THE REASONS BEHIND PROJECT FINANCING INDIVIDUAL ELEMENTS
OF THE CHAIN FOR LNG INVESTMENT PROPOSALS
Abstract
This paper discusses the rationale behind project financing of individual elements of the LNG chain instead of integrated financing option. Although integration is a proven means of capturing the necessary economies of scale and synergy in the business world and corporate strategy, theoretical analysis and empirical evidences disprove its contribution to efficient LNG investment financing. The LNG chain and industry itself demands substantial investment, adjustment to environment of the importing parties and its own dealings with its environment. Aggravated this complex operating environment is the due diligence that has to be applied by creditors. With financial evidences explain the importance of efficient source of capital, project financing is found as a credible strategy in hedging the risks and maximizing the returns of LNG projects.
Introduction
Liquefied natural gas (LNG) is important to the society because it is used for cooking and heating serving as daily necessity for households and other entities[1]. Although natural gas has vast global reserves, its supply is concentrated to locations and countries far from the users. In effect, the primary concern of every government is the security of supply for their own citizens. Many LNG exporters, however, only possess twenty eight percent (28%) of the world’s reserves which undermines the capability of gas powerhouses such as Russia and several Arab countries that hold at least fifty percent (50%) of the world’s total gas supply[2]. Resources are waiting to be exploited but the apparent limiting factor is the ability of potential suppliers to successfully finance their exploration and/or production endeavors and successfully market their produced. The focus of this paper is to the former factor (i.e. financing) but availability of markets which can be restricted by political/ social boundaries can appear significant to explain financial bottlenecks in LNG investment (i.e. payback period). Specifically, it will research the comparative significance of individual financing and integrated financing for the LNG supply chain; namely, gas production, liquefaction, LNG tankers, LNG receiving terminals and pipelines (see Figure 1). Addressing the issue requires insertion of theories, cases and financial presentation to rationalize the upper-hand of project financing of individual LNG chain elements.
Overview of LNG Project Investment
Figure 1 shows that every LNG exporting country must invest in constructing and maintaining LNG supply chain for its own use and also export earnings. For importers, they can prevent costs in the start-up elements of the chain like production or liquefaction to focus investment in LNG turnover from exporters. The chain is integrated either by pipeline or transport. Source basins and liquefaction plants are connected by pipelines for processing and storing purposes. As almost all LNG are transported through water, liquefaction plants are built near marine locations for ease of loading to tankers for overseas travel. As tankers arrive to importer’s receiving terminals, it will be stored, re-gasified and delivered to end-users through pipelines. Due to this structure, LNG exporters are confronted with the problem of addressing financing issues of one of the most expensive energy business. There are four main financing elements of LNG chain in exporter’s eyes which are gas production, LNG plant and LNG shipping that incur 15%-20%, 30%-45% and 10%-30% of all the project costs respectively[3]. The positive operating environment, however, resulted for the reduction of these costs in recent years but industry measurement is difficult as most of cost-savings are site-dependent (i.e. location of LNG project).
Liquefaction plant is the biggest cost contributor to the chain due to isolation and modernization required to run it safely and efficiently. In its construction phase, it will cost the project .5 to .0 Billion half of which is dedicated to development of trains while the remaining are allocated for equipment and other materials[4]. According to Jensen Associates, the cost of building a new greenfield is more expensive than simply expanding existing ones (i.e. introduction of bigger trains may as well deliver economies of scale). Cost reduction schemes of LNG projects can be supported by focusing on the following areas; namely, reduction of design complexity, bigger and smaller number of trains, modernized equipments, improved process techniques and entering competitive lump-sum bids. Expanding plants is rational for natural gas powerhouses but not on subsistence production/shipping countries.
Ships that transport LNG from the plants are mostly owned by exporters and importers due to their specific design. There are few shipping companies for general LNG shipping requirements but the charter rate is not fixed (i.e. can range between ,000 up to 0,000 per day) and depends on various factors such as price of ship, financing/ operational expenses and sensitivities to time and distance[5]. Alternatively, purchase of LNG tankers is available at a cost of 0-0 Million. Cost-savings can be attained when there are more shipyards for price/ service competition, longer shipping contracts, possessing merchant fleet for flexibility, efficiency of fuel and building large ships. However, risk is attached to building bigger ships such as incompatibility with existing terminals designed for smaller ships. Expected economies of scale is not obtained and also substantial investment in both shipping contract or purchase is jeopardized. Lastly, re-gasification terminals range from 0 Million to Billion depending on the level of modernization[6]. The most expensive area in these terminals are the storage tanks (i.e. 1/3 of all related costs) as well as aquatic facility. As terminals are located in more challenging sites, the greater the cost of tank-type required and ship channel needed.
