INTERNATIONAL PROJECT FINANCE WHAT DO DERIVATIVE INSTRUMENTS OFFER BY WAY OF RISK MANAGEMENT IN OIL AND GAS PROJECT FINANCING?

Transcription

1 INTERNATIONAL PROJECT FINANCE WHAT DO DERIVATIVE INSTRUMENTS OFFER BY WAY OF RISK MANAGEMENT IN OIL AND GAS PROJECT FINANCING? CHIEMEZIE EJINIMMA Abstract: The evolution of derivatives is one of the great achievements of modern finance, and it has become an essential tool in risk management, basically offering organisations the possibility to reduce risk within the larger financial system, which they do not have direct control over, thereby allowing them to focus on the risk they are better able to manage. However the concern has been on the application of these derivative instruments especially among end users, with respect to specific projects. Recognising the need for proper risk management strategies in attracting debt finance for projects, this paper tries to analyse how derivatives can be used to mitigate key risk components capable of adversely affecting the viability of oil and gas projects. The conclusion highlights the necessary conditions for effectively extracting the best out of the use of derivative instruments for risk mitigation.. OTC IPE NYMEX SYMEX LIBOR List of abbreviations Over The Counter International Petroleum Exchange New York Mercantile Exchange Singapore International Monetary Exchange London Inter Bank Offered Rate

2 1. INTRODUCTION Designed as an alternative form of arranging capital for investment purposes, project finance came about as a method of raising long-term debt financing for projects based on the expected cash flow to be generated by the project alone 1. In other words, the essence of the project lending is its focus strictly on the project being financed, thus the lender principally looks to the project as the source of repayment. This presupposes a critical analysis of the constituents of the project. Traditionally, oil and gas projects have been financed using company internally generated funds or through corporate borrowings from commercial lenders 2. But the tightening of credit standards partly due to market volatility and constricted margins especially in downstream projects has made corporate borrowing less available, especially for independents and companies with lower credit standings. This has necessitated a movement toward project finance. Though this move, is not strictly as a result of a quest for alternative financing, but also as a means for allocating the many risks inherent in the sector. The oil and gas industry is characterized by large-scale projects, which have long gestation period and are highly capital intensive in nature, more so, they lack the variety of end products open to most companies. Though oil remains the largest single product category in international trade both in terms of value and volume 3, its unprecedented price volatility following the oil shocks of the last 30 years has had a dramatic impact on industry profits as well as producing countries revenues. Gas on the other hand is a more constrained product trading mainly in the regional markets and involving inflexible projects. Though the peculiarities of the oil and gas industry still makes project financing within the sector inherently high risk, lenders can reduce the risk by careful analysis, 1 Nevitt, P.K. and F.J. Fabozzi, Project Financing (London: Euromoney Books, 2000) 2 Milbank, et al., Project Finance: The Guide to Financing International Oil and Gas Projects, 1 (England: Euromoney Publications PLC, 1996) 3 International Trade Statistics 2003, (Last visited 16/04/04) 1

3 skilful structuring and an overall risk management strategy, and this is where the use of derivative instruments comes into play. Derivative instruments can be defined as instruments whose values depend on, and are derived from the value of an underlying asset, reference rate or index and they exist as both exchange-traded and privately traded contracts 4. The use of derivatives is increasing at a rapid pace; this is evident from the exploding derivatives market and from various surveys 5 on derivatives which holds that well-run corporations and financial institutions are constantly using derivatives, as informed professionals understand the critical role that derivatives can play in re-apportioning and reducing risk for companies doing business across international borders and expanding within the global economy. Thus derivatives use is driven by two motivations - Risk management, and Speculation. This paper focuses on the first stated motive behind the use of derivatives. The paper is structured into four parts; Chapter 2 analysis risk management in oil and gas project finance, firstly by giving hindsight into the structure of oil and project finance, and then reviews the risks which can affect the viability of projects, with emphasis on market and financial risks. Chapter 3 then goes ahead to discuss how derivatives in its different structures can be applied to reduce the identified market and financial risks. Chapter 4 makes concluding statements and presents suggestions to enhance the effective use of derivatives. In carrying out this research, a major limiting factor has been the time constraint, coupled with the fact that it was not possible to get primary information from oil and gas companies, thus secondary information have been relied on. Nevertheless, effort has been made to prepare an objective paper within the prevailing constraints. 4 Chance, D.M., An Introduction to Derivatives and Risk Management, 31(Orlando: Harcourt College Publishers, 2001) 5 Horng, Y. and P. Wei, An Empirical Study of Derivatives Use in the REIT Industry, Real Estate Economics, Vol. 27 (1999) 2

