LNG Export Tolling Facilities – New Frontiers, New Solutions
by Steven Miles and Jason Bennett, Baker Botts LLP
Tolling and other similar payment-for-services commercial structures for processing goods have been around since at least the Industrial Revolution in Europe, and thus have historical precedents that make the basic economic bargain well-understood. The rapid development of LNG regasification facilities based on tolling models during the period from the early 2000s until today builds upon this historical precedent and provides a wealth of background for the LNG industry that has been utilized in structuring many of the numerous proposed LNG liquefaction tolling export projects (LNG Tolling Projects) currently under development in the U.S. Despite such experience, the past is oftentimes only a starting place for new endeavors of the scale of modern U.S. LNG Tolling Projects. The daunting development and construction costs for liquefaction projects, the risk profile of the participants in such projects, the need to source and transport gas supplies from a robust and publically-traded gas supply market, the unique U.S. regulatory environment, and the changing nature of the global LNG industry make development of today’s LNG Tolling Projects a new frontier that requires bespoke solutions for developers/owners of such facilities (Owners) and for the customers (Customers) purchasing the long-term liquefaction processing capacity usage rights at such facilities. The common thread to all of the economic models for LNG Tolling Projects in the U.S. is that they attempt to balance the rights, obligations, and risks of the Owners with those of the Customers in a manner that allows for the successful development, launch, financing, and operation of such projects.
Because the circumstances of each proposed LNG Tolling Project in the U.S. vary substantially, the types of rights, obligations, and risks that are important to the development of each project, and the relative weighting and importance of each of them to that development, will vary from project to project, reflecting those different circumstances. Thus, a comprehensive one-size-fits-all summary of the rights, obligations, and risks for the Owners and Customers of U.S. LNG Tolling Projects, and the balancing of such rights, obligations, and risks between them, is not practical, or likely even possible in anything less than a multi-volume tome. As a compromise, this article attempts to briefly summarize the most important and most typical rights, obligations, and risks that Owners and Customers attempt to address and balance in their negotiation of long-term liquefaction tolling services agreements (LTAs) that are used as the foundation for large-scale U.S. LNG Tolling Projects. We briefly review in this article (i) the different goals of the Owners and Customers for U.S. LNG Tolling Projects, and (ii) the key rights, obligations, and risks being negotiated by the parties to a typical LTA, as well as the relative balancing of each of them between Owners and Customers.
Owner and Customer Goals
While there are a few hydrocarbon resource holders that are considering development of LNG liquefaction export projects in the U.S., most of the developers of U.S. liquefaction export projects are independent project development companies that do not have hydrocarbon resource positions and thus focus largely on tolling models for those projects and on tolling payments from Customers as their primary revenue source. For an LNG Tolling Project, the Owner’s goals generally include:
covering the all-in development, construction, and operation costs of the LNG plant;
achieving a sufficient rate of return;
obtaining non-recourse financing for the project at an acceptable cost and debt-to-equity ratio;
assigning all commodity risks, including marketing risks and losses of gas and LNG, to Customers;
avoiding liability for inter-Customer events, such as one Customer's losses arising from another Customer’s failure to deliver feedstock natural gas or its failure to lift LNG; and
allocating the risks of operation according to an appropriate risk-reward balance between the Owner and its Customers that reflects the economic upside of each party and its ability to manage risks.
One of the primary ways in which LNG Tolling Projects in the U.S. are different than liquefaction export projects in other countries is that the LNG exporters are not required to have dedicated upstream hydrocarbon reserves to support the project and might acquire gas supplies from the market in a variety of ways. However, for all pure LNG liquefaction tolling models (not including quasi-tolling models whereby LNG is sold at a price that includes a tolling fee), the Customer ultimately is required to procure its own gas supply in related or unrelated transactions and is thereby exposed to commodity risk, whereas the Owner is not similarly exposed. For pure LNG Tolling Projects, each Customer’s goals generally include:
obtaining economically competitive LNG from a reliable source;
investing time and capital into a viable project that will reach a positive final investment decision (FID);
managing project risks and potential cost-overruns that will be passed through to Customer;
limiting credit exposure and commodity risk (via hedging or otherwise), to the extent practicable and economically rational; and
retaining as much production and delivery optionality and as many arbitrage opportunities as possible.
While the LTAs are limited in the extent to which they can address all of the goals of the Owners and the Customers to the full satisfaction of both parties, many LNG Tolling Projects attempt to improve the alignment between the Owners and Customers outside of the LTA as well, by inviting the Customers to acquire a stake in the ownership of the such projects.
Key Rights for U.S. Liquefaction Projects
Due to the absence of full natural economic alignment between Owners, as pure tolling company operators, and Customers, as commodity owners, there are a number of important rights that are generally negotiated in an LTA that could increase the value of the agreement to either party and that might differentiate between the value obtained by different Customers of the same LNG project under
different LTAs. Thus, the division of rights between Owners and the Customers is a key negotiating issue for LTAs.
The basic right sought by each Customer of an LNG liquefaction tolling facility is a right to deliver natural gas and to produce, store, and offtake LNG from the LNG plant, typically on a pro rata basis with other foundation Customers, based on each such Customer’s contracted share of the nameplate capacity of the LNG plant. Customers also generally seek non-discriminatory treatment by Owners among all foundation Customers, except with respect to rights based on the quantity of capacity reserved (e.g., lifting rights). Likewise, rights to excess production are typically provided on a “club rules” basis, with equivalent pro rata rights among foundation Customers for excess production. Additionally, one of the important differences between a tolling agreement and an LNG sales agreement is the Customer’s right not to deliver natural gas or produce LNG. Thus, the operational flexibility and procedures for exercising a turn-down right under an LTA can be an important topic.
