LXL Energy Handbook 2015 by LXL LLP

LXL Energy Handbook - 2015 A Guide to the Energy Industry for the In-house Energy Lawyer, Focusing in 2015 on Financial Collateral and Credit Support

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A birdâ&#x20AC;&#x2122;s eye view

Contents Message to the Reader

1.0 Global Trends and Recent Developments in International Finance and Energy

2.0 The Role of Collateral Support in the Energy Sector

2.1 Commercial, Credit and Political Risk 2.2 Secured and Unsecured Obligations 2.3 Payment and Performance Obligations 2.4 Comparison of Parent Company Guarantees and Letters of Credit as the Most Common Types of Collateral

13 13 16

3.0 Collateral Support in Practice

3.1 Upstream 3.2 Mid-stream 3.3 Downstream 3.4 Acquisitions 3.5 Decommissioning

25 28 30 32 37

4.0 Negotiating Collateral and Commercial Considerations

4.1 Parent Company Guarantees 4.2 Letters of Credit

41 42

5.0 Concluding Remarks

Glossary 46 2015 - A birdâ&#x20AC;&#x2122;s eye view of the energy industry

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A birdâ&#x20AC;&#x2122;s eye view

Message to the Reader This is our fourth annual handbook written for lawyers working in the energy industry. Time goes by quickly! In the series so far we have covered Gas and LNG, International Arbitration, and Acquisitions and Disposals. This year we are looking at the role of Financial Collateral and Credit Support in the energy sector. As the price of oil hits lows not seen for a long time providers of finance and concerned counter-parties will look ever more closely at the collateral on offer to support transactions. This handbook seeks to help the inâ&#x20AC;&#x201C;house lawyer and negotiator in these situations. We must of course stress that we are not providing any legal advice in this handbook and as such we must exclude any liability that may arise upon reliance on any of its content. Thanks this year go to my colleagues Paul Flood and Ali Lazem who have taken a complex subject and made it look relatively easy. If your client or your corporation finds itself in a situation where it requires or is being asked to give collateral support we very much hope that this handbook will help you and that you will think of using LXL if we can be of any additional assistance. Once again many thanks for reading this!

Alan Jones LXL LLP 28th February 2015

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

1.0 G lobal Trends and Recent Developments in International Finance and Energy

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Crude oil is the most traded commodity in the world. This fact is not surprising since, together with human labour, it is at this juncture of humanity the fuel that feeds our daily lives. Crude oil and its derivatives are all around us, from the visible – for example the petrol that is pumped into our cars, to the invisible – such as the vegetables we eat which are harvested using machinery lubricated with petroleum-based fluids. It is no surprise, therefore, that the spot price of crude falling from $112 per barrel in June 2014 to under $50 by January 2015 has caused major concerns across the entire industry. Even if there are prospects of a recovery, the climate of uncertainty this has created will remain for a significant time to come. Reasons for the Decline in Oil Price Oil prices are determined by actual supply and demand on the one hand and expectation on the other. Demand is affected country to country based on economic activity, and even seasonal weather. Basic economics dictates that prices are at equilibrium when supply and demand are balanced, high when demand is great and supply low, and low when supply significantly outweighs demand. With oil the basic rules apply, and other factors also come into play. The combination of a fall in demand (actual and expected) and especially an increase in supply, as well as political factors and decisions, have led to the recent decline in oil prices. Some specifics include: Chinese demand China’s economic growth of 7.4% in 2014 was its lowest in 24 years, and as China is the world’s second largest economy and biggest producer of goods in the world (production requires energy) this has affected the energy market and continues to do so. Here, we can identify two ways the oil price has been influenced by the Chinese economy: i) the divergence between oil supply and actual demand resulted in a drop in oil price; and ii) China’s growth is now expected to moderate even further in 2015, meaning a decrease in expected global demand as a result. United States demand The United States (US) is the largest consumer of oil, but its investment in shale has made it the biggest producer at the same time. US demand and supply therefore plays a pivotal role in the global market: i) an increase in US supply means a decrease in domestic US demand for overseas oil, i.e. whilst the US still imports oil, its imports have fallen, resulting in less

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

demand from other oil producers, thus increasing non-US producers’ supply and therefore global supply; and ii) the increase in US supply means an increase in global supply, and clearly both therefore result in a greater divergence between global supply and demand. OPEC supply Saudi Arabia would normally lead the OPEC cartel into decreasing its daily oil production in order to regulate global oil prices when prices are falling thereby maintaining a balance between supply and demand and therefore keeping oil prices stable. The OPEC countries have not done so on this occasion, resulting in oil prices continuing their steep decline from June 2014 to February 2015. Not reducing oil production has both commercial and political impacts. From a commercial perspective, low oil prices affect US shale production (see Financing Issues and Squeeze on Investment sections below), and with shale producers forced to squeeze investment, sell at a loss and even facing bankruptcy, OPEC countries will reinforce their dominant position in the global energy market. Iraqi supply The billions of dollars of investment into Iraqi infrastructure has also raised global oil supply, with Iraq’s production increasing to a record 4 million barrels per day (bbl/d) by December 2014, compared to its 3 million bbl/d in 2013. Financing Issues Falling oil prices obviously adversely affect profits of oil companies as well as the revenues of oil-producing nations’ exchequers. Low oil prices also result in a squeeze on investments – due in part to less profits that can be retained and pumped back into the companies, and from a squeeze on financing. It seems likely that potential lenders will be extra diligent when lending to companies that operate in a currently highly volatile market and who might not be able to find, extract and produce enough oil to pay them back. They will be concerned that long term low prices will not allow enough oil to be extracted at a feasible price for companies to meet their debt service obligations. This is currently the status, with many exploration and production

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

(“E&P”) companies, large and small, at risk of default and needing to restructure current debts because low oil prices set against oil actually produced simply does not balance the books. Apart from financing difficulties this may cause it seems likely that the increased climate of financial uncertainty will cause participants in the oil and gas industry to take a more cautious and conservative position on financial risk in their dealings with others in the industry at all levels of operation. At the same time as balance sheets are squeezed there may be more reluctance to provide collateral particularly where there is an associated financing cost. Potentially these considerations could make transactions even more difficult particularly for those participants who cannot demonstrate financial strength in a challenging market. There may also be a regulatory effect, particularly in relation to projected decommissioning liabilities where a fall in price has the potential to require the earlier provision of security than had previously been expected. It also seems likely that where regulatory approval is needed the financial stability of the party seeking that approval will become even more important. From October 2014 to February 2015, the credit rating agency Standard & Poor’s downgraded the rating of 19 high-yield oil and gas companies, with eight put into junk status, particularly relating to US shale E&P companies. The shale boom in the US has been majorly funded by around US$300bn in loans and US$200bn in high yield debts. Analysts estimate that North American shale requires a selling price of US$60-100 per barrel to break even on their finance arrangements, especially because of the high cost of hydraulic fracturing and horizontal drilling. Some indebted companies, in the US and elsewhere, might be forced to continue selling oil and gas at a loss. Analysts (CreditSights) foresee an increase in oil and gas loan defaults from 4 per cent to 8 per cent. Bonds in oil and gas companies account for approximately 15 per cent of the US$1.4tn junk-bond market (i.e. those fixed income, non-investment grade instruments with a higher default risk than investment-grade bonds). Clearly, the leverage taken by oil companies coupled with the risk of default and the junk in the bond market could result in a similar catastrophe as the 2008 financial crisis. Squeeze on Investment Low prices are testing producers’ resilience to obtain financing and drive

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

cost efficiency. Maintaining high levels of production is also problematic, as evidenced by the drop in oil rig rates and utilisation in the US (see below). International oil and gas services company, Schlumberger, announced write downs of US$1.7bn in its 2014 fourth-quarter results, and it plans on cutting 9,000 jobs as a result of the oil prices. Shell, ConocoPhilips and many others have announced 2015 budget cuts, for example:

• Shell aims to cut US$15bn in global spending over the next three years;

• ConcocoPhilips will cut its 2015 spending from around US$17bn to US$11.5bn;

• O ccidental plans to spend US$5.8bn in 2015, down 33 per cent; • BP has frozen wages for 2015; and • Chevron has delayed its 2015 budget. Domestic E&P in the US, particularly in relation to shale gas and oil, is a prime example of the effect of low oil prices on investment. For example, by mid-January 2015, there were 1,366 rigs drilling oil wells in the US, compared with 1,609 in October 2014. The drop in the region of 15% was sharp, especially considering that in the four weeks to mid-January 2015 the rig count dropped by 196, whereas the decline was 38 rigs in the preceding four weeks. Mergers and Acquisitions In order to survive, some companies, even major competitors, will have to merge or be acquired. In November 2014, service companies and major competitors Halliburton and Baker Hughes agreed to merge in a US$34.6bn deal whereby Halliburton acquired the shares in Baker Hughes. Other major acquisitions include the agreement concluded in December 2014 for Repsol to acquire 100% of the shares in Talisman Oil for US$8.3 billion plus the assumption of Talisman’s debt (approximately US$4.7 billion). Some E&P companies are also seeking to streamline their businesses by focusing on certain regions and selling their interests in other areas (particularly those with aged fields).