4 2. RISK MANAGEMENT IN PROJECT FINANCE Risk can be said to be a situation where the future outcome is not known with certainty, but where the various possible outcomes can be predicted from knowledge of past or existing events 6. The outcome referred to is in regard to cost, loss, or damage. The process of assessing and modifying on a continuous basis the many trade-offs between risk and reward is known as Risk Management 7 No business activity is without risk, thus one of the key criteria in embarking on a project is to identify the principal risks to which it is exposed and to manage those risks. An essential element of this aspect of management is the understanding of the level of risk the stakeholders in the project are prepared to bear. Normally the lenders to a project (which are principally banks) are risk-adverse. As a rule of thumb, banks will not accept risks which are unable to be subjected to proper assessment or analysis or which are conceivably open-ended in their effect 8. Thus banks demand predictability. Before delving into the realms of risk assessment and management, the structural aspects of oil and gas project finance will be examined STRUCTURE OF AN OIL AND GAS PROJECT FINANCE A fairly standard approach to structuring a project s financing in the oil and gas industry is for the sponsors to establish a single purpose vehicle company. The vehicle company in relative terms often have a small capitalization as compared to the financial needs of the project. Funding of the project is then routed through the vehicle company. Traditionally, information of such financing will not appear on the sponsors balance sheet, i.e. they are classified as off-balance sheet items. If it does, it is only as a footnoted contingent liability. Similarly, the assets acquired in the course of carrying out the project appear on the financial statements of the vehicle company 6 Helliar, C., Risk, Derivatives and Management Control, (Unpublished PH.D Thesis submitted to the CEPLMP, University of Dundee, 1999). 7 Gastineau, G.L. et al., Risk Management, Derivatives, and Financial Analysis Under SFAS No. 133, (Virginia: Blackwell Publishers, 2001) 8 Vinter, G., Project Finance: A legal Guide, 95-96, (London: Sweet & Maxwell, 2 nd ed. 1998) 3

5 alone. From the above it can be rightly inferred that one purpose of project finance is to minimize the sponsors exposure to risk and thus help to preserve its own credit standing and future access to financial markets. Single purpose vehicle companies may take a variety of forms; this is primarily based on the sponsors. If the project involves multiple sponsors (such as Exxon, Shell, BP), a separate corporate entity, partnership construction trust, or a contractual joint venture may be created. Smith 9 in his analysis suggests that the presence of multiple sponsors may be necessitated by the following reasons: The oil or gas resource is jointly owned The government of the country where the project is located mandates joint venture with local interests. The size of the project is massive that it yields greater economies of scale than several smaller units The capabilities of the sponsors are complementary The project obviously exceeds the technical, human, or financial resources of a single company There is a clear need for risk sharing Subsequent to the establishment of the vehicle company, the financing of the project is designed to cater for the totality of the envisaged risks involved. This paper looks primarily at the market and financial risk, which affects the viability of a project MARKET AND FINANCIAL RISK EVALUATION. In concise terms, market risk refers to issues surrounding the existence of the consumers or buyers of the product of the project as well as fluctuations in price of the product. While financial risk refers to the occurrence of losses from movements in interest rates and exchange rates 10. Market risk evaluation requires the assessment that the demand for the project s products or services will be adequate to generate the revenue needed to cover the 9 Smith, R.C. and I. Walter, Global Banking, 61 (New Yo rk: Oxford University Press, 1997) 10 See supra note 6, p. 16 4