Overview of LNG Financing
In the financial side, the cost of LNG project is incomparable to organizational projects due to substantial requirements. LNG supply chain is break-down into different task projects which is a modification of Figure 1; namely, drilling of wells and construction of offshore platforms and gathering systems, building of liquefaction plants and LNG trains, establishment of facilities such as ports to use together with trains, construction of tankers and building of receiving terminals for re-gasification. The view of LNG chain as activities amplifies the need to finance each through variety of sources of financing. For example, there are some banks that offer ship financing but lack expertise or banks that do not offer both. Another, receiving terminal can be entered under joint-venture between the exporting and importing entities as it will be beneficial to both cost and strategic structures. Due to this, access to various financing sources is crucial to LNG projects that aspire flexibility without damaging the overall funding needs of the entire chain. This is concretized by the fact that no single financing source is perfect such as borrowing to commercial banks has threat of regularity due to low exit barriers and potential mergers while export credit agency have slow execution of the funding contract.
Project financing is the recent development on LNG financing particularly in EU nations[7]. It is a paradigm shift from traditional methods which is triggered by the emergence of LNG spot market and understanding of its implications by the international funders. In addition, contributions to paradigm shift came from deregulation of state utilities, risks associated in future market base, inconsistent process reliability and speculations in ship construction. Yesterday, LNG projects beliefs that prevented short-term contracts, selected suppliers that have exclusive responsibility for the completion and inserting restrictive clauses have all changed for the purpose of flexible agreements. Since project financing of individual elements of the value chain has different financing schemes and supporting creditors, there could be problem of coordination as participants in one element (i.e. liquefaction) will not be involved to the other (i.e. shipping). On the other hand, the success of the overall project relies on the success of individual elements. However, when credit facilities are integrated (i.e. integrated chain financing), coordination will be enhanced and cooperation will lead the overall project to success.
There are financing risks and consideration in each element of the LNG chain. The production phase is typically demanded by the financier to have sufficient supply of natural gas in its basin/ well. This will assure that smooth flow of operations until liquefaction. To ensure basin reserves, verification of supply is applied. The financier also looks to the possibility of incurring added-value by-products and its ability to be produced without adversely affecting the mainstream issue of LNG production. Without enough ability to secure reserves, lenders would require sales purchase agreements (SPAs) that can obligate the contracting party to develop natural gas reserves perhaps through exploration to specific future date.
In the liquefaction phase, lenders may require due diligence evaluation of the entire processes. As mentioned, liquefaction incurs the biggest costs among the LNG project elements. As a result, creditors put emphasis on this aspect above the effort from other elements. LNG projects have two options in operating liquefaction plants; namely, depletion sales agreements and portfolio basis. The first necessitates an importer to buy the project’s produced using the project’s output while the second gives the opportunity for the supplier to get gas from its preference (i.e. in the case that supply in the liquefaction is insufficient or under delay). Accordingly, lenders require different evaluation treatment. For example, distance of the debtor to its partners under portfolio basis will be emphasized as the wider the area will demand higher fas gathering costs. Also, the general impression about liquefaction from commercial banks is that most projects have questionable LNG technology as equipments are not tested. When breakdown occurs, refinancing can be very problematic.
In shipping phase, the concern of the lenders becomes broader to include political and country risks that can affect routing of vessels when LNG is in transit. In addition, risks attached to narrow routes and dangerous water flows dictate the physical safety of transit of LNG and should also be considered in lender evaluation. When the non-integrated LNG project decided to create its dedicated fleet, lenders would consider timely completion to extend shipping financing. Standards set by international authorities and associations will also be checked and compare if the current project can match them accordingly to prevent stoppage or not providing plying certificate to strict borders. In the case of chartering project, the ability of the supplier of fleet is studied to assure on-time delivery and also the ability of the debtor to pay charges or any interest from contractual debts.