Apart from the core tolling rights negotiated in most LTAs, there are other optional rights that might be covered by one or more LTAs for an LNG Tolling Project, including:
whether Customers have a right to make use of the short-term excess LNG production capacity of the LNG plant and on what terms;
whether Customers have a right to participate in or control any de-bottlenecking or expansion of the existing facilities;
the extent of Customers’ operational flexibility for deliveries of natural gas and offtake of LNG; and
the extent of any inter-customer agreements or arrangements, whether mandatory or permissive, that could provide Customers with greater operational flexibility or risk mitigation possibilities.
In exchange for the above rights, Customers of U.S. LNG Tolling Projects are generally under many of the same legal obligations, including the obligation to pay the tolling fee for use of the facility, regardless of whether such Customer elects to uses the services of the LNG plant to produce LNG. Additionally, while LTAs generally provide Customers with some flexibility for not making use of the tolling capacity such Customers have purchased, there are oftentimes minimum natural gas delivery obligations associated with keeping the plant cool and additional delivery obligations that apply once Customers have elected to produce (or failed to opt out of producing) LNG. In a tolling model, Customers generally have no right to offtake LNG except to the extent they have delivered, are deemed to have delivered, or are obliged in the near future to deliver natural gas corresponding to such LNG offtake. Similarly, where Customers have delivered natural gas they will have a corresponding right and obligation to offtake such LNG in accordance with the lifting program that allocates lifting slots to each Customer.
In addition to the foregoing, because natural gas is delivered as a co-mingled stream but is lifted in separate bulk cargoes, with Customers taking turns lifting whole cargoes, and because it is not economic in most circumstances for Owners to build sufficient LNG storage tank capacity such that each Customer has its own segregated storage, each Customer is inherently dependent, under most LTAs, on the performance by other Customers of their gas delivery and LNG offtake obligations, in order to ensure that the facility neither experiences LNG shortages (tank-bottoms) nor completely fills the tanks such
that LNG production must stop (tank-tops). Thus, in a variety of inter-customer agreements, such as operation and cooperation agreements or pooling agreements, the Customers at many LNG liquefaction tolling facilities often agree to obligations directly with other Customers regarding their own performance.
Key Risks and Division of those Risks
While not a comprehensive overview of all of the important risks that could affect the Owners or the Customers in respect of the development and operation of an LNG Tolling Project, the following list represents typical risks that Owners and Customers will attempt to address in an LTA and other pre-agreements and related agreements:
Pre-FID Risks -- One of the key risks for LNG Tolling Projects is the possibility that the project never achieves a positive FID due to a failure to obtain required permits and approvals, a failure to attract sufficient high-quality Customers, or for a variety of other reasons. While a failure to achieve a positive FID primarily affects the Owner of the LNG Tolling Project, it also affects Customers who have committed to the project and forgone other alternatives. Additionally, a unique feature of some U.S. LNG Tolling Projects is that the Customers may have either purchased equity prior to a positive FID for such project or have otherwise funded development costs for the project on a non-recourse basis, putting them at risk for such investments.
Construction period risks -- LNG Tolling Projects encounter varying risks related to construction delays or problems that result in LNG marketing risk for Customers and may even encounter uncertainties as to whether and when the project will be completed. There are examples in the LNG industry of delays in completion of LNG liquefaction projects, but the tolling model and its allocation of risks and rewards puts new and different pressures on the Customers and Owners that require careful advance consideration in the LTA.
Financing risk -- Because of the nature of a tolling model, the parties will need to consider the risk that the Owner is unable to obtain a sufficient level of non-recourse financing or may only obtain such financing at an unacceptable cost (which might ultimately be borne by Customers). Such outcomes could be driven by project risk, lending market risk, or by a failure of Customers to provide sufficiently creditworthy support for their obligations under the LTA.
Owners’ risks during operations -- The LTA will need to address a number of risks during the operating period that will provide it and its lenders with sufficient comfort that Customers will perform. Such risks include: Customers’ failure to pay the tolling fee, Customers’ failure to deliver committed natural gas supplies or to offtake LNG in a timely manner, as well as allocation of regulatory and fiscal risks arising after execution of the LTA.
Customers’ risks during operation -- Because Customers are relying not only on the Owners, but likely also on the other Customers, to perform their respective duties in order for the LNG plant to function properly, and because the Customers’ losses due to commodity exposure arising from Owners’ performance are not symmetrical with Owners’ potential losses, Customers have a number of important risks to address in the LTA and related agreements. Those risks include:
o failures by Owner to perform the LTA services reserved by Customer, whether due to Owner’s fault or due to force majeure circumstances;
o failures by other Customers to perform;
o impacts of failure of one component in Customer’s value chain (e.g., gas supply, transportation, shipping) on Customer’s ability to monetize the remaining components of its value chain, taking into consideration mitigation strategies (e.g., sale of gas back into the grid, or diversion of a cargo) available to such Customer);
o changes in circumstances resulting in regulatory and fiscal risks arising following the execution of the LTA, such as a loss of the right to export LNG, which the Owner of an LNG liquefaction tolling facility typically attempts to pass to its Customers;
o feed gas price levels and volatility that create price mismatches with Customers’ LNG purchasers or that make the resulting LNG uncompetitive with other sources of global LNG; and
o expansions of the LNG plant and other changes in circumstances that could negatively affect Customer or the performance of the Owner or the LNG plant.
The development of the U.S. liquefaction tolling industry is rapidly evolving, with numerous proposed LNG Tolling Projects that both attempt to provide unique value to Customers but also attempt to develop a balance of rights, obligations, and risks between Owners and Customers that allows for the successful development, launch, financing, and operation of such projects.