Bringing LNG to New Markets: Key issues and solutions

The last two decades have seen exponential growth in LNG receiving facilities around the world. Between 2000 and 2010, the number of countries which have the ability to import LNG more than doubled, reaching 23 in 2010.*At the end of 2017, this figure stood at 36.** At the end of 2010, there were 83 LNG import projects globally,* but by the end of 2017 this figure had increased to 121.** Global regasification capacity from these terminals was 572 MTPA at the end of 2010.* By March 2018, this figure had reached 851 MTPA.**

While the vast majority (82 per cent) of operational LNG import projects are still land-based, the use of floating LNG import solutions has become increasingly popular in recent years. In 2017, of the seven new LNG import terminals that started operations, three were floating terminals (43 per cent) and of the 19 terminals being constructed as of early 2018, eight were proposed to be floating terminals (42 per cent).**

The use of floating LNG import terminals has been (and is expected to continue to be) particularly important in opening up new countries and markets to the global LNG market, predominantly because of the lower capital expenditure involved and the shorter timescales in bringing the project online.

However, in developing any LNG import terminal (floating or land-based) in a new market, there are a number of threshold commercial issues that need to be considered in determining whether such a project is commercially viable. These will vary from one project to another but may well include consideration of questions such as:

• how predictable and stable is the demand and downstream market price (which will usually depend on how quickly regasified LNG can displace other fuels in the market)? and
• what downstream infrastructure is required to deliver the regasified LNG/power to the market?

This article considers some of these threshold issues and the commercial and financing structures and solutions that may be utilised to address them.

The scope of the project

A key threshold issue to be considered in developing LNG import projects in new markets is the scope of the project – that is, whether it should be limited to the infrastructure which is strictly necessary to receive LNG and then regasify and send out that regasified LNG or whether it should also include any downstream infrastructure, such as gas pipelines or even power generation facilities.

In markets with developed gas and power infrastructure, LNG import projects have tended to be limited to the provision of only the infrastructure needed for the import of LNG. For example, if a floating solution is being used, the scope of the project may be limited to the lease (or purchase) of a floating regasification and storage unit (FSRU) and the construction of the onshore infrastructure needed to connect the FSRU to the existing power station or the existing gas grid in the country. Typically projects which are tendered on this basis are structured on a tolling basis. This means that the project developer will exist as a third party provider of infrastructure only, and it will not be responsible for procuring LNG or selling regasified LNG (or power) into the market. The infrastructure provider’s obligation will be to make the LNG regasification terminal available to customers and to provide services to these customers, such as receiving LNG, regasifying LNG and sending out regasified LNG to customers. The customer will be responsible for procuring the LNG and on-selling gas or power to end users. This structure relies heavily on there being a creditworthy customer to purchase LNG and utilise the services of the terminal, and there being existing gas and/or power infrastructure available in the host country.

Many countries which are seeking to add LNG import capacity will be able to provide both creditworthy LNG buyers and an existing network of gas and power infrastructure. In those countries, traditional projects with a limited scope and which are based on a tolling structure may well work and be the preferred option. However, in certain new, emerging LNG import markets which lack a creditworthy LNG buyer and/or do not have existing gas and power infrastructure, this structure can present some significant challenges. As a result, in some new markets, different commercial and financing structures and solutions are needed.

Increasingly in emerging LNG import markets, bidders are being asked to propose solutions with a much broader scope, which effectively package together the supply of LNG, the building of the LNG import infrastructure and also the in-country infrastructure needed to deliver gas or power to end users (for example, gas pipelines or gas-fired power stations).

From the perspective of the project developer, at one level, there are strong arguments in favour of the scope of their project being extended as far downstream as is required to reach end users. This all-encompassing project scope gives the project developer the ability to influence the development of the downstream infrastructure, and also helps to overcome some of the challenges outlined above relating to the lack of downstream infrastructure.

On the other hand, having such a wide project scope further increases the project’s exposure to host country risk, which may affect the appetite of potential debt and equity investors, as well as increasing the capex required to fund the project and introducing additional commodity price risk into the project structure.

