Growth in the LNG buyer market is beginning to change the shape of the LNG supply chain and potentially the risk profile of LNG financings. Despite the fact that LNG is not a globally tradable commodity, LNG project bankers are nervously expecting to be asked to accept Sales Purchase Agreements (SPAs) based on gas market prices achieved, sometime in the future. In effect, there is a risk/reward argument brewing, the fallout from which will not only be significant for future LNG development but the burgeoning number of power generation markets in which LNG is playing a growing supply role.

Despite the global increase in LNG markets - increased production from the Middle East will see trains go to the UK and the US for the first time, and in the Pacific Basin, China and India are emerging as the region's principal LNG offtakers - the transition of LNG from boutique fuel to a fully tradeable commodity is some way off.

"A big theme at the moment is that some people have been saying that LNG is going the same way as the crude market, so it's a truly tradeable, global commodity - which we just don't see happening anytime soon," says Frank Harris, vice-president Global LNG at Wood Mackenzie.

Given the ramp up in production and the proliferation of new buyers - the days when Japanese and Taiwanese state-owned power companies were the only major buyers are long gone - it is surprising that a fully-fledged LNG market is not emerging. Furthermore, the move away from pegging long-term purchase on the price of crude oil to a gas-pegged price is symptomatic of a developing liberalised market.

"There has been a transitional phase since the traditional Asian model characterised the LNG market, where the Europeans have come in for some volumes - such as the short to medium-term deals Gas Natural agreed with Qatargas, and similar deals in Oman," concedes Harris. "But the pendulum has almost swung the other way: now we are witnessing the re-emergence of long term contracts, but with Atlantic Basin offtakers rather than Pacific, particularly out of Qatar."

Consequently, long-term purchase agreements have yet to be displaced as the cornerstone of LNG project financings. That taken together with the diversity of market prices at the offtaker end mean that a global market, and a global price for LNG, is unlikely in the foreseeable future - if at all.

Nevertheless, changes in the supply chain could yet affect risk profiles. Qatargas 2 will be the first Middle East project to exhibit a new integrated supply chain model. Seventy percent owned by Qatar Petroleum and 30% by Exxon, Exxon is both a project sponsor at the upstream, and the offtaker at the UK terminal in Wales, and together with QP effectively manages all aspects of the chain.

The move has been broadly welcomed by bankers in the region. The one thing that has bedevilled LNG projects in the past has been the elaborate chain. Projects tend to get very strong sponsors on the upstream - for example Qatargas2 has Exxon Mobil with a AAA credit and QP with an A+ credit - and weaker on the downstream. To have them across the whole chain is a tremendous plus from a lenders' perspective.

But rather than exert a downward pressure on senior debt levels, projects following the new model will probably aim at a similar margin and transfer more market risk to lenders.

What risks will bankers take?

"The pressing issue from a banking sense is what price risk are banks going to be asked to take," says James Bishop, director, project and export Finance, HSBC. "Whereas traditionally LNG SPAs have used oil price as a basis for the LNG price formula with the added protection of a floor, banks are now expecting to be asked to accept SPAs based on actual gas market prices achieved: for example, LNG going to the US market is expected to be priced using the Henry Hub index.

"As LNG gradually becomes a more widely traded commodity lenders still take great comfort from the take-or-pay element of SPAs mitigating the volume risk." It is unlikely that unmitigated volume risk will form the basis of any LNG deal anytime soon with the mire of the merchant-backed power projects still fresh in the mind of bankers. Project companies' financial advisers must therefore tread tentatively before pushing the envelope further than price risk, with long term purchase agreements crucial for lending support.

As the risk profile changes, the credit work for senior lenders on these deals becomes more market-orientated. Perceived technology risks have fallen and lenders are looking more closely at market characteristics and coming to a decision on the robustness of the project economics in that market. This burden becomes more difficult once the formula price of LNG is divorced from crude oil prices. "There is an opacity issue here," says one banker. "The gas market is far less transparent than the oil market. Yes, in the US there's Henry Hub, but there's certainly no quoted UK gas market." Although both the US and UK markets are deep and liquid, they have very different characteristics - and are not analogous. What happens in the US on price won't necessarily happen in the UK and vice versa.

