Risks of FMR investments and mitigating factors

RISKS OF FMR INVESTMENTS AND MITIGATING FACTORS

Despite offering attractive returns on paper, FMR projects are subject to a variety of risks that must be seriously evaluated and can, to an extent, be mitigated. These risks fall primarily into five categories:

1. Associated gas supply risk. Often, the quantity and quality of associated gas are not fully known up front, particularly when the oil company has kept a poor record of its flaring activities, perhaps because of inadequate regulation and enforcement. The future decline rate of a flare is also a significant unknown, and forecasts in that respect are far from reliable. Several strategies can be considered to mitigate this risk: – Project capex should be sized on the basis of a conservative estimate of associated gas volume during the project duration, to avoid being left with ample spare capacity. This sizing could take the form of an estimated average volume flared assuming a conservative decline rate. Alternatively, capex should be tuned to the estimated volume after two or three years of decline rather than at inception. – Clustering several flares will allow developers to hedge their bets and make up any shortfall from a specific flare with gas from another one. – Using modular and movable equipment will allow developers to increase or decrease capacity efficiently and shift equipment among different flares at the target site. – Where possible, nonassociated gas should back up associated gas to mitigate supply risk and extend the economic life of the projects, allowing for investment to be amortized over a reasonable term and enhancing the financial attractiveness of FMR projects. – Factor in variations in associated gas composition in project design criteria. Often the trade-off for higher flexibility in this respect is accepting a lower conversion yield or a higher capex in order to minimize potentially serious constraints over the project life cycle. – Developers can attempt to sign a deliver-or-pay agreement binding the oil company to deliver a guaranteed volume of associated gas or pay penalties, although oil companies are likely to resist this arrangement. 2. End-product price risk. The financial returns of FMR projects are significantly affected by changes in end-product prices (electricity or gas), as demonstrated in chapter 3. This risk is more prevalent in projects selling the end product externally and is muted, or absent, in gas-to-power projects selling electricity for the oil company’s own use; because a reliable power supply is critical to field operations, oil companies are usually willing to lock in an electricity price for the duration of the FMR project. Conversely, external offtakers are in many cases not willing to sign long-term contracts. The strategies to mitigate this risk include the following: – Negotiating with the oil company a tolling fee remuneration structure that shifts (at least partially) onto the company the risk of end-product price volatility; – Evaluating in the project design phase the risk that new capacity from competing fuels (including renewable energy) may negatively affect market prices in the future;

– Installing modular and movable equipment to avoid being left with stranded or underused assets; – Signing offtake agreements for periods shorter than the target project duration, to eliminate volatility at least partially over the project life cycle; and – Building a diversified portfolio of FMR projects with different off-takers or end markets, if feasible. 3. Off-taker payment risk. FMR projects are exposed to the risk that the off-taker (for example, power distribution company) may not honor its contractual obligations, perhaps as a result of financial difficulties unrelated to the FMR project itself. This risk is not dissimilar from the risk incurred by many infrastructure projects and may significantly affect the ability to leverage the FMR project with nonrecourse debt. The strategies to mitigate this risk include – Seeking guarantees from the off-taker parent company or controlling entity, especially if it is the government; – Seeking guarantees or insurance for breach of contract from commercial or concessional providers, including development banks; – Evaluating the creditworthiness and reliability of the off-taker through due diligence, including analyzing any history of nonpayments in other projects; and – Where feasible, building a diversified portfolio of FMR projects with different off-takers. 4. Project execution risk. FMR projects include many moving parts and stakeholders. They are often in remote locations with limited infrastructure. If infrastructure needs to be built, the buy-in of local stakeholders may be necessary (for example, for obtaining the necessary rights of way for power transmission lines). Delays can occur during manufacturing or construction, along with inconveniences in other links of the value chain (downstream or upstream), which are out of the project sponsors’ control. The only mitigating strategy against these risks is to design watertight engineering, procurement, and contracting and to employ reputable contractors and established original equipment manufacturers. The latter also increasingly act as turnkey FMR project developers. By using and being in control of their own equipment, original equipment manufacturers-developers can exercise greater control over project execution. 5. Macroeconomic and political risks. FMR projects face a variety of macroeconomic risks, including those affecting oil companies. A significant drop in oil prices, for instance, may affect production at a given oil field and with it the supply of associated gas. Macroeconomic volatility may also affect prices and demand of the FMR project’s end product. Currency volatility could have severe repercussions for some FMR projects: in many countries the price of associated gas is in US dollars, loans are denominated in US dollars or other hard currencies, but off-takers’ tariffs and tolling fees are in local currency terms, exposing projects to local currency depreciation risk. Political risks in oil-producing countries include extended operational disruptions, often attributable to social unrest or pipeline damage, nationalization of oil fields or forced renegotiations of terms and conditions, and changes in legislation affecting the oil industry. These risks are not unique to the FMR sector,

and some are simply part of the business for the oil and gas sector. Mitigating strategies include – Negotiating force majeure clauses in associated gas supply contract and offtake agreements, although the negotiating power of independent FMR developers may be limited; – Political risk insurance from commercial or concessional providers, including development banks, if available at affordable terms; – Currency hedging, if available at affordable terms in the project country; and – Multicountry portfolio diversification, where feasible.

Although this report focuses on a project-level analysis of returns and risks, FMR projects are heavily affected by the national regulatory framework with regard to flaring, venting and methane emissions. Critical regulatory aspects to be investigated in project design phase include the following:

• Ownership of the associated gas. In many jurisdictions or contracts, who owns the associated gas is not defined. In most cases, oil companies are authorized to use associated gas for own consumption or reinjection, but rules regarding associated gas monetization may not be as clear-cut. • Flare and emissions disclosure rules and their impact on the accuracy of the data provided by the oil companies to FMR developers. • Flare and methane emissions payments and penalties and their indirect impact on FMR project economics. For instance, an oil company subject to heavy fines for flaring may be prone to supplying associated gas to the FMR developer at very advantageous prices. • Rules providing or denying third-party access to oil and gas facilities, which could affect an FMR developer’s ability to establish operations on-site. • Tax rules, including whether an FMR project is treated as an upstream or (more likely) midstream player and the ability to take advantage of accelerated depreciation schemes.