The plunge in oil prices in 1998 cast a pall over what had been the best market for financing oil and gas projects since the early 1980s.
Prior to the gloom over oil prices, prospects had been bright for oil and gas project financing. During a fundamental industry recovery in the latter half of the decade, analysts noted a resurgence in the availability of funds for oil and gas ventures. In addition, the types of financing proliferated: project finance, bank debt, high-yield debt, equity, mezzanine financing, and others.
The boomlet of oil and gas project financing that peaked in 1997 and began to fade early in 1998 stemmed from a convergence of factors that largely can be traced to recovery from the 1986 oil price collapse. As part of that recovery, petroleum operating companies and service-and-supply firms cut costs and concentrated on profitability. While they sreamlined organizations and improved efficiency with new technology, demand growth strengthened prices for oil and natural gas.
Analysts in 1997 were confidently predicting that the recovery in the oil and gas industry would last at least past the turn of the century. That sort of confidence presaged a continuing borrower`s market, as petroleum projects attracted financing and oil and gas companies tidied up balance sheets.
What especially grabbed the petroleum finance markets` attention in 1997-98 was a string of megaprojects in Latin America whose financing deals shattered records and traditions.
But in 1997 the Asian economic bubble burst, the Organization of Petroleum Exporting Countries increased production quotas for the first time since the Persian Gulf war, and oil prices fell. The outlook for project financing radically changed.
Trends
In late 1998, it was unclear how long the oil price doldrums would last. And the finance talk turned more to that of funding mergers and acquisitions as the industry prepared for another flurry of consolidation.
Banks and other institutional lenders became more selective than before in their choice of oil and gas projects and coventurers. They seemed increasingly averse to lending in general, as much because of the global economic malaise as from concerns over the outlook for oil and gas prices.
A handful of innovative financing deals in Latin America in 1997-98 showed that a fundamentally sound petroleum project grounded in a long-term perspective could withstand another dip in the perpetual rollercoaster ride of oil and gas prices. They also showed that hunger for foreign investment, pulled by democratization, market reform, and privatization, remained as strong as ever. Growing evidence of political stability in Latin America, as the comfort level on property rights and legal rights improved, put the emphasis more on project economics for prospective lenders and credit agencies and less on host country politics.
The trend suggested that expanded access to capital in the petroleum industry in the late 1990s was not the result, as it was in the late 1970s and early 1980s, of overly optimistic expectations of oil and gas prices. A more important factor was project and company cash flow and the ability to weather market weakness.
Another crucial element of the energy financing climate of the 1990s was the evolution of a new, integrated species of energy company in the U.S. The evolution resulted from the combination of deregulated segments of the electricity and natural gas industries into "one-stop shopping" energy megamarketers delivering energy regardless of the fuel source.
Deregulation and movement toward convergence of the gas and electric power markets increased demand for energy financing by encouraging construction of efficient power-generation plants and expansion of the transmission grid in the U.S. and by stimulating the interest of U.S. firms in power projects in developing countries.
A new phase of petroleum industry restructuring, meanwhile, promised to change the financial landscape.
Oil and gas company merger and acquisition activity, especially in the U.S. and Canada, set a frenetic pace in 1997-98.
While the megamerger of British Petroleum Co. plc and Amoco Corp., announced in summer 1998, stunned the industry, it was not likely to be the last merger of such scope. Coming on the heels of megamergers in the service and supply sector, it was seen as heralding a new round of consolidation among the world`s biggest petroleum companies.
Before then, the focus had been on reengineering, rationalizing assets, and paring costs. The BP-Amoco marriage sharply switched the focus for operating companies to revenue growth and scale.
Tools for financing
A number of new tools for creative financing in the oil and gas industry emerged in the 1990s.
In addition to the usual methods involving conventional project financing, derivative-linked instruments, forward sales, and securitizations, there were new spins on the old methods, as well as new methods employing various hedging techniques and tax-driven financings (e.g., monetizing tax credits).
Operatingcompaniesincreasingly turned to innovative financing approaches for oil and gas projects, including monetization of project cash flows or the use of long-term capital markets.
The energy industry and its financiers sought fresh innovations to structure financing of projects. The capital-intensive petroleum industry remained attractive for financing because of its ability to sustain cash flows and the long-term viability of the commodities it produces and markets.
Size also kept the energy industry attractive to financing. From January 1990 to mid-1998, loans worth more than $1.2 trillion were arranged for the global energy industry, Petroleum Economist reported in its June 1998 issue. The energy sector had traditionally dominated the lending markets, accounting for 12% of the total market by value, the biggest market share of any sector, according to Petroleum Economist.
