Bending the rules of LNG

This year, the LNG industry will celebrate its 50^th birthday. LNG will play a vital role in the projected growth of natural gas to 25% of world energy mix by 2035.¹ So far, growth in LNG has been characterised by significant capital requirements to cover the cost of entry and the long-term commercial structures that support such costs. The mainstay of greenfield LNG projects has been a long term investment grade buyer sitting at the receiving end of such projects. LNG suppliers and sponsors have, therefore, traditionally required security of long term offtake prior to proceeding with the new LNG projects (as do the lenders who provide capital on a limited recourse basis). While sponsors and lenders in other capital intensive industries, such as power, have at times bent that rule, in the LNG sector there have been very few exceptions.

Cost effectiveness and the social and environmental issues associated with using coal and nuclear energy will continue to be the driving force of increasing demand for LNG. This, in the medium term, will likely result in some sub-investment grade countries investing in their own regasification capacities. LNG sellers appear to have taken note of the rising global demand trend for LNG supply, and interest in developing regasification capacity within sub-investment grade markets.  Success of all or many of these newly emerging LNG initiatives in sub-investment grade credit environments, however, are by no means assured. This article looks at factors that may increase the probability of success of these initiatives.

The great shift in the LNG market and the emergence of new buyers

Japan and South Korea have been, and are expected to remain, the backbone of the global LNG demand market.  These countries, combined with the UK, Spain and India, counted for nearly 67% of world LNG imports in 2011. Japan will continue to retain the lion’s share of global demand for LNG in the coming years as it attempts to meet its increasing demand for power, and move away from nuclear energy following the Fukushima disaster. Indeed public safety concerns during the crisis were such that Japan took 48 of 50 nuclear power plants taken off line.  Those safety issues have remained fairly even with the government's public relations campaign to the contrary.

The recent shale gas technological revolution has resulted in a number of major LNG buyers to become suppliers of LNG. The US is the best example.  Shale gas production there grew by staggering 37.9% in 2011. The US EIA predicts that shale gas production will continue to significantly affect its domestic energy needs, resulting in the US becoming a net natural gas exporter by 2016. Other markets such as China, India and Europe may soon experience a shale boom of their own. Outside North America, China is expected to be the most successful in developing shale gas, which according to the 2013 BP World Energy Outlook will by 2030 account for as much as 20% of total Chinese gas production. China national oil companies has been aggressively trying to acquire the technology required for developing shale gas resources as evident from China National Offshore Oil Corporation's acquisition of Canadian oil and gas company, Nexen, reportedly for a deal value of US$15.1 billion. There are a series of new LNG projects currently under construction in Australia, and new promising discoveries have been announced in Africa. If these new projects are completed, they would double the current available LNG capacity of around 400 million tpa by 2025.  Such a sharp rise in the supply market must be equally met by a rise in demand from existing and new markets to be financially beneficial to all parties involved.  

Today, emerging LNG markets account for about 4.5% of world LNG trade, but this is likely to change as an additional 30 or so countries including, Vietnam, Uruguay, South Africa, the Philippines, and Croatia have announced plans to build capacity for LNG regasification and usage. The common driver for these countries seeking LNG is that other feedstocks, such as heavy fuel oil and diesel, used to generate power, are more costly, leading to power prices that are multiples of those in the US and Europe. In contrast to traditional LNG buyers, most of whom are located in strong credit environments (such as Japan, Korea and Taiwan), however, these newly emerging importing countries have lower investment grade credits that are less likely to support an FID (and any commercially acceptable associated project financing) for the mega-capital expenditure required to purchase, transport and liquefy the gas.

LNG supply and credit considerations

The global LNG market is facing an intense competition between the LNG suppliers and this trend will continue in the coming years. LNG suppliers increasingly need to offer a very competitive price and various contractual flexibility to the buyers to secure their long term sales. Those LNG suppliers that are free of lender imposed credit constraints may continue to afford to shop for better sale terms and stronger buyers.  However, others will increasingly face the choice between excess capacity and unattractive sale terms or buyers with a weaker credit.

With certain traditional markets no longer providing the opportunity to absorb LNG at attractive prices, newly emerging sub-investment grade buyers entering the stage may potentially offer a better opportunity to LNG suppliers. LNG suppliers will need to carefully balance risk and return considerations in deciding whether such opportunities are viable. The risk for the LNG suppliers that will be selling from an existing portfolio or from a project that has recouped the initial investment, will be the opportunity cost and remarketing risk.  However, for LNG sponsors seeking to procure foundation buyers for their greenfield projects, or those LNG suppliers with long term project finance debt, commitment of volume to a market where there is a potentially higher risk of default could compromise the viability of those projects or detrimentally affect those suppliers.

