10 KEYS TO A SUCCESSFUL LNG EXPORT PROJECT

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1 10 KEYS TO A SUCCESSFUL LNG EXPORT PROJECT April 13, 2015 By: Philip Weems and Kathryn Marietta Introduction With dozens of LNG export projects proposed around the globe in a low oil price environment, it is essential that project sponsors today consider those attributes that facilitate a successful project. Historically, proposed LNG export projects that many at the time considered viable were, in the end, cancelled for a variety of reasons (e.g. projects in Bolivia, Venezuela, Nigeria, Iran, Canada, Alaska, Indonesia, Russia, and Australia). The competition is fierce and the capital costs are steep. Not all of the proposed projects will realize success. We will look at a number of characteristics that successful LNG export projects typically share. We will also consider the difference in oil and LNG markets, as a general understanding of these differences facilitates a deeper understanding of the unique traits of an LNG export project. While oil and LNG are both hydrocarbon based products, they are fundamentally different when it comes to the market, and terms on which they are bought and sold. Oil and LNG are Different Crude oil trading takes place in a large, flexible, worldwide trading market. These markets are well established and very global. Standard terms and conditions are available in the market place and these typically dictate terms of sale. Transactions are completed quickly, often by reference to the standard terms and conditions, where a relatively brief confirmation (which includes commercial terms like price, volume, shipping terms, and place of origin and delivery) is the only document negotiated. These negotiations can occur in a matter of hours (or less). Cargoes are often sold on a short-term basis or a cargo-by-cargo basis to the highest bidder, and are often traded on the water. The total number of LNG shipments is only about 10% of crude oil shipments. Most LNG cargoes are shipped under long-term contracts and are sold prior to a sponsor taking the final investment decision on the liquefaction export project. The terms and conditions for the sale of LNG are buyer and seller specific and highly negotiated. Because of the long-term nature of the LNG sale and purchase agreements, opportunity may exist in fluctuating price markets to divert sales to other LNG buyers. Flexibility for increased and decreased volumes is often negotiated into the contract. Take-or-pay provisions give rise to terms allowing for make-up quantities to be delivered at a future time. The foregoing discussion gives basic insight into the very different markets that exist in the LNG and crude oil trading arena. This serves as background as we now address the characteristics of successful LNG projects. Success in an LNG Project LNG export projects have numerous stakeholders and are complex technically, contractually, and structurally. In our view, an LNG export project that receives necessary Host Government support; is developed, marketed, funded /financed and constructed; and delivers LNG to markets on a continuing basis is a successful project. Achieving this success takes time and

2 significant investment of resources and capital. However, even successful LNG export projects (i) can be delayed for many years even decades (e.g. Nigeria); (ii) can result in company that originally discovered gas not being the one to ultimately benefit from LNG sales (e.g. Qatar); or (iii) have major issues over their lifetime, including gas reserves (e.g. both Egypt plants) and technical issues (e.g. Norway). Achieving funding and construction may not result in success under these criteria if the project is unable to deliver LNG on a continuing basis; for example, the Angola LNG project started construction in 2008 and eventually began exporting in 2013, only to be shut down soon thereafter due to reported design flaws and corrosion of nearly-new equipment. 10 Keys to Successful LNG Export Project Development 1. Prior Long-Term Sales/Tolling Commitments that Provide Assurance of Adequate Revenues. A major challenge confronting every LNG export project is to aggregate sufficient advance LNG sales to allow an affirmative final investment decision. Again, gas is not oil LNG may have no real value until it is sold. Development will not proceed until target sales quantities are secured. Once sufficient LNG sales have been contracted, the project is well on its way to completion. Final investment decision kicks off construction and the beginning of the significant capital expenditure phase of the project. LNG sales contracts are typically 20 year commitments. Advance sales from 5 MTPA LNG plant (1 Train) will have a value of tens of billions of dollars. As is profoundly evidenced in the current environment, global LNG market prices vary greatly depending on supply, buyer demand, and commodity prices. LNG buyers have numerous options in today s markets Attractive to Premium Asian Buyers. The project must be both well planned and economic, such that it achieves pricing that meets economic hurdles for both the liquefaction development and for the buyer. Ideally, the project will be attractive to the premium buyers who have sufficient creditworthiness and significant long-term gas demands. Historically, LNG prices in Asia have been twice as high as prices paid by long-term buyers in other regions. In fact, Japan, South Korea and China combined to purchase over 60% of all LNG imported in Strong Resource Base. Gas field characteristics vary from field to field. Buyers look for reliable, steady supply and are attracted to large gas reserves given the long term nature of LNG sale and purchase agreements. Over the course of field life, some fields experience steep declines, in some instances while local gas demand escalates (e.g. Egypt, Oman and Bontang and Arun in Indonesia). This results in issues for some projects and compromises the seller s ability to continue to export and supply 1 One recent change in the North American market has, in some cases, allowed projects to go forward to FID notwithstanding that LNG sales have not been secured. Some tolling projects that are underway in North America have advanced when capacity in an LNG train has been contracted under long-term tolling agreements to allow (i) project financing and (ii) project developers to take a positive final investment decision. In some instances, customers who will not consume the LNG themselves have been willing to commit to these long-term tolling agreements even though they have not yet executed resale contracts with third party LNG buyers. 2