In the actual delivery to the buyer, lenders encourage LNG projects to create SPAs to prevent default of payment from the buyer. SPAs does not provide benefit of buyer to refuse receipt of delivery as indicated in the contract or failure of payment. Lenders also insert profit floors to assure that the operations of the debtor will gain positive results to the loan contract in favor of lenders. Specifically, lenders want projects to implement a minimum price to secure arrival at profit targets. To be able to execute this, lenders would intend to analyze the composition and characteristics of the buyer/ market to rationalize any profit formula it would take and give to debtors as basis for pricing decisions of the latter. Lenders are also required to investigate the consuming market environment to check the need of having insurance. For example, the 9/11 attacks in the US struck suppliers due to unforeseen risks that had yet to be addressed prior to actual occurrence.
Theoretical Analysis about LNG Projects
The Effects of Poor Management
One-half of software investment is exhausted by repair and maintenance[8]. There is an implied problem in the planning stages especially on checking how the project can perform financially based on the nature of innovation. Apparently, a high-level of innovation is a source of high design costs and difficulties[9]. Without proper planning, the project would fail to estimate a diverse set of project parameters (e.g. scope, time, resources, materials, etc.) which may lead to a project team that cannot effectively control the project itself. Without control of the project, it would be easy to presume that project members cannot direct its development towards pre-determined goals.
Planning is a forward-thinking approach and this covers activities to be done throughout the project especially for contingent situations. Project planning is applied in feasibility study, build method, execution strategy and all the way down to risk management[10]. With just one management lapse in estimating parameters for every stage in the project, objectives that focuses on cost, time and quality can be overlooked. The caution becomes more valuable when implementing a new project in which an organization is not familiar with. For example, several emission control technologies are “proved” to be very efficient pollutant remover but are “found” to be very expensive emission technologies[11].
A manufacturer may have immediately dwelt into this project especially without knowing initially the “found” cost factor of the technology. The learning curve or the derived learning curve can polish project planning inaccuracies in establishing parameters. However, with poor planning, available learning curves would not be used and exploited probably due to immediacy of project completion. This can in turn pose threat to parameter accuracy especially on associated risks. The level of information in the earlier (pre-project planning) stages of the project is of the highest but its quality and accuracy is in question[12] and such information needs to be rationalized as the project progresses. Without continuous planning management, one or two objectives will necessarily be at stake.
Perhaps, the root of failure to achieve some objectives of a project can be traced as far back to defining the project. To define a project is to have a picture of work to be done, to have a yardstick to measure success and recognize any changes in the scope of work[13]. It serves as the backbone and rationale for any existing project. With poor planning associated with its establishment, inputs can inadequately and inaccurately install objectives. Inability to forecast, accept and address changes to the project would lead to solving problems that should be avoided if only anticipated and integrated while defining the project. As a result, elements of time, quality and cost will be adversely affected because the project team will try their best to balance the three which is suggested to be an indication of poor planning.
When planning is essentially corrupted, execution stage would be readily accumulating the poor management outcomes. Scheduling, resource allocation and cash flow analysis are derived from absurd parameters. This situates implementation where contingent actions are the only key to revert the poor planning. However, even if contingent actions are applied, potential value and level of impact are in very low heights with the cost of changing original plans accelerate in its highest trend[14]. On the other hand, if as early as the planning phase poor management is eliminated, the reverse positive side of revising plans can be obtained. Nevertheless, these only shows that the accumulated problems at the hype of execution stage tend to aggravate the project’s failure to address its objectives especially when actual cost (e.g. employee turnover, machine repair, low productivity) emerges.
The Inherent Problems in a Project
By merely looking in the project life-cycle components, inherent difficulties of a general project are obvious. There are four phases to complete a project and they are interdependent with one another. A successful execution of concept phase is contributory but not the determinant of the quality in design phase while solid network diagrams and resource histograms does not assure effective implementation. In addition, although the project team has already created their “perfectly planned” project, approval from top-management is pre-requisite in order to move in higher phases. This process may necessitate changes according to resources and the level of belief of the management with regards to the project. As a result, the perfect plan turned out to be blemished by organizational authorities where technical know-how is impeded by managerial skill. Project members and its leader are not the only people connected with the project and this fact may hinder for the former to maximize their abilities for the sake of successful project implementation.
