29 May 2007
Many petrochemical transactions in the Middle East are project financed. As with project documents in most non-recourse or limited recourse financings, the driving force behind the structure of petrochemical project documents is an optimal allocation of risk based on allocating risks to the party best capable of controlling or mitigating them. However, the typical allocation of risk in petrochemical transactions will often drive the uninitiated to outbursts of horror.
There are good reasons for why this is the case, many of which are unique to the petrochemical industry, such as the commodity nature of the product produced, the track record of the entity supplying feedstock and market practice.
Petrochemical plants tend to produce commodity products, which benefit from well-established markets. The price for commodity products is established by the market and usually no single producer or off-taker is in a position to materially affect the market price. An additional element in petrochemical commodities markets is the existence of a number of entities whose business is to act as intermediaries between producers and the market.
There are various ways in which the commodity nature of petrochemical products affects how risks are allocated between the project company and off-takers.
• Price risk.
As price is ‘taken’ by producers, the profitability of any given plant depends on, inter alia, the market for the product and the ability of the project to be a ‘low-cost’ producer to survive the cyclical nature of most petrochemical products. The lenders must determine whether a particular market is worth investing in. As such, price risk in petrochemical off-take agreements is typically allocated to the project company and product price is structured accordingly.
• Volume risk.
A project company can get the market price for all of its products. It is therefore essential that the project company sells as much of its product as possible. This risk is typically allocated to the off-taker through binding obligations to lift a certain amount of product each month.
• Identity of the off-taker.
Given the existence of a number of intermediaries in the market, the identity of the off-taker is relatively unimportant. As such, termination provisions of commodity off-take agreements are relatively unrestrictive.
The remedies imposed on an off-taker for failing to lift the MCQ are also
affected by the commodity nature of most petrochemical products. The liability of the off-taker for the unlifted product is structured in the form of cascading scenarios:
i) if the product is capable of being stored and the project company can store the unlifted product, compensation may be limited to the costs of storing the unlifted product;
ii) to the extent the unlifted amount cannot or has not been stored, the compensation payable by the off-taker may be limited to the difference between the price for the unlifted amount received by the project company from a third party purchaser and the price the project company should have received for the unlifted amount pursuant to the contract; and
iii) if neither of these scenarios are available to the project company and it must shut down or curtail production due to such failure to lift, the off-taker may be required to pay compensation equal to the fixed costs incurred by the project company due to curtailing or shutting down production, plus amounts payable by the project company to other contractual parties, such as feedstock suppliers.
History of feedstock suppliers
The most important distinction between feedstock agreements is where the supplier is a governmental or private entity.
• Non-governmental suppliers.
Typically, in these types of agreements, the parties’ obligations regarding specific quantities of feedstock crystallise on a monthly basis based on an annual contract quantity agreed by the parties. Once that obligation crystallises, the project company must pay for that specific amount, regardless of whether it is capable of accepting it, although this is subject to certain events, such as scheduled maintenance and force majeure. Similarly, the supplier must pay the project company compensation if it fails to provide the agreed amount of feedstock.
• Governmental suppliers.
The difference between feedstock agreements used by the various states in the Middle East cannot be overstated. The standard feedstock agreements of some states are notoriously lacking in any binding obligation to supply feedstock or to compensate the project company for any supply failure. Other states, meanwhile, offer feedstock agreements that (to varying degrees) are structured much like non-governmental feedstock agreements, containing binding obligations to supply feedstock and provisions compensating the project company if a supply failure occurs.
Construction contracts in petrochemical transactions are almost always lump-sum turnkey contracts. To a large extent they do not differ much from construction contracts that are typically used in non-recourse financed transactions. However, it is common in petrochemical transactions for a project company to source the construction of the plant, and the design technology on which such plants are based, from two separate entities. Market practice accepts that design technology risk may be allocated between the project company and the contractor in different ways without undermining the non-recourse nature of the financing.
• The wrap.
Project companies may ask contractors to wrap the licence technology as part of the construction contract. One method is to novate (by way of a tripartite agreement between the licensor, the contractor and the project company) certain provisions of the licence agreement to the contractor until the plant is taken over by the project company. During this step-in period, the contractor benefits from any liquidated damages, warranties and guarantees available under the licence. The quantum of performance-liquidated damages payable by the contractor is at levels typical of construction contracts.
• The bundle.
A variation is to contract with a single entity that can fulfil both the licensor and contractor roles. Usually the construction contractor and the licensor are affiliates, although licensor and preferred contractor can also be bundled. Bundling involves providing the project company with the construction of the plant and the licence to operate as a single, seamless package.
• The certification approach.
The market has accepted project companies assuming technology design risk provided that technology risk (which remains with the project company) is separated from the construction risk (which remains with the contractor). One method is to divide the steps leading to the stage where feedstock is introduced to the plant into separate certification processes. These certification processes focus on major equipment and selfcontained units, rather than on the plant as a whole. Once the project company has certified that each piece of major equipment and each unit have passed the relevant tests and have achieved the relevant specifications, the contractor is
permitted to request that the ‘ready for start-up’ certificate for the plant be issued.
These have been difficult times for companies undertaking petrochemical projects. Increased competition for construction services has favoured the bargaining position of construction contractors. Lump-sum turnkey construction contracts are becoming increasingly difficult to obtain, leading to the return of completion guarantees from the sponsors for construction risk.
Project companies are reassessing all of their contracts in order to reallocate some of the risks that construction contractors are increasingly unwilling to take, except at a price few projects can stretch to. It seems clear that more innovation in how such risks are allocated will take place and that the gap between what is acceptable in petrochemical non-recourse financings and other forms of non-recourse financings may get even wider.
•Bimal Desai is a partner and Emil Pellicer is an associate at Allen & Overy