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Price Reviews In the 2012 edition of the LXL Handbook, we provided a broad overview of the key terms which will usually be found in gas/LNG purchase contracts and considered certain key changes over recent years. These included in particular a shift of focus for buyers away from security of supply and towards price flexibility, resulting in shorter contracts (between 15 to 20 years). We also observed that many “new” form SPAs include a periodic renegotiation of pricing provisions (commonly every three to four years). From a buyer’s perspective both of those features are designed to take advantage of falling prices by allowing a buyer to explore alternative sources of supply and by invoking its rights of renegotiation of the price. Clearly therefore in the present climate one would expect buyers under contracts with price review clauses to be exercising their rights which may result in disputes with sellers as to their entitlement to do so. More generally, one would expect the negotiation of price review clauses in future SPAs to be the subject of an increased level of attention. It is also inevitable that sellers will be faced with less profitable contracts and may even be placed in financial difficulty where buyers are able to take advantage of price review clauses or simply seek a commercial renegotiation. In an extreme case this may result in an increased risk of default in project financings and require lenders to step in and be proactive in managing cash flow. Decommissioning It is likely that the increased financial uncertainty will lead to an increased emphasis on decommissioning issues, particularly in some older fields (e.g. in the North Sea). In particular, any negative effect on industry profits may cause concern about the ability of participants to meet decommissioning costs. In addition, in those regimes which provide for collateral for decommissioning to be provided only after a “trigger date” on which the value of reserves is less than a specified percentage of anticipated costs, the effect of falling prices will accelerate that date. In some jurisdictions, therefore, there is the possibility of collateral being required earlier than anticipated, precisely at the time when profits are under pressure. We would expect that decommissioning issues will become even more important in the next few years, both in relation to discussions with regulators and between co-venturers and/or any historic participants who may have decommissioning responsibilities.

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

2.0 The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

“An oral contract is not worth the paper it is written on.” – Sam Goldwin

Concluding Remarks

Glossary

A bird’s eye view

2.1 Commercial, Credit and Political Risk Clearly, any business activity by its very nature involves risk with the key being to understand and successfully manage that risk. If used and managed properly collateral can be a useful tool to do that. The difficulty, however, is that collateral is often tested only after an unexpected event (such as the insolvency of a party) has occurred by which time it is too late to correct any errors. It is, therefore, vital that any collateral package is properly structured and documented, failing which it will simply give a false sense of security. In most aspects of oil and gas transactions there is an allocation of commercial risk between the parties, for example by the assumption of business liabilities in an asset transfer. In general terms, collateral can give little protection against that type of risk which is essentially a matter for commercial assessment. However, once a balance has been struck between the parties, a properly structured collateral package can guard against one party failing to honour (or being unable to honour) its obligations. To that extent it could be said that the real purpose of collateral is to mitigate this type of credit risk. In the field of political risk it is relatively unusual for any form of collateral to be provided as between commercial parties – in practice the main forms of protection are through contractual provisions, investment treaties and multilateral support. Although this handbook touches briefly on third party bonds and guarantees, political risk is generally outside its scope.

2.2 Secured and Unsecured Obligations “Collateral”, in the broadest commercial sense, can have two quite different meanings – firstly a direct form of security (for example by way of mortgage) over assets to allow the holder to take priority as a secured creditor over other creditors, or secondly some form of right against a third party (e.g. a parent company guarantor or provider of a letter of credit). Although many transactions in the energy sector do involve direct security (for example project financing) this handbook deals with collateral in the second sense as a risk management tool between commercial parties.

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

The following are the key types of collateral commonly found in the energy sector:

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Cash/Securities Deposit – in its simplest form this involves a party subject to an obligation (“Obligor”) to deposit either cash or investment securities (e.g. government bonds) and make these available to be applied against the relevant obligation. This can be a simple and effective way to provide collateral in specific situations – for example the deposit of cash with a regulator against future decommissioning costs by way of “cess payments”. From the point of view of the provider it does, however, tie up cash or assets and so may be inefficient and expensive. From the point of view of the party taking the deposit depending on jurisdiction, there may be structural/risk issues such as enforcement on insolvency of the Obligor where there may be competing claims from other secured creditors as well as custodian risk. In general terms, these factors make this type of arrangement relatively unusual between commercial parties. Parent Company Guarantees – this type of arrangement (commonly referred to as a “PCG”) involves one party (“Guarantor”) undertaking as a contractual obligation to another (“Creditor”) to be responsible for the obligations of a third party (“Principal Obligor”) if that party defaults in respect of specific obligations. In many cases the Guarantor will be a parent (either ultimate or intermediate) of the Principal Obligor but this type of arrangement may include upstream guarantees by subsidiaries or a cross guarantee structure involving some or all of a group of companies to create joint and several liabilities. As explained in more detail below, in some jurisdictions (particularly under English law), a PCG will also invariably include an indemnity as a separate obligation. Although some company groups may have an internal charging system for any inter-company PCGs there is no direct cost associated with a PCG. Principal Obligor

Primary obligation to pay/perform

Concluding Remarks

Glossary

A bird’s eye view

etters of Credit (“LoCs”) – a LoC is simply an undertaking (usually L by a bank or other financial institution) to another party (“Beneficiary”) to pay an amount of money up to a specific limit upon demand made within a specified time period. The obligation to pay is a direct obligation of the provider (“Issuing Bank” or “Issuer”) and, except in the very limited circumstances described below, that obligation does not depend upon the Beneficiary being able to show that there has been any sort of default or that it has suffered any sort of loss as a result of that default. For that reason LoCs (as well as Third Party bonds and guarantees) are often described as “primary” obligations in comparison with PCGs which are “secondary”. Principal Obligor

Primary obligation to pay/perform

Creditor (Beneficiary)

Indemnity

Issuing Bank (Issuer)

Primary obligation to pay in accordance with terms of LoC

The Issuer will always look to the Principal Obligor for an indemnity in respect of any payment together with a fee to reflect its cost of capital – in some cases this will be through a separate contractual indemnity, or, more commonly, as a result of the LoC being issued as part of the Beneficiary’s line of credit. There will, therefore, be a direct financing cost to a party requesting the issue of a LoC to another.

hird Party Bonds and Guarantees – these instruments (for T example performance bonds or advance payment guarantees) are also an undertaking (again often by a financial institution) to pay an amount of money (usually on demand) and can be categorised as primary obligations. As explained in more detail below, care needs to be taken in relation to this type of instrument to ensure that it does not take effect as a secondary obligation. Again, the provider of such bond/guarantee will invariably require an indemnity and payment of a fee.

