Chile has learnt a painful lesson from the over-reliance on its neighbours for its energy supplies, and is looking elsewhere for its long-term energy needs. A decision by Argentina in March last year to ration gas exports – an attempt to stave off an energy crisis in its own country – continues to place pressure on the Chilean grid. Chile's electricity sector consumes around 90% of Argentine exports, and these exports fuel around a third of the country's electricity.

Major power producers have offset the shortage by supplying other fuels via swap agreements, but these have become increasingly difficult in recent months.

Although the cuts subsided towards the end of last year they had a profound affect on energy prices in Chile, and have spawned a political will to find new sources of energy.

Better Asia than Argentina

Leading the move away from Argentine exports is state energy company ENAP, which is heading and coordinating a $450 million project to be able to receive, store and regasify liquid natural gas in Chile. The LNG facility, with a capacity of 3 million cubic metres per day, is likely to be located in Quintero in central Chile's Region V.

Beyond simply looking for alternatives to Argentine gas, ENAP has stressed the need for the proposed investment by forecasting an increase in gas consumption from the present 22 million cu m to 44.7 million cu m by 2011. "The National Energy Commission's (CNE) indicative work plan foresees that the future energy offer will grow 11%, with projects that incorporate close to 900 MW to 2008. The first ones to enter will be power plants with combined LNG," Enap chief executive, Enrique Davila told local media shortly after a roadshow in Europe last October.

The trend towards combined technology power plants capable of using LNG has underlined the need for an LNG terminal even further. Under the terms of the proposal the company, advised by Citigroup, will structure a tender for a long-term contract to supply LNG, with ENAP heading up a consumers' pool with the country's major gas consumers and distributors.

The sponsor is expected to purchase half of the facility's capacity with third-party generators and distributors taking the remainder. With an estimated cost of between $300 million and $500 million, the project involves the construction of a re-gasification plant, together with an unloading pier, storage facilities and ducting to connect the plant with the existing gas distribution network.

The company's advisor, Citigroup, refused to comment on the progress of the project, but bids are expected in July with the tender due to be awarded in October to be able to hit the government's objective of completing the terminal in 2008. Last year's roadshow attracted interest from such important suppliers as TotalFinaElf, Repsol, BP, Shell and Tractebel. There is also interest from major Asian producing countries such as Indonesia and Malaysia.

Recently, ENAP's central role in guaranteeing demand through a long-term supply contract has been boosted by an agreement with utilities Endesa and Metrogas – announced in April. As part of the agreement, Endesa Chile has promised to buy 1.7 million cubic metres per day (cmpd) to fuel the planned expansion of its San Isidro power plant, while Metrogas has so far not released details of the quantity it will receive.

Significantly, although San Isidro has an existing contract for Argentine gas for another 15-16 years, the chief executive of Endesa Chile, Hector Lopez, has indicated that it has concerns that this contract may be limited to two or three months a year. Developers are concerned that falling investment in Argentina's gas exploration will only serve to increase the shortage in the long-term. "Argentina production levels are tapering off because there is not enough capacity," says one banker looking at the project on behalf of clients. "So if Argentina does not provide some incentives, then production levels will continue to fall then the likelihood is that Chile as a country will be exposed to some political risk in Argentina."

Power producers feel the squeeze

While pricing of the offtake agreements is yet to be defined, Endesa's internal studies indicated LNG to be the best source of fuel for new thermal plants, according to Lopez.

Its diesel-gas swap, which had allowed San Isidro to keep running on gas, was suspended at the beginning of April by Argentina's distribution authority. Metrogas chief executive Eduardo Morande said that while his company has done everything it can to secure supply for home consumers and local industry, it cannot totally guarantee supplies under any circumstance.

While the crisis is underlining the need for ENAP'S regas terminal, it is also examining other solutions that could steal a march on the LNG option. But as the system comes under increasing strain with the onset of winter, the shortages that Chile experienced last year, may well be even more intense this year. "Our electrical system is in a critical situation. We are not receiving gas in the central part of country and receiving a small amount of gas in the northern system with no real connection between the systems," says Javier Contreras, head of corporate finance at Grupo Santander in Santiago.

"In Santiago and Valparaiso reserves are at very low levels. We have not got the gas from Argentina for power generation, and diesel sales are at maximum capacity. If we don't have rain for various months we are going to be using the reserves in the country," says Contreras. "The most fundamental driver of the system is the matter of urgency."

While the energy crisis has given birth to the LNG project it has also revived interest in such renewable energy projects as geothermal and wind power proposals. A day before ENAP announced its deal with Endesa and Metrogas it also reached an agreement with Enel to reactivate a geothermal exploration project in Calabozo and Chillán in the south of Chile. The exploratory joint venture was originally signed in 2001 with CFG France. Spanish developers are also looking closely at the prospect of large-scale wind farms in the country.

