World’s biggest project financing will look to capital markets

 by Simon Pirani

The Sakhalin II liquefied natural gas project (LNG) in the Russian Far East, which is set to become the world’s biggest ever project financing, may turn to debt capital markets for tenors longer than those available from multilateral agencies or commercial banks. 

Sakhalin Energy, the project company majority-owned by Shell, last month announced that about half of the estimated $10 billion cost of its 9.6 million tonnes per year LNG plant is likely to be debt financed.

A project information memorandum went to potential lenders on 11 June. A project bond, most likely to be issued in the US under Rule 144a, is one of a suite of financing options being studied.

Most of the debt will come from a group of multilaterals and export credit agencies led by the Japanese Bank for International Cooperation. But up to $2 billion is expected to be needed from commercial lenders and/or a bond issue, depending on market conditions. Financial close is expected in the first half of 2004.

CSFB, who were taken on in December 2000 as financial advisers to Sakhalin Energy, would be strongly placed to win the mandate for a bond issue. But if a portion of the debt is syndicated to the bank market, another arranger, or more likely group of arrangers, would be brought in; BNP Paribas and Societe Generale are among the front runners with relevant experience.

Peter Firmin, director in CSFB’s global energy group, said: “At this stage a bond is a possibility, not yet a probability. Its attraction is that capital markets can offer a longer tenor than straight bank debt, or even agency money – and with a very back-ended structure, which is attractive in the current climate. Clearly the sweet spot for capacity and liquidity – tenor and pricing – is distribution via the Rule 144a market.”

Robin Baker, managing director and head of project finance (oil and gas) at Societe Generale, said that, partly because of Russian content requirements in the production sharing agreement (PSA) under which Sakhalin II is being developed, “there may well be a funding need in addition to agency lending”. SG has expressed an interest in an arranging role for bank debt, he said.

Sakhalin Energy’s decision about how much money to borrow, and from whom, will ultimately depend on market conditions. One precedent it would be happy to follow is that of Rasgas, the Qatari LNG project for which Goldman Sachs arranged a $1.2 billion project bond in the Rule 144a market in December 1996, which went alongside a $1.35 billion worth of ECA-backed bank loans. JBIC and Japanese commercial banks played a key role.

The timing was perfect: the bond was sold before the Asian and Russian crises caused havoc in emerging markets. Since then, others have not been so fortunate. A banker who worked on that deal said: “The 144a market’s great advantage is that it can be very long term. But issuers are at the mercy of market sentiment. After the success of Rasgas, a series of similar deals were expected, but conditions made some of them impracticable.”

In Venezuela’s heavy oil sector, the Cerro Negro and Petrozuata projects raised capital markets debt, but the Sincor (2000) and Hamaca (2001) projects fell back on more restricted ECA funding. In late 2001, the owners of the Oman LNG project were poised to issue a bond to refinance a $1.3-billion 1997 project debt financing, but the 11 September terror attacks and their political fall-out caused a switch to the less fickle, but costlier, bank market.

Qatar is investment grade; Russia is not. But Sakhalin Energy and its advisers hope the incredibly positive sentiment that has made Russia a runaway favourite for emerging market investors this year will make a bond possible.

That’s next year’s problem. This year, Sakhalin Energy intends to finalise commitments from the multilaterals and ECAs, An initial meeting was held with them in the last week of June.

JBIC, which played a leading role in the Qatar and Oman financing, is expected to provide the lion’s share of agency funding for Sakhalin II, which will primarily serve the Japanese market. A JBIC spokesman said that the project, which is “of great strategical importance”, is now going through the bank’s appraisal procedures.

The project now being financed is the second of two phases. The first phase, which was completed in July 1999, brought into production a 1 million tonne per year oil field. JBIC, the European Bank for Reconstruction and Development and the US Overseas Private Investment Corporation jointly provided a $348 million project finance loan – which is expected to be refinanced by next year’s deal.