Creditor

Indemnity

Guarantor

LXL Energy Handbook - 2015

Secondary obligation if Principal Obligor fails to pay/perform

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

2.3 Payment and Performance Obligations Almost every contract where collateral is taken will involve obligations to pay specific amounts of money as well as to perform certain obligations. In the case of LoCs and other primary obligations there is no need to distinguish between a failure by the Principal Obligor to make a payment or to perform an obligation – the only relevant question is whether the conditions of the relevant collateral instrument have been satisfied. In relation to PCGs it is common for a PCG to guarantee both payment and performance (or to procure performance) by the Principal Obligor. In some cases this raises the concern that the PCG is intended to be a primary obligation rather than a secondary undertaking. Similarly, in English law guarantees it is common for the Guarantor to undertake “as principal and not merely as surety”. It is clear that under English law these words will not, on their own, mean that a PCG will be interpreted by an English court/tribunal as a primary obligation. However, as explained below, careful drafting of a PCG is important.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

2.4 C omparison of Parent Company Guarantees and Letters of Credit as the Most Common Types of Collateral Parent Company Guarantees As explained above a PCG (also referred to in English law as a contract of surety) is a contract by one party to be responsible for the obligations of another. Under English law (Statute of Frauds 1677) it must be in writing1 but otherwise there is no specific form. However, as explained below there are certain matters which will always need to be addressed in an English law PCG – although a detailed analysis is outside the scope of this handbook it is important that at least the basic principles are understood. Since a PCG is a contract the normal rule as to consideration must apply. There is, however, no requirement for separate consideration for the guarantee where there is some benefit to the Guarantor in the transaction. In many cases (for example where a parent is giving a PCG for a subsidiary in an acquisition of an asset) that will be clear. However, the position may not be so clear in upstream guarantees (where a subsidiary guarantees the obligations of a parent) or corporate cross guarantee structures in which cases a party taking a guarantee should exercise care. Although a PCG is a contractual document English law recognises an equitable relationship between the parties. This has two main consequences:

(i) a guarantor has the right to an indemnity from the principal debtor for any amounts he pays; and

(ii) he may be discharged from his obligations if there are any dealings between the creditor and principal debtor without his approval which may prejudice that right.

For these reasons English law guarantees will always have clauses designed to waive these rights and to prevent the guarantor from enforcing any indemnity in competition with the creditor. The inclusion of these clauses may be an important “badge” if there is any issue as to whether a particular instrument is a PCG with secondary liability or if it is intended to create a primary payment obligation (in which case these clauses would be redundant). One of the key issues in any guarantee is the scope of the obligations which are covered. In some cases (for example a financial guarantee for repayment of a loan) this can be simple to define. In other cases, however, it may be more difficult, but in general terms, it is important

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

for all parties to understand what those obligations are. In some cases a party seeking a guarantee may try to include language in the indemnity provisions which suggests that the obligations of the guarantor go beyond those of the Principal Obligor – for example an indemnity against all losses suffered as a result of the performance or non-performance of the relevant contract by the Principal Obligor. In such cases it is important for the guarantor to include language to the effect that the liability of the Guarantor shall not exceed that of the Principal Obligor. Even where it is clear that this is intended to be the case (since it is simply a restatement of the general principle of secondary liability of a guarantor), such language is often included even though, arguably, it is redundant. It is also important (particularly from a Guarantor’s perspective) to consider whether there should be any time/financial limits in a guarantee, particularly if the guaranteed obligations are open ended – for example an indemnity. In relation to financial limits under English law there is a highly technical distinction between a guarantee of the whole of a debt with a limit and a guarantee of part only – from the perspective of a party taking a guarantee it is important that it is structured as the former rather than the latter which is why English law guarantees will always refer to a guarantee of the whole debt subject to a limit of X. As explained above there is no specific form required for an English law guarantee and (in theory at least), under English law, a simple written statement by A to B that it guarantees the obligations of C would be sufficient. However, in view of the complexity of the relationship between Guarantor, Principal Obligor and Creditor and the various defences and other rights available to a guarantor over time various clauses have been developed to deal with these issues. Although there is no standard form most commercial guarantees will contain a number of very similar provisions and it is important for anyone negotiating a guarantee to understand at least the basic principles. It is also important for a party taking a guarantee not to simply follow an existing form unless it is from a trusted source and has been properly reviewed.

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Letters of Credit In its original usage the LoC was designed as an instrument to allow an exporter of goods to ensure that he would be paid. In summary, the process involved the buyer of goods obtaining a LoC from his bank naming the seller as Beneficiary. Under the LoC, the buyer’s bank (Issuer/Issuing Bank) would undertake to pay a specific amount (the price) to the seller on delivery of documents (usually a bill of lading) within a specified period of time with these documents proving that the goods had been delivered for shipment and that title had passed to the Buyer. LoCs remain an important part of most complex international trade transactions (including physical energy trading transactions). However, they have also developed into standalone collateral instruments operating separately from any underlying trade finance transaction. Although many of the fundamental principles are common to all LoCs these are often referred to as “standby” LoCs to differentiate them from LoCs in trade finance transactions which are usually described as “documentary credits”. Although each financial institution will have its own preferred form of LoC, the form is generally much simpler than a PCG. The document itself is usually very short (one or two pages) but will incorporate lengthy standard terms by reference to the current version of either the Uniform Customs and Practice for Documentary Credits (UCP 600) or International Standby Practices (ISP 98). Although there are a number of differences between UCP 600 and ISP 98 (with UCP 600 applying to all types of commercial and standby LoCs and ISP 98 being specifically drafted to apply to standby LoCs) in practice either is likely to be acceptable to a beneficiary. Care does, however, need to be taken in relation to:

a) governing law (which needs to be expressly covered in the LoC since it is not dealt with in UCP or ISP);

b) the conditions for drawdown; and

c) the time limit/expiry of the LoC which are covered in more detail below.

For a party who is asked to provide a LoC (or more accurately to obtain a LoC from its bank) it is important to understand two principles. The first is that in dealing with the LoC the issuing bank will effectively be acting as principal for its own account and dealing with its own primary liability. The second is that the bank will regard the LoC as part of the line of credit and subject to the right to be indemnified. In this respect

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

there is a major difference with the situation under a PCG where there is a degree of common corporate interest involved. As explained in more detail below this significantly increases the risks for a party providing a LoC as opposed to a PCG and means that there will be a level of direct cost. The exact cost will depend on the relationship between the issuing bank and the party requesting the LoC but typically will be in the region of 0.75% to 1.5% of the principal amount of the LoC. One of the fundamental principles in relation to a LoC (and a key differentiator from a PCG or any other sort of secondary obligation) is the “independence” principle. In summary this is the principle that a LoC is a primary obligation of the Issuer which must be honoured in accordance with its terms and independently of the transaction in relation to which it is issued. Contrast this with the position of a guarantor under a PCG where that guarantor is entitled to take advantage of any defence which the principal obligor may have. The most common type of standby LoC will be “on demand” – that is payable on simple presentation of a demand by the beneficiary. This then raises the possibility of an improper drawdown of the LoC by the beneficiary and the circumstances in which they should be prevented from doing so (e.g. by way of injunction). Although most jurisdictions recognise that there are some circumstances where this should be done there are no uniform principles (which is why governing law may be very important) – under English law the commonly accepted test is whether drawdown would be a “manifest fraud”. Clearly this is an extremely difficult test to satisfy – but if a party providing a LoC from its bank cannot do that its only choice will be to allow draw down and seek to recover the proceeds from the beneficiary in subsequent proceedings. This may present difficulties – for example where the beneficiary is in a jurisdiction where proceedings may become drawn out and may place the party trying to make recovery under financial pressure since it will still be liable to indemnify the issuing bank provided it has paid out in accordance with the LoC.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

to be held until that contract has been performed) or advance payment guarantees (where a third party promises to pay an amount equivalent to an advance payment). Despite the terminology most of these are not “guarantees” in the sense of suretyship but are primary financial obligations and the terms of the document will make that clear. There have, however, been a number of cases in which there has been some uncertainty in the drafting with the issuer of a “guarantee” claiming it was entitled to refuse payment until there was evidence of a breach by the primary obligor and the beneficiary arguing that it was entitled to immediate payment. These cases underscore the importance (particularly for the beneficiary of a bond or guarantee from a third party) of understanding and negotiating what it is being offered. In contrast with LoCs (which tend to be in standard form) the form of such bonds and guarantees is usually a matter for negotiation and a party taking such collateral should be prepared to negotiate the form. In very general terms LoCs can offer a reasonably simple form of managing specific financial risk (e.g. trading margins) and/or regulatory type risk (e.g. decommissioning liabilities (where the applicable regulatory regime allows it)) or providing an alternative to cash collateral. As discussed below, however, they are relatively expensive and inflexible in managing wider commercial risk and PCGs may be a better option. It is also important to bear in mind that, as a primary obligation, a LoC is a credit obligation of the issuing bank and is, therefore, only as good as that bank’s credit rating.

