Investing In Canadian LNG Part 2 – Key Commercial, Legal And Risk Allocation Issues

As interest in Canada’s budding Liquefied Natural Gas (LNG) export industry grows, what are the key commercial and legal considerations raised by investing in Canadian LNG?

In Part 1 of our series, we looked at Canadian LNG from a global context and highlighted key features of Canadian LNG export projects relative to their international counterparts. In this Part 2, we discuss:

• LNG export project economic models, and
• LNG export project risks, risk allocation and due diligence.

Join us for Part 3 of our series, where we’ll discuss (1) LNG export project regulatory issues and due diligence, and (2) Indigenous partnerships and investment in Canadian LNG. Visit fasken.com and subscribe.

LNG Export Project Structures and Economic Models

There is no standard structure for an LNG export project. Choice of structure occurs on a project-by-project basis and depends on a variety of factors such as (1) the business model(s) of the project parties, (2) regional natural gas production, infrastructure and markets, and (3) financing considerations.

That said, over the more than six-decade evolution of the LNG industry, LNG export projects have generally come to adopt one of four project structures or “economic models”. Importantly, a project’s economic model will inform potential investment in the project and what legal and commercial issues are raised. We note:

• Integrated Model: The key feature of an integrated LNG export project is that the owner(s) of the export facility also own the associated natural gas reserves. The parties may also own any pipeline infrastructure joining the natural gas production with the export facility as well as infrastructure downstream of the facility (e.g., overseas regasification terminals). As such, the export facility generally operates less as a distinct profit centre and more as a component of a larger operational structure involving multiple affiliates and non-arm’s length arrangements. Stated differently, the purpose of a party’s participation in the export facility may not be revenues from operating the facility itself but securing feedstock for its overseas power generation (e.g., a foreign state-owned utility) or maximizing the value of its LNG sales (e.g., a vertically integrated global LNG company active across the LNG value chain from production and liquefaction to shipping and trading).
• Merchant Model: The owner(s) of a merchant model LNG export project do not have equity interests in the LNG value chain either upstream or downstream of the export facility. They purchase feedstock natural gas from unaffiliated upstream producers, liquefy it at the facility for their own account, and then sell the LNG to third parties. This can be done on either an FOB basis (where the buyer takes title to the LNG at the export facility) or on a DAP or DAT basis (where the seller is responsible for maritime transportation and delivery of the LNG to the buyer at an overseas receiving facility). The profitability of the project is determined by the difference between the price paid for the natural gas (and its transportation and liquefaction) and the price paid by the LNG buyer.
• Tolling Model: Similar to a merchant model project, in a tolling model LNG export project the facility owners are not involved in the LNG value chain either upstream or downstream of the LNG facility. Their participation in the LNG value chain is limited to providing liquefaction services at the facility in exchange for a fee and typically involving a “use or pay” component. Third parties supply the feedstock natural gas and take possession of LNG post-liquefaction, either for onward sales (e.g., an LNG marketing company) or for their own purposes (e.g., a foreign state-owned utility). The export facility operates as a distinct profit centre driven primarily by the terms of the tolling agreements between the facility owner(s) and their customers, and (unlike under a merchant model) the facility owner(s) need not enter into either natural gas purchase agreements or LNG offtake agreements with third parties.
• Hybrid Model: Hybrid LNG export projects can combine various elements of integrated, merchant and tolling models to accommodate the needs of different project parties in the circumstances. This may be necessary where the proponents include a variety of business interests such as SOEs, private energy companies and financial investors. One example is a hybrid merchant/tolling model where the export facility owner(s) provide a marketing service to LNG buyers whereby they source and take title to the feedstock natural gas before delivering the LNG in exchange for fixed monthly charges regardless of whether the buyer offtakes the LNG. Another example is an LNG offtaker taking an ownership stake in a merchant or tolling project. This allows the offtaker to diversify its risk exposure (e.g., where the cost of LNG has risen, this will be partially offset by the offtaker’s equity stake). A third example is that equity investments in LNG projects by purely financial players are becoming more common, including as this can greatly reduce the amount of project financing necessary.

LNG Export Project Risks, Risk Allocation and Due Diligence

As mentioned, an LNG export project’s economic model will inform potential investment in the project. It will also inform what legal and commercial issues such investment raises, including the risks to which the different project parties are exposed. These should be carefully diligenced in connection with the proposed investment and should in turn inform negotiation strategy and the ultimate terms of investment.

LNG export projects – like any significant infrastructure investment project – are subject to numerous material risks. Working along the LNG value chain from upstream to downstream, these can include (1) exploration and production risk, (2) unplanned interruptions to pipeline capacity, (3) unplanned interruption to liquefaction capacity, (4) unavailability of maritime carriers, and (5) unplanned interruption to regasification capacity. Commodity price risk will apply to both natural gas purchases and LNG sales. Less industry-specific risks will include credit risk, completion risk, and political risk.

The different economic models an LNG export project can adopt provide examples of these risks and associated risk mitigation strategies in practice:

• In an integrated model project, ownership of the associated natural gas helps insulate the project party(s) against commodity price risk and supply risk but exposes them to exploration and production risk. The project parties enjoy a measure of flexibility in that they may be able to adjust LNG production in response to changing market conditions, e.g., ramp down liquefaction to instead sell produced gas into regional markets.
• The owner(s) of a merchant model project are directly exposed to commodity price risk both upstream and downstream of the facility, as well as to counterparty risk on either side. The latter risk can – depending on regional markets – be mitigated on the upstream side by diversifying supply sources, e.g., through a mixture of long-term, short-term and spot contracts with multiple producers.
• The owners of a tolling model project face demand risk for their liquefaction services. To address this, customers will typically pay a fixed tolling fee to reserve capacity at the facility and then pay a variable usage fee based on the quantity of liquefaction services provided. The reservation fee allows the project to recover fixed costs, including debt repayment, as well as a return on capital. The usage fee allows for recovery of the costs associated with liquefaction.

Investment in an LNG export facility should come with a clear understanding of the allocation of the project’s various risks across the project parties and value chain. Such a holistic understanding will be particularly important to the project’s lenders (if any). Key to this exercise is identification of each material project risk and on which party(s) such risk falls. For example, in the case of an unplanned interruption to the export facility, it may be that a majority of risk is allocated to the facility operator, but that a portion of risk is also allocated to the facility’s LNG offtakers. Also key to this exercise will be ensuring that the interaction of the various contractual arrangements comprising the project’s value chain are as seamless as possible. An example is the cohesive interface of force majeure clauses such that no gaps or inconsistencies result.

It is theoretically possible for a group of partners in an LNG export facility to be fully aligned in interest, e.g., where each party has the same equity stake in each component of an integrated project. In practice, it is more likely that different project parties will be invested in different parts of the project’s value chain and have varying equity or contractual interests (e.g. where a natural gas supplier or LNG offtaker holds a minority equity interest in the export facility). This may in turn create material conflicting commercial interests depending on the circumstances. The potential for such tension should be anticipated from the inception of the negotiation of the project agreements, and may be particularly complex in the case of a hybrid model project.

LNG Export Project Structures and Risk Profiles Simplified and Compared

To facilitate the easy comparison of the different LNG project structures and risk profiles, we’ve prepared the following summary table.

Coming Soon: Regulatory Considerations and Indigenous Investment in Canadian LNG

Canadian LNG is heating up. Join us for Part 3 of our series, where we’ll discuss (1) LNG export project regulatory issues and due diligence, and (2) Indigenous partnerships and investment in Canadian LNG. Visit fasken.com and subscribe. Meet the members of our Energy and Project Development groups. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.