3 agreed quantities. Force majeure and other contractual consequences may come into play as resources are depleted. Projects with high percentage of liquids have typically been more competitive, as the sale of higher priced condensates has historically leveraged project profits. Gas supply quality is a consideration when attracting premium buyers, as coal seam gas and shale gas (typically having a lower gross heating value) are typically less attractive to many Japanese buyers. 4. Host Country has Predictable Legal, Contractual and Regulatory Foundation and Evidences Support for Project Without question the sponsor s relationship with the Host Government is critical to project success and timing of such success. Host Government support is essential to the project and is often times a critical path factor when establishing project timelines, and the failure to obtain Host Government support will cause delay or cancellation (e.g. the decades-long battle between East Timor and Australia over sharing revenue from the Greater Sunrise fields). The sponsor must examine and understand the general legal, regulatory, contractual, and fiscal framework which will apply, as well as the interplay among these regimes and the manner in which implementation occurs. In addition to the foregoing, LNG export projects often require a separately negotiated legal and fiscal regime, which in some regions is established in an LNG Project Agreement and implemented through related legislation (e.g. For Peru, The Law for the Promotion of Investments in Gas Processing Plants and its regulations were enacted in 2004, followed by an Investment Agreement executed between Peru LNG and the Peru Government on January 12, 2006). Equity and debt investors will not be keen to accept exposure to risk of changes in laws or in tax which could adversely impact LNG project s economics they seek fiscal certainty when backing a project (such as that historically provided by the Nigeria LNG (Fiscal Incentives, Guarantees and Assurances) Act 1990 and that recently provided under Mozambique s December 2014 Decree Law on Area 1 and Area 4 LNG Projects). The more stable the agreement is with the Host Government the higher the likelihood of project success not only for the sponsor, but for all stakeholders. It is critical to project success that international arbitration of disputes is agreed with the Host Government as this provides the lenders, sponsors and other stakeholders a higher degree of certainty should a dispute arise. 5. Competitive Cost of LNG Project A successful LNG export project will implement a thoughtful approach to the construction delivery system that generates a competitive engineering, procurement, and construction contract. There are few qualified contractors to build and operate onshore or offshore projects and labor constraints are common when staffing during the construction phase. Construction costs for a typical LNG export project have in general doubled in the last decade and in some cases are up 200%+. Rising costs have caused cancellation of new trains (e.g. Browse Australian projects) as projects lose commerciality with higher costs. By way of example estimated capital expenditures for (i) offshore wells and facilities can exceed $4.5 billion dollars, (ii) two trains in an LNG plant can exceed $9 billion dollars, and (iii) shipping arrangements can cost $2-$3 billion dollars. The total cost of floating liquefaction projects is yet to be established. 6. Sound Commercial Structure Based on Industry Norms Critical to project success is the thought and consideration given to project structure to ensure a sound project specific approach is adopted. There are numerous governance and project 3

