Coal-to-Liquids Projects in the United States

Coal-to-Liquids Projects in the United States

June 01, 2008

It is a challenge currently to construct plants in the United States to turn coal into transportation fuels, but the market is well on the way to solving the challenges. Several large coal-to-liquids plants are likely to be under construction by the end of the decade.

High oil prices and abundant coal reserves in the United States make such plants potentially-attractive investment opportunities. The United States has the largest known coal reserves in the world. The plants are profitable if oil prices remain at least at $45 to $55 a barrel.

Coal-to-liquids, or CTL, involves the conversion of coal to liquid fuels either directly or indirectly. Direct liquefaction is not yet commercially proven, but the indirect method, which involves an intermediate gasification stage followed by liquefaction, has a proven track record. The most common version of this technology is the Fischer-Tropsch process, which uses a catalyst such as iron or cobalt to turn synthesis gas made from coal into liquids.

The most widespread use of CTL technology is in South Africa, where an estimated 300,000 barrels of gasoline and diesel are produced every day. China is an emerging CTL player with a series of plants under development, and its first large-scale CTL plant is scheduled to come on line in 2008. China’s unconventional oil supply from coal-to-liquids plants is estimated to reach 750,000 barrels a day by 2030, according to the International Energy Agency.

In the US, there are several plants under development, including Rentech plants in Montana and Mississippi, a DKRW plant in Wyoming and a Baard Energy plant in Ohio. CTL enjoys considerable support from the United States Air Force, which has already begun certifying its fleet of aircraft for a blend using 50% CTL fuel and expects the entire fleet to be fully compatible with the blend by 2016. If current expectations hold true, the US military will being purchasing 400 million gallons of CTL fuels annually by 2016.

Challenges

The technology faces a variety of obstacles in the United States, the foremost of which is environmental. In many respects, fuel produced from CTL is cleaner than fuel from crude oil, because of inherent impurities found in crude oil, such as sulphur and nitrogen oxide, can be filtered from coal in the gasification process and in post-gasification treatment.

However, the CTL process produces relatively high carbon emissions. According to a recent study funded by the National Energy Technology Laboratory, the US Department of Energy and the US Air Force, the carbon dioxide emissions of CTL, on a well-to-wheels basis, are 1.8 times more than petroleum, due to the energy used in the conversion process and the high carbon content of the coal feedstock. The CO2 issue is a significant political obstacle to widespread CTL development in the United States.

The large capital outlay required for a CTL project is another significant hurdle. To be efficient, CTL projects must produce upwards of 15,000 to 25,000 barrels a day, and the capital cost of such a project is measured in the billions of dollars.

In addition to the size, the complexity of CTL projects is a significant challenge when it comes to financing the projects. A typical indirect coal liquefaction plant requires the seamless integration of roughly seven separate functions, including not only the gasification technology and the liquefaction technology, but also often an on-site power plant. The perceived technology risk is not only the sum of the risks presented by each technological component, but also the risk that the components will not integrate harmoniously. Although a number of creditworthy contractors are active in this area, these contractors are reluctant to bear full responsibility for these risks and, as a result, significant guarantees of overall performance and schedule are not yet available.

Because of the size and complexity of CTL plants, full commercial operations may not commence until five years after the start of construction. As a result, projects that use debt financing are likely to incur significant interest expense during construction. This not only increases the overall project cost, but also reduces the attractiveness of bond and term loan B-type financing structures, which customarily require the borrower to draw down all or a significant portion of the funds available under the credit facility at financial closing.

Developers of CTL projects must also contend with commodity risk. Although the volatility of the oil market is a challenge to all forms of alternative fuels, this challenge is greater in the CTL context given the length of the construction and ramp-up phases for a CTL plant. The use of coal also means there is commodity risk because the price of coal is not highly correlated with the price of synthetic fuel.

Overcoming the Challenges

The early developers of CTL projects in the United States have begun tackling the challenges. Thus far, developers have proposed to address the CO2 issue primarily by sequestering CO2 in the gasification stage and disposing of it through enhanced oil recovery. There are several enhanced oil recovery operations currently in the US, several of which already accept CO2 by pipeline. However, the capacity of these operations to accept CO2 is limited, and CTL will compete with other suppliers of CO2, including coal-fired power plants. In addition, carbon sequestration will not truly take off in the United States without construction of a network of CO2 pipelines that mirrors the existing network of natural gas pipelines and without further development of the laws governing underground storage of carbon emissions.