Although the standby LoC is one of the most common ways for a financial institution to provide primary collateral there is also a market for other forms commonly described as “bonds” or “guarantees”. Common uses might include performance bonds (where a third party undertakes to pay a specific percentage of a contract sum

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Obtaining Payment Some of the key differences between PCGs and LoCs relate to the mechanism for obtaining payment. In the case of a PCG, before any demand can be made, the primary obligation must have fallen due for payment/performance and, where applicable (e.g. for payment of an amount of money) a demand must have been made. It is only at that time that a creditor becomes entitled to make a demand under the guarantee. After the creditor has made that demand the obligations of the Principal Obligor and the Guarantor operate independently of each other and can be enforced separately or together. In theory at least it is open to a creditor to collect in the full amount of any claim from both the Principal Obligor and the Guarantor but in practice this almost never happens since the creditor cannot retain more than he is owed and will be liable to account back to the Guarantor (in the case of over compensation). There is no specific time limit for making a claim under a PCG although this must be done before any claim against the Principal Obligor becomes statute barred (because the Guarantor could take advantage of such a defence) – broadly, under English law within 6 years of the relevant claim arising.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

(unless the LoC is on demand) it is important that the underlying contract provides that failure to renew a LoC is a default. Finally it should be noted that a LoC will normally specify a place for payment (e.g. “on demand at our London branch”) and may require a “sight draft” or similar (essentially a form of demand). It is important that these conditions are complied with fully, particularly if the default is due to insolvency in which case the Issuer may wish to try and avoid payment if possible on the basis that its indemnity is worthless. One other key difference between LoCs and PCGs is that a LoC will always be for a specific maximum aggregate amount of money. In some cases (e.g. a specific amount of trading margin) this may not be a difficulty. However, if the amount required is fluctuating frequently (particularly if it is increasing) it may be necessary to amend the amount. This can be done only with the agreement of the Issuer which in some cases may be prepared to do so only if the LoC is cancelled and reissued. This illustrates one potential drawback of LoCs as compared with PCGs because LoCs do require a degree of monitoring/ administration and any errors can be very costly.

In the case of a LoC the only question is whether the requirements set out in the LoC have been satisfied. This raises two issues – firstly the form of any demand to the Issuer and secondly the timing of that demand. A LoC will provide either: (a) that it is “on demand”, or (b) specify what is to be delivered (for example a certificate signed by a director stating that the Obligor has failed to comply with its obligations). As explained below, an on demand LoC is effectively a deposit of cash which can be drawn down at any time by the beneficiary without justification. In the case of a LoC specifying a document to be delivered, the document must comply with the description and, in the case of English law, must not be manifestly fraudulent. In relation to timing, any demand under a LoC must be presented before the expiry date. This will be a date specified in the LoC (usually 12 months after issue) although the LoC may contain an “evergreen” clause which provides that it will be automatically renewed at expiry unless the Issuer notifies the Beneficiary to the contrary in a specific period (usually at least 30 days) prior to expiry. The issue of expiry can cause difficulties – first it is essential that any demand is made before expiry and, secondly,

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

3.0 Collateral Support in Practice

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

“If I have seen further than others, it is by standing upon the shoulders of giants.” – Isaac Newton

Concluding Remarks

Glossary

A bird’s eye view

3.1 Upstream In relation to any discussion of collateral in upstream arrangements, the Joint Operating Agreement (JOA) is fundamental. The JOA is a contract between the co-venturers and effectively creates and regulates the Joint Venture (JV) between them. JVs can be in the form of a corporation, limited liability company or partnership. Where the JV operates as a corporation or limited liability company, the co-venturers will take shares in proportion to each of their JV interests and the JV will have a separate legal personality and be able to enter contracts in its own name. In contrast, where it operates as a partnership (or an unincorporated association) the JV has no corporate personality and it simply operates to allow the parties to share costs, risk, property and production amongst themselves. In practice, most JVs in the oil and gas industry will operate as an unincorporated association – this allows the parties to be separately taxed and to each maintain separate liability according to their percentage share and may also offer a greater degree of flexibility in the choice of co-venturers or in any subsequent changes to be made. As between the parties themselves, the choice of an incorporated or unincorporated JV has little bearing on the questions of collateral – however, when dealing with parties outside the JV, the structure chosen may make a difference. By its very nature, the exploration of a particular field is both risky and expensive. At the beginning of its life a JOA is essentially a method of allocating capital and operating expenditures and risks. Assuming that a project is successful during the production phase, the JOA’s function is then largely to regulate the smooth operation of a field and to allocate the rewards. Finally, as a project matures, the JOA needs to deal with further expenditure and risk including, in particular, how and when decommissioning liabilities are quantified and paid for. It is therefore critically important for each joint venture party to consider not only how it manages its own exposure (particularly at the early and late stages of a project), but also whether it is adequately protected if its co-venturers cannot manage theirs. The day-to-day running of the JV (including the negotiation and entry into the various support contracts with third parties for, e.g. seismic surveys, drilling, testing, decommissioning) will be delegated to one of the JV parties as Operator. Where the project is operated through

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LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

an incorporated entity the Operator will act as agent for that entity; where it is an unincorporated association, it will be agent for the individual co-venturers. In either case the Operator’s powers and responsibilities will be set out in the JOA with a joint operating committee supervising. Generally, the liabilities of the Operator will be very limited – usually only in the event of its wilful misconduct or gross negligence (or in the event that it has not kept adequate insurance in place in respect of all the joint operations) given that no party would otherwise wish to assume the role of Operator in light of the potentially huge liabilities. In practical terms, therefore, a party to a JOA is effectively delegating authority to a third party either to act on its behalf or on behalf of a company in which it is a shareholder, without any recourse to that third party except in extreme circumstances. In order to meet the financial obligations of a project, the Operator will issue cash calls on the parties. In many cases, the JOA will provide for some parties to “carry” others (often the host government parties) – that is to pay the cash calls for their percentage share to be repaid only if there is sufficient production share available for it to be repaid. This does of course increase the amount of capital at risk for the carrying parties. Similarly, where a party defaults on a cash call, it is essential for the benefit of the project as a whole that the remaining parties make up the expenditure, effectively carrying the defaulting party. It is in relation to this element of financial risk that issues relating to collateral can arise and it is important that these issues are carefully considered at the time of the original JOA and throughout the life of a project (and, in particular where there is a change in any of the parties through transfer of an interest or change of control). One of the ways in which most JOAs will seek to protect a non-defaulting party is by depriving the defaulting party of its voting rights initially and the inclusion of a process resulting in the defaulting party losing its interest. The exact way in which this is achieved may be through forfeiture or, in some jurisdictions (such as England) where forfeiture is not recognised, by a mandatory transfer of the interest in a process known as “withering” as compensation for damages. However, whichever mechanism is used, the fundamental problem remains that the remedy is effective only if the interest which is transferred is at least of equal value to the liability of the defaulting party. If it is not (for example

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

because of an early default in a project which does not progress to production or because of a later default in respect of decommissioning) the only remedy for a non-defaulting party(ies) is to pursue a damages claim. Although any properly drafted JOA will include such a claim, this will simply rank as an unsecured claim and therefore not provide adequate protection, which in turn raises the question of whether a PCG should be required. In some cases (e.g. where the co-venturer carries its own credit rating) it may be reasonably clear that a PCG should not be necessary. In other cases (e.g. a start-up) it may be clear that it should be required. However, there may be a middle ground (for example, where the co-venturer is the locally incorporated entity of a major) where it is less clear. It is also possible that any discussion of this subject may involve raising the possibility that a party may be allowed to go into insolvency (bankruptcy) by its parent as justification for a PCG. The nature of any discussion may vary depending on the stage of a project and the time of any discussion, for example, an incoming party seeking consent late in a project where decommissioning is looming may be at more of a disadvantage than a party in the initial stages. As mentioned above the position may be slightly different where the JV is dealing with third party contractors. Although those dealings will generally be managed by the Operator, it is reasonable for a contractor to understand which entity(ies) will be liable for payment. Where the JV is carried on through an incorporated vehicle, this will involve an analysis of the entity and the shareholders behind it. It is in this particular case that a third party bond or guarantee or standby LoC may be appropriate. However, where recourse is to the ultimate co-venturers it is possible that a contractor may require one or more PCGs by way of collateral. In summary, therefore, it is difficult to predict exactly how the climate of financial uncertainty will affect collateral in upstream contracts. It is, however, possible to be clear on two points: first, that in a climate of financial uncertainty it will become the norm for PCGs to be required and that all participants in the industry need to be ready to address this; and, secondly, that the transfer/change of control provisions in JOAs (particularly relating to financial capacity) will be scrutinised even more carefully than in a more benign climate.

