This Paper is an attempt to provide both a general overview of issues that arise in Oil and Gas Financing as well as the creation, perfection and enforcement of security for Oil and Gas Project Financing.
Through a wide-angle lens, Oil and Gas lending is not very different from "hotel lending." A package of oil and gas producing properties and a chain of hotels both include significant real estate assets and virtually every category of personal property recognized by the U.C.C. (Uniform Commercial Contract). All of these asset categories must be addressed in the collateral documents.
Note however, that there are issues that arise in oil and gas lending which are absolutely unique to this area. Most of the unique issues are the product of state law idiosyncrasies we shall therefore limit our paper to identifying the areas where these issues arise rather than in providing a compendium of answers.
Generally, Lien and Security Interest provisions have taken on an increased significance due to recent downturns in the Oil and Gas Industry and the resulting frequency of bankruptcy and financial difficulty among Oil and Gas companies.
The Purpose of this Paper therefore, is to examine the precautions parties can take to preserve lien and security interest right and ensure that their rights will be given the highest possible priority in the event a party to an agreement becomes insolvent or fails to meet his obligations under an Operating Agreement.
See generally: Annot, The Operator's Lien, 12(2) Tex. St. B. Sec. Rep., Oil Gas & Min. L. Rep. (July 1986); Bradford, The Ownership of Pre-Petition Oil Runs in Bankruptcy: Using the Texas and Oklahoma Constructive Trust Laws to Gain Priority in Payout, 38 Okla. L. Rev. 483 (1985); Grinstead, Protecting the Oil Field Creditor, 56 Okla. Bar J. 1203 (1985); Noblin, The Effect of Bankruptcy and Encumbrances on Mineral Interests in Mississippi, 53 Miss. L.J. 551 (1983); Ray, Oil and Gas Bankruptcy; A Preventive Approach, Inside Management, June 1986, at 55.
OVERVIEW OF OIL AND GAS FINANCING:
Structured financing techniques in oil-and-gas finance have grown more popular over the past several decades. Large-scale oil and gas projects have been popular subjects for project financing since the inception of the market.
Securitization, in particular, has played an important role in project finance by increasing oil and gas sponsors' access to affordable financing from the capital markets and helping banks refinance their project loan exposures. As a consequence of the current credit crisis, structured project financing methods are even more important than in the past. Without the potential benefits of structured financing, oil and gas project lending in the current credit-and capital constrained environment could contract precipitously.
Project finance is the extension of credit against the future cash flows of a project as collateral. More specifically, Standard and Poor's (S&P) defines a project finance transaction as "a cross between a structured, asset-backed financing and a corporate financing ... typically characterized as non-recourse financing of a single asset or portfolio of assets where the lenders can look only to those specific assets to generate the flow needed to service its fixed obligations, chief of which are interest payments and repayments of principal."
In a typical project, the sponsor-working with its bankers, financial advisers, and legal advisers, sets up a Special Purpose Entity (SPE) to house the assets and liabilities of the project. Even if the SPE is a subsidiary of the project sponsor(s), the project SPE is typically a ring-fenced, bankruptcy remote entity.
In the Oil and Gas industry, project sponsors include integrated oil and gas companies (both corporate. and state-owned), Exploration and Production (E&P) firms, Oil and Gas reserve owners, midstream and midmarket oil and gas distributors and processors, refineries, municipalities, and other end users. A typical oil and gas project is subject to financial and nonfinancial risks alike. The nature of these risks to which the project's participants are subject however vary.
Typical examples of projects in the Oil and Gas market include oil and gas exploration projects, drilling platforms and fields, refineries, and distribution networks (e.g., pipelines and storage).
Providers of Oil & Gas Project Financing Most of the private sector funds for large-scale projects come from three principal sources: the project equity investor(s); bank lenders; and bond holders. In addition, government-sponsored enterprises and various multilateral agencies also provide project financing, especially in infrastructure-related finance in developing countries.
Equity:The equity investors in a project are its residual claimants. Equity usually provides about 30 percent of the total financing for a project and might sometimes be held entirely by the project sponsor. If any of the project's assets already exist at the time the project is initiated, the sponsor can convey those assets to the project SPE.
In addition, the sponsor can make further investments in the project SPE to help fund the working capital layer.
In some cases, project sponsors are unwilling or unable to own enough common equity in the project SPE to satisfy lenders' leverage ratio requirements. In such situations, the project SPE might issue additional equity to outside investors. Such equity offerings often take the form of preferred equity that entitles the holder to a priority for dividends (some or all of which the sponsor may guarantee) and possibly other corporate governance rights (e.g., management participation if preferred dividends are in arrears).