Striking the right balance in relation to this issue will depend on numerous factors, including the composition of the consortium backing the project company and their ability to manage the LNG purchase, onshore risk and the financeability or otherwise of the downstream assets.

The remainder of this article focuses on some of the key structural and commercial peculiarities which need to be considered to help navigate some of the challenges in putting together that integrated structure.

An integrated solution

Figure 1 shows a simplified version of a typical integrated project structure. In a typical integrated project, the project company is the entity which will enter into the necessary project contracts for the infrastructure to import LNG – if a floating solution is being used, this will include a charterparty for an FSRU, FSU and/or FRU.

Figure 1 – Typical integrated LNG regasification project structure

Depending on how far downstream the project scope goes, the project may also include any necessary contracts for the construction and ownership of the gas pipeline and/or the associated power station in the host country.

In addition, the project company will also enter into a contract with an LNG supplier to purchase LNG, and then one or more contracts with the customer or end user under which the project company sells either regasified LNG or power.

A key feature of this structure is that the project company is offering an integrated solution to the new country, by contracting for everything that is needed to deliver regasified LNG and/or power into the country, without the need to procure from another party the gas transmission or power infrastructure.

However, a major downside of this structure from the perspective of the project sponsors, is that the project company, being at the heart of this model, is exposed to commodity risk (because it is buying LNG and selling gas or power). Therefore, the project company will need to ensure that the terms of the gas sales agreement (GSA) or power purchase agreement (PPA) are, to the extent possible, back-to-back with the terms on which the project company purchases LNG under the LNG sale and purchase agreement (LNG SPA).

This structure also means that the creditworthiness of the project company will ultimately be dependent on the ability of the end users to pay for the end product (whether that is gas or power).

These risks give rise to:

• the need for greater contractual flexibility than the LNG industry has traditionally been used to; and
• in many cases, credit issues associated with a less creditworthy customer and how those issues can be mitigated.

Contractual flexibility: volume

In relation to contractual flexibility, there are two main areas where greater flexibility will be required under the LNG SPA than has traditionally been offered in the LNG industry. The first of these is in relation to the volume of LNG that the project company is obliged to purchase from the LNG supplier. There are a number of areas where volume flexibility becomes relevant.

First, given that the project company will be developing significant infrastructure in the new market, and will be exposed to project construction risk in relation to a potentially wide project scope, the project company may need flexibility from the LNG supplier as to when commercial start-up will be. This flexibility may take the form of allowing the project company to delay the commercial start date in order to manage any up-front delays.

Then, once the infrastructure is built, commissioning and building up to full commercial operations may take some time, so the project company may also need to include provisions in the LNG SPA allowing it to gradually ramp-up volumes of LNG purchased in line with its obligations and ability to deliver regasified LNG/power.

Finally, once the project is fully operational, the project company may also need some flexibility over the annual contract quantity (ACQ) of LNG that it is required to take. This may take the form of upward/ downward flexibility built into the LNG SPA, subject to agreed limits in the contract year and/or over the life of the contract.

In addition, if the end customer under the GSA needs the flexibility to scale-up the contractual volume once demand for gas increases in the country, the project company might need to agree with the LNG supplier that the project company has equivalent rights to increase the ACQ under the LNG SPA to meet that increased obligation under the GSA. If the LNG supplier is not willing or able to do this, the project company might be willing to take the risk that it can procure alternative LNG on a term basis in the market at the time, on sufficiently back-to-back terms.

The project company will also need to bear in mind that the step-up in the contractual volume under the GSA/ PPA may necessitate a requirement for replacement infrastructure or the procurement of additional infrastructure.

In the event that the project company is not able to achieve the volume flexibility that it requires in the LNG SPA, it may be able to achieve the volume flexibility needed by virtue of GSA/PPA terms in other ways. For example, it may be possible for the project company to:

• procure additional volumes from the spot market. The project company will need to asses if it makes sense to have a lower firm contractual volume under the LNG SPA, with the project company accessing the spot market for any incremental volumes it requires; or
• achieve the volume flexibility it needs through access to flexible storage. It may be that an FSRU provides the necessary storage quickly, cost effectively and flexibly to help the project company mitigate and manage any mismatch in volume flexibility between the GSA and the LNG SPA.

