Gas storage facilities projects used to be few and far between, but demand for storage is increasing as more companies look to back-up sources for reliability in the face of recent price volatility and the spate of natural disasters interrupting supply.

As a result, recent months have seen many new projects raise financing, and even more loom on the horizon. Cliff Wilson, a managing director at CIT, believes that there is tremendous interest in building gas storage facilities going forward. He says: "The National Petroleum Council is saying that we need over 700 billion cubic feet of storage between now and 2015. There are more than 70 sites being looking for permits, or where companies are looking to expand existing facilities."

Hurricanes Katrina and Rita highlighted the need for back up sources for reliability, according to Chinelo Chidozie, associate director in utilities, power, and project finance at Standard & Poor's. "Capacity is typically held by parties with varying needs," she says. "Local distribution companies and regulated power generation companies are most likely interested in reliability of supply."

"Unregulated power generation companies want both back up supply and deliverability; marketers could be looking at opportunistic positions and industrials, with recent high price volatility caused by supply disruptions, would most likely be able to use the flexibility of salt dome storage to smooth out price movements in the regional commodity market," says Chidozie. "A no LNG scenario may magnify the effects of supply interruptions, which may be a positive for storage." Both for reliability needs and for opportunistic plays storage has become attractive.

In addition, changes in regulatory requirements have given a boost to the market. One analyst says: "More activity in terms of financing has been partly driven by regulation, as the FERC has changed how storage assets have been regulated." In the past developers had to justify need in order to get approval for a new project. Says Chidozie: "But now they are letting the equity providers take on market risk you do not have to show the asset is needed, but there are also no guarantees on returns."

A faster approvals process and an aggressive new breed of developer mean that a number of deals have closed in the past few months. Most recently, SG Resources and ArcLight Capital Partners completed the refinancing package for their Southern Pines Energy Center natural gas storage facility, with SunTrust Capital Markets arranging the financing.

The deal involved $235 million of financing, including a $135 million seven-year term loan B and a $100 million five-year revolver. The finance package, which was 3.5 times oversubscribed, will cover additional construction costs and take out a $115 million construction loan from CIT. B loan pricing was flexed down to 187.5 basis points from 225bp.

February saw the close of the $335 million NorTex gas storage deal – put together by Barclays Capital and WestLB to finance the expansion of two facilities for Falcon Gas Storage. NorTex is quite different from most other recent transactions, in that arrangers chose to access the commercial bank market, rather than term loan B. It includes a syndicated loan of $280 million and a $55 million working capital facility.

Both the specifics of the project and changing attitudes on the part of project finance bankers made it possible to get the deal done. Although it was not rated, the deal had to appeal to both banks and institutions to mitigate the risk of syndication post closing.

Manish Taneja, managing director and global co-head of loan and debt capital markets at WestLB, says that agent banks underwrote and closed the financing pre-syndication, and nearly 100% of the required capex was financed with debt. "WestLB structured the credit as having significant equity contributed in-kind in the form of existing assets that don't require construction to be successful. These include the operating Hill Lake facility, with upgrades nearly complete, recoverable oil and liquids reserves in place at both Hill Lake and Worsham-Steed, and the as-is value of Worsham-Steed."

In addition, cashflow during construction is trapped and any excess cash above the contracted minimum will serve as contingent equity. "The deal was financed with no additional cash or contingent equity from sponsors," says Taneja. "Construction risk was mitigated by a series of liquidity provisions we put in place, including oversized budgeted contingency, and contingent debt in the form of sublimate under the working capital facility earmarked for cost overruns once contingency is spent and completion delays if any."

Storage rides the credit gush

Taneja says that market dynamics for gas storage financings have been affected by the same trends as other, more mainstream financings. "In the last 18 months, there has been a huge increase in liquidity in leveraged institutional loan markets and increasing demand from CLOs and hedge funds for senior and lien-subordinated secured floating rate paper."

A number of banks have been able to get comfortable with the gas storage story, but according to Taneja this is more on the origination side than as lenders. He says: "Credit approvals for underwriting, sub-underwriting or even participating in gas storage syndicated bank loans are difficult to predict and even more difficult to obtain for project finance banks and even banks active in oil and gas lending."

Most financings within the gas storage space have been ratings-driven B loan deals. Notes Taneja: "At least one was done as an unrated bilateral institutional loan, and a couple as unrated bank financings." However few have been done using traditional project finance. The main reasons for this are the absence of long-term creditworthy offtake contracts, exposure to volumetric and, in some cases, price risk, and most importantly, lack of effective construction risk transfer to a creditworthy, deep-pocket entity, which are all important to make this an attractive proposition for project banks.