Commercial Bank Lenders:Commercial banks are the largest providers of funds for large-scale, capital-intensive projects, often accounting for as much as 50 percent of the overall project funds and up to 100 percent during pre-completion. Project loans from banks generally take the form of senior loans, both secured and unsecured. Senior secured project loans generally give banks a security interest in the core assets of the project. Typical forms of collateral pledged to creditors in senior secured oil and gas project loans include the following: real estate; mineral and drilling rights; lease rights; licenses, permits, and concessions; and related equipment. In some cases, as we discuss later, collateral also includes a security interest in collections from the sale of related oil and gas.
Unsecured project loans are backed by the general credit of the project SPE and not by a lien or security interest. Nevertheless, by virtue of the ring-fencing of the project itself, senior unsecured project loans are still de facto secured by the project itself. Senior unsecured bank creditors thus are exposed to a much better-defined universe of credit risks in a project financing than in a more traditional unsecured loan to a corporation for general corporate purposes. Some sponsors (e.g., sovereigns) with outstanding debt that is entitled to a negative pledge provision will prefer such senior unsecured project financing because it avoids such negative pledge provisions.
526 ENERGY AND ENVIRONMENTAL PROJECT FINANCE LAW AND TAXATION
For a discussion of the use of derivatives in project finance, see Chapter 18. 6 /d. STRUCTURED FINANCING TECHNIQUES IN OIL AND GAS PROJECT FINANCE
Commercial bank project loans usually have maturities of five to ten years at most. Interest is generally floating based on the London Interbank Offered Rate (LIBOR). Most such loans, moreover, are syndicated. The syndicated loan package usually includes term loans, revolvers, and possibly bridge loan facilities designed to help facilitate subsequent bond financings that follow after completion (because bond holders are less comfortable with construction and other pre-completion risks).
3. Investors in Debt Securities: Debt securities issued by an SPE include short-term commercial paper, medium-term notes, and bonds. Bonds typically associated with oil and gas project financings include fixed-and floating-rate debt, convertibles, Eurobonds, and structured finance issues such as collateralized debt obligation (CDO) notes. Investors in project bonds include pension plans, insurance companies, hedge funds, finance companies, and other asset managers.
Project financing bonds may be taxable issues or tax-exempt securities. Certain types of municipal securities and industrial revenue bonds, for example, are often issued to raise project financing on a tax-exempt basis.
4. Multilateral Agencies: Especially for quasi-public Oil and Gas projects, one or more Multilateral Agencies (MLAs) often play an important role in helping complete a project and/or facilitating its ongoing operations. The World Bank, for example, often takes an active role in the pre-completion phases of energy-related projects in the developing world. MLAs also play an important role in projects by either guaranteeing a certain amount of purchases of output produced by the project (either by agreeing to be a project off-taker directly, or helping arrange and secure off-take agreements by providing guaranties and subsidies to actual off-takers). In addition, many MLAs will provide political risk insurance to protect a project participant against the risks of capital controls, expropriation, or other adverse and unexpected political events.
MLAs are also often involved in project financing, especially for projects in developing countries. In addition to providing direct extensions of project credit, MLAs often assist project borrowers by providing credit enhancements or guaranties that enable the project SPE to increase the amount of its total borrowing and/or decrease its cost of debt capital. MLAs often associated with Oil and Gas projects include the World Bank, International Finance Corporation (IFC), Regional Development Banks, Export-Import Banks, and other Export Credit Agencies (ECAs).
ENERGY AND ENVIRONMENTAL PROJECT FINANCE LAW AND TAXATION
STRUCTURED FINANCE IN PROJECT FINANCE
OIL AND GAS FINANCING – THE NIGERIAN PERSPECTIVE:
Marginal Fields development is an offshoot of Federal Government policy to kick start indigenous participation in the Upstream Sector of the Petroleum industry. The government sought to achieve this objective by ensuring the farm out of marginal fields within the concessions of the major multinational Oil operators to the indigenous operators.
Despite this laudable policy of the Federal Government, the success of the indigenous players’ incursion into the upstream sector could be said to be very ‘marginal’ as not many have made appreciable progress with their farmed-out concessions. Why? The financial demands of oil exploration and production are extremely high and the funding capacity of the indigenous marginal field owner is the reverse –very low.
Given the above, financing marginal fields through foreign investments has become an attractive option for the indigenous companies. However, the perceived high risk factors associated with marginal field investments in Nigeria has caused potential foreign investors to seek legal structures that provide some assurances on the security of their investments.
There is a reported huge reservoir of Marginal Oil Fields in Nigeria conservatively estimated to contain over 2.3 billion barrels of Stock Tank Oil Initially In Place (STOIP) strewn over 183 Marginal Fields. However, no fixed rules have been laid down for a universal definition of the term Marginal Field. This is due to the simple reason that technical, strategic and economic factors guide the categorization of an Oil Field as being marginal. The basis of consideration is seemingly subjective depending on the interest of the party.