Mentioning the important part of the project team to any project’s success, the aspect of human resources is unfolded. There are many purpose of project teams; namely, to achieve the schedule of work, to apply a diverse set of skills, brainstorming, decision-making especially in risky situations and serve as a platform for motivation and mutual support among members[15]. In effect, a project team is simply that part of an organization that is directed to achieve certain goals which made it to partially “disintegrated” from the latter structure. Such process does not include disintegration of resources needed to complete the project rather simply giving the team a room to act for itself independent to some extent.
However, whereas the quality of the project heavily relies on this mini-organization, managing teams is not easy. Oticon, the world’s pioneer manufacturer of hearing aids, developed a human resource strategy (called project driven approach) that requires each employee to join and perform well in a particular team to retain employment and be subject to promotion[16]. In this way, the management activated a “packaged” relationship between Maslow’s security and membership needs[17]. Applying the (employment) hierarchy of needs, Oticon succeeded in expediting the theoretical framework and positioned employees to address higher-level needs. This can enhance motivation as well as the effort given to work or project as employees would focus on self-esteem and status/ prestige needs. Project leaders are also given the authority to select their project members according to the former developed project plan which set the tone for cooperative behavior[18].
In the contrary, Oticon’s project-based organization is a rare corporate strategy and has been implemented and tried for years. It was also triggered by loosing sales and competitive environment that innovation for its products was deemed very important[19]. Most organizations are different and would prefer stability because it is less risky and more predictable. Another, Oticon’s product line is more or less revolves on hearing aids where most businesses of today have diversified (product/ market/ capital) portfolios. Due to this, the need to adapt a project-based approach is not necessary. In effect, the acceleration in hierarchy needs would not be possible while individual motivation will not be in its optimal level.
This is aggravated by the overly-focus objective of a general project on time, cost and quality. As a result, human resources are assumed to be very flexible and can accept contingent actions not according to what is planned. Task is delayed to reduce cost but the project team gets a compulsory non-productive days. On the other hand, task is accelerated to beat the deadline but the project team is least prioritized over the cost of materials. In view of these generally practiced concepts, the project team could end-up in resistance. According to Sims (2002), the chief reason of change failure is resistance[20]. Thus, the nature of contingent planning and actions in a project is attackable by the nature of human resources to retaliate if individual needs are undermined.
Efficient Financing Methods
Diversifying Investment Risks
Single-asset investments are high risk strategy. although owning a house has basic need, security and personal implications to family that they are willing to purchase it with a macro-economic guide[21]. On the other hand, portfolio risk has the capability to diversify the risk of individual portfolios to hedge the total risk of an individual. To measure the risk of a portfolio, correlation and covariance will be used. The first step to do is to get the return of the portfolio. This is merely the sum of expected returns of single-asset multiplied with their proportional share in the investment amount. Say I have 00 and opted it to invest in stocks and bonds in two different companies. If I will invest 50:50 on each financial instrument, their earlier computed single-asset expected values (i.e. returns) should be reduced to 50% and be totaled. However, in the same manner, their earlier computed standard deviation (i.e. risks) should be reduced to 50% or their share of the 00 investment.
Markowitz also came out with the development of efficiency frontier[22]. This frontier not only shows the optimal portfolio but also indicates how a risk-taking investor can maximize returns. The frontier assumes that there is no effect from trading costs like commissions rather the factors that can affect decision is on return and risk factors. All points in the efficiency frontier are diversifiable because it is a combination of risk-return trade-offs. The investor can then measure their amount of investment appropriate for their risk-averseness and perhaps liquidity. The point however of the efficiency frontier is that all investors are risk averse. This contention is suitable because at the heart of Markowitz efficiency frontier is diversification strategy to minimize the level of risks. All the points that lie in the efficiency frontier and therefore its constituent assets diminished specific risks associated with individual assets. This is because of diversification. However, it is to be noted that systematic risk or the risk in the market or external factors are not stabilized and always moving. As such, these risks are non-diversifiable and thus immune to the techniques offered by the frontier.