6 project s operating costs and debt service requirements, as well as a fair return to the sponsors. Considerations here will include: the existence of a local, regional or international market; commercial accessibility to markets; envisaged competition from a similar existing or proposed project 11. Financial risk evaluation on the other hand, entails an assessment of the potential impact on the viability of the project of financial developments outside the immediate control of the project sponsors or lenders, such as: volatility in interest and exchange rates; fluctuations in commodity prices (in relation to the projects supplies and raw materials); rate of inflation. An occurrence of all or some of the above stated market or financial risks could have a crippling effect on the viability of a project, thus a critical assessment and management of these risks is imperative COMPLEXITIES IN RISK MANAGEMENT Risk management problems are often complex; a good reason for this is that the market and financial risks faced by oil and gas project companies often has a long horizon. Also the location of the project is resource specific. For example a U.S. sponsor company may consider undertaking an oil or gas project in the North Sea and arranging the financing in pound sterling over the ten years it will require completing the project. Such a transaction involves long-term interest rate risk and foreign exchange risk, which might prove difficult to manage. Managing the market and financial risks associated with oil and gas projects would definitely require an assortment of financial derivatives instruments. 3. DERIVATIVES AND RISK MANAGEMENT Since the price shocks of the 1970 s, oil markets have passed through a great deal of unease 12, prompting structural changes in the industry. The traditional approach to counteracting risk has been through such methods as sheer size, diversification, and 11 Clifford Chance, Project Finance, 43 (London: IFR Publishing Ltd, 1991) 12 Majed, G.R.I., A Survey of Financial Derivatives Utilised Within the Petroleum Industry, OPEC Review 20(1) (1996) 5

7 vertical integration of the upstream production and downstream refining assets. Finnerty 13 argued that the increase in market volatility and the frequency of tax and regulatory changes stimulated financial innovation and had led companies to try to lessen the financial constraints that they faced. In our own context, project sponsors and lenders can maximize their efficacy despite the number of constraints imposed by markets, governments and themselves, through financial innovation. Derivatives being at the forefront of financial innovation have been used successfully in project financing to control costs of funding, prices of output or values of currency. As Nevitt and Fabozzi 14 highlight, the ability to control project risk using derivatives have transformed hitherto marginal or unprofitable projects to highly profitable concerns. In the same vain, projects have been able to achieve lower funding costs from commercial lenders due to risk reduction arising from the proficient use of derivatives Structures of Derivatives Transactions In essence, derivatives transactions are bilateral contracts. As earlier defined, they are payment exchange agreement whose value depends on or derives from the performance of an underlying asset, reference rate or index. Derivatives transactions cover a wide range of underlying constituents 15, ranging from interest rates, exchange rates, commodities, equities and other indices. They can be either, standardised and traded on exchanges, or custom-made and sold over the counter (OTC) 16 by dealers or financial intermediaries. Over time so many derivatives have been created, but basically, they can be classified 17 into two major groups: forwards-based derivatives and options-based derivatives. 13 Finnerty, J.D., Financial Engineering in Corporate Finance: An Overview, 14-33, Financial Management, (Winter, 1988) 14 See supra note 1, p Stout, L.A., Insurance or Gambling? Derivatives Trading in a World of Risk and Uncertainty, 38 Brookings Review 14(1), (Winter, 1996) Reynolds, B., Understanding Derivatives, 9 (London: Pitman Publishing, 1995) 17 ibid 6