As Taneja explains, it is impossible to secure liquidated damages for performance or delays for subsurface works and it is uneconomic to try to obtain turnkey EPC contracts for the surface works. "Gas storage financings require many deviations from traditional project finance structures, and call for other structural features that are able to provide effective risk mitigation for rational, yield-oriented investors but don't fit the boxes traditional project banks try to check."

Wilson at CIT, however, believes this is changing: "Each market is very different and has own attributes. Commercial banks historically have been project finance lenders. Many required longer term contracts much like pipelines, but many commercial financial lenders now don't need the long-term contract and feel comfortable lending into greenfield projects."

He adds: "Everyone is becoming much more educated as to what the risks are and how they can get comfortable with them. If you think about the different components in an EPC contract, and depending on what kind of facility you are looking at, there will be some form of pipe laying, below-ground work, and so on." Very few engineering firms would have the ability or capacity to wrap each element in a competitive way, he explains. "So having non-EPC wraps around these projects has been accepted for a number of years."

"For market risk, a number of firms are getting comfortable with how anchor tenants are using storage sites – for example as a piece of the portfolio or an integrated part of their gas management tools," he says. "There are a number of different ways to take a look at it, and many bankers are coming to understand this."

Changing ratings

In the past, rating agencies have been quite conservative in rating deals, which made storage a difficult sell to conservative lenders and the broader debt capital markets. Chidozie at S&P says that this could change on a case-by-case basis, but it depends on how things play out. "Post construction, to the extent that higher demand translates into higher storage rates that lead to credit improvement, the ratings are likely to reflect this."

She says that the three salt dome storage projects that S&P has recently rated were each at different levels of construction, which accounts in part for the ratings they received. The $320 million financing for Plains All-American Pipeline and Vulcan Capital's JV, Pine Prairie Energy Center, closed last May and was rated B+; the $185 million Bobcat deal, which consisted of a $120 million B loan and $65 million delayed draw bank piece, launched in February by RBS for Haddington Energy Ventures and GE Energy Financial Services, was also rated B+; while the $235 million SG Resources deal was rated higher at BB-.

Bobcat, for instance, missed out on the BB/Ba level rating that would have allowed it to reach a much wider universe of institutional loan players. Moody's in particular, stressed that the project's location on the Gulf Coast left it vulnerable both to competition and the threat that LNG imports in the area would not live up to expectations. Sources close to RBS, which ultimately closed the B loan with 10 participants and the bank piece with six, expressed shock that the agencies took such a conservative line. "There's no way that there will be no more LNG coming in at all," one banker noted.

"Construction could arguably be the riskiest part of the project's life cycle, when a lot could go wrong and there is significant down-hole risk," says S&P's Chidozie. Cost overruns and delays are also possible. And Bobcat and Pine Prairie did not have the traditional EPC wrapped contracts with guarantees and liquidated damages. Notes Chidozie: "When lenders bear the risks associated with construction, it is reflected in the rating."

In addition, the length and terms of the contracts are significant credit considerations, notes Chidozie. "The projects are not fully contracted, and most of the existing contracts expire before the loan matures. These projects may have to re-contract when market rates are significantly weaker," she says. Finally, these loans may have to be refinanced in an uncertain market environment. "Because of the lag in supply adjustments in response to changes in demand, an over build scenario is always possible."

As Wilson at CIT says, not all natural gas storage facilities are created equal. "Location is very critical, as are the pipes they connect, who is using the facility and why, and when and how they go about signing up contracts. All of this is very important."

He adds: "For example, there are some independent developers that think if they approach an anchor cap payer they will take the majority of the economics during the period of the contract, so the developer will start construction of the project with permits in hand but without contracts." This is quite different from ten years ago when most developers would have come in with a long-term contract and the project financing already in place.

Says Wilson: "Now we are seeing both of these, and those in between where the anchor tenants are standing for a substantial amount of capacity and developers are putting in additional contracts as they get close to COD date. We are really seeing many different approaches being used and being quite successful."

In addition, the diversity of types of developer is adding a new dimension to the market. Although the majority of the projects under way or being looked at are owned by LDCs and pipeline companies, there are around 40 companies independent of the pipelines that are looking at greenfield projects or looking to extend existing facilities. One market participant explains: "Projects involving the pipeline companies tend to roll into rate base where they have a capped rate of return for cost of service, as opposed to independents who can get market-based rates and therefore better returns."