The Petroleum (Amendment) Decree No 23 of 1996, upon which plank the Marginal Oilfield became a policy of Government, introduced paragraph 16A to the 1st schedule to the Petroleum Act. It provides that the holder of an Oil Mining Lease may with the consent of the Head of State farm-out any oil field within its leased area or the Head of State may cause the farm-out of a marginal field that has been left unattended for a period of not less than 10 years from the date of first discovery.
In addition, the Office of the Presidential Adviser on Petroleum and Energy in July 2001 released the Guidelines for Farm-out and Operation of Marginal Fields which constitute the protocol for the government regulator, farmors and farmees in marginal fields operations. The 2001 Guidelines made tacit attempt in streamlining the definition of a Marginal field given the omnibus provision of the Decree No 23 of 1996. It made more lucid the specific characteristics of a marginal field and therefore dousing fears of an apparent expropriation powers given to the Head of State to cause farm-out of any oilfield within the concession of the major oil companies left unattended for 10 years.
Furthermore, the 2001 Guidelines made regulations on the nature of companies that can participate in the marginal fields. Unlike the 1996 Guidelines released by the DPR that permits 40% maximum foreign “equity” participation, the 2001 Guidelines does not provide a ceiling on the extent of foreign investors’ participation. Instead the farmee company is required to be “substantially Nigerian” and registered solely for exploration and production.
What is substantially Nigerian? This is a matter of conjecture. In practice however the operators (Directorate of Petroleum Resources and the farmee’s) have used the 40% rule as the benchmark for determining the question of what is substantially Nigerian. It would therefore be safe for purpose of this article to assume the state of affairs to be that a foreign investor should not own more than 40% equity participation in the company. What then are the options that are readily available for the securitization of foreign investments in marginal fields? There are a myriad of options of which I will discuss three possibilities.
EQUITY PLUS PARTICIPATION OPTION:
Typically a foreign investor may be called upon to finance more than 40% of the production cost in the marginal field developments. This is not an implausible position given that with the right technology and best practices, an average operating cost per barrel is $12. In such a situation, it becomes an issue how such an investor can be restricted to less equity participation than the expected investment.
Humphrey Onyeukwu - email@example.com
Centre for Energy, Petroleum, Mineral Law and Policy, University of Dundee
The equity plus option is therefore a mode of operation that allows the foreign investor inject more than 40% of the project cost and in return gets the minimum 40% participation PLUS other compensations. The plus variables may differ from deal to deal and may include board positions in the company reflective of the level of investment. Remember that it is perfectly legal for a company to grant “minority” equity holders with other ancillary stakes more seats on the board. Management agreements in favour of the foreign investor and other control modes can also be entrenched as the pluses that make the 40% equity interest mere foundational. How will profit be shared? This will be left for the company to determine. Obviously the basic rules of return on investment are applicable using other payment modes not specifically headed as dividends. And even if dividends are lopsided it is a corporate decision not subject to scrutiny.
SPECIAL PURPOSE VEHICLES OPTION:
Another veritable means for securitization of foreign investments is creating a Special Purpose Vehicle under a Partnering and Alliance arrangement. The Partnering arrangement would afford an unincorporated Joint Venture agreement between the Host Indigenous Company and the foreign investor using a Special Purpose Vehicle (SPV).
Humphrey Onyeukwu - firstname.lastname@example.org
Centre for Energy, Petroleum, Mineral Law and Policy, University of Dundee
The Special Purpose Vehicle would be an agent of the joint venture parties and will be delegated the rights and obligations of the farmee under the Farm-out Agreement. In this way, the SPV has de facto managerial control of the marginal field operations to the extent that impacts directly on the marginal field operations. Also, a production sharing arrangement may be structured into the joint venture agreement whereby the funding and production cost borne by the foreign investors is amortized through an irrevocable assignment of cost oil for a specified period of time.
CRUDE OFF-TAKE AND SALES AGREEMENT:
The Crude Oil Off-take and Sales Agreement can also be used as an instrument for securing foreign investments in Marginal Field operations. The agreement could provide for an irrevocable assignment of crude to the foreign investor or his assigns as the sole buyer, reserving him the rights of pre-emption. This agreement would be drawn to take into cognisance the level of investments of the foreign investor and the fluctuating price of crude in the world spot markets. It should be noted that the insertion of renegotiation clauses in such Agreements should mitigate potential hardship suffered from force majeure due to the peculiarities of the volatile Niger Delta region.
The bid to attract foreign investors for Marginal Fields in Nigeria would be given greater impetus by creative solicitors who seek to find options or hybrids of several options that make the parties comfortable to proceed.