Venezuela a hotspot
Venezuela was a hotspot of innovative project financing approaches. It fit the classic example of what had always driven petroleum company project financing: huge capital spending requirements needed to transform vast resources into producing, cash-generating assets that could be met only partly from internal cash flow.
With the La Apertura campaign of opening its petroleum sector to foreign investment, Venezuela activated the other catalyst of major project financing in the region: equity participation by foreign partners and from the banking sector and capital markets.
This campaign spawned a host of billion-dollar projects in Venezuela, many of them involving the massive heavy and extra-heavy crude oil resources of the Orinoco oil belt.
In financing such projects, lenders or bond investors took secured positions, with the expectation of being paid back by cash flows after project completion.
The trend posed a challenge for credit rating services, such as Moody`s Investor Services, to analyze and rate credit-worthy projects in countries with relatively low foreign currency sovereign ceilings due to economic, political, and financial risks. In such cases, said Moody`s, the credit ratings for projects financed in currencies outside the host country are capped at that nation`s foreign currency ceiling. But Moody`s noted that, in some selected instances in the oil and gas sector, it "pierced" the foreign currency ceiling, or rated certain projects above the sovereign ratings of the countries where the projects are located.
The foreign currency ceiling became a key consideration in developing a project credit rating in a cross-border project financing. It demonstrated that government`s capability to make available foreign exchange to service cross-border debt, including its own. In the event of a financial crisis, government intervention, usually through its central bank, may crimp access to foreign exchange, thus hindering even the most credit-worthy borrower`s ability to make timely payments to service debt. Accordingly, for any project`s debt obligation to be rated higher than the sovereign ceiling, it must be considered to be at lower risk of default than the government`s own senior bonds, Moody`s said.
Despite certain legal protections that might be in place, a government might, in the case of crisis, choose to override those protections. So there would have to be other compelling political or economic motivations to safeguard against such a risk.
In the case of Petrozuata, a $2.45 billion joint venture of Conoco Inc. and Venezuelan state oil company Petroleos de Venezuela SA (Pdvsa), Moody`s was able to rate the project above the country`s sovereign ceiling.
Among its justifications, Moody`s cited:
- The strategic importance of the oil industry-in particular Pdvsa`s to the government-and its role in the economy, hence the minimal risk of interference in project operations or cash flow.
- Pdvsa`s status as a top priority for Venezuela`s Central Bank to make foreign exchange available, even ahead of the central government itself. Pdvsa also maintained a U.S.-dollar offshore rotating account that was always fully funded before funds were remitted to the Central Bank. Pdvsa had never delayed payment or defaulted on any debt.
- The significance of the Petrozuata project`s success as a test of Pdvsa`s future ability to attract foreign oil companies to Venezuela`s oil sector and to invest in heavy oil development.
- A highly fungible commodity, i.e., crude oil, that generated U.S. dollars.
- The size of the asset base: The Petrozuata concession alone contains a heavy oil resource of about 22 billion bbl.
Petrozuata financing
While Moody`s was able to pierce the sovereign ceiling in rating Petrozuata`s debt financing, the project`s finance structure also garnered universal acclaim, with many finance publications calling it the "deal of the year," even the "deal of the decade."
The joint venture company Petrozuata was formed to produce 1.6 billion bbl of extra-heavy oil in the La Faja region of Venezuela`s Orinoco heavy oil belt and upgrade it into a synthetic crude oil, most of which was to be processed at Conoco`s refinery at Lake Charles, La. Crude production was scheduled to start up late in 1998 and continue for the 35 years of the contract term.
Petrozuata completed the biggest financing effort, with the tightest spreads to that time, for a project in Latin America.
Among its other records, Petrozuata, at the time:
- Was the largest emerging-market project financing bond from a sub-investment grade country.
- Achieved the lowest interest rate spread ever achieved for an emerging-market project finance bond or emerging market bank financing without political risk insurance.
- Was the highest-rated Latin American project finance bond.
- Had the longest tenor for an emerging-market project finance bond or emerging-market uncovered bank financing.
Petrozuata`s financing was structured to maximize the benefit of dollar-denominated offshore receivables.
All but 4% of project revenues were to be denominated in dollars and paid to an offshore trustee. Lenders` assurance came from a 6-month debt service reserve, collateralization of all project cash in dollars and local currency, and certain limits on cash held by the project in operating accounts.