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Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

3.2 Mid-stream In the case of a transportation system involving multiple users, there will be commingling of hydrocarbon molecules injected by the various shippers. Clearly, it will not be possible to separate out those hydrocarbon molecules at the delivery point meaning that where the product injected by various shippers is of different quality a shipper which injects high quality product will recover something less valuable than he has injected and a shipper which has injected a lower quality product will benefit. It is, therefore, necessary to include a mechanism in the relevant contractual documentation to equalize matters between them. That mechanism is commonly referred to as a “quality bank”. Before considering the operation of a quality bank and the function of collateral it is important to understand that the fundamental principles involved apply to a wider commercial context than the oil and gas industry – for example where securities are held by a custodian bank on behalf of a number of customers in a pooled account. It is also important to understand that such principles are usually tested only where there is an unforeseen intervening event – for example the insolvency (bankruptcy) of one of the participants – and that they are likely to involve complex issues of ownership, equitable principles (such as trust law) and a balancing of loss between parties. In considering any such structure it is, therefore, important to take into account the worst possibility even if it seems unlikely. Although the documentation is inevitably complex, the principles involved in the operation of a quality bank are relatively simple: essentially all shippers agree that a calculation agent will periodically (commonly twice in each calendar month) compare the quality of product injected by each shipper as against the value of the commingled product taken out by all shippers and, using a pre- agreed valuation mechanism calculate the amount due from those shippers which have benefitted to those shippers which have been prejudiced. The collection and distribution of those amounts is then managed by an account trustee which receives payments from those individual shippers liable to make payment and distributes funds to those who are entitled to receive payment. The account trustee is given power (acting as trustee) to enforce payment of any amounts which a shipper is liable to pay.

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

It is not necessary for the payment/collection mechanism operated by the account trustee to be in the same jurisdiction as the pipeline operation and, in some cases (for example where the pipeline jurisdiction does not recognize the concept of a trust fund operated by a trustee) it cannot be the same. As a result of each calculation some shippers will have financial obligations to the others which are enforceable only through the account trustee. For this reason it is common for quality bank documentation to require collateral to be provided to the account trustee either through a PCG or LoC. For the quality bank to operate properly in the relevant timescales it is essential that this collateral can be collected quickly by the accounts trustee for distribution. It is, therefore, important that the account trustee does not become involved in a dispute with a guarantor over whether calculations are correct (which a guarantor would be entitled to raise) or in any difficulties of enforcement (for example because a guarantor is in a different jurisdiction). For these reasons most quality banks will provide that collateral is to be provided by either cash or LoC in a form which will allow the accounts trustee to draw down on demand. In this way all participants in the quality bank can be certain that quality bank payments will be made promptly. From the perspective of a participant which is owed money by other shippers the provision of collateral as an on demand LoC (meaning that the account trustee can simply demand payment without giving any sort of reason) is a very useful feature. For a party providing collateral, however, it is effectively providing a fund which can be drawn at any time. As explained above in the absence of manifest fraud the independence principle will prevent it from restraining the account trustee drawing down the LoC even if there is a genuine dispute about the calculations. At the same time it is likely that its remedies against the account trustee will be limited to willful misconduct. Accordingly, unless it is able to restrain distribution of the trust fund after it has been drawn down by the account trustee (which would involve court proceedings in the jurisdiction in which the trust fund is located) its only remedy will be to seek resolution of the dispute in its favour and then recovery from any participants it can show to have been overpaid. The operation of a quality bank with LoC collateral is a good illustration of the benefits and pitfalls of LoC collateral – at one level it is a quick and straightforward way to enforce payment but on another it may leave the paying party in a “pay now sue later” situation. It also operates as an illustration of the importance of prompt, proactive action if there

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

is a drawdown in circumstances where there is a dispute – although it may not be possible to prevent drawdown it may at least be possible to keep funds held up (in this case in the hands of the account trustee) in a more favourable jurisdiction rather than being forced to take multiple recovery actions.

3.3 Downstream Long-term petroleum sale and purchase agreements create significant payment obligations for buyers, and sellers will often demand collateral support in respect of the buyer’s payment obligations. The type of collateral support given by a buyer is often subject to negotiation and dependent on the bargaining power of the parties respectively. Short-term sales agreements, including SPOT market trades, also often require collateral support which in practice is often given as letters of credit. Collateral support in downstream contracts is a rather standard feature. For example, clause 19.1 of the European Federation of Energy Traders (EFET) Master LNG Sales Agreement, requires “credit support” in the form of “a parent guarantee, a letter of credit, or other form…” however there are no prescribed forms attached to the model contract. The EFET model LNG sales agreement also contains a “performance assurance” provision which basically allows a party to require a re-guarantee. This kicks in when either party reasonably determines that the financial condition of the other party and/or its collateral support provider has become impaired (collateral support provider could be a parent or other entity that has provided a guarantee, the issuing bank in the case of a letter of credit, etc.). Although such provisions would likely be triggered by a seller requesting new or extra collateral from the buyer, it is not uncommon for a buyer to request (new) collateral from the seller: for example if a seller’s credit rating is downgraded, the buyer might require a guarantee from the seller’s parent or financially stable sister company to cover the seller’s financial commitments to the buyer – such as for shortfall penalties. The performance assurances listed by the EFET Master LNG Sales

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Agreement include prepayment, an irrevocable standby letter of credit by a reasonably accepted international bank, or a guarantee from the party’s parent or other entity. The AIPN model LNG sales agreement also contains collateral support provisions. AIPN’s model LNG sales agreement is drafted as a master agreement. A master agreement is for SPOT trading and contains provisions agreed by the buyer and seller for future (and usually non-obligatory) sale and purchase of product (in this case, LNG). When the parties wish to buy and sell LNG, they enter into a contract for each particular sale which incorporates and supplements their master agreement. The AIPN model LNG sales agreement’s credit support provision puts a duty on both the buyer and the seller to provide one another with collateral support as required in the ‘confirmation memorandum’ (which is the contract entered into between the parties to record the terms of a particular sale and purchase of LNG). The model contract suggests an irrevocable standby letter of credit or corporate guarantee of which prescribed forms are annexed to it. AIPN’s model gas sales agreement differs from its LNG model sales agreement in that it is a long-term contract, i.e. not for SPOT trading. The AIPN gas sales contract requires as a condition precedent evidence of each party’s financial standing and therefore their ability to satisfy their respective financial obligations under the agreement. Such evidence can be in the form of:

(i) a guarantee or standby letter of credit issued by a bank;

(ii) an on-demand bond issued by a surety corporation;

(iii) a corporate or government guarantee; or

(iv) s uch other financial security as is agreed by the buyer and seller.