Contractual flexibility: term

The second area where greater contractual flexibility will be required under the contracts underpinning the project is in relation to the term of the agreements.
Traditionally, the length of the term of the contracts underpinning investment in the LNG industry has been long. Project developers can introduce additional flexibility into these new types of project by seeking to shorten the term of the project contracts.

The ability to shorten the term of the relevant contracts will depend on a number of factors, including:

• the length of time needed to amortise the capex of the regasification project. This will depend on the profitability of the project company and the scale of the downstream infrastructure which needs to be built;
• the minimum contract length that the vessel provider is willing to accept. This will in part depend on whether the vessel provider has confidence that it will be able to redeploy the vessel in other projects; and
• the minimum contract length that the LNG supplier is willing to accept. Portfolio suppliers may find it easier to accept shorter term contracts than greenfield liquefaction projects, so the project company will need to assess what type of LNG supplier is right for the project.

There is also likely to be a trade-off between the term of the initial contract and the contractual volume flexibility. The shorter the term, the less volume flexibility may be required.

Figure 2 – Options for end buyer/customer credit support

Contractual remedies if the customer defaults

Projects for the supply of LNG into new markets also give rise to issues surrounding the creditworthiness of the end buyer/customer (which will in turn drive the creditworthiness of the project company).

The standard contractual remedies which are typically included in any contract for the supply of regasified LNG, and which should be reflected in the LNG SPA entered into by the project company, are as follows:

• suspension of deliveries;
• enforcement of contractual remedies for failure to take (for example, take-or-pay);
• termination;
• enforcement of contractual remedies on termination (for example, damages); and
• enforcement of arbitral awards/judgments against the buyer’s assets.

The same remedies will be relevant when dealing with a less creditworthy end buyer/customer. However, in practice enforcement of those remedies will be significantly more difficult, for the following reasons:

• the customer may have limited assets;
• the customer’s assets may be secured in favour of lenders;
• enforcement of foreign arbitral awards/judgments may be challenging; and/or
• the customer may have less commercial flexibility to reschedule.

Credit support

For the reasons discussed above, the project company will need to consider what form of credit support should be provided by the end buyer/customer. The range of credit support instruments and techniques which might be considered, from the conventional to the more innovative, are set out in figure 2 above.

Prepayment structures are very common in the oil and hard rock minerals sectors. On an LNG import project, one possible option may be for the end customer to borrow, perhaps on a sovereign basis from a MLA, and pay the proceeds into an escrow account from which payments will be made to the project company upon deliveries of regasified LNG or power.

In other cases, there may be one or more significant sources of demand for power or regasified LNG, such as a mine or an industrial processing facility standing behind the project’s
customer. In those circumstances it may be feasible to mitigate the credit risk on the customer by providing that, if the customer defaults and the PPA or GSA is terminated, the ultimate large-scale consumer (that is, the mine or processing facility) will contract direct with the project company. Again, this is a mechanism that is common in other sectors and could be deployed here, subject to, for example, regulatory constraints about what type of entity can sell gas or power in the country in question.

Finally, another novel solution may be for the project company to be structured to take advantage of other revenue streams against which its right to payment by the customer can be set off. For example, if the purchaser of regasified LNG (or its affiliate) sells crude to an affiliate of the project company, could the two revenue streams be set off against each other? However, this may well raise political obstacles for the country in question because, for example, it could be seen as selling its crude at a sub-market price under the set-off mechanism. It may also hinder the flexibility of the initial shareholders in the project company to sell down.

The appropriateness and feasibility of different credit support structures will need to be carefully considered, because the project company’s creditworthiness is ultimately driven by the creditworthiness of the end buyer/customer and the credit support arrangements which the project company has in place with end the buyer/customer. Both the LNG supplier and the vessel provider will want to understand the credit support structure the project company puts in place with the end buyer, so that they can assess what protections they need to include in their respective contracts with the project company.

A careful consideration of the project scope and the issues presented at an early stage, with a view to putting in place the right structures and solutions, can greatly contribute to the success of a project selling LNG to a new market.

* IGU World LNG Report 2010.

** IGU World LNG Report 2018.