Connacher Finance Corporation (CFC) closed a $195 million debt package with BNP Paribas on 20 October. The financing for an Alberta oil sands project features a unique use of physical hedges to compensate for the sector's exposure to commodity risk. The strategy has enabled the developer to stay independent at a time when the costs of oil sands projects have increased pressure towards consolidation.

BNP was sole arranger, bookrunner and syndication agent on the deal. The facility comprises a $180 million term loan B, maturing in 2013 and priced at 325bp over Libor, and a $15 million working capital facility maturing in 2011 and priced at 300bp over Libor. Connacher has used an interest rate swap, with an all-in interest rate of 8.52%, on $90 million of the term loan B debt over its seven-year maturity.

Connacher opted for the term B market because short-term bank debt did not appeal, according to Richard Gusella, president and CEO of Connacher. In addition, Connacher has a provision to expand the term loan by $150 million, giving the developer some flexibility in expanding the project.

The loan was syndicated to institutional investors, primarily in Canada and the US. Together with C$103 million ($92 million) of cash equity from Connacher Oil and Gas (CLL), the debt will fund project costs amounting to $289 million, including refinancing existing debt and assuming the borrower fully draws on the bank revolver.

The term loan B facility will also be used to repay $51 million in bridge debt raised to fund Connacher's acquisition of the Great Falls Montana Refining Company from Holly Corporation earlier this year. BNP also provided the bridge facility for the acquisition, and Mustang Capital Partners was adviser to Connacher. The refinery is currently processing roughly 9,600 barrels per day (bpd) of Bow River crude oil from Canada, and Connacher bought it in March 2006, at roughly the same time as it bought Luke Energy, an Alberta natural gas producer.

The remainder of the loan will fund a one-year debt service reserve during the construction phase of Connacher's Great Divide project and also finance future development of the facility. Connacher is currently constructing the first phase of Great Divide – a greenfield oil sands project in Northern Alberta. Connacher acquired the lease in 2004 and expects phase one to be operational by 2008, in record time. Great Divide is Connacher's largest asset – spanning 80,000 acres of oil sands leases. It is scheduled to produce up to 10,000 bpd of bitumen once online.

According to Gusella, these oil sand leases provide lenders with high prospects of recovery, amounting, in his words, to an "implied guarantee". He turns Connacher's size into an advantage, noting that the assets on which the financing is secured are its main properties.

The project involves steam assisted gravity drainage (SAGD) production of bitumen and sale of diluted bitumen. It is located 50 miles southwest of Fort McMurray in Alberta; since Connacher acquired the land in 1994, over $1.6 billion has been invested in Canadian Oil Sands. Pod 1 received regulatory approval earlier this year, and Connacher has plans for five more pods. It will likely seek approvals for Pod 2 and Pod 4 in 2007. The credit facilities are supported by CFC's assets, lease acreage, contracts and regulatory permits.

As a smaller developer, Connacher did not want to take the risk of getting the project up and running only to face rising fuel costs, and shortages, and therefore higher costs, of the diluent blended with bitumen in order to meet pipeline specifications. In addition, as SAGD requires continuous steam input, Connacher has to be able to sustain itself through periods of volatile differentials for heavier crude which could result in low or negative income.

Connacher bought the Montana Refining Company to mitigate this risk, acknowledging the difficulty and expense of commodity hedging. Similarly the Luke Gas facility provides a physical upstream hedge for gas – the largest operating cost component of oil sands projects.

Moody's gave the credit facilities a B1 rating, and CFC a B1 corporate family rating. Standard and Poor's rated the debt BB- and assigned a B+ to Connacher's overall corporate credit rating. Moody's said that its rating reflects timing, development and production cost pressures associated with oil sands projects, volatile and cyclical oil prices, and deep bitumen price differentials relative to light sweet crude oil. In addition, the tight labour and supplier markets now associated with Canadian oil sands, the Fort McMurray area specifically, may affect the project's timing.

Some of the risk is mitigated through various means, including CFC's use of SAGD technology, which has proved to be less prone to cost increases than mining and integrated oil sands developments. The Montana refinery provides a hedge for diluent costs and for price differentials between heavy crude oil and light oil. Similarly, the gas reserve owned by Connacher provides a natural gas hedge. The Great Divide project is located beside ample pipelines, utilities, and Highway 63 for ease of transportation, which also mitigates some risk.

Connacher's timing was good. While its pricing is considerably wider than some of the earlier oil sands deals to come to market, it was able to pick up the hedge assets early at an attractive price. Producers looking to adopt its strategy will find that such price protection no longer comes as cheaply.

Connacher Finance Company
Status: Closed 20 October 2006
Size: $289 million
Location: Alberta, Canada
Description:
Refinancing of the acquisition of Montana Great Falls oil refinery and development of Great Divide oil sands project.
Sponsor: Connacher Oil and Gas
Debt: $195 million
Sole arranger, bookrunner and syndication agent: BNP Paribas
Legal counsel to the sponsor: Macleod Dixon (Canada), Simpson Thacher (US)
Legal counsel to the underwriter: Bennett Jones (Canada), White & Case (US)
Lender technical advisers: Stone & Webster, Muse Stancil
EPC Contractor: BDR Engineering Limited