Clearly, it is standard for petroleum sales agreements for both buyer and seller to be assured of the other’s financial capacity to pay. From the seller’s perspective, it will want assurance that the buyer has immediate financial capacity to stick to its payment obligations and has the credit rating to reassure the same for future obligations. Likewise, a PCG or sister company guarantee from the buyer will further reassure the seller that it will receive payment for its sales petroleum should the buyer default. A seller might also request a PCG from the buyer after conclusion of the contract should the buyer’s credit rating be downgraded further along the line. A buyer will request collateral support

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

from the seller to safeguard it in the event the seller fails to perform its obligations (e.g. delivery obligations), whereby for example the seller will be liable to pay shortfall penalties. The same rationale behind the seller’s request for collateral support applies to the buyer’s request.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

LXL Energy Handbook - 2015

A bird’s eye view

a. Direct obligations which will arise in the future subject to satisfaction of conditions precedent – for example the obligation of a purchaser to pay the price or for a seller to transfer an asset. Clearly, these obligations arise at the time of the transaction documents and any PCG must cover those obligations and come into effect at the same time as the transaction documents. In most if not all cases these obligations will be satisfied at completion.

b. Indemnity obligations by the buyer to the seller which will take effect at closing – examples of these obligations might include indemnities from the buyer to the seller in respect of business liabilities, environmental/decommissioning liabilities, or tax liabilities. In considering these obligations it is important carefully to analyse when an obligation takes effect – in the case of business liabilities it will often be from a date preceding the date of the transaction documents (often referred to as “the Effective Date”) whereas in the case of environmental/decommissioning obligations it may include all historic liabilities. In the case of taxation however, the conventional transaction would involve the buyer and seller each taking responsibility for their own tax liabilities before and after the transaction. The important distinction between this type of obligation and the type of direct obligation in (a) is that these obligations will not have any substantive effect unless completion occurs and will continue after completion – potentially for an indefinite period.

c. Obligations to third parties – where assets have been the subject of successive transactions in the past it is not uncommon for a seller to seek to pass on some or all of its obligations to an earlier party (for example an environmental/decommissioning indemnity) to a buyer and to seek some form of collateral. Essentially this can be done in one of two ways – either by the buyer agreeing to counter indemnify the seller (in which case the obligation becomes an indemnity type obligation as in (b) above) or by the buyer undertaking to procure the release of the seller from its obligation. In many cases these will be combined with the

In broad terms there is a distinction to be drawn between asset sales (whether by way of farm in or a simple sale of assets) and share sales. However, it should also be noted that in some sectors the hive –down (in which a particular asset or group of assets are transferred to a newly formed company owned by the seller before the shares in that company are transferred to the buyer) is commonly used: as explained below such transactions can cause complex issues in relation to parent company guarantees. As a general principle in any acquisition collateral will normally be provided by means of parent company guarantees rather than by LoCs. In an asset sale such collateral has two main purposes – first to secure the specific obligations of the parties relating to the acquisition under the transaction documents (e.g. the obligation of the purchaser to pay the price) and, secondly in relation to the broader obligations a party may assume as a result of the transaction (e.g. the assumption of ongoing business liabilities). Although it is usually relatively easy to identify the former category the second category can present more problems. Similarly, as explained below there can be difficulties in establishing exactly when a PCG should come into effect and when it should cease to be effective. As discussed below this difficulty does not usually present itself in a share sale except where there is hive down immediately preceding the share transfer – this is because the target company comes with all existing liabilities.

Glossary

The difficulty can be illustrated by looking at the various types of obligations which appear in most asset acquisition transactions. These can be broken into a number of categories:

3.4 Acquisitions The dramatic fall in oil prices will, no doubt, have a significant effect on the level of acquisition activity in the oil and gas sector and the analysis of risk and reward. For some potential buyers it may present an opportunity to acquire assets at a low point in the market. However, for both potential buyers and sellers it may also lead to a greater awareness of financial risk in a transaction and the need to mitigate that risk as far as possible.

Concluding Remarks

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Contents

Global Trends and Recent Developments in International Finance and Energy

Message to the Reader

The Role of Collateral Support in the Energy Sector

buyer undertaking to use reasonable endeavours to procure the release of the seller as a condition precedent to closing with the seller having the right to waive the condition on the basis that there will be an indemnity if it does so. In such circumstances it is important for the documentation to provide clearly what will constitute “reasonable endeavours” by the buyer particularly in relation to the provision of any alternative guarantee: if it does not do so it runs the risk of giving an open ended commitment with a potential breach of contract claim against it.

d. Other obligations – e.g. liability for breach. Clearly, the purpose of holding collateral is to obtain security for the relevant obligation. From the point of view of the provider of a PCG it is important to understand and analyse what this may mean: for example a guarantor which guarantees all the payment obligations of a buyer under a sale agreement will potentially be exposing itself to a liability for damages for non- performance rather than just non – payment of the purchase price. In these situations therefore if the guarantor does intend there to be a limit on its liability the onus is for that guarantor to make sure that is clearly set out in any PCG.

In summary, therefore in considering a PCG there are three critical questions:

(i) W hat are the guaranteed obligations covered by the PCG? Is it simply a limited obligation (e.g. to pay the price) or does it extend beyond that to other obligations under the contract? And if it does can those obligations be performed?

(ii) W hen does the PCG become effective? In some cases this will be obvious – for example where it relates to a direct obligation under the sale agreement. In other cases it may be more difficult – for example where it relates to an indemnity to a third party which only becomes effective after completion.

(iii) W hen does the guarantee terminate? Again, in some cases where the obligation is a single act it is pos-

LXL Energy Handbook - 2015

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

sible to be certain when the PCG will cease to have effect. However, where the obligation is an ongoing or indefinite obligation (e.g an indemnity) there will be no time limit. Is this acceptable? As noted above the hive down can create particularly complex issues in structuring PCGs arising from the fact that by definition the hive down vehicle will be a newly incorporated special purpose entity (which the buyer will require to ensure that it is a clean vehicle) and that there is a two stage process involving a transfer of assets followed some time later (usually at least 7-10 days) by a share transfer. One particular difficulty is that other parties (for example co –venturers or regulators) may require PCGs as a condition of the asset transfer – clearly it would be wrong for the ultimate buyer to provide these before the share transfer but equally clearly the seller will require to be satisfied that any PCGs it provides will be released. Taken together these factors can make the drafting of sufficiently precise conditions precedent which define the buyers (and therefore guarantor’s) obligations extremely complex. Also as is noted above in many cases a seller of assets will have given indemnities to third parties (for example in respect of decommissioning and/or environmental liabilities) supported by its own PCG which can be released only by that third party. Although some sellers may be prepared to accept a counter indemnity from the buyer that leaves open a degree of risk for the seller. As a practical matter the only way to remove that risk is for the buyer, seller and third party to agree to release the sellers PCG and replace it with a new one from the buyer’s parent. As noted above this will commonly be included as a condition precedent which can only be waived by the seller. Ultimately, therefore it is a commercial matter for the seller whether it is prepared to take that risk and allow the transaction to proceed even it is not released from historic guarantees – this may become an important factor in future transactions as the risk/reward balance shifts due to oil price changes. One issue which can often create difficulties is where there are multiple guarantees for the same obligation. Essentially this can happen in two different ways – first where the same obligation is repeated in different documents between the same parties with separate guarantees (e.g. where there is a decommissioning indemnity in an SPA which is repeated in a separate Decommissioning Security Agreement) or secondly where the same indemnity supported by a PCG is given to two separate parties (e.g. where a buyer gives a decommissioning indemnity in an SPA but

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

also replaces an indemnity given to a third party to obtain the release of a PCG). These situations can cause complexities but, as a practical matter, it may often be the case that the overlap is not a cause for concern on the basis that by performing the obligation any liability will be reduced/eliminated under any PCG which covers that obligation. Again, however, the important point is to understand clearly the underlying obligation and to make sure that there is no potential mismatch between the overlapping PCGs. In summary, therefore almost any acquisition is likely to involve some form of PCG support which may range from a limited obligation to underwrite the payment price for the shares or assets to a more complex long term obligation potentially overlapping with other PCGs. The critical point is to establish and maintain a clear picture of what obligations are being guaranteed and to draft the documentation accordingly including, in particular the definition of “Guaranteed Obligations” or similar terms. This will almost certainly involve a clear analysis and understanding of the obligations in the underlying transaction and the consequences of any breach. Unless it really is intended that all contractual obligations are covered, generic language (“such as all payment or performance obligations”) should be treated with care.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

