Bryan Gundersen, partner, Kensington Swan, looks at contracts and the allocation of risk in relation to projects in the energy sector, in light of the Crown’s original investment in the Maui field.
MARKET RISK CAN BE TOUGH on investment parties even though they may think that they have got it appropriately allocated at the time of contracting.
Key contract risks involve the resource; production; transport; financial; and, most importantly, the market itself.
After the Maui field was discovered the Maui gas contract involved the Crown purchasing gas from Shell, BP, Todd and Offshore Mining (which was owned by the Crown and had a 50 percent interest in the field.
The intended market for the gas was as a fuel source for a series of thermal power stations that the Crown intended to construct. The first ones were to be built at Huntly and two large power stations in Auckland. The contractual arrangement called for the construction of a high pressure gas transmission network connecting the field to the power station in Huntly and envisaged an extension of that pipeline to Auckland.
The market risk was largely allocated to the Crown via ‘take or pay’ provisions i.e. a commitment to take and, if not taken, pay for a minimum contract quantity of gas each year. This assured Shell, BP, Todd and Offshore Mining of what was perceived to be an adequate cash flow to finance the development of the field.
However, it became clear that the demand for electricity was much less than estimated; indeed, the two new power stations in Auckland were not required. Therefore, the market risk ‘came home’ to the Crown in the form of having to pay for gas which it was not able to take. The market risk also ‘came home’ to the seller (Shell, BP, Todd and Offshore Mining) because as the gas was not taken, they could not access and sell the condensate that would have been produced in association with the gas and, therefore, did not earn the revenue they had anticipated. The Crown incurred a ‘double whammy’ on the market risk. As buyer, it had to pay to seller (Shell, BP, Todd and Offshore Mining) for gas not taken (albeit 50 percent to its subsidiary, Offshore Mining), and also lost (via Offshore Mining) 50 percent of the condensate revenue.
The Crown, via the Liquid Fuels Trust Board, then looked for alternative uses for Maui gas and this leads to a second example of market risk.
It decided to build a chemical grade methanol plant at Waitara Valley to be operated by Petralgas New Zealand – a Canadian company. Since then, and as a result of a series of acquisitions, this plant has been acquired by Methanex Corporation of Canada.
The second step of the Crown was to build an ammonia urea plant, also in Taranaki. This plant is now owned by Bay of Plenty Fertiliser, a subsidiary of Fernz Corporation; and the third step was to build a large scale gas to gasoline plant at Motunui. This plant is also now owned by Methanex Corporation.
“At the time of entry into the Synfuel project contracts, the forecast price of gasoline made the project look compelling and any market risk assumed by the Crown looked negligible.”
As can be seen, there was a compelling motivation for the government to see Maui gas used for these purposes, because it owned half of the Maui gas field, had signed a 30 year take-or-pay agreement for gas, and wanted to realise the associated production of what was then very valuable condensate.
The owner of the gas to gasoline plant was New Zealand Synthic Fuels Corporation (‘Synfuel’). This was a classic public private partnership.
Synfuel was a joint venture between the Crown (75 percent) and Mobil Oil Corporation (25 percent) whereby Synfuel was responsible for the construction and operation of the plant (gas to methanol and methanol to gasoline trains), and arranging the US$1.75 billion project financing for the construction. The Crown paid Synfuel a processing fee for processing Maui gas into methanol and the methanol into gasoline, with the Crown being owner and responsible for the sale of the gasoline.
The Synfuel plant at Motonui came on stream in late 1985 and for several years produced about one-third of the country’s gasoline requirements. The plant was built in just over three years, at 17 percent under budget, and operated extremely well, consistently producing high quality gasoline at well over nameplate capacity.
However, as owner and being responsible for the sale of the gasoline, the Crown faced the market risk of the price of gasoline. At the time of entry into the Synfuel project contracts, the forecast price of gasoline made the project look compelling and any market risk assumed by the Crown looked negligible. At the time, the Synfuels plant was seen as a significant shift from the situation where New Zealand was 85 percent dependent on foreign oil to one where it played an essential part in supplying the domestic petroleum market and contributing directly to reducing the country’s vulnerability to uncertainty in supplies of imported crude oil.
But things turned ugly for the Crown.
The New Zealand dollar fell in value against the US dollar thereby increasing the cost of Synfuel’s debt servicing (which the Crown paid for via the processing fee). More significantly, and against all predictions, oil prices collapsed in 1986.
Again, the market risk ‘came home’ to the Crown. In 1990 the then government, burdened with the resulting operating losses, decided to sell its shareholding in Synfuel to Fletcher Challenge.
As part of the sale arrangement, the government repaid the balance of Synfuel’s debts ($1196 million, December 1989) and Fletcher Challenge was paid $112 million to take over the Crown’s loss making interest. The overall cost to the taxpayer was thus around $1300 million.
Subsequently, ownership of the plant passed to Methanex Corporation of Canada and gasoline production eventually ceased with the plant now being a major export earner through the production of chemical grade methanol.
It has been argued that given market developments since then, had the Crown retained its interest in the project over its contractual life and levied 3-4 cents/litre (1990 real) on all gasoline sold, the Crown would have met all costs and recovered all operating losses, and still be the owner of a valuable public asset. Proving just how hard it is to guess what markets will do over time.
Market risk can be very tough!