MEG Energy completed the $750 debt financing of its Christina Lake oil sand project on 3 April. The deal is the first use of a B loan to finance an oil sands project, and one of the first B loan project financings to use a delayed draw structure. The deal has already sparked a copycat – fellow oil sand producer OPTI Canada recently announced a Term B refinancing of its bank debt.

MEG is a start-up producer that owns a lease on a 52-section oil sands block that contains roughly 4.8 billion barrels of bitumen, equivalent to 2 billion barrels of oil. Among its main investors are Warburg Pincus and CNOOC. Its entry into the oil sands industry, led by management with past form on such projects, is well timed.

Oil sands projects, which take the heavy bituminous sands of the Canadian northwest and turn them into synthetic crude oil, struggle with economics that cannot compare to, say Saudi Arabian reserves. But in environment of high oil prices, and in light of the US' stated goal of sourcing more oil from reliable countries, Alberta's reserves look attractive.

There are two principal means of extracting syncrude from oil sands. The first is to mine the bituminous sands conventionally, and then separate the syncrude from the sand, but the principal method currently in use is steam-assisted gravity drainage. This uses two horizontal wells – a top one to heat the oil sands with steam, and a lower one to drain off the softened bitumen.

This technology has been in use, with various improvements, at most of the recent developments. OPTI uses a variant that has been patented by Ormat of Israel. The process is energy intensive, since the steam used in the process comes from burning gas, but so long as the price of gas roughly tracks the price of oil, the project benefits from a natural hedge.

MEG's lease lies roughly in the middle of the stretch of northeastern Alberta that houses the oil sands. It lies adjacent to Devon Energy's Jackfish project – indeed the two sponsors are jointly developing the 340km Access Pipeline to bring their output to the Edmonton marketing hub. EnCana also has a property at Christina Lake, and its experience bringing its property into production has been useful in reassuring MEG's investors.

The sponsor engaged Credit Suisse, which led the Targa deal for Warburg Pincus, and Lehman Brothers as bookrunners for the debt, which consists of a $700 million term loan, split equally between drawn and undrawn portions, and a $50 million revolving credit. The revolver comes from Canadian commercial banks, led by Scotia Bank, with BMO and CIBC participating.

The delayed draw portion of the loan is something of a novelty for B loan lenders, particularly for project financings. B lenders usually prefer to put their money to work immediately, rather than providing commitments that stretch over a long period – longer than many actively trading funds prefer. Yet the innovation is another example of the B market's ability to match terms with the bank market.

According to sources close to the lead arrangers, which insisted that buyers commit to the drawn and the undrawn tranches equally, funds could blend the pricing and credit of the tranches, but were also able to trade them separately. The universe of B loan investors is wide enough that finding willing buyers of such risks is relatively simple.

The debt attracted strong commitments – enough that the bookrunners were able to tinker with the pricing on the two tranches. The drawn portion went down in price from 225bp over Libor to 200bp, although the undrawn portion went up from 75bp to 100bp. Investors thus enjoy a spread across the two tranches of 150bp.

This will go up, however. The length of the delay in draw, at up to 24 months, is unprecedented, as is the absolute size of the tranche and its size relative to the drawn portion. But investors are familiar with delayed draw debt, which played a small part in April's LSP Gen financing (see Deals and Developments, this issue). And the current froth in the debt market makes it possible for a bookrunner to push the limits of what is possible in the market.

The construction period for the project is probably the main imponderable associated with the financing, since many projects of a similar size have suffered from overruns, and current commodity prices have increased construction costs across the project finance market. Still, the project benefits from a C$175 million three-year interest reserve account, and a C$72 million cost overrun fund.

The financing's close was contingent on MEG raising C$200 million in additional equity – it had already raised C$424 million of private equity, and had spent C$260 million by the end of 2005. The equity raising was a success, and attracted $350 million in orders for placement agents CS and Lehmans. The shares were allotted to existing shareholders, as well as some new US investors.

Oil sand projects, a creature of high oil prices and constricted production, are tremdously lucrative, provided these prices stay high. Macroeconomic observers might note that corrections in the world prices are possible in the long term, as demand patterns respond to these prices. If not, MEG has the remaining 43 square miles of 52 square-mile lease to explore.

More important for the debt markets, staggering cash calls for construction projects will be a common tactic for borrowers with long lead time projects. Sources at the bookrunners say that forthcoming B loan financings for construction projects, particularly those with strong collateral packages, will feature delayed draw elements.

MEG Energy
Status: Closed 3 April
Size: C$1.264 billion ($1.15 billion)
Location: Alberta, Canada
Description: 4.8 billion barrels of bitumen oil sands project
Sponsor: MEG Energy
Debt: $750 million
Lead B loan arrangers: Lehman Brothers, Credit Suisse
Revolving credit lead arranger: Scotia Bank
Independent engineer: Purvin & Gertz
Sponsor legal counsel: Latham & Watkins (US), Bennett Jones (Canada)
Lender legal counsel: Simpson Thacher (US), Blake Cassels & Graydon (Canada)