3.5 Decommissioning The question of decommissioning liabilities is a global concern, particularly in mature/declining fields such as the North Sea. Although regulatory regimes around the world have different ways of treating decommissioning, one common feature is a calculation of the anticipated value of reserves at any given time against the anticipated decommissioning costs calculated on a net present value basis. Any fall in the oil price can, therefore, only serve to decrease the anticipated value and, accordingly either require increased provision, where the regulatory regime requires decommissioning costs to be provided for in cash on an ongoing basis or bring forward the “trigger date” where decommissioning is provided for only when the value/costs reach a certain ratio. In either case this raises potentially significant issues in an industry facing financial pressure. In jurisdictions which do not require cash/collateral to be provided on an ongoing basis there is often a “last man standing” statutory regime which allows recourse to parties which have had an historic interest in a project in addition to those parties with interests at the time of decommissioning. For example, in the UK, the decommissioning regime is set out in the Petroleum Act 1998 as amended by the Energy Act (the Petroleum Act) and administered by the Department of Energy and Climate Change (DECC). Under the Petroleum Act, DECC can serve a notice (commonly referred to as a “section 29 notice”) on any current licensee and this notice remains in place even after disposal of that interest by the licensee, unless and until the notice is withdrawn by DECC. Even then such a notice can be reissued in certain circumstances although DECC have made it clear that this would be as a last resort. Although this has a number of advantages (principally that it does not lock up cash until a later stage) such a system can create a complex series of relationships among successive owners and a complicated collateral structure. Fundamentally, a decommissioning regime based on English law involves the creation of a trust fund after the relevant trigger date which is available to meet decommissioning liabilities. This fund involves either the depositing of cash by a participant with an independent trustee or the issue of the equivalent value of LoCs. By establishing the fund as a trust fund the intention is for it to be “ring fenced” and available for decommissioning liabilities even in the event of insolvency of a party. After the trigger date the amount of the fund is adjusted to

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

take into account future anticipated decommissioning costs. In the UK after recent legislative changes designed to assist the oil and gas industry the amount deposited can be reduced to the post-tax cost to a particular party provided it has entered a tax deed with the UK government. Again, the recent fall in oil prices has significantly increased the attractiveness of this option.

be divided up so that it ceases to apply to decommissioning obligations only for part of a project it is possible that the holders of such PCGs will effectively be holding double security. Regrettably, these issues can increase delay and cost in transactions and may lead to litigation about the degree of liability of individual parties under the collateral they have provided.

However, the picture is complicated because any party which has held an interest in the project can be jointly and severally liable for decommissioning costs with all or any of the project parties at the time of decommissioning. Accordingly, on any disposal of any interest it has become standard practice for the seller to seek an indemnity from the buyer in respect of any decommissioning liabilities (usually referred to as a “bilateral decommissioning security agreement”) and to require collateral for that indemnity. In most cases that collateral is required to be in the form of a PCG (subject to the Guarantor having an appropriate rating or in default a LoC from an equivalent bank) until the trigger date and thereafter in the form of a LoC. Again, in most cases the amount of any LoC cover required is reduced by the amount of any cash/LoC placed in trust under the statutory scheme.

In brief, therefore, while it is clearly important that decommissioning liabilities are properly provided for it is to be hoped that the change in the financial climate will not lead to parties seeking to maintain an additional layer of collateral based on an unrealistic analysis of the risk to them.

Although the principles behind the structure are relatively simple the implementation is not straightforward particularly in light of the changed tax position. In particular, many historic bilateral decommissioning security agreements require collateral to be calculated on a pre-tax rather than post-tax basis thus leading to a higher requirement than under the statutory scheme. This raises the possibility that a party may be providing fully under the statutory scheme but may be required to provide additional LoC collateral to a predecessor in title for the same liability. This is unfortunate at a time of financial pressure. A second issue arises in relation to PCGs provided before the trigger date. Where a party has provided a PCG to a predecessor in title and wishes to dispose of an interest the holder of the guarantee is entitled to require a replacement. In some cases the criteria which must be satisfied by a replacement PCG are clear – however, in others the test may be more subjective (e.g. reasonably acceptable). In those cases it is possible that a more conservative approach may lead to disputes as to what is reasonable and what is not. Finally, there are often difficulties where there is a transfer of part only of an interest – since a PCG cannot

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

4.0 Negotiating Collateral and Commercial Considerations

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

“A negotiator should observe everything. You must be part Sherlock Holmes, part Sigmund Freud.” – Victor Kiam

Concluding Remarks

Glossary

A bird’s eye view

4.1 Parent Company Guarantees In negotiating a PCG the most important issue for both parties is to identify the obligations which are the subject of the guarantee and any financial or time limits. By definition this will involve a careful review of the underlying transaction and the nature of the obligations being undertaken by the Principal Obligor. It will also be important to consider when the PCG needs to become effective – for example on an acquisition whether it is at the time of the relevant contract or whether it is a condition precedent to take effect at closing. The parties should also consider whether there is any overlap with other PCGs given to the same or other parties covering the relevant liabilities and whether there should be any pre agreed release/replacement provisions (for example reducing the security provided under a Bilateral Decommissioning Security Agreement by the amount of any security provided to a regulator). It is also important to remember that a PCG is only as good as the underlying covenant and, unless security is taken, will simply rank as an unsecured obligation of the Guarantor. The financial strength of the Guarantor is therefore important and should be assessed carefully. If it is important that particular specific criteria are satisfied (e.g. maintenance of a certain level of credit rating) it may be appropriate to consider including a provision in the relevant contractual documentation requiring alternative security (perhaps in LoC form) if the position should change. It may also be appropriate to consider change of control and/or transfer provisions. After considering structural issues the form of any PCG is also important: as noted above it is essential that any PCG is carefully drafted and that the clauses in it are not simply treated as “boilerplate”. It is also important (particularly in the case of third party provided bonds and guarantees) not to assume that any document described as “standard form” or “market” must be in the correct form particularly if they involve obscure or unclear terminology: it should always be possible for a person seeking inclusion of a particular term to explain why it is appropriate. Finally, in relation to formalities it is important (particularly for a party seeking to rely on a PCG) to ensure that appropriate corporate formalities are followed including (particularly in relation to “upstream” guarantees) that there are no concerns about whether there is any sort of commercial benefit to the guarantor.

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LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

4.2 Letters of Credit In the case of LoC collateral, for a provider the key issue is cost and the terms of any indemnity. For a party considering taking a LoC, the position is more complex. Unless the LoC is on demand, the first question is what has to be done in order to make a valid demand and in particular whether it will be possible to give any required statement as to breach. The form of the statement should be considered and, in particular, terms such as those requiring signatures to be authenticated by a Beneficiary’s bankers, should be viewed with caution. Finally, the expiry date needs to be checked carefully – if there is no “evergreen” clause it is important that the time for performance of the relevant obligation falls within the period of the LoC (so that a statement that there has been a breach can be made). Even if there is an “evergreen” clause where the LoC is not payable on demand it is important that the underlying documentation makes it clear that there will be breach of the relevant contract if notice is given so that demand can be made within the relevant period.

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

In relation to corporate formalities in the vast majority of cases there will be no requirement for any additional diligence or formalities beyond the issue of the LoC. Finally, it is essential that a party holding any form of LoC cover sets up a proper administrative system to ensure that they are in place, deal with any amendments and, most importantly, monitor expiry dates. It is also important that the personnel involved in that exercise understand the practicalities involved in making demand (e.g. can issue sight drafts and obtain relevant signatures) and that they have the support available if it becomes necessary to act quickly – for example to restrain the payment away of the proceeds of any LoC which may have been wrongly drawn down.

As explained above most banks will have standard form LoCs – although these are generally not negotiable they should be checked carefully and, in particular, to ensure that they refer to the current version of the UCP (currently UCP 600) or ISP (currently ISP 98), that they specify where payment is to be made (and that it is an acceptable jurisdiction) and that the governing law is appropriate.

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

5.0 Concluding Remarks

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Life should never be dull and the energy sector in 2014 could not be said to be that. However, too much excitement can be equally challenging. The dramatic fall in oil prices has shaken up the sector. Some may say that this shake up is well overdue. Certainly the consumer will see (and already is seeing) significant benefits as fuel prices fall, reducing petrol and heating bills and indirectly lowering the costs of both basic and luxury goods (for example food and cars). Some may also say that it is no bad thing to be forced to look at the structure of a business and energy companies and those servicing them are no exception. Perhaps for too long high prices and high profits have let bad habits slip in – an expectation that success is consistently easy to achieve, that costs do not necessarily need too much scrutiny, that relationships with lenders, counterparties or others are never going to change fundamentally and do not require too much attention. This is where opportunities to do better present themselves. Realising she would never be a nun the young postulant Maria repeated the words of her Reverend Mother to her soon-to-be husband Captain von Trapp in The Sound of Music: “When the Lord closes a door, somewhere He opens a window.” Let’s hope quite a few windows will be opening in 2015.

