities leave no other options.

The biggest hurdle to wide-scale commercial implementation of CTL has been the price of oil. The “break-even point,” or the price that a barrel of oil must reach in order for it to equal the unit production cost of an equivalent amount of synthetic fuel using CTL technology, depends on coal prices.  The current break-even point in the United States is between $20 to $40 per barrel of oil, according to John Doyle and Bob Kelly with DKRW Energy, a firm that is developing a CTL project in Wyoming.  The reason for such a wide range is the coal used as a feedstock in such projects varies in price.

Despite the relatively high break-even point by historical measures, CTL projects are attracting attention. “The recent persistence of high oil prices has stoked significant interest in the CTL area from both industry players and financial investors,” said Paul Ho of Credit Suisse. “Technology providers, coal companies and others see a great opportunity for working together, while financial investors find the upside very attractive.”

There are currently no CTL projects operating on a commercial scale in the United States.  At least three large projects are under development.  In addition to the DKRW project in Wyoming, Rentech has announced plans to develop CTL facilities in Illinois and Mississippi.

One of the leading proponents of CTL is Governor Brian Schweitzer of Montana.  Montana has the nation’s second-largest coal reserves, an estimated 120 billion tons, or enough to produce an estimated 180 billion barrels of CTL fuel. To put this in perspective, the United States consumed 7.5 billion barrels of oil in 2004 of which 4.3 billion barrels were imported.  Schweitzer argues that CTL projects could eliminate any need to import oil from abroad.

The United States lags behind other countries that are looking currently at CTL.

China, the world’s top producer of coal, plans to invest $15 billion in CTL projects over the next several years.  Royal Dutch/Shell and SASOL are building 10 CTL projects in China independently of the government effort. Two of the SASOL facilities illustrate the large scale of new CTL projects in terms of both cost and output: the projects cost $3 billion each and will jointly produce 440 million barrels a year at a projected cost of $15 a barrel.  Additionally, China’s largest coal company, which is state-owned, is currently building a project in Inner Mongolia that is projected to convert one million tons of coal a year into synthetic fuel in 2007, with plans to increase output to 20 million tons a year by 2020.

The Philippines are looking at building a CTL project that would produce as much as 60,000 barrels of synthetic fuel a day and cost an estimated $2.8 billion. The output from the project would supply about 15% of transportation fuel in The Philippines and save consumers $3.2 billion a year.

India, the world’s third-largest coal producer, has taken initial steps toward developing a CTL project.  The state-owned coal company and oil company have formed two joint ventures, one to develop a CTL project and the other to increase coal production to supply the project.

US Incentives

The new energy bill that President Bush signed into law in early August provides grants, government loans, loan guarantees and tax subsidies for CTL projects.

The bill authorizes the US Department of Energy to spend another $1.8 billion on a “clean coal power initiative.” Seventy percent of the money must be spent on gasification-based projects. The Department of Energy is authorized to commit up to $200 million annually during the period 2006 to 2014 for loan guarantees, loans and direct grants to project developers for gasification-based projects.  However, some of the funds have already been “earmarked” by Congress, or directed to named projects. The earmarks require that at least five of the projects that receive aid must use petroleum coke as a feedstock.

The energy bill also provides a 20% investment tax credit for spending on gasification projects, but only in the following industries: chemicals, fertilizers, glass, steel, petroleum residues, forest products and agriculture. The material being gasified can be any “solid or liquid product from coal, petroleum residue, biomass, or other materials which are recovered for their energy or feedstock value.” The equipment must turn the material into a “synthesis gas” composed primarily of carbon monoxide and hydrogen. The gas must be used as gas or for “subsequent chemical or physical conversion.” Anyone hoping to claim a tax credit for a gasification project must have his or her project certified by the Internal Revenue Service. Total credits for all projects are limited to $350 million.  No more than $130 million in credits can be allocated to a single project.  The energy bill also authorizes $1.3 billion in spending from 2007 to 2013 on new projects under a “clean air coal program” and $500 million in spending from 2007 to 2011 to increase environmental performance at existing facilities.

The energy bill also authorizes an “incentives for innovative technologies” program through the Department of Energy that will provide federal loan guarantees of up to 80% of the cost of new gasification equipment at fuel manufacturing facilities.

Separately, a federal highway bill also enacted in August contains a 50¢-per-gallon tax credit for diesel fuel produced from coal using the Fischer-Tropsch process.

Finally, the US Department of Defense is moving to implement a “clean fuel initiative” under which the department will assess the feasibility of converting military ships, aircraft and vehicles to alternative fuels. The US military is the largest single consumer of imported oil in the country, consuming 300,000 barrels per day.

New low-sulfur diesel regulations are also providing another boost for CTL projects in the United States.  New rules issued by the US Environmental Protection Agency reduce the maximum allowable sulfur content in diesel fuel from 350 ppm to 10 ppm starting in 2006.  Refiners are scrambling to meet the deadline.  CTL fuels could provide a partial solution.  CTL produces a clean fuel: sulfur, mercury and arsenic can be isolated and removed during the Fischer-Tropsch synthesis and then sold for use in other industries.  Additionally, the carbon dioxide byproduct can be collected and injected underground, which would help CTL projects comply with any future carbon dioxide emission limits.  CTL fuels also produce significantly lower levels of carbon monoxide, nitrous oxide and particulate matter than even low-sulfur diesel.

