This article was originally published in the June 9, 2008 issue of Texas Lawyer.
The perfect storm of difficult financial markets, commodity price volatility, rating-agency scrutiny and high-cost liquidity has challenged energy companies and financial institutions to create nontraditional structures for commodity trading and price-risk hedging.
Under traditional trading or hedging, an energy company must post cash or letters of credit to secure its counterparty's exposure to the energy company, to the extent that the exposure exceeds a certain amount. Often the allowed amount of unsecured exposure depends on the energy company's credit rating, with requirements for how much collateral the energy company has to post increasing as its credit rating decreases.
Never-before-seen price volatility beginning in 2006 stressed these margin requirements, forcing borrowers to put up more and more cash to secure their payment obligations, and made large debt programs ever more difficult to manage and expensive to support. Now, the debt markets are in gridlock, default rates are spiking and investors are fleeing to safety. This makes liquidity (if it can be found) expensive for energy companies with even the most well-managed balance sheets.
Interestingly, at the same time as many energy companies' liquidity needs have been rising due to increasing payment obligations and collateral-posting requirements, the companies' hedged assets, such as the oil and gas properties pledged as collateral, have been increasing in value.
The increased asset values have created an opportunity to address growing commodity exposure and limited debt resources through several structures that unlock the asset values without having to raise liquidity. Also, the so-called right-way nature of the asset valuations — whereby the asset values increase with the increase in exposure — has helped the trading counterparties become comfortable with collateral such as power plants and oil and gas properties.
Lawyers must become familiar with these creative financing structures. They include credit sleeves, guarantee facilities, collateral trusts and joint ventures with the commodity arms of investment banks.
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Credit Sleeves: Under a typical
credit sleeve, the energy company, in effect, rents a
highly rated balance sheet. Instead of the energy company
directly trading and hedging with third parties, the sleeve
provider acts as an intermediary to sell to or purchase
commodities from third parties on behalf of the energy
company or to hedge or obtain hedging from third parties on
behalf of the energy company.
The sleeve provider maintains all contractual relationships and liabilities with the third parties with whom the energy company desires to trade or hedge, and the third parties are willing to trade and hedge with the highly rated sleeve provider with minimal collateral requirements.
In return, the energy company pledges assets such as power plants, pipelines, or oil and gas properties, as well as the value of its contracts, to the sleeve provider and pays a fee for the use of the balance sheet.
- Guarantee Facilities: With a
guarantee facility, a party with a stronger balance sheet
guarantees the energy company's obligation in
exchange for payment. As with a credit sleeve, the energy
company rents a highly rated balance sheet. But unlike the
credit sleeve, with a guarantee facility the energy company
continues to trade and hedge directly with its existing
counterparties. The guarantee provider simply guarantees the
company's liability to its counterparties instead of
trading and hedging on behalf of the company. Because the
guarantee provider is highly rated, typically the third
parties will not require any additional credit support or
collateral. The same collateral arrangements that would work
for the credit sleeve would also work for the guarantee
facility.
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Collateral Trust Arrangements:
Under a collateral trust arrangement, a company segregates
the assets around which it is trading and hedging, and it
pledges those assets to secure its obligations. Considering
the complexity and expense of mortgaging power plants,
pipelines and minerals, the company typically pledges the
assets to a collateral trustee, which holds collateral for
various trading counterparties' and sometimes also
for lenders.
The trading counterparties may have a first lien to themselves, share a first lien with lenders, or have a second lien or sometimes even third lien, depending on the asset type and valuation. Often a capped amount of cash margin is also required since an arrangement with other creditors sharing the same collateral may limit the liens' value.
- Joint Ventures: Lawyers can
also use joint ventures to work out these deals for clients.
The joint ventures often combine an experienced trading arm
of an energy company with an investment bank or other trading
partner with a strong balance sheet that needs the energy
company's trading expertise. The joint ventures,
however, are quite complicated to structure and have had
mixed success.
Wrangling Finance
The lawyer's challenge in these structures is to ensure compliance with debt covenants, to negotiate trading and hedging agreements with the counterparties, and to structure a collateral package that is free from other creditor's claims.
Counsel not only needs to know the nuts and bolts of secured credit but also the nature of commodity price and hedging exposure, plus the remedies suppliers and hedge providers need to protect their positions when a default occurs.
The structures involve dovetailing supply, derivative and loan agreements; credit support agreements; and needs of the capital and bank markets. Often the collateral package must also be bankruptcy remote, so the energy company's creditors can't reach those assets; this requires structured finance and bankruptcy counsel's expertise.
Many existing credit facilities do not clearly permit these lien sharing arrangements. In those cases, lawyers must obtain consent to the liens from bondholders and banks. The consent process can be time consuming and somewhat expensive, but most of these arrangements succeed, because the creditors see the value to the company's having ample low-cost liquidity.
With the growing prevalence of these structures, companies, when entering into new credit facilities, should insist on flexibility to put these structures in place with the knowledge that the market readily seems to be accepting that flexibility.
Likewise, since most existing energy supply and hedging arrangements contemplate cash margin or letters of credit — not sharing collateral pools or using a guarantee — lawyers must renegotiate trading and hedging contracts. This process is time consuming, but is an essential element to these structures.
The final hurdles involve helping the energy company meet its commercial and competitive needs when moving the pieces of its trading business around to suit the new arrangements. For example, with a sleeve the company's choices become limited; with a guarantee a company often needs to implement more complex risk management controls and processes; and, with the collateral arrangements and joint ventures, employees as well as assets will need to be moved. Sensitivity to these commercial needs and risks are essential to successfully implement any program.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