Marathon Oil of the US was one of Sakhalin II’s original sponsors, with 37.5%, but sold that stake in 2000 to Royal Dutch Shell, now operator and owner of 55% of the project. Mitsui (25%) and Mitsubishi (20%) are the other shareholders. With Marathon’s departure the project has no US sponsor, and so OPIC’s involvement will be replaced by a small commitment from the US Export-Import bank. The EBRD, for which Russian project finance is a key area, is in the talks and through its “A”/”B” loan structure may involve commercial banks.

ABN Amro has been retained as financial adviser to the multilateral lenders, and White & Case as legal advisers. ABN has an impressive record in Russian oil and gas finance, and in 2001 advised the state-owned oil company Rosneft on a $1 billion+ deal that brought the Indian oil company ONGC into the nearby Sakhalin I project operated by Exxon. At the time, that was Russia’s largest cross-border M&A deal.

In May this year Sakhalin Energy announced the development date and awarded an initial $2 billion engineering, procurement and construction contract – to build a plant to liquify Russian natural gas – to a consortium of Russian and Japanese companies. An oil and gas pipeline system to serve Japan, an oil export terminal, and the installation of two offshore platforms, are also planned.

One issue to be ironed out in the coming months is whether Gazprom, Russia’s state-controlled gas monopoly, will join the project. Gazprom ceo Aleksei Miller has talked to Shell boss Phil Watts about the possibility, and focused on LNG in a keynote speech to the triennial world gas forum held in Tokyo in May. Shell emphasises that while bringing in Gazprom would be infinitely desirable from a strategic viewpoint, any deal will be “strictly on a commercial basis”.

The institutions working on the deal will be pondering two other factors in the next six months: Russia, and the LNG market.

The rise and rise of Russia as a magnet for emerging market funds is the best possible preparation for a Sakhalin II project bond. The boom is breaking one record after another: in February, Gazprom, which is Russia’s largest company, issued a $1.75 billion ten-year eurobond. It was the biggest ever from an emerging market corporate and still five times oversubscribed. The no.2 oil company Yukos, whose merger with Sibneft in April was Russia’s biggest ever domestic corporate deal, has been talking to bankers about a $1billion + eurobond later this year to help pay for it. That would provide another important indication of market sentiment.

In the syndicated loan market, where Russian oil companies are playing banks off against each other and pushing margins below Libor + 3%, no.l oil company Lukoil is this month expected to mandate an arranger for a $500 million seven-year deal. That will be a record tenor for the structured commodity finance market.

Sakhalin Energy will hope to follow the trend. Firmin of CSFB said that the date of development announcement “is a very big vote of confidence in Russia. The Gazprom bond was a clear sign of investor interest in, and appetite for, Russian deals.” That appetite could grow bigger in March next year, when president Vladimir Putin hopes to romp through a presidential election to a second term that will provide renewed political stability. Perhaps only a substantial oil price fall can spoil the Russian party.

For Sakhalin II, the LNG market is a factor that has become less predictable. When the sponsors decided in May to give the go-ahead, only a quarter of Sakhalin II’s output was covered by long-term supply contracts – with Tokyo Energy and Tokyo Electric Power Company. That’s an unusually small proportion by industry standards, and a senior gas market analyst said: “Shell, Mitsui and Mitsubishi appear to have torn up the rule book.”

The Sakhalin sponsors argue that the low proportion of long-term contracts signed simply reflects the dramatic changes in the market, where spot sales now play a much greater role. As Alfred de Witte, finance director of Sakhalin Energy, said in a recent presentation: “Customers want variations in supply terms and that reduces the certainty for lenders. We see the emergence of supply side tenders.”

Challenges such as this mean that the world’s biggest ever project financing will also be the most interesting.

A version of this article was published by Euromoney magazine, July 2003.
Posted July 2003; © 2003 Simon Pirani

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