Financing gas storage projects

David Schumacher,McDermott Will & Emery LLP, Houston

Developers of natural gas storage projects planning to use debt financing to fund construction must be aware of key risks arising from the project's development and implement mitigation measures necessary to make the project financeable.

With domestic natural gas production increasing, gas storage capacity will continue to be important to the US natural gas market. Indeed, developers are looking to install additional gas storage capacity. FERC reported in April that 11 certificate applications are awaiting FERC approval. Other planned storage projects have been publicly announced.

In addition to issues such as the storage facility's location, its design and engineering, and its operational characteristics, the following are some of the material issues that could impact a project's financeability:

Regulatory risk

Governmental approvals are required for the construction and operation of a gas storage project. For gas storage projects providing interstate service, the primary governmental approval is a certificate of public convenience and necessity from FERC.

FERC's regulatory regime governing the construction and operation of gas storage facilities, and thus the criteria that a project sponsor must satisfy to obtain a FERC certificate, has become stable and fairly predictable. A FERC certificate is not, however, the only governmental approval that a project sponsor must obtain. A number of state and local permits also are required.

Management of the approval process is critical. The project sponsor is tasked with obtaining multiple approvals at the same time. Having personnel and advisors that understand each governmental agency's approval process is necessary to ensure that each approval is obtained in a timely and cost effective manner. Delay in obtaining these approvals or obtaining approvals with unfavorable conditions will not only delay a developer's construction commencement and, possibly, completion, but also will hinder the developer's ability to obtain debt financing.

Construction risk

Gas storage projects are not typically constructed under fixed price, turnkey construction contracts like other project financed energy infrastructure. Instead, project developers usually enter into construction contracts with multiple construction contractors often with cost-plus pricing. Thus, the project sponsor assumes more construction management and construction cost risk. These risks, if not managed correctly, can adversely affect the project sponsor's ability to timely complete its gas storage project on budget and thus its ability to attract debt financing.

Project sponsors must be prepared to address construction risks. For example, unknown subsurface conditions are a material construction risk that can cause construction costs to exceed the initial budget. Having an experienced construction manager can help the project sponsor control and mitigate unanticipated construction problems. Also, negotiating construction contracts with pricing structures that incentivize the contractor to complete tasks on budget, together with provisions that narrow the contractor's right to obtain work scope change orders, will help mitigate construction risk. Finally, developing a realistic construction budget with adequate contingency that is funded by debt or equity sources also is vital to achieving construction completion.

Real estate issues

As with any project development, the project sponsor must obtain adequate real property rights to construct and operate its storage project. Real estate can be acquired on a fee simple basis or by lease. Easements and rights of way are obtained for pipelines that will connect the storage caverns to other pipelines. The project developer must pay attention not only to surface property rights but also to subsurface property rights.

Typically, lenders providing secured debt for gas storage projects will require title insurance for the mortgaged real property. The lenders also may require title opinions to provide comfort with respect to necessary subsurface mineral rights.

If the main project site is leased property, the lenders will require that a financeable lease be in place. Among other things, the lease will need to continue beyond the debt's maturity date, include lease payments that are consistent with the project's cost structure, and allow the lenders to "step-into" the lease upon a project company loan default. In addition, the lenders will require non-disturbance undertakings from the real property lessor to protect the lenders' leasehold mortgage rights.

If the gas storage project is authorized under a FERC certificate, the project sponsor can use its eminent domain authority to obtain necessary real property rights that it could not obtain by deed, lease, or easement agreement. However, eminent domain authority will not eliminate the lenders' requirement for title insurance and other protections. A condemnation proceeding takes time and money; thus, there is no certainty that the real property rights being condemned will be available when needed.

Commercial risks

Once complete, the project's viability depends on its customers' commitments under gas storage contracts. Project sponsors often use precedent agreements to obtain capacity commitments prior to construction commencement. Under a precedent agreement, the project sponsor and customer agree to enter into a gas storage contract if certain conditions are satisfied. If the conditions are not satisfied, the precedent agreement can be terminated. These conditions usually require that, by certain dates, the project sponsor obtain internal approvals necessary to proceed with project development, obtain certain material governmental approvals (such as a FERC certificate), and achieve project completion. The potential customer also may have certain conditions it must satisfy.

Lenders will agree to provide debt against the precedent agreements so long as each customer's rights to terminate are limited to conditions that the project sponsor is likely to achieve. One example is a customer right to terminate the precedent agreement if the project is not timely completed. Lenders have been known to finance with this condition in place so long as the date by which completion must occur is consistent with the construction schedule (including any reasonable schedule contingency).

