With North America being the region of current focus as a result of the many LNG export projects that have access to North America grid gas, third party LNG tolling is front and center. The relationship between the owner of the LNG liquefaction facilities and the tolling customers is very different from the project company structure that has been used in past years across the globe. While LNG projects are structured in a variety of ways, the North American models are very much evolving. Globally, LNG liquefaction facilities were historically constructed to facilitate sales of stranded gas, where gas could not be moved to market due to lack and expense of more traditional infrastructure. Due to the advancement of technology indicating shale gas is now becoming increasingly commercial, in many situations in North America gas is now stranded due to lack of market, yet there is access to very mature and extensive infrastructure. As we previously saw in import terminals in North America, there is a trend in many of the U.S. export projects for companies to develop LNG facilities without ownership of upstream assets. This trend gives rise to true third party tolling, and expands the ability of many smaller players to participate in the LNG business either as tolling customers or owners of infrastructure.
In implementing the third party LNG tolling structure, characteristically the project tolling company (i) provides a liquefaction processing service to suppliers of natural gas for a fee, (ii) is not affiliated with, or owned by, the tolling customers, (iii) may assume a negotiated and capped amount of liability commensurate with reasonable business risk, (iv) requires security from the tolling customers to protect its interests in the facilities and satisfy the lenders as to the credit risk of the tolling customers, (v) does not take title to, or risk of loss of, the natural gas, LNG, or by-products, and (vi) does not take any commodity risk. Given the proximity to the grid with presumably abundant supplies of natural gas for most U.S. projects, dedication and availability of gas reserves is not typically a point of consideration. This paper will highlight key considerations when negotiating a third party tolling arrangement reflecting the arrangements we are seeing in many of the U.S. projects.
The manner in which capacity is allocated is not necessarily consistent for different projects. In fact, one tolling project may offer different tolling customers different use rights in the LNG liquefaction facilities. The two most typical alternatives are (i) the right of a tolling customer to process a fixed volume of gas, and (ii) the right of a tolling customer to have a capacity right (expressed as a percentage) of the processing capacity of the LNG liquefaction facilities. Whether a tolling customer has a volumetric right or a capacity right (percentage of capacity) will impact other terms in each partys tolling agreement. Primarily the tolling customers rights to excess capacity in the plant will vary. Typically a party with a capacity right enjoys excess capacity of the plant and may thereby have the right to schedule excess liftings. If all tolling customers have a volumetric right, the tolling agreements need to specify how excess capacity will be treated for each tolling customer. All tolling customers may not have the same right to excess capacity in the LNG liquefaction facilities. The issue of excess capacity is often a point of tough negotiation.
The fee structure in a third party tolling agreement typically is aimed to provide a utility level rate of return since the tolling company takes limited risk. The interplay in arriving at pricing is driven by the (i) capital expenditure in construction of the facilities, operating costs, and a fair profit margin for the investors taking the project risk; and (ii) evolving market price discussions with LNG buyers who, in some cases, hope to delink pricing from oil based indices to gas based indices. Market pricing is not intended to be a point of discussion in this paper other than to note pricing discussions and decisions will certainly play a role in the viability of many of the proposed projects in North America.
Typically, the fee has a component that is payable whether or not the processing service is made available, either for pre-agreed volumes of gas to be delivered for processing or for a capacity right in the LNG plant. The tolling company typically requires a baseline cash flow to cover expenses that arise whether or not the processing service is utilized or available. Often times the processing fee supports the project financing for the export facilities. The lenders drive certain aspects of the fee structure to ensure that credit risk is properly placed, and that the payment stream is a constant throughout the life of the financing. In addition, the tolling arrangement is most often a send-or-pay arrangement, meaning the tolling customer pays for the tolling services whether or not the tolling customer actually uses such services.
While various forms of security may be required by lenders, a security over the revenue stream from the tolling agreement is critical to the banks, and, to the extent more than one party is tolling through a facility, to the tolling customers as well. Every participant has a vested interest in the viability of the tolling company. The use of a secured escrow arrangement gives (i) the banks comfort of having control over the proceeds securing the project debt, (ii) the tolling company security that its toll will be paid, and (iii) the project participants assurance that the overall project is sustainable.
Unlike other provisions of a tolling agreement, the fee structure may not be consistent across tolling agreements in the same project. In order to achieve project success, fiscal viability is critical, and the ability to generate sufficient cash flow to support the project debt and other requirements of the lenders is essential.
Given the significant amount of exposure for the tolling company in the event it is unable to deliver and its limited upside, often times damages for the tolling company will be capped in the event of a breach by the tolling company.
While some terms may differ in various tolling customers tolling agreements applicable to the same project, there are a number of provisions that should be consistent. Tolling customers will require continuity across the tolling agreements in critical areas.
It is essential that provisions addressing lifting and scheduling terms and procedures (including port use agreements or conditions of use), measurement methodology, and allocation of LNG and other by-products be consistent for all tolling customers in one project. Clear and non-discriminatory allocation procedures and measurement principles allowing accurate determination of each tolling customers entitlement to lift LNG and by-products is important not only to the project participants, but also to the financiers. Allocation procedures and measurement methodology should apply equally to all tolling customers and they should be auditable by all tolling customers utilizing the LNG liquefaction facilities. Disputes concerning these provisions are typically subject to expert determination.