Financing Challenges

The first CTL projects to be built in the United States will be constructed either by a well-funded multinational corporation with both the ability to absorb the full impact of any downturn in the price of petroleum and access to sufficient capital to complete construction, or by developers using traditional project financing techniques to mitigate the risks both to themselves and their financing sources of lower diesel prices, technology failures and construction delays.  Developers will find it a challenge to devise structures that properly mitigate these risks.

There are two main risks: commodity risk, and technology and completion risk.

Commodity risk is central to CTL projects.  Developers, especially those seeking to finance on a limited-recourse basis, will have to address the risks that the price of oil will drop below the point where the project can break even economically or that the price of coal will increase making synthetic fuel uncompetitive with petroleum-based diesel.

There are several strategies used in combination to limit exposure to commodity risk.  Starting with the risk of falling oil prices, one strategy is to enter into futures contracts based on the price of diesel. This would provide predictability to a portion of a project’s revenue stream, although this strategy tends to be prohibitively expensive in volatile markets, such as the diesel market, if implemented for the longer term.  Another strategy is to enter into long-term fixed-price contracts, similar to those used in the ethanol and biodiesel industries, for at least a portion of the facility’s output.  This approach has the benefit of providing a more predictable revenue stream, but would probably require the owners of the project to forego much of the upside potential of the project.  A third method is to capitalize on the flexibility of the CTL process by designing the facility to produce co-products for which long-term fixed-price offtake contracts are available.

In addition to exposure to oil price risk, projects are exposed to the risk of rising coal prices.  While a large component of the cost of synthetic fuel is the price of coal, the selling price of synthetic fuel is not highly correlated with the cost of coal. The independent power industry attempted to solve a similar problem caused by the lack of correlation between the price of natural gas and electricity by buying natural gas fields and entering into long-term contracts at fixed or capped prices to ensure a predictable price for gas.  Similarly, CTL developers could obtain access to predictably-priced coal by purchasing a coal mine or entering into long-term coal supply contracts at a fixed price or with a cap.

Given that very few commercial-scale CTL projects have been constructed, the markets are likely to perceive a high degree of technology and completion risk for the first few projects that are built.  Developers, especially those seeking to finance on a limited recourse basis, can limit their exposure to technology and completion risk by entering into lump-sum, fixed-price turnkey construction contracts.  Such arrangements would probably be preferred by third-party equity investors and be required by project finance lenders.  The construction contract would have to have performance and schedule guarantees, as well as a fixed price and a single point of responsibility for all contractor liabilities.

The performance guarantees would be comprised of guarantees of the quantity and the quality of output as well as the reliability of the production process.  Lenders are likely to require quantity guarantees to ensure that projected revenues are sufficient to satisfy debt service and stringent quality guarantees because of the first-in-kind nature of the projects.  As we have seen in the biodiesel and ethanol industries, quality guarantees may be essential to facilitate market acceptance of a new product like synthetic fuel.  For instance, it will be essential that vehicle manufacturers warrant the performance of their vehicles on synthetic fuel and that existing distribution channels for diesel accept synthetic fuel.

The reliability guarantees would measure long-term availability of the facility to produce synthetic fuels and the other co-products.  Reliability guarantees are especially critical in a CTL project, as it employs technology similar to that used in IGCC projects.  IGCC projects have suffered from long-term reliability issues in the past.  As such, the debt and equity markets are likely to scrutinize the reliability guarantees offered by the contractor.  Fortunately, it appears that these reliability problems are being corrected and gasification technology licensors could be more willing to provide long-term performance guarantees.

The schedule guarantees would obligate the contractor to pay the developer delay damages if construction has not been completed by a date certain. These damages, in conjunction with contingency funds, would be necessary to ensure the financing parties that the developer will be able to pay interest during construction and other fixed-cost obligations, including payroll, insurance and take-or-pay obligations, in the event of construction delays.

Moreover, even if the construction contract contains appropriate performance and schedule guarantees, obtaining meaningful guarantees could still prove to be difficult due to the mammoth size of CTL projects.  Ordinarily these guarantees could be given by turnkey contractors and supported by guarantees from the process technology licensors, but technology licensors of the Fischer-Tropsch process tend to be too small to provide a creditworthy guarantee of the magnitude required, and even the largest turnkey contractors and the licensors of gasification technology, such as General Electric, Shell and ConocoPhillips, may be reluctant to accept this potential liability alone.  As a result, developers may be forced to accept non-traditional construction arrangements that will require careful structuring and risk analysis.

Given the need to share this risk, one likely scenario is that the first projects will be constructed by joint ventures between two or more contractors.  Although a joint venture approach may ultimately be the best alternative, developers should appreciate that there would no longer be a single point of responsibility on the contractor’s side.  The financing community tends to prefer a single point of responsibility to prevent finger-pointing issues.  However, this obstacle has been overcome in the past either by a willingness of the parties to the joint venture to accept joint and several liability with respect to the project company or through a sensible construction coordination arrangement.

Finally, the construction contract should have a guaranteed maximum price or the equity should be willing to provide appropriate completion support.  Debt sources will likely be concerned that project cost overruns could occur due to unforeseen circumstances that may arise in connection with the design and construction of any new facility, especially one that is the first of its kind.  As a result, the lenders are likely to seek assurances that either the contractor is willing to absorb any unforeseen cost increases or that the equity has access to a reasonable amount of additional funds that could be used, if necessary, to pay for any cost overruns.

At the end of the day, CTL technology has the potential to provide an abundant supply of relatively clean energy.  The primary obstacles to widespread adoption of CTL are the continuing uncertainty over the price of oil and the need to find a project structure that allocates risks in a way that is simultaneously attractive to the investing, lending and construction communities.