We hope that you have enjoyed this contribution on Financial Collateral and Credit Support and that the few insights we have added for the beneﬁt of the in-house energy lawyer will prove helpful. Safe Journey. LXL LLP

LXLEnergy EnergyHandbook Handbook - 2015 LXL - 2015

LXL Energy Handbook - 2015

Contents

Message to the Reader

Glossary

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

Advance Payment Guarantee A promise by a party (usually a bank) to pay a party (a Beneficiary) an amount equivalent to an advance payment made by the Beneficiary to a third party, e.g. when a contract requires the buyer (Beneficiary) to make an advance payment to the seller, the bank guarantees to the buyer that the advance payment will be paid back to it by the bank if the seller fails to perform its obligations under the contract (e.g. to deliver goods). Beneficiary A person/entity that is eligible to receive the benefit of something, e.g. money. Bill of Lading A legal document between the shipper of particular goods and the carrier transporting those goods, typically detailing the type, quantity and destination of the goods. When payment for goods is by documentary credit, it is common practice for the shipper (i.e. the seller / beneficiary) to present the bill of lading to the issuing bank to be able to receive payment. Cess Payments Royalties/tax payments. Contract of Surety An agreement under which one party (“A”) accepts responsibility for another party’s (“B”) specific liabilities to a third party (“C”) in the event of default. For example, a PCG under which the parent (“A”) undertakes to be responsible for its subsidiary’s (“B’s”) decommissioning liabilities to the regulator (“C”).

LXLEnergy EnergyHandbook Handbook - 2015 LXL - 2015

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A birdâ&#x20AC;&#x2122;s eye view

Credit

Guarantee

Something of value (e.g. funds, goods, services) due to be repaid at a later date â&#x20AC;&#x201C; in the context of this handbook, credit means money.

A binding legal commitment to repay a debt if the original debtor defaults (a secondary obligation).

Creditor

Guarantor

An entity that has extended credit (e.g. Issuing Bank) to another and is therefore owed money.

A party that gives a guarantee. Indemnity

Cross Guarantee A guarantee given by entities belonging to the same corporate group which are neither a parent nor a subsidiary (e.g. sister companies). Default The failure of a party to fulfil a contractual task/obligation, e.g. payment obligations. Documentary Credit A form of LoC used in trade finance transactions whereby a shipper/ seller of goods (beneficiary) can obtain payment for the goods from a bank (issuing bank), with the bank then seeking reimbursement and compensation from the buyer (i.e. requesting party). Evergreen Clause A clause in a contract that provides for automatic extension/renewal of the contract. This can be found in some LoCs (especially standby LoCs).

LXL Energy Handbook - 2015

A promise of money/payment given by one party to another to cover damages/losses triggered by a specific event. ISP 98 International Standby Practices 1998 which is a set of rules and best practice for users of standby letters of credit. Issuing Bank / Issuer A bank/credit institution that issues a LoC and pays on demand/on presentation of specific documents. Letter of Credit (LoC) A letter from an Issuer to a holder of the letter whereby the Issuer gives a primary obligation to pay the holder according to the terms of the LoC (e.g. presentation of specific documents such as a bill of lading). Obligor A party subject to an obligation.

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A birdâ&#x20AC;&#x2122;s eye view

Parent Company Guarantee (PCG)

Sight draft

A guarantee given by a parent company.

A document which accompanies a LoC and demands the Issuer to pay the Beneficiary/holder of the LoC immediately upon presentation of the sight draft, LoC and any other required documents (such as bill of lading).

Performance Bond A type of primary obligation by a third party (usually a bank) which undertakes to pay a specific percentage of a contract sum to be held until that contract has been performed. For example, the bank pays into a bond 20% of the contract price which is held until the Principal Obligor has fulfilled its contractual commitments, and where there is a default by the Principal Obligor, the performance bond is paid to the Beneficiary.

Standby LoC A collateral instrument which creates a primary obligation on the Issuer to pay the Beneficiary according to the terms of the LoC. For example: Primary Obligor defaults in its obligation to pay/perform so the Beneficiary demands payment from Issuer under the standby LoC and the Issuer recovers any payments made from the Principal Obligor through an indemnity given by the Principal Obligor to the Issuer.

Primary Obligation An obligation that must be fulfilled by the party which has given the obligation and which is not reliant upon the default by another party.

An obligor which has given an initial obligation (e.g. a buyer which has agreed to pay for petroleum).

An equitable or beneficial right or title to property typically used in the energy industry for mid-stream pipeline transportation where commingling occurs and whereby money is held in trust by an account trustee for and on behalf of parties who have injected high quality product into the pipeline system but take out lower quality product due to other parties injecting lower quality products into the system.

Requesting Party

UCP 600

A party that requests an Issuer to issue a LoC for the benefit of a Beneficiary/Creditor.

Uniform Customs and Practice for Documentary Credits which is a set of rules on the issuance and use of documentary credits.

Secondary Obligation

Upstream Guarantee

An obligation that must be fulfilled by the party which has given the obligation only when another party defaults on a Principal Obligation.

A guarantee given by a subsidiary to its parent company.

Principal Obligor

Trust

LXL Energy Handbook - 2015

Contents

Message to the Reader

Global Trends and Recent Developments in International Finance and Energy

The Role of Collateral Support in the Energy Sector

Collateral Support in Practice

2015 - A bird’s eye view of the energy industry We would like to conclude this handbook by providing a “bird’s eye” view of the energy industry in the year 2015 and beyond: • Brent crude price to average at US$58/bbl in 2015 and US$75/bbl in 2016. • Henry Hub natural gas price to average at $3.05/MMBtu (million British Thermal Units) in 2015 and $3.47/MMBtu in 2016.

Negotiating Collateral and Commercial Considerations

Concluding Remarks

Glossary

A bird’s eye view

“Energy forecasting is easy. It’s getting it right that’s difficult.” – Graham Stein

• OPEC supply of petroleum and other liquids, which averaged at 30.1 MMbbl/d (million bbl/d) in 2014, to fall by 0.1 MMbbl/d and 0.4 MMbbl/d in 2015 and 2016 respectively; this is notwithstanding the growth in Iraqi and Iranian production which will be counterbalanced by a fall in production of other Gulf producers. • Non-OPEC supply increased by 2.1 MMbbl/d in 2014 and this will increase by 0.8 MMbbl/d in 2015 and 2016, the lower increase largely due to the decline in oil prices resulting in less investment – e.g. in US shale E&P and depleting fields such as the North Sea. • Global consumption of petroleum and other liquids to reach 93.1 MMbbl/d in 2015 and 94.1 MMbbl/d in 2016.

• Natural gas price in Europe to remain volatile due to the ongoing crisis in Ukraine – the crisis will also result in greater investment in LNG terminals on the continent so countries can have greater security of gas supplies; this also means potentially higher global prices for LNG (due to increased demand for LNG). • I nvestment in renewable energy jumped by 16% in 2014 (investment totalled US$310bn) which reflects greater government support globally (including government schemes to meet carbon emissions targets) and advances in renewables technology (such as solar photovoltaics) – investment is expected to continue in the sector for a foreseeable time to come. • Africa will also benefit from investment in renewable energy on small community scales to alleviate poverty issues and promote economic growth. • With the world economy expected to double in size in the next 20 years, demand for energy is expected to increase by 40% and two-thirds of that demand will be met by oil, gas and coal. • Over the past decade, petroleum demand has risen by 2.5% per year on average, this figure is expected to be 1.5% per year over the next decade due to greater energy efficiency and slower growth in China and India as well as investment in renewable energy. • The Arctic remains an attractive region to E&P companies but has not been sheltered from economic and political factors: some E&P plans in the Arctic are therefore expected to be put on hold indefinitely or modified resulting in delays (including e.g. as a result of sanctions on Russia preventing joint ventures with Rosneft and proposed regulations in the US Arctic).

LXLEnergy EnergyHandbook Handbook - 2015 LXL - 2015

LXL Energy Handbook - 2015

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LLP 28.02.2015. No part of this manuscript may be copied or reproduced without the consent of the author