Promising studies have shown that the carbon emissions of a CTL project can be reduced beyond that of a conventional petroleum refinery by co-gasifying a modest amount of biomass with coal. According to a study funded by the three US government agencies mentioned earlier, a 20% reduction in carbon emissions can be achieved through CTL (as compared to the production of low-sulphur fuel from an existing conventional petroleum refinery) by co-processing coal with 10 to 18% (by weight) of biomass, such as switchgrass, poplar trees and corn stalks.

It is too early to provide a meaningful opinion on whether CTL projects will be able to pass on the costs of complying with any carbon controls in the United States. The US is still debating what form such controls will take. They are not expected to be enacted until after the next President takes office.

The high capital costs of these projects can be partially mitigated through proper tax structuring. The US government offers as many as six subsidies that will pay anywhere from 30% to 55% of the capital costs of CTL projects. First, depreciation can account for anywhere from 17¢ to 30¢ per dollar of capital cost. Second, developers may be able to deduct 50% of the cost of the Fischer-Tropsch liquids train immediately in the year the plant is placed in service, which accounts for another 2.6¢ per dollar of capital cost. This deduction is only available in cases where the developer signed a binding contract by December 2007 with a construction contractor to build the liquids train. Third, there is a refined coal credit of $5.88 per ton that is available to developers that convert coal into a gaseous, liquid or synthetic fuel that will be resold for the purposes of making steam. Fourth, there is also a potential 20% investment credit that could be applied towards the gasification component of the plant. Fifth, transportation fuels collected through the Fischer-Tropsch process can qualify for an excise tax credit of 50¢ a gallon. This credit can only be claimed through September 30, 2009 on output, although it is likely to be extended by Congress. Sixth, and finally, CTL projects can take advantage of a government inducement to encourage Americans to manufacture at home. Currently, 6% of the income of domestic manufacturers is not subject to federal tax and starting in 2010, the incentive will be increased to 9%.

Although few developers have the income to take full advantage of these tax benefits, developers can use structures, such as a sale-and-leaseback or partnership flip structure, to convert the tax subsidies into cash.

The technology and completion risks in CTL projects are expected to diminish dramatically as the United States market becomes more familiar with CTL technology. In the interim, and in the absence of creditworthy contractors willing to offer guarantees of performance and schedule on a complete facility, these risks must be built into the project as a contingency fee. Although such fees can become prohibitively expensive, they can be significantly reduced by obtaining guarantees for the individual components that make up the plant, such as the gasifier, the air separation unit and the Fischer-Tropsch unit. The remaining risks — integration, cost overrun, labor coordination and the like — can be addressed through additional contingency. A number of creditworthy contractors, who may be able to provide such guarantees, are active in this area.

The commodity risk tied to oil can be addressed through a variety of approaches. One strategy is to enter into futures contracts based on the price of diesel. This would make a portion of a project revenue stream more predictable, but this strategy tends to be prohibitively expensive in volatile markets, such as the diesel market, if implemented over a long term.

Another strategy is to enter into long-term fixed-price contracts for at least a portion of the facility’s output, similar to those used in the ethanol and biodiesel industries. 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. Although the US Department of Defense would appear to be a prime candidate for these types of contracts given the projected need of the Air Force for synthetic diesel and jet fuel, the value of this opportunity is limited by restrictions that limit the ability of the US military to enter into binding agreements with terms in excess of five years.

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.

The project might benefit by having the offtakers prepay for the output. The prepayments can be structured so that they are economically a type of soft debt that the developer can use to pay part of the capital cost of the project and repay by delivering fuel in kind. It is “soft” debt because it would not have the same default triggers as more traditional bank debt. Under US tax rules, the project may be able to delay reporting the prepayment as income and report it ratably over the contract term as the prepaid fuel is delivered.

With respect to coal, CTL developers could ensure the availability of predictably-priced coal by purchasing a coal mine or entering into long-term coal supply contracts at a fixed price or with a cap. A similar approach was taken by the independent power industry to resolve the lack of correlation between the price of natural gas and electricity.

As with any new type of project, it is just a matter of time before a financing template will eventually develop along with a “market” approach to tackling the various risks.