4 structures that have been adopted by project sponsors. A variety of structures are viable when establishing the project, and buy-sell models, tolling models, and integrated project models should all be at least considered. Unique characteristics of a particular project will dictate structure and will drive tailoring of existing models for a given project. Lenders and Buyers will carefully evaluate the commercial structure and the strength of the entire LNG value chain. 7. Financeable Project The ability of sponsors to attract financial support is fundamental, especially given the unprecedented cost of recent export plants (such as Inpex s $34+ billion Ichthys LNG project in northern Australia expected to start up in 2016). A project is more likely to be financeable if there is a predictable, clear, and coherent legal framework in existence or established by the Host Government. The commercial structure that attracts financing ensures both a predictable longterm cash flow and take-or-pay contracts with credit-worthy buyers, and has survived risk analysis across the entire LNG value chain. A construction contract that limits construction phase risk, incorporates a well-managed fee structure with certainty as to schedule and is led by an experienced contractor or contractor group with a sound delivery history invites investment. The financiers will also be encouraged by an experienced operator and limited scope for increases in operating costs. Although no LNG export project has so far defaulted on repayment of its project financed loans, the recent inability of both project-financed Egyptian projects to resume LNG exports (due to gas shortages) necessary to support debt service may lessen some of the traditionally strong enthusiasm lenders have had for the LNG export sector. 8. Buyer Participation in Project Premium buyers may insist on taking equity in the export project. This concept of buyer participation has moved outside of the premium buyer arena in the last few years. A positive approach to involving key buyers in project participation has lately been the norm in LNG export projects and the sense of partnership between the seller and buyer fosters a long-term successful relationship, thereby enabling overall project success. For example, for Freeport LNG s first liquefaction train under construction in Texas, tolling customers Osaka Gas and Chubu Electric had sufficient confidence in the project to invest approximately $1.24 billion in equity. Such investment helped the project secure approximately $4.4 billion in debt financing for the first train from the Japan Bank for International Cooperation and six Japanese commercial banks (with the portion of the loans financed by the commercial banks being insured by Nippon Export and Investment Insurance). 9. Few partner conflicts of interest The term sponsor has been used in the singular in this article. However, the sponsor is typically a venture of among numerous participants who have gas discoveries in one or more fields. Conflicts among sponsors can arise when different LNG portfolio priorities exist (i.e. competing LNG projects or supply),. Disagreement can impact project success (such the current arbitration between Total and Oil Search over development of Papua New Guinea's Elk and Antelope gas fields), especially when there is misalignment across the various segments of the LNG chain. Optimally existing agreements (such as joint operating agreements) do not hinder development and partners are able to agree and work together in project development. The relationship among sponsor participants should not be underestimated. Disagreement among these participants (e.g. the lingering dispute over the ownership of the Brass LNG site in Nigeria) can weaken the relationship with the Host Government, cause concern from potential financiers, 4

5 and cause significant project delays. Optimally the State is not in the role of both a partner and the regulator. If the State is in both roles, care must be taken in documenting its role under various contractual arrangements. 10. Timed with Buyers Windows of Demand Differences in market demand timing and supply infrastructure lead times can hamper an otherwise viable LNG export project timing can be everything. Historically market demand seems to come in waves. Increased demand may be present when (i) existing buyers are in market seeking additional or replacement LNG supplies, (ii) buyers seek to diversify supply sources to mitigate risk and ensure reliable supply, (iii) new markets develop and new buyers are in market for large baseload LNG supplies. The key is to know the market, anticipate demand waves, and match projected export project in-service date with the forecasted demand timeline. Summary History has shown that the success of LNG export projects, or lack thereof, has been influenced by many factors, several of which are within the sponsors control or influence. Being cognizant of key success factors can help sponsors stay focused on critical project variables that can dictate whether a projects succeeds as planned, succeeds with delays, or fails. It ensures that areas outside of the direct control of the sponsors are given the proper level of attention and are approached in accordance with market norms. 5