Market risks were reduced when Conoco committed to buy all of the project output at a market-indexed price. At the same time, Petrozuata had the right to sell the synthetic crude it produced to third parties on the world market, which could help project economics.
To maximize flexibility on project implementation, the partners provided lenders a completion agreement, with Petrozuata acting as a general contractor and dividing the project`s components into manageable contract pieces and agreeing to fund cost overruns. This, said Conoco, could reduce the total project construction cost by about 15% and allowed the project to proceed without requiring the lump-sum contracts that typify project financings.
To add still more flexibility, Petrozuata and adviser Citibank designed a mechanism to buy down debt to levels that maintain modeled debt-service coverage ratios in case the project missed its design capacity targets.
Credit Suisse First Boston was engaged to raise the long-term portion of the financing. Petrozuata went to the capital markets with a 144A bond issue, which evolved into a three-tranche offering: a $300 million, 12-year tenor tranche that was priced at 120 basis points over applicable treasuries (7.63%); a $625 million, 18-year tranche that was priced at 145 basis points over treasuries (8.22%); and a $75 million, 25-year, bullet tranche that was priced at 160 basis points over treasuries (8.37%). The bond offering was oversubscribed.
Petrozuata then focused on the bank market in order to gain some added flexibility. The syndication for the $450 million bank facility was led by Credit Suisse First Boston, Union Bank of Switzerland, ING, and NationsBank. This part of the financing consisted of a $200 million, 14-year amortizing tranche and a $250 million, 12-year amortizing tranche. The bank financing was well received and also was oversubscribed.
Cerro Negro
Moody`s similarly assigned a Baa1 rating to three senior secured bond issues totaling $600 million, issued by Cerro Negro Finance Ltd., a special-purpose financing vehicle incorporated in the Cayman Islands.
Proceeds of the offering were to be utilized as part of the financing to develop the $1.9 billion Cerro Negro extra-heavy crude oil project in Venezuela. The project was to export heavy synthetic crude. The venture was indirectly owned 41.67% by Mobil Corp., 41.67% by Pdvsa, and 16.67% by Veba AG.
The Cerro Negro project is being developed through an unincorporated joint venture established in Venezuela to develop, transport, upgrade, and market extra-heavy crude oil from the Cerro Negro area of the Orinoco oil belt.
Development of oil field facilities commenced in April 1998 and included the drilling of about 400 horizontal oil wells over the 35-year production life of the Cerro Negro contract area, and the installation of downhole pumps and surface gathering and processing facilities. About 100 wells were to be drilled by 2002 in order to meet initial production targets. The venture also involved construction of two 197-mile pipelines to connect the field facilities to Jose, where the oil would be upgraded and exported.
The venture was scheduled to begin production of 58,000 b/d of 8.5° gravity crude oil in 1999, which was initially to be blended with 20,000 b/d of condensate to facilitate transport and marketing of the heavy crude. After completion of a heavy oil upgrader at Jose in 2001, the venture would have the capacity to process 116,500 b/d of extra-heavy crude, to produce 105,000 b/d of 16.6° gravity syncrude.
Project costs were estimated at $1.66 billion, including interest and financing costs. Bond proceeds of $600 million and bank financing of $300 million were to constitute the debt portion of the financing for the project, which was not to exceed 60% of total capitalization (debt plus equity) at completion. The bonds had maturities of 11, 22, and 30 years, with a weighted average life of about 15.95 years. The net proceeds of the bond offering were to be held in a bond proceeds account, outside of Venezuela, with funds disbursed to pay project costs as incurred.
While Moody`s gave Petrozuata and Cerro Negro equal ratings, it compared the two projects and considered Cerro Negro the stronger of the two (see table).
Colombian project financing
Capital required for Colombia`s state oil company to participate in a world-class oil field development in Colombia were raised through a novel approach.
Empresa Colombiana de Petroleos (Ecopetrol) in 1998 raised $290 million through the issue of notes secured with oil production risk.
Oil Purchase Co., a special-purpose firm based in the Cayman Islands, issued $290 million in notes backed by rights to a volume of oil from Colombia`s giant Cusiana and Cupiagua oil fields, then under development by a group led by British Petroleum Co. plc.
Revenues from export sales of the Cusiana complex crude to a unit of Spain`s state oil company Repsol SA would pay for the notes, which had an expected final maturity of 4.5 years and an average life of about 2.7 years.
Moody`s gave the notes a Baa3 rating, while Standard & Poor`s gave them a BBB rating, piercing Colombia`s BBB-foreign currency rating.