On the upside, the interconnector with continental Europe should dampen the UK gas market's volatility. The first measure of the banking community's appetite for project debt from a strong sponsor across the chain with some market risk can be weighed when commitments for the Qatargas 2 financing come in.

Vessel supply

LNG shipping - or the relative lack of it - is also having an influence on the development of an LNG spot market. An open LNG market is restricted by the lack of flexible shipping and the mismatch between ports and tankers, and re-gas terminals and the richness of gas.

"People talk about flexible shipping but it's really only Shell that has that," says Harris. "Inherently shipping gives you some optionality, but you have to look at it from an integrated perspective. True flexibility is only possible where you've got some surplus in your liquifaction output, flexible shipping and optionality around your regas terminal and markets. If you're a new player in the industry, trying to get involved in a project on a long term deal from A to B, getting involved in shipping doesn't necessarily position you to take advantage of arbitrage."

The spot market's relationship with shipping is a chicken and egg scenario: an oversupply of shipping is required to facilitate the spot market, but a growing spot market is required to drive extra ship orders.

Shipping is not the only restriction on the spot market, there are also onshore capacity issues - for example, there have been instances in the past where cargoes have tried to get into Cove Point or Elba Island to access the premium New York market, only to fail because the pipelines have been contracted on a long term basis, so have sailed back to the Gulf Coast taking a discount on Henry Hub.

These factors are further drivers for upstream corporates to take on wholesaling risk on balance sheet, and push for an integrated supply model, so that they control the entire supply chain from upstream through to onshore infrastructure.

In addition to Exxon's integrated chain on Qatargas 2, the Qatari government is making a major play into LNG shipping through the government backed corporate, Qatar Gas Transportation Company (Q-Gas). The company's aim is to become one of the world's largest owners/operators of LNG tankers. Q-Gas will have two dry docks and own 77 vessels by 2010, with the aim of chartering the ships back to the state-backed projects - Qatargas and Ras Gas have contracts to supply LNG to Europe and the US for 25 years.

Comparing these figures with 165 LNG vessels worldwide and 66 on order, there are some understandable fears of a shortage of LNG vessels and ship yard space.

"The LNG market still looks broadly balanced but there is some speculation, particularly with new Greek shipping players coming in," says Harris. "Speculators see the market warming up, so there is the potential for things to get tight. Although companies have been taking on options, including orders for new ships, there are very few ships that have been taken on a purely speculative basis." Despite the emergence of Q-Gas there has been a proliferation of single upstream project based shipping deals - some viewed as asset-backed, some viewed as project financed, and some hybrid - that has thrown up an interesting mix of project financiers and shipping bankers.

Strangely lender friendly

LNG vessels present a distinct advantage over traditional ship financing by offering two levels of security, both the value of the asset and the long-term sales purchase agreement.

Conventional debt-to-equity ratios on LNG shipping deals come in at around 25/75. However, the recent Ras Gas 2 vessel financing came in with a 20/80 ratio, and is priced at 115bp in the sponsor guarantee period, stepping up to 125bp. The guarantee ends one year after the vessels start operating.

A sign of lender confidence, the financing was originally structured as a two-vessel $292 million facility, but the borrowing consortium opted to double the facility to $569 million to cover four vessels when primary syndication was 80% oversubscribed. Twenty-three banks came into the deal including lead arrangers ANZ, Bank of Tokyo-Mitsubishi, BNP Paribas, Calyon and SMBC.

Although there has been some movement in the borrower's favour, LNG vessel financing is still more expensive and has more strictures over equity than traditional project finance asset classes - such as higher levels of equity, guarantee, resell support and cost over run support. The technology risks for newbuild, even as the ships become ever larger from a conventional 160,000 cubic metres to an expected 250,000 cubic metres, are negligible, so the borrower friendly terms can be put down to inertia from previous financings or, more likely, the difficulty of redeploying LNG vessels. In effect there is a correlation between the ease of deployment and debt margins - indicative of the fragmented nature of the LNG market generally.