8 Forwards-based derivatives There are three main types of forwards: Forwards contracts Futures contracts Swaps A forward contract can be said to be the simplest form of derivatives. It is an agreement between two parties, which obligates one to buy and the other to sell some commodity at a specified later date and at a price established at the time of contracting 18. Forwards contracts are mainly OTC products. Thus, each party to the forwards contract bears the risk that the other party defaults on future commitments. This explains why futures contracts are often preferred to forward contracts. Futures contract on the other hand, is a forward contract traded on an organized exchange with contract terms clearly specified by the rules of the exchange 19. The principal difference between futures and forward contracts lies in the fact that futures are traded in exchanges, in which a clearing house interposes itself between buyer and seller and guarantees all futures transactions, while forwards are OTC products. The 3 major futures exchanges are the New York Mercantile Exchange (NYMEX), the International Petroleum Exchange (IPE) and the Singapore International Monetary Exchange (SYMEX) 20 A swap as the name suggests, is an agreement between two parties to exchange one stream of cash flows for another stream of cash flows over a period in the future 21. The cash flows can be fixed at outset or calculated by factors in the performance of the underlying product. Swaps are can be classified under the following headings 22 : interest rate; currency; commodity; and equity swaps. Options-based derivatives 18 Kolb, R.W., Financial Derivatives, 2 (Florida: Kolb Publishing Company, 1993) 19 ibid, p See supra note See supra note 4, p Hull, J.C., Options, Futures, and Other derivatives, (New Jersey: Prentice-Hall International, Inc. 1997) 7

9 An option simply stated is the right to buy or sell, for a limited time, a particular good at a specified price 23. Thus the option contract provides one party (the option holder) with a right but not an obligation, to buy or sell an underlying product at an agreed price on or before a set date to a counter party. While the counter party (the option writer) is obligated to sell or buy the underlying product if the holder exercises the right. A value is therefore attached to the option, which is called the option price or option premium 24. From the foregoing, it can be rightly deduced that the option-based contract is one-sided, i.e. if the right is exercised, it follows that the holder has a favourable outcome and the writer can have only an unfavourable outcome and vice versa. Although there are several other varieties 25 combinations of the above two classes. of derivatives, they are variants or 3.2. USES OF DERIVATIVES INSTRUMENTS IN MARKET AND FINANCIAL RISK MANAGEMENT RISKS ASSOCIATED WITH PRICE FLUCTUATIONS AND VOLATILITY OF EARNING: In an oil and gas project financing, lenders and sponsors rely on revenue from the project to meet operating costs expenditures, debt service and returns on investment. The project loan will typically be made on the projects output (commodity) price projections. Thus there is an inherent exposure to market risks here arising from price fluctuations due to economic factors outside the control of the lenders and sponsors. This may have adverse effect on the earnings of the project. The use of petroleum futures contracts traded in the futures exchanges can reduce this risk to a minimum. For example, at any one time, petroleum futures such as crude oil futures are available for up to 12 and 36 future delivery months on the IPE and the NYMEX respectively, 26 with the associated advantages, which include a high degree of liquidity, low transaction costs and low default risk, the exposures to market risks can be greatly reduced. 23 Kolb, R.W., Financial Derivatives, 5 (Florida: Kolb Publishing Company, 1993) 24 Briys, E. et al., Options, Futures and Exotic Derivatives: Theory, Application and Practice, 9-20 (Chichester: John Wiley & Sons Ltd, 1998) 25 Bernstein, P. et al., The Question of Derivatives, 55, Journal of Accountancy 179(3) (1995) 26 See supra note 12 8

10 Oil or gas swaps can also be used to package and transfer the oil or gas price risk from the project company (the seller) to a financial intermediary. No physical oil is actually exchanged, but the project company is actually guaranteed a fixed price for a predetermined volume of oil by means of the contract papers. This in effects insulates the project company from adverse market risks. When the physical oil market moves against the project company, it receives a payment that in effect provides it with the agreed fixed price, in the same vain, if the physical market moves in favour of the project company, the gain is passed on to the financial intermediary, therefore preserving the fixed price level. The pair of offsetting financial transactions between the project company (the seller) and the financial intermediary is the essence of a swap. In effect, a fixed price is exchanged (swapped) for a floating market price. Swaps can even be used to collateralise a project loan in the first place, thereby helping sponsors to convince a bank to value existing reserves at a higher level for purposes of financing. This in effect could even give sponsors an advantage over competitors in developing new oil reserves. In some cases, 27 the project company might be required to execute a swap in order to receive a loan; otherwise the bank might have to do a swap to hedge its own loan exposure. The use of oil or gas options will provide the project company with the protection needed, and leave it with the full benefits associated with a favourable development of the commodity price. Risks associated with movements in foreign exchange rate Oil and gas projects produce revenues in one currency (usually in U.S. Dollars), but might be financed by obligations payable in another currency (e.g. Sterling), this automatically gives rise to currency risk. Thus any significant devaluation in the revenue currency as a result of movements in exchange rate, will impair the project s ability to repay its lenders, unless there is a corresponding increase in revenues as a result of price increases. 27 Razavi, H., Financing Energy Projects in Emerging Economies, (Oklahoma: Penn Well Publishing Company, 1996) 9