The tolling company typically has broad latitude in the event a tolling customer fails to lift a scheduled delivery of LNG in a timely manner, which include rights and discretion to dispose of the LNG that was not lifted. The tolling agreement generally has specific rules concerning excessive berth time as well. The requirement of the tolling customer to meet lifting obligations is critical to ensure continuity of operations at the LNG liquefaction facility.
Lifting terms, measurement, and allocation are typically integrated into the tolling agreement; however, these terms may also be included in a standalone agreement that is signed by all tolling customers, thereby facilitating information flow for, among other things, the creation of the feed gas supply schedule, annual LNG lifting program, allocation of LNG and by-products, ship standards and vetting, and determination of liability.
The annual LNG delivery program should be developed based on information from all tolling customers and implemented on a non-discriminatory basis. Development of the annual delivery program is generally fluid and involves collaboration among project participants. It is through the annual delivery program that the tolling customers effect delivery of their LNG and by-products to third parties, thereby monetizing their gas entitlements. Information is gathered annually from all project participants with respect to planned facility maintenance and shutdowns, gas delivery expectations, and other relevant projected events that will impact or influence development of the delivery program. The annual delivery program is usually refined on a monthly basis when the ninety-day forward schedule is developed. This schedule reflects changes to the annual delivery program and further defines the lifting schedule.
In the context of development of the annual delivery program and ninety-day schedule, the project participants will also need to agree to terms allowing for, or putting a framework around, changes to the annual delivery program and procedures for allocating excess liftings in accordance with the various tolling agreements that apply to the project. Cooperation and agreement by all project participants is critical to this scheduling process.
Depending on storage capability and the manner in which gas will be delivered to the tolling company for processing, if there are two or more parties tolling through the same project, the tolling customers may desire a coordination agreement. This agreement typically provides for borrowing and lending among tolling customers, flexibility for the tolling customers to have control over the annual delivery program and gas delivery schedule prepared by the tolling company, and allocation of liability. While the tolling company must establish an annual delivery program, as discussed above, it is in the interest of the tolling customers to have this flexibility if they can collectively agree to changes. Of course any changes proposed under a coordination agreement are subject to the approval of the tolling company.
Choice of governing law and dispute resolution provisions should be consistent in all tolling agreements for a single project. Should a dispute arise under the tolling agreements it is very likely that multiple, if not all, tolling customers using the same LNG liquefaction facilities will be impacted. The dispute resolution process is streamlined and more effective if all parties to a dispute are party to the same dispute resolution proceedings. Experts are often used as a dispute resolution option when technical or financial disputes arise. Again, without continuity across the agreements, these provisions may not be available in the event of a dispute if all parties are not subject to the same dispute resolution and expert provisions and the same governing law.
Optimally, a tolling facility will establish a uniform liability regime with clearly defined recourse that is consistently applied and non-discriminatory in nature. The liability and recourse regime applies to the tolling customers, plant operator, facility owners, lifting coordinators, ships using the LNG facilities, and other project participants. Tolling customers under separate agreements require consistent treatment of all users in the event of a failure to supply gas, failure to lift LNG or by-products, off-spec gas or LNG, partial or complete plant shutdown, force majeure, and similar events that may impact all tolling customers. A concise liability regime typically applies across the project, thereby giving project participants and financiers a high degree of certainty should an incident occur.
Other key terms addressed in a third party tolling agreement include retainage, expansion of the LNG liquefaction facilities, and quality of feed gas and LNG. Retainage is typically handled on a pro rata basis and not the subject of significant discussion. On the contrary, rights to new capacity in the event of an expansion of the LNG liquefaction capacity may be very important to some tolling customers and is at times the subject of significant negotiation. In addition, tolling agreements used for one project where there are multiple tolling customers must have consistency when addressing specifications of the gas and LNG. Failure to meet the required gas specification will result in significant liability for the tolling customer who delivered off-spec gas.
Continuity should exist in the various tolling agreements that apply to the same project in both substance and in terminology. Most critically, the tolling agreement will likely reflect certain terms agreed to with the LNG buyers in the SPAs, especially if the LNG buyer is arranging transportation and takes delivery of the LNG at the LNG export facilities. For example, port usage terms addressing liability and procedures, requirements for notification of approaching vessels, document delivery and facility access rights and limitations, and other document interfaces require a high degree of consistency in both of the tolling agreement and SPAs. The LNG buyers will likely require the continuity, and continuity enables the tolling customer to meet its obligation as a seller under the SPAs.
Tolling arrangements are complex and critical components of LNG project structure. Imbedded in the tolling and lifting agreement is a mechanism by which project participants are allocated LNG and monetize their gas entitlements. Third party U.S. tolling arrangements are growing in number as a result of increased commerciality of large gas reserves in areas with mature infrastructure and grid access to the liquefaction facilities. The numerous North American projects that are under development and in early stages of conceptualization certainly demonstrate this growth.