Salomon Bros., joint lead manager with Chase Securities Inc. in the transaction, claimed the deal constituted the first asset-backed note offering from Colombia to have a rating higher than Colombia`s foreign currency rating. It said the transaction achieved the first securitization of oil production risk while also incorporating key elements of an export-receivables securitization.
Puerto Rico project
In another Latin American energy project financing breaking new ground, Enron International and Kenetech Energy Services by 1998 had closed financing on their $670 million EcoEléctrica liquefied natural gas terminal and cogeneration project proposed for Puerto Rico.
The project entailed construction of a liquefied natural gas terminal, cogeneration plant, and desalination unit off southern Puerto Rico. EcoEléctrica would include a 500-MW, combined-cycle cogeneration power plant fueled mainly by LNG and imported from Trinidad and Tobago`s 400 MMcfd Atlantic LNG project.
Enron and Kenetech said that the project financing-already a challenge because of the project`s size and unique nature-was further complicated by the fact that no project financing combining an LNG terminal and power plant had ever been completed.
EcoEléctrica project costs were to be financed during construction with a $603 million construction loan and a $67 million sponsor construction loan. Loan payments were to be made solely from cash flow, with additional nonrecourse financing provided for working capital and servicing debt and letters of credit issued for power and fuel contracts.
Although a long-term fuel agreement is usually needed prior to financing, Enron was able to rely on its experience in gas contracts and fuels hedging to give the banks a project model that supported the project`s finance economics; this allowed financing on the project to close prior to completion of an LNG supply contract with Cabot Corp. structured more like a U.S. pipeline gas supply contract than a typical LNG supply contract. EcoEléctrica also entered into a contract with ProCaribe, an Enron LPG facility adjoining the EcoEléctrica site, to import and provide a terminal for the LPG needed for the first 6-8 months of operations while the LNG terminal and storage tanks were being completed. Thereafter, the ProCaribe facility was to provide back-up LPG fuel storage for EcoEléctrica. With its capability to also be fueled by No. 2 fuel oil, the project`s fuel flexibility was another plus for lenders.
Low oil prices` effects
Even "deals of the decade" can come under pressure when the commodity that underpins them loses value.
Late in September 1998, Moody`s had lowered the debt ratings on the financing entities created to support financing of the Petrozuata and Cerro Negro projects.
Moody`s lowered the ratings on the asset-backed global notes of Pdvsa Finance Ltd. to A3 from A2, and senior secured bonds of both Cerro Negro Finance Ltd. and Petrozuata Finance Inc. to Baa2 from Baa1.
The move followed Moody`s downgrading of the ratings of Pdvsa to B2 from B1, as a direct result of the lowering of Venezuela`s foreign currency (sovereign) rating to B2-which in turn stemmed from the slide in oil prices in 1998.
The lowering of these ratings reflected Moody`s view of their increased risk profile caused by potential budgetary pressures on Pdvsa that could, at least temporarily, affect its ability to support its various obligations as a sponsor of these entities. Furthermore, Venezuela`s lowered credit quality modestly increased diversion risk. Despite the lowered ratings, Moody`s noted that the ratings remained significantly above the sovereign ceiling, "reflecting the inherent strengths in their structures-including secured offshore accounts, strong foreign partners, significant reserve dedications and guaranteed offtake agreements-which overall, help to mitigate the likelihood of diversion by the Venezuelan government of the product or cash flow."
Also, the economic importance of Pdvsa to Venezuela, coupled with the need for continued foreign investment in the oil sector, remained a positive factor, Moody`s said.
This further illustrated the need to tie an oil and gas project to the kind of innovative financing structure that can withstand the volatility of oil and gas prices. The pioneering steps taken in financing some key Latin American energy projects in 1998 thus can serve as a model for innovative oil and gas project financing.
 |
Pipelaying was under way in 1998 for the first of two 125-mile pipelines from Petrozuata`s production site to the Jose industrial complex in Venezuela. One of the lines was to transport extra-heavy crude mixed with diluent north to Jose; the other would return diluent to the production site. The project financing structure set up for Petrozuata, a Venezuelan joint venture of Conoco Inc. and Petroleos de Venezuela SA, was called the "deal of the decade." Photo courtesy of Conoco.
 |
 |
Construction was in progress in 1998 at Jose, Venezuela, on the $1 billion Petrozuata upgrader. The upgrader, slated to come on stream in 2000, is based on Conoco`s delayed coking technology and is designed to upgrade diluted Petrozuata crude to synthetic crude oil and byproducts. The deal setting up the financing for the Petrozuata project established a string of records in 1998. Photo courtesy of Conoco.