The precedent agreement also includes the key commercial terms that will be included in the storage contract executed upon satisfaction of the conditions. Among the commercial terms that impact financeability are the customer's capacity commitment, the rates (particularly the reservation charge) that the customer will pay, and the duration of the commitment. In addition, the credit support that the customer agrees to provide is a significant issue. For FERC regulated facilities, FERC allows project sponsors constructing new capacity to obtain customer credit support that is reasonable to support the construction. This is different from the usual FERC rule, which allows the regulated gas company to request that a customer provide credit support covering up to three months of service.

A storage project's interstate service also will be governed by a tariff. The tariff contains standard operating terms, such as curtailment priority, use of receipt and delivery points, gas quality specifications, and imbalance terms, which are fairly consistent across all tariffs. However, there are certain tariff terms to which a project's lenders will pay particular attention. For example, the project company's capacity release mechanism should contain terms that ensure a release will not affect the credit profile of the pipeline company's customers. This is particularly true in the case of a permanent capacity release. The tariff should allow the storage company to reject a releasing shipper's release from liability following a capacity release if the storage company's credit position would be adversely affected. In addition, terms governing the rights of a releasing shipper and a replacement shipper if its capacity release counterparty does not perform should be detailed. Finally, shipper events of default and the storage company's remedies upon such a default should be included in the tariff.

Finally, a storage company's hub services, such as park-and-loan services, often provide the project company with the opportunity to profit through storage rates based on gas market prices. With this upside comes certain risks not found in the standard fee-for-storage arrangement. Thus, project lenders will often require that the project developer establish a risk management plan that sets the credit criteria that the project developer must apply before entering into these service arrangements. These risk management plans are intended to limit the risk that the project company would face when entering into these hub services agreements, including the risk of a customer not returning "loaned" gas.

Operation and maintenance

The project developer can either hire its own employees or contract with a third party to operate its project. If the project developer will operate the project using its own employees, it should create an operating plan that establishes operating criteria and standards for the benefit of its employees. The project lenders' independent engineer will likely report on the adequacy of this operating plan.

If the project developer will hire a third party to operate its project, an operating agreement will establish the operator's duties Before entering into an operating agreement, the developer should ensure that the third-party operator has the experience and personnel necessary to operate the project. The operating agreement should provide a fee structure that incentivizes the operator to operate the project efficiently and that is consistent with the developer's budget. In addition, the operator should be required to maintain certain levels of insurance and provide regular operating reports.

Base gas

Base gas (or cushion gas) is permanent gas inventory kept in the storage caverns to maintain the project's pressure and deliverability rates. A storage project's base gas requirement depends on the characteristics of the storage caverns.

Base gas can be a significant capital cost. The project developer has a few options for acquiring base gas, including the following:

Purchase: The project developer could purchase the required quantity of base gas. The benefit of this approach is that once the base gas seller is paid it has no further claim against the delivered gas, thus eliminating a project company creditor who has rights to a critical capital asset. The risk is in the forward purchase of the base gas, particularly the gap between the purchase commitment (which could be as early as financial close) and performance (which occurs near project completion). The most significant risks are the price the project sponsor will pay for the delivered base gas and the possible deterioration of the gas supplier's credit between contract execution and base gas delivery. Finally, the project sponsor must ensure that it will have the funds necessary to make a significant payment when the base gas is delivered. To address this risk, the construction budget and project loan commitment should be sized properly to account for this expenditure.

Lease: A project sponsor also could lease base gas. The benefit of a base gas lease is that the project sponsor's total outlay for the base gas should be less than if the base gas were purchased and its payment obligations could be spread over the lease term. The risk is that the lease structure can be complex. Moreover, the lessor becomes a creditor of the project owner that, though its leasehold interest in the base gas, has a claim on an important capital asset of the project. As a result, the project's lenders are likely to require that the lessor enter into intercreditor arrangements to ensure that, if the project developer defaults under the lease or becomes insolvent, the lessor does not immediately require redelivery of the base gas without giving the lenders an opportunity to cure.

Storage services agreement: Some project developers have used gas storage contracts to obtain base gas. Under these contracts, the customer agrees to leave in storage as inventory a certain quantity of gas for some agreed period. The benefit of this approach is that the project developer obtains access to base gas at little or no cost. The risk is how the project's tariff could impact this arrangement. For example, the tariff's curtailment procedures could adversely affect this arrangement if the project company must curtail service having the same quality as the base gas storage contract.

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