11 Derivative instruments can be used to reduce the foreign exchange risk that the project company faces. Using an illustration; suppose the project company is due to pay 1 million to one of its British lender banks in 90 days, the cost in U.S. dollars of making the payment depends on the sterling exchange in 90 days. Say the 90-day forward rate for /$ is , the company can choose to hedge by entering into a long forward contract to buy 1 million in 90 days for $1.7 million. This in effect locks in the exchange rate for the sterling it requires. If the exchange rate rises to , the company is better off by $100, plus the extra charges associated with a default on loan repayment, if it hedges. On the other hand if the exchange rate falls to , hedging makes the company worse off by $100,000. This illustration shows that the purpose of hedging is to make the outcome more certain, it does not necessarily improve the outcome. To further illustrate the point, suppose the project company expects to receive $1.7 million in 3 months from sales, going into the foreign exchange forward contract at the rate of /$ ensures that the company can meet its loan obligation of paying 1 million even if the ruling rate at the day of payment has increased to /$ But if the ruling rate decreases to , the company will still be bound by the forward contract it has entered at the rate of , thus losing a $100,000 since it will still purchase the required 1 million for $1.7 million. By trading in the foreign exchange forwards market as illustrated, the project company has effectively established a rate for its currency. Thus the company has used the forwards market to reduce the risk associated with adverse fluctuations in foreign exchange rate. As an alternative, the project company can buy a call option to acquire 1 million at a certain rate say , in 90 days. If the actual exchange rate in 90 days turns out to be or above, the company exercises the option to buy the sterling it requires, but if the actual exchange rate turns out to be below , the company buys the sterling in the open market (and discards the option since they are now worthless). Thus, option trading in effect also enables the company to insure itself against adverse rate movements while benefiting from favourable movements. 28 1,000,000 * = $1,800,000. (Therefore $1,800,000 - $1,700,000 = $100,000) 10

12 Interest rate Exposures Derivatives can also be used in mitigating interest rate risks. Financing issues such as locking in favourable financing rate opportunities, and ensuring positive returns on investments can be efficiently managed using interest rate swaps. Interest payments can be exchanged between two parties in order to achieve changes in the calculation of interest on the principal, for example from floating (i.e. variable) to a fixed rate of interest. Thus the project company can borrow from its bank at a floating rate 29 and then swap this into fixed rate with a swaps dealer. Depending on the movements in interest rates, the project company may gain at the expense of the dealer or vice versa. But one sure thing is that the project company at any point in time during the contract will not payout more than the fixed rate. To illustrate, suppose the project company takes out a loan with its bank in which it pays an interest of LIBOR plus 200 bps 30 on the principal. If the company expects rising interest rates, it means the cost of its loan will go up. If this happens, the project company may enter into a pay-fixed, receivefloating swap contract with a dealer. If the floating rate agreed with the dealer is also LIBOR plus 200 bps, and the fixed rate is F, the scenario will be as follows: Project company will pay LIBOR bps on loan Project company will receive LIBOR bps on swap from dealer Project company will pay F on swap to dealer Net payment = F Note that in the in the interest rate swap contract, no principal payments are made, just the net interest owed will be paid by the party owing. Other derivatives instruments can be employed to reduce the risks associated with interest rate fluctuations. Some of them combine elements of different derivatives instruments, these are called hybrids Floating rate is susceptible to rising interest rate 30 bps means basis point, and one basis point is one-hundredth of a percent, so 100 basis point is 1 percent, thus 200 bps is 2 percent. 31 See supra note 4, at