The Case of ACME
A firm’s capital structure is usually a mix of financing alternatives generally classified as debt and equity financing[23]. The latter refers to long-term borrowings while the former refers to long-term funds. Optimal capital structure is achieved when the firm’s cost of capital is minimized and its market value is maximized[24]. In the case of ACME, the 0M cost of new production facility in the US has several financing sources to consider before arriving at a specific capital structure. In the case of acquisition, seller financing is possible when ACME has a target company with goals suitable with ACME’s pursuits[25]. Aside from ease of preparing a contract, ACME can readily start operating the new plant and derive potential benefits. The problem, however, is the obligation of ACME for periodic payments or face litigation as well as the probability of being in default in case the acquirer found reasons to withdraw the acquisition due to internal problems or absence of synergy[26].
The plant acquisition can also be financed through the aid of government programs. It is coined as the most popular federal program that offers up to seventy percent of business acquisition. In the contrary, the offer is intended for small business targets and requires applicant-acquirers to obtain 25%-33% of the loan in cash or cash equivalents[27]. ACME’s 0M facility seemingly is under medium to large business. On the other hand, there are commercial banks that can be an option at times of huge financial requirement. However, unlike the government, banks do not aspire to be looked by the society as charity organizations. Rather, they have almost the same objectives with business borrowers, that is, to profit. Due to the conflict of interest, banks demand rigorous loan requirements from applicants like financial strength, cash flow, debt and equity ratio and collateral[28]. The bigger the loan, the more stringent screening will take place.
There is a way to get-off this through mezzanine financing. The borrower will finance the deal with the bank and secure the loan with “ballooning” equity ownership. The drawback, however, lies in the idea that when the business started to earn positive cash flows, its distributable profits is largely attributable to the bank in question due to exhaustion of ownership use to survive the business during the early days of the project’s financing[29]. Asset-based lenders (ABLs) is a fragment of mezzanine financing because the commercial banks does not take ownership to fulfill the obligation of the lender but only some assets of the business like plants, A/R or inventory. This is less risky than the preceding option but can dissolve the working capital of ACME use to calm shareholders and other creditors about its future prospects.
Further, luring private investors or requesting additional funding from existing shareholders is a lucrative strategy when a firm is on the verge of acquisition[30]. This is because there is a higher probability that it can obtain equity investment in this particular engagement than start-up setting. This can be in the case of initial public offering (IPOs) in which there is a stock sold to investors giving them the right to receive dividends or payback after every profitable periods. Even though this is a simple and ready strategy for ACME, the firm should take caution for investors who are just “playing” in the stock market as well as internal processes that lead it to Enron-like scandals. This difficulties as well as monitoring costs can be minimized if venture capitalists will be entertained. The strength of such strategy is that they have long-term perspective for applicants who have passed screening. However, ACME may loose control of its operations as venture capitalists typically assist the loan grantees to develop new products.
Conclusion
Both financial and project based theories and cases supported the strength of diversifying the risk of LNG project investments through borrowing from several creditors. Although financing integration is undermined, the strategy provided the necessary speed for the project to reach its payback period at the earliest possible time. If different lenders will handle due diligence and operational appraisal of each chain, the faster the results will be obtained and the project can execute its intended plans more smoothly and with minimal delay. In the case that it fails the requirements of the lender, it can easily access other lenders without the chain effect that can pose threat to the continuity of other elements despite the non-support of the lender to one of them. Combination of financing sources can also provide the needed diversification in order to minimize the default of the lender to support each element of the chain. The ambiguous environment of the buyers of the project’s produce can also require additional source of financing like government partnerships. With strictly integrated financing option, the project is limited its flexibility to partner to other entities without prior approval from its overall financier.
The strength of individual element financing is to be able to maximize a number of financing options available to the project. The substantial costs of investments and complexity of energy industry in terms of spot pricing places the project in enormous risks which it cannot survive if it will not borrow additional liquidity and security to other entities. Poor management due to single lender becoming very influential to the direction of the LNG chain should also be prevented and lender bargaining power should remain at bay. It is to note that the primary interest of lenders is to recoup the interest and principal from the debtor and it is easy for the former to close or sell the assets of the debtor in times of recession and financial crises. With several creditors honing the potential of each chain, the project can take its plans accordingly. Perhaps, integration should come in the strategic level rather on the financial level of the project. When operations are integrated, economies of scale and lean production/ distribution can be obtained. However, for financial issues, the project must take all precautions to minimize its risks and keep its longevity.
Figure 1: LNG Supply Chain
LNG Terminal LNG Carrier LNG Receiving Power Station
Natural Gas Well Terminal
Town Gas
Bibliography
Credit:ivythesis.typepad.com
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