As different energy sources battle to fill the gap left by Argentine gas exports, sponsors and lenders will be watching closely to see what steps the country's other major generation companies take to secure their long-term energy supplies. In particular they will need to watch for the return of competition from Chile's neighbours and how any new contracts will be regulated.

Peru: ship or pipe?

Tractebel, responsible for the domestic distribution of natural gas from Peru LNG's Camisea project is looking to secure a deal to supply the north of Chile via pipeline. "That is an issue which of course will need to be reviewed for this LNG terminal," says Jose Larrain, partner at Chilean law firm Baeza Larrain & Rozas. "Apparently the delivery of the gas will not be very substantial. It would be limited because the government does not want to be so restricted with its gas supplies coming from abroad."

Chile is likely to follow the course set by Spain which has limited the extent of its dependence on imports from Algeria to 60% of its total LNG imports. "The government doesn't want to have any political risk associated with securing gas," says Larrain. "In my view they will try to create the necessary arrangements so that there is no risk from a future agreement with Argentina or Peru."

Furthermore the construction of the LNG import terminal could result in Peruvian exports moving through Peru LNG's export terminal in Pampa Melchorita, 105 miles south of Lima. With an initial output of 600 million cubic feet per day (cfpd), the Peru LNG export facility is one potential supplier for Chile's own terminal.

The pipeline element of the $1.6 billion Camisea project has already closed, with Transportadora de Gas del Perú (TGP) completing a $270 million equivalent domestic financing for the construction of a 714 km LNG pipeline from the Camisea field to Lima and a 540 km liquids pipeline from Camisea to the port of Pisco on the Pacific Ocean coast. The total cost of the pipelines, which will have a capacity of 285 million cfpd and 50,000 barrels per day, is estimated to be $850 million. Hunt Oil is leading the construction of the export terminal, which could be much larger by volume than the pipeline.

Even though Chile and Peru share a land border, trading natural gas via LNG could be more cost-effective than the construction of a natural gas pipeline, according to some experts. Largely the success of the project will depend on the extent to which ENAP is prepared to provide the commitments on pricing and long-term demand needed to justify a project that is likely to be more costly than gas imports piped in from neighbouring countries.

"Chile has the financial wherewithal to do this, if they make the strategic decision. It would be a financing prospect if the government creates the right environment to assure the demand for gas," says Ralph Scholtz, head of project finance in Latin America for BNP Paribas. "The best scenario for Chile would be that the project justifies itself economically on its own merit, but it would be hard to imagine that you would bring gas into Chile, in the form of LNG, cheaper than from neighbouring countries."

Bidders have estimated the LNG imports would cost $3.20-$4.50 per million british thermal units (BTU) compared to the $3.00-$3.50 per million BTU Chile currently pays for Argentinean natural gas. With the economics going against justifying the Peruvian LNG project on its own merits, the government will need to provide the required guarantees in terms of long-term contracts or deregulation of pricing in the generation market that will enable power generation companies to charge more to consumers.

"It is basically an exercise in risk allocation; I don't think anybody will be willing to build an LNG terminal if they do not have the demand contracted" says Scholtz. "Economically for most of the country, it is always going to be cheaper to bring it in from Argentina. You will certainly need a heavy element of support in terms of offtake."

Preparing for a responsible Argentina

Critical will be the long-term commitments that prevent offtakers from returning to cheaper Argentine supplies in the future. "From the outside it looks like an insurance policy and you need an insurance policy if you think its possible that your house burns down. By promoting an LNG receiving terminal, Chilean government is prioritizing fuel procurement diversification," says Scholtz.

Politically, the experience of having the gas turned off by Argentina has been a sobering wake-up call for one of Latin America's most dynamic economies. "I do not think that we are going to have another agreement with Argentina," says Larrain. "That agreement is also costly from an economic point of view. The cost of gas coming from Argentina is, of course very high, even though to produce it can be very cheap. Anything that can be done with Argentina will be done with some kind of security which makes it expensive."

One of the developments that could help with pricing, according to Contreras, is the proposed reform of the electricity law. "There have been some claims from the sector that the government should provide new guidelines on future prices for long-term contracts that would allow certain projects to be go forward," he says.

Generation companies under the existing system have their future prices regulated by an index linked to a note price that takes into account the availability of the different energy sources. "Indexation in the long-term contracts to the note price has been a problem once you have a major change.

Because of that a lot of contracts between companies and distribution companies have not been adjusted to the new situation," say Contreras. In the future, he says, the inertia in the system would be eliminated with "a more comprehensive framework with more flexibility to agree on long-term contracts without indexation to the note prices". The reforms under discussion cover different issues affecting transportation, force majeure and price generation and fixing.