13 4. CONCLUSION Derivatives could be complex, and they have quite often been criticized 32 for having been the source of large losses by some corporations. But are the instruments really at fault? Chance 33 answers this with the aid of another question: is electricity at fault when someone with little knowledge mishandles it? Derivatives are powerful instruments with a high degree of leverage, thus large gains or losses can result from small price changes. Thus an effective use demands the following: Having the requisite knowledge of its structure and applicability The reason for using it should be properly understood; there could be a high appeal to use it for speculation (not covered in this paper) instead of for hedging, and this could be very dangerous. The appropriate type of derivative should be selected for different situations. If the above demands are met then based on the analysis carried out in the previous section, the question What do Derivative Instruments Offer By Way Of Risk Management in Oil and Gas Project Financing? can be answered as follows: Derivatives instruments reduces the risk associated with price fluctuations and volatility of earnings, movements in foreign exchange rate, and Interest rate Exposures, to the least minimum. Derivatives are not an end in themselves. Rather, they are merely a category of tools, though a very efficient set of tools available for risk management in oil and gas project financing. 32 EIU, Strategic Derivatives: Corporate Practices for Today s Global Market Place, (London: The Economist Intelligence Unit Limited, 1995) 33 See supra note 4, p19 12

14 BIBLIOGRAPHY SECONDARY SOURCES Books Briys, E. et al., Options, Futures and Exotic Derivatives: Theory, Application and Practice, (Chichester: John Wiley & Sons Ltd, 1998) Chance, D.M., An Introduction to Derivatives and Risk Management, Orlando: Harcourt College Publishers, 5 th ed. 2001) Clifford Chance, Project Finance, (London: IFR Publishing Ltd, 1991) EIU, Strategic Derivatives: Corporate Practices for Today s Global Market Place, (London: The Economist Intelligence Unit Limited, 1995) Gastineau, G.L. et al., Risk Management, Derivatives, and Financial Analysis Under SFAS No. 133, (Virginia: Blackwell Publishers, 2001) Hull, J.C., Options, Futures, and Other derivatives, (New Jersey: Prentice-Hall International, Inc. 1997) Kolb, R.W., Financial Derivatives, (Florida: Kolb Publishing Company, 1993) Milbank, et al., Project Finance: The Guide to Financing International Oil and Gas Projects, (England: Euromoney Publications PLC, 1996) Nevitt, P.K. and F.J. Fabozzi, Project Financing, (London: Euromoney Books, 2000) Razavi, H., Financing Energy Projects in Emerging Economies, (Oklahoma: Penn Well Publishing Company, 1996) 13

15 Reynolds, B., Understanding Derivatives, (London: Pitman Publishing, 1995) Smith, R.C. and I. Walter, Global Banking, (New York: Oxford University Press, 1997) Articles Bernstein, P. et al., The Question of Derivatives, Journal of Accountancy 179(3), (1995) Finnerty, J.D., Financial Engineering in Corporate Finance: An Overview, Financial Management, (Winter, 1988) Helliar, C., Risk, Derivatives and Management Control (Unpublished PH.D Thesis submitted to the CEPLMP, University of Dundee, 1999). Horng, Y. and P. Wei, An Empirical Study of Derivatives Use in the REIT Industry, Real Estate Economics, Vol. 27 (1999) Majed, G.R.I., A Survey of Financial Derivatives Utilised Within the Petroleum Industry, OPEC Review 20(1) (1996) Stout, L.A., Insurance or Gambling? Derivatives Trading in a World of Risk and Uncertainty, Brookings Review 14(1), (Winter, 1996) OTHER SOURCES Internet International Trade Statistics 2003, (Last visited 16/04/04) 14