Humphrey Onyeukwu - email@example.com
Centre for Energy, Petroleum, Mineral Law and Policy, University of Dundee.
SECURITY IN OIL AND GAS FINANCING: UNRECORDED LIENS AND SECURITY INTERESTS:
Joint development of Oil and Gas Properties has become a commonplace means of risk reduction among oil and gas companies. Operating Agreements set out the obligations of the parties to share the expense of exploration, drilling, and production, and the rights of the parties to share in the benefits of the operation. Remedies--methods for recovering expenses in the event a party to the agreement defaults--are also included in the Operating Agreement.
The American Association of Petroleum Landmen Form 610-1982 Model Form, Operating Agreement (A.A.P.L. 610-1982 Operating Agreement)1 grants to the Operator designated therein, a lien and security interest in specified property of the Non-Operators, to secure payment of the Non-Operators' proportionate share of expense.2 A like lien and security interest in the property of the Operator is granted to Non-Operators to secure payment of the Operator's share of expense.3 This lien and security interest gives the parties to the Operating Agreement a right to sell the property of a defaulting party in order to obtain money for the payment of expenses. As discussed below, this sale may occur under the supervision of the court or non-judicially, depending upon the terms of the contract and the extent to which state law will allow non-judicial foreclosure.4 1/ American Association of Petroleum Landmen (A.A.P.L.) Form 610-1982 Model Form Operating Agreement is the form most commonly used in the industry for structuring joint operations of property for oil and gas.
2/ A.A.P.L. Form 610-1982 at art. VIIB.
4/ See infra text accompanying notes 103-107.
In addition to the A.A.P.L. 610-1982 Operating Agreement, parties may enter into API Unit Operating Agreements, Federal Unit Operating Agreements, and Offshore Operating Agreements, which agreements also provide for the granting of liens and security interests. These operating agreements generally do not provide that the Operator grants a lien and a security interest to the Non-Operators. The granting of such mutual liens and security interests so that every party, Operator and Non-Operator alike, is secured can be accomplished by amending the Operating Agreement or by a separate document.
The Problem with Unrecorded Liens and Security Interests:
In the past, it has not been customary in the oil and gas industry for Operators to record liens and security interests arising under the Operating Agreement.5 Recently, however, a slumping economy, falling oil prices, and governmental regulation have caused an increasing number of bankruptcies and an increasing incidence of delayed payment or non-payment of expenses by parties to Operating Agreements. Excessive borrowing and easy credit have come to haunt even the most effectively managed companies. Financial strain, and the nature of debtor/creditor laws in the U.S. have rendered unrecorded lien and security interest rights, less valuable than they may have been in the past.
5/ On rare occasions, Operators have filed the Operating Agreement of record.
Generally, persons with like interests in the property of a debtor stand an equal chance of recovering a judgment in their favour. However, procedures exist by which creditors can give their interests priority over the interests of other creditors. For example, an unrecorded security interest is subordinate to the interests of creditors who have taken steps to perfect their interests.6 In addition, under Real Property Laws, the holder of an unrecorded lien will lose his lien if the debtor transfers his property to a purchaser for value who does not know there is a lien on the property.7 The Bankruptcy Code also reduces the value of a debtor's unrecorded liens and security interests. When the debtor files for bankruptcy, his property is transferred to the trustee in bankruptcy, who is considered a purchaser for value without notice of any unrecorded lien on the debtor's property.8 He can thereby avoid any unrecorded transfer of property and/or any encumbrance on property.9 Finally, the trustee is given the power to accept or reject, at his discretion, any executory contract between the debtor and another party, including any agreement for future assignment of an interest in the debtor's property.10 Thus, in the absence of recordation, the rules governing debtor and creditor relationships reduce the value of lien and security interest rights in proportion to the number of creditors with like claims on the property of the debtor.
6/ U.C.C. § 9-312(5) (1972). Mechanics' and Material-men's liens are created by the statutes of a number of states and in some states these statutes may protect a working interest owner who has expended monies on behalf of a debtor working interest owner. Some states explicitly provide for a statutory operator's lien. Derman, Joint Operating Agreement: Working Manual, Natural Resources Law Section Monograph Series No. 2, Pages 27-29 (1986); Haas and Wickes, Oil and Gas Liens, 31 Rocky Mtn. Min. L. Inst. 18.03, §18.04 (1986).
7/ See, e.g., Ca. Civ. Code Ann. § 1214 (West 1982).
8/ 11 U.S.C. § 544(a) (1982).
10/ 11 U.S.C. § 365(a) (1982).
It is essential that the oil and gas interest owner understand the means available to a creditor for protecting his rights and gaining the highest possible priority for his claims.
Recording security interests and liens may also give added force to demands for payment and may provide the necessary leverage for obtaining payment from a debtor who has not yet reached insolvency.