Even though some countries with good credit ratings, such as Kuwait, Indonesia, and Malaysia, are becoming LNG importers to compensate for their declining domestic gas production, an LNG supplier will have to assess such risks on a case-by-case basis, commencing first with the actual risk of default. The buyer may be based in a country with acceptable country risk or possess adequate sub-investment grade credit. The impact of usage of regasified LNG in the buyer's projected credit rating and the buyer's country risk, however, should also be analyzed to ensure supply of LNG does not detrimentally affect such buyer or the relevant market in the long term.  Take, for example, independent power projects (IPPs) that may be burning liquid as a feedstock. Using natural gas instead of liquid feedstock would place the new gas-fired IPPs in more competitive position than the existing coal-fired counterparts, as the cost using coal is higher.  In an unregulated electricity market, this could substantially impact the existing power generators which in turn impacts the country's electricity supply volume.  The spiraling cost of switching facilities to gas as seen for instance in Australia, moreover, could offset the economics of investing in downstream LNG and gas infrastructure.

Overcoming challenges and getting the deal done

While LNG suppliers are increasingly looking with interest at new ‘non-traditional’ markets, and may become comfortable with certain risk/reward propositions, greenfield LNG initiatives will increasingly become challenging. Adequately addressing some of these challenges will undoubtedly increase the chances of success.

Some of these challenges relate to the multiple parties that are involved in successfully importing LNG: the LNG sponsors, the LNG terminal owner/operator, the LNG transporter, LNG buyer/gas seller, owner/operator of the regasification infrastructure, owner/operator of the pipeline infrastructure, and the end users. Intertwined in this are the number of projects that need to be financed and developed to construct and convert the LNG supplied to gas for end users.

Regasification infrastructure and pipeline infrastructure will need to be financed and built. End users will need to develop, finance and construct their own projects in order to burn natural gas (the IPP will need to undertake conversion processes to convert to natural gas, or the new gas-fired power plants will need to be developed and constructed). These projects, although potentially developed by different parties, are all inter-dependent and cannot function without one another. A complicating challenge for such projects is the existence of a number of lenders with competing interests to limit the potential project risks. Certainly, risks can be mitigated by combined gas-to-power schemes, where LNG is imported, regasified and converted into power by the same entity on the same site. This combination has the benefit of minimising the number of parties and, more importantly, wrapping the capital projects, such that any lender to the project will not have to rely on other capital projects being funded.

Another challenge relates to the regulatory framework. In countries with no existing gas infrastructure an entire regulatory framework needs to be put in place to regulate the importation of LNG, which can be a complex and time-consuming undertaking. Countries with pre-existing gas infrastructure and a pre-existing regulatory framework will be viewed as more realistic buyers of LNG. For example, Argentina, although it is a sub-investment grade country, has been able to build two LNG import terminals and has further facilities in the pipeline because it was already a gas consuming country, with a regulatory regime and pipes to carry the gas around the country.

Conclusion

The global LNG market is changing. New developments in East Africa and shale gas in the US will soon enter the supply side of the market. At the same time, the demand side is altered by smaller sub-investment grade countries entering the market and by events such as the Fukushima nuclear disaster that have prompted governments to rethink nuclear power as an optimal energy source. It is important that the supply side recognises the shift in market. Not every supplier will be able to enter into long-term contracts with at a competitive price with a top investment grade countries such as Japan and Korea, or buyers with extremely high-credit rating. New sub-investment grade countries and entrants to the LNG market should be looked as providing opportunities for these LNG suppliers to develop their projects.  The adoption of necessary regulatory framework and a commitment to develop the necessary infrastructure facilities to utilize the imported gas in these countries, however, are critical conditions that needs to be addressed before supplying LNG to these countries can be perceived to be viable for the LNG suppliers. In the end, adapting to the new changes by all parties involved will ensure that they will stay a head of the LNG market curve.

Reference

1. The 2012 World Energy Outlook produced by the US Energy Information Administration (EIA).

Written by Poulad Berenjforoush and Peter Maldonado.

Notes

Poulad Berenjforoush is an Australian-trained lawyer with an LL.M. degree from Georgetown University Law Center and an LL.B. degree from the University of Sydney. He has previously worked at Baker & McKenzie in Sydney and Dentons in Washington D.C. Most recently he was an analyst at Taylor-DeJongh in Washington D.C.

Peter Maldonado is current analyst at Taylor-DeJongh with a Dual Masters (MA/MBA) from American University's School of International Service (SIS) and the Kogod School of Business. 

The authors want to thank Paolo Curiel, Senior Director at Taylor-DeJongh, for his valuable comments and guidance in writing this article.

Read the article online at: https://www.lngindustry.com/liquid-natural-gas/08012014/bending_the_rules_of_lng_004/