Growing Capital Demand Creates New Structures for Midstream Investing

Changes in consumer demand, businesses shifting consumption patterns, growing demand from emerging and frontier markets, implementation of new regulatory mandates, availability of alternative energy feedstock sources, and aging infrastructures needing replacement have led to greater needs for capital for midstream energy assets.  These include refineries, power plants, LNG terminals and other facilities, both in developed and emerging markets.   Just for North American natural gas, for example, the INGAA foundation is projecting midstream capital demands of $205 billion over the next 25 years.

The demand for capital for midstream projects is truly global, with 12.5m barrels per day of petroleum refining capacity expected to be added over the next five years, equivalent to 60 new large-scale refineries. This has been mainly driven by National Oil Companies investing in assets for strategic energy security purposes with key examples in India, China, Brazil, Angola and Nigeria. Similarly, 770 billion cubic meters per year of incremental combined LNG regasification and liquefaction capacity is to be built up to 2015 to support the shift to natural gas consumption in a number of developed markets and to exploit global price arbitrage opportunities between markets. This increase in LNG liquefaction capacity would be equivalent to approximately 15 percent of the current global natural gas consumption.

Increasing requirements to maintain healthier leverage ratios and operating risk capital in the context of volatile commodities markets, however, have limited energy players’ ability to fund their investments from their own balance sheets.  This has stimulated the demand for alternative capital and commercial structures which reduce these players’ capital requirements.

Energy corporations have improved their liquidity and leverage ratios over the past three years to address market risk and challenging debt capital markets, according to our analysis of the balance sheets of energy corporations. Debt-to-asset ratios have been reduced by eight percent by utilities and three percent by international oil companies over the past three years.  Liquidity ratios have, in turn, increased by 4 percent and 15 percent, respectively, for utilities and IOCs, increasing the availability of risk capital.

Need for Joint Energy Investments

Capital markets firms and energy companies are developing joint investment structures designed to support investment strategies while mitigating capital and liquidity requirements constraints. These structures aim to provide customized risk, return and capital sharing among main equity investors to suit individual investment profiles. In such structures, market, credit and operational risks are allocated and limited to specific energy-focused companies, enabling more cautious investors seeking stable returns to provide larger amounts of capital while achieving stable returns. Such joint-investment structures have opened up opportunities to a wide range of investors — such as infrastructure funds, private equity funds and OEMs — to invest direct equity in midstream energy assets.

In 2010 for example, the Blackstone Group and First Reserve purchased the remaining stake in PBF Energy Company from Petroplus Holdings1 and in 2010 the Canada Pension Plan Investment Board invested $250 million (Canadian) directly into Laricina Energy Ltd. 2

Joint-investment structures can take a number of forms such as a combination of commodities off-take and preferred supply structured contracts; tolling and leasing; joint ventures with preferred commercial rights; outsourced operations through BOOT (build-own-operate-transfer) and service contracting; and other contractual arrangements. These structures all offer the possibility of restricting the exposure to specific risks to certain investors, helping limit the potential downside of return expectations for the remaining investors.

Executing Joint-Energy Investments

Developing joint-investment structures is complex and requires advanced investment underwriting capabilities, especially the use of advanced forecasting, valuation, risk and structuring numerical models. Experience with leading global commodities trading organizations, IOCs and energy-focused infrastructure funds points to five key elements of optimal investment structures:

  1. Commodities Supply, Demand and Pricing Forecasting Models
  2. Integrated joint venture financial modelling
  3. Financial structuring and commercial optimization
  4. Commercial and financial risk analysis
  5. Allocation and creation of joint venture capabilities

Corporations, however, often fail to fully address these five elements before making a final investment decision regarding a specific energy asset. As a result, some investments do not leverage accurate long-term supply and demand commodities forecasting models with embedded pricing elasticity, leading to poor projections of gross margins.

When using financial models, some companies only calculate returns using their own internal terminology, failing to estimate the projected returns of co-investors based on standard commercial terms.  This leads to problems during negotiation of terms, as one party cannot evaluate the trade-offs associated with conceding certain terms to the other party. Some terms such as swing optionalities, exit optionalities, conversion options and others also need to be modelled through full stochastic risk simulations in order to assess the variability in returns projections, but this is often omitted during the investment risk analysis. Finally, trading and marketing activities and all associated transfer prices with parent companies are often poorly defined, leading to unbalanced profit centers and governance roadblocks for joint ventures.

Optimal JV Energy Investment Execution

Through improved commercial and capital structures, energy companies can overcome such difficulties in joint-energy investments.  Advanced numerical models and approaches supporting a robust investment evaluation process can help address the five key elements of successful joint-energy investments.  These consist of:

–          An accurate and comprehensive view of commodity supply, demand and pricing through advanced optimization and forecasting capabilities

–          A financial valuation model that captures all optionalities and commercial arrangements to derive the specific return for all invested parties

–          An optimal joint venture commercial structure through utilizing leading financial engineering and capital optimization capabilities

–          An accurate assessment and quantification of embedded market, credit and operational risks through sophisticated risk modeling

–          A robust design of the joint venture framework, and alignment of responsibilities and accountabilities for trading and marketing capabilities and associated transfer price agreements

Ultimately, portfolio management decisions which are based on current financial valuation and structuring techniques will help provide a key competitive advantage to energy players, confirming assets are structured to optimize returns.

High levels of future investments required and balance sheet restructuring will yield to a high volume of energy asset transactions. Energy players and other investors in the sector that will target these assets now need to focus on improving their investment underwriting capabilities through the development of advanced commercial and capital structures that will underpin their future investments.

  1. Reuters, “Petroplus says plans to exit PBF Energy venture”, 26 Sept. 2010
  2. Company release, “Laricina Energy Secures $250 million Investment From Canada Pension Plan Investment Board and Announces Private Placement Offering for up to an Additional $51 million”, 6-July 2010