Southern Lights: Undiluted joy

Enbridge's financing for the $2.2 billion Southern Lights diluent pipeline coped with a series of financial, commercial and legal challenges capably. It raised $1.735 billion in debt from 21 banks in September 2008, as the credit crunch moved into its most difficult phase. It managed to adapt a complex project structure to an industry, the Canadian oil sands, in difficult times.

The deal is a rare project financing for Enbridge, which, aside from a minority stake in the Alliance pipeline, tends to finance its assets on balance sheet. Enbridge operates as a common carrier, serving all oil and gas producers equally, and negotiating shipping conditions with the Canadian Association of Petroleum Producers, a trade group.

Southern Lights forced it to operate differently. Enbridge developed the project after approaches from BP and StatoilHydro, which wanted to transport lighter grades of oil as diluent from the US Midwest to the oil sands region of Alberta. The diluent is needed to make the heavy oil sands crude thin enough to transport by pipeline.

The alternatives to piping diluent include upgrading crude from the oil sands on site, an option that suffers from limited upgrader capacity, and shipping diluent in by rail, an expensive and logistically cumbersome process. Enbridge's existing pipeline assets carry oil in the other direction, and are in many cases designed for different grades of oil.

Southern Lights involves a mixture of new and refurbished or repurposed pipeline running from Edmonton, Alberta, to Manhattan, Illinois, almost 2,600km. It consists of a reversal of Enbridge's Line 13, which runs through Alberta, Saskatchewan, Manitoba and Minnesota, from Edmonton to Clearbrook Minnesota, the construction of a new light sour crude pipeline to replace some of that pipeline between Cromer, Manitoba and Clearbrook, and construction of a new diluent pipeline between Clearbrook and Manhattan.

By using a mixture of existing assets and new construction Enbrdge could ensure it provided a reasonable price to the shippers and also stick as far as possible to its existing, and hard-won, rights of way. Before the sponsor even contemplated financing the project, it needed to navigate its relationships with existing shippers by making sure that it could still meet its commitments even if it reversed the direction of Line 13. Building a new light sour pipeline was part of the bargain it struck with CAPP.

Enbridge first discussed Southern Lights with shippers in early 2006, and gained the approval of CAPP and assembled its suite of contracts in late 2006. In early 2007 it went out to banks with a request for proposals from banks, and by August had closed a corporate-guaranteed $500 million bridge loan with Royal Bank of Canada and Société Générale as lead arrangers.

The two leads had to contend with two unusual features – construction risk and the collateral package. Enbridge is managing construction of the pipeline through a series of smaller subcontracts, but is not providing a completion guarantee. It locked in many of the pipeline's costs in advance, and might benefit from a cooling construction market on the rest, but banks needed to be comfortable that it had control of the process.

Enbridge is providing C$176 million, split between C$148 million in cash equity, C$16 million in non-cash equity and C$12 million in contingent cost overrun equity, and $538 million, split between $427 million cash, $73 million non-cash and $38 million contingent. The cash and non-cash equity will be provided after construction debt has been used, while the contingent equity would come if the project uses up its cost overrun debt facilities.

The sponsor, therefore, has an incentive to control costs, even though it can pass on the all of the costs of the pipeline, as well as the cost of building the new light sour crude pipeline, to the shippers. Despite the fact that the counterparties on the 15-year transportation service agreements are BP (Aa2/AA+) and Statoil (Aa2/AA-) are highly-rated, Enbridge rejected the idea of using a bond financing, deciding that bond markets would attach too high a risk premium to the project's construction.

The collateral package presented a more complicated picture, because the construction financing would cover an asset – the light sour crude pipeline – that would be transferred outside the project company at completion. The Canadian portion of the new pipeline will be exchanged for equity in the diluent pipeline, and the US portion for the US portion of the existing pipeline, the latter exchange qualifies as like-for-like under the US tax code.

The financing breaks down into C$430 million in Canadian debt, of which C$385 million is construction, C$30 million cost overrun and C$15 million is debt service letter of credit, and $1.305 million in US debt, of which $1.17 is construction, $90 million is overrun and $45 million is debt service. All facilities have tenors of construction plus four years, and are priced at 175bp (over Libor for the US debt and CDOR for the Canadian debt).

The debt has a 15-year amortization schedule, distribution locks if coverages fall below 1.2x, and is set for a capital markets refinancing if conditions improve. The financing brought in another 19 participants, the result of an early and aggressive marketing effort that involved bank meetings in New York in June 2008 and Calgary in July. The financing closed in late September despite Lehman Brothers' collapse and the resulting problems for European project finance lenders.

Southern Lights is a complex undertaking, and not likely to inspire any copycat diluent pipeline financings. It should meet the demands of the region's remaining oil sands producers, and will benefit from a slowing construction market and increased amounts of spare refining capacity in the US. But Enbridge thinks that shifting patterns of crude consumption in the North America might require some other project financings. Northern Gateway, designed to move crude from Alberta to Canada's west coast for shipping to Asia, is one candidate.

Southern Lights Pipeline
Status: Closed 29 September 2008
Size: $2.2 billion
Location: US and Canada
Description: 2,600km diluent pipeline construction and redirection
Equity: $714 million
Sponsor: Enbridge
Debt: $1.735 billion
Initial mandated lead arrangers: RBC, SG
Co-arrangers: BTM UFJ, EDC
Documentation agents: ABN Amro, Scotia, ING, Mizuho, WestLB
Participants: Alberta Treasury Branches, Caisse Centrale Desjardins, Canadian Western Bank, Commonwealth Bank of Australia, Fortis, ICICI, Landesbank Baden-Wuerttemberg, London Life, Manulife, SEB, Toronto-Dominion Bank and UBOC
Sponsor legal counsel: Fraser, Milner, Casgrain (Canada), Vinson & Elkins (US)
Lender legal counsel: Blake, Cassels & Graydon (Canada), Latham & Watkins (US)
Independent engineer: RW Beck
Insurance adviser: Moore-McNeil
Collateral agent: Deutsche