Supplementing banks

Although LNG debt is much sought by the lending community and has produced considerable international bank appetite, this appetite will be stretched in the latter half of 2004 and 2005. The market - both geographically and by sector - is set for a sizeable influx: the Qatargas 2 PIM asking for in excess of $1.5 billion is with banks, the Oman LNG Train 3 PIM (otherwise known as Qalhat LNG) is with banks, and ELNG Train 2 is expected to be launched by the end of the year. And into 2005 and 2006 financing for a further train of Qatargas 2 is slated, as is financing for Qatargas 3 and Ras Gas 3 - the first LNG trains out of the Middle East to the US.

Where Qatargas 2 looks set to be a template for the integrated model, bankers will be keen also to see how a financing of this scale will be put together. The financing is split into three portions: upstream, shipping, and UK receiving. The upstream portion will be the largest, and comprise a number of tranches across international and Islamic debt markets, and include an ECA tranche - thought to be from US Ex-Im and Sace. Although, for ease, convenience and cost project companies prefer to use international banks, the expertise and appetite of regional and Islamic institutions is increasing, and recourse to other sources will be vital for Qatargas 2-sized financings.

"There is greater liquidity in the Middle East from the regional banks than there was five years ago: they've got deeper pockets, they can offer longer tenors and they're keen to displace international banks," says Simon Elliston, co-head of infrastructure and energy in Europe, Middle East and Africa Citigroup. "If you're looking to finance a project in the Middle East now, you're looking at regional banks, international banks, Islamic financing, maybe conduit structures, maybe - in the appropriate circumstances - bond markets, and you maybe look at export credit agencies."

A large and relatively untapped pool of additional liquidity lies with Islamic institutions. The potential of Islamic financing was arguably first fulfilled in the Shuweihat IWPP financing in late 2001, with a $250 million Islamic tranche lead arranged by Abu Dhabi Islamic Bank (for details see www.projectfinancemagazine.com). And the recent Taweelah A2 refinancing was structured with a pre-agreed, safe-harbour woven into the terms that allows banks to securitise their participations without requiring the consent of the borrower (see this issue's Deals and Developments). This structure is a useful tool for institutions averse to longer tenors - such as local, regional and Islamic institutions - because it shores-up the expectancy of refinancing by allowing banks to issue bonds in the secondary market through an SPV.

Funding sources - the new school

Whatever the merits of particular sources of liquidity, the extent to which less favourable sources will be used will depend on the size of the financing and the deal's position in the deal pipeline. Elliston says: "There are some countries that have been modest in their demands of the financial markets over recent years and therefore there's untapped availability for them, and there are others that have been greater users and it sounds in some of those countries that liquidity is insufficient from typical sources and they are having to revert to sources they are less comfortable with, like export credit agencies."

That export credit agencies need to adapt to the market rather than the market adapting to their terms, is something most ECAs concede. Whereas ECAs are usually first into an emerging market, the Middle East and LNG in particular has been a bank-led market, and ECAs need to have consideration for the characteristics of this market, rather than rigorously apply internal policies, if they wish to up their exposure in the region.

"Export credit agency involvement does not have to be a last resort - ECAs need to operate as a partner to banks and respond to market characteristics rather than just policy or guidelines driven," says Rajesh Sharma, director, energy, project finance, Export Development Canada. "The Middle East needs additional sources of liquidity from outside the region to address demands posed by a large deal flow and tight regional liquidity. This additional liquidity can come from ECAs. But to be relevant to this market and be viewed as an important partner to deals, ECAs need to recognize that they are entering an established bank driven market and take a flexible approach to achieve timely closings."

The liquidity issue, if it becomes an issue, will be resolved - with or without ECA input. The LNG market is too popular with the commercial bank market to come unstuck. Nevertheless, integration of the supply chain poses difficult decisions for the lending community. In exchange for assuming responsibility across the whole of the supply chain through to upstream onshore infrastructure, sponsors will attempt to shift more price risk to banks at no extra margin. The problem for bankers will be finding a way to quantify that risk if gas price SPAs become the norm and matching the margin expectations of sponsors with those of their own credit committees.