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Alternative Financing Structures within Commodities Arrangements Craig Enochs Jackson Walker, L.L.P. Houston, Texas.

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Presentation on theme: "Alternative Financing Structures within Commodities Arrangements Craig Enochs Jackson Walker, L.L.P. Houston, Texas."— Presentation transcript:

1 Alternative Financing Structures within Commodities Arrangements Craig Enochs Jackson Walker, L.L.P. Houston, Texas

2 Agenda Prepaid Swaps 3 Contact Information 4 Page 2 First Lien Structures 2 Introduction 1

3 Credit Markets and the Commodity Industry Page 3  Credit at one time was an afterthought in wholesale commodity and derivative transactions:  THE GISB contained a one-paragraph adequate assurance provision  The ISDA was used by many without a Credit Support Annex 1 Introduction “Those were the days…”

4 Credit Markets and the Commodity Industry Page 4  Credit Defaults in the late 1990s:  Credit terms more closely scrutinized in commodity trading agreements  More credit support required, usually in the form of parent guaranties supplemented by cash or letters of credit  Bankruptcies in the early- to mid- 2000s:  Tested parties’ ability to enforce guaranties and receive payment following default  Some guarantors issued guaranties exceeding their net worth  If subsidiary trading party was insolvent, parent guarantor frequently was insolvent as well 1 Introduction

5 Credit Markets and the Commodity Industry Page 5  What else could go wrong?  More bankruptcies  2008 financial crisis  Credit downgrades across the board  Dodd-Frank uncertainty  Where does that leave us today?  Companies have been forced to become more sophisticated and innovative in addressing their credit risk  Some forms of collateral that previously were popular, such as credit default swaps, surety bonds, and some sovereign debt, are now less attractive or are unavailable 1 Introduction

6 Credit Markets and the Commodity Industry Page 6  2 Growing Issues Facing Commodity Market Participants:  Inability to access credit markets in order to fund existing or new commodity operations and add value to company  Lending markets remain tight  Cost of credit continues to rise  Inability to post collateral to trading counterparties under physical and financial commodity transactions  Related to the first issue—more difficult and expensive to get revolving cash or letter of credit facility  Physical and financial deals are core to business, so how do parties manage exposure? 1 Introduction

7 Credit Markets and the Commodity Industry Page 7  2 Examples of Alternative Credit and Financing Structures: 1 Introduction How can I trade when collateral is tight? First Lien Credit Facility How can I fund inputs for commodity production? Prepaid Swap Transaction

8 First Lien Structures Page 8  General Overview  Debtor under an existing credit facility has provided a first lien and security interest in a tangible asset to lenders  Debtor enters into trading agreements with hedge counterparties relating to the asset, and offers first lien as collateral  Ex: Debtor enters into ISDA with Gas Annex in order to purchase fuel for electric generation facility  Hedge counterparty holds first priority lien and security interest on the tangible asset pari passu with lenders 2 First Lien Structures

9 Page 9  General Overview (cont.)  Lenders willing to share first lien because trading relationship with hedge counterparty:  Reduces risk  Ex: If hedge counterparty sells natural gas to run debtor’s power plant, reduces the risk that the plant will be unable to produce electricity  Increases value of the asset  Ex: If debtor sells a power plant’s electricity to hedge counterparty, this mitigates the risk of not finding a purchaser for the plant’s output or that power prices may decline over time 2 First Lien Structures

10 Page 10  Documents in First Lien Structures  Loan Documents: May impact a hedge counterparty’s rights in relation to other lenders  Credit Agreement  Intercreditor Agreement  Security Agreement or Collateral Trust Agreement  Designation and Joinder Agreement  Trading Documents: Between hedge counterparty and debtor  First lien protections often documented under an ISDA, but can be incorporated into NAESB or EEI 2 First Lien Structures

11 Page 11 2 First Lien Structures 3 Types of First Lien Credit Structures ThresholdReplacementTail Risk First lien wholly replaces any other collateral obligations Debtor not required to provide cash, letter of credit or guaranty Cheaper to implement than other forms of credit support Hedge counterparty assigns a value to the first lien Such value establishes debtor’s fixed collateral threshold Debtor only provides alternative forms of collateral if hedge counterparty’s exposure exceeds collateral threshold Debtor initially posts collateral up to a fixed amount First lien covers debtor’s “tail risk” over and above the credit limit Debtor’s collateral obligations are fixed despite market fluctuations altering exposure

12 First Lien Structures  Debtor’s Order of Preference for First Lien Structures  Replacement Structure  Debtor provides no collateral except the first lien  Tail Risk Structure  Debtor’s collateral obligations are fixed up to a certain amount, and the first lien covers all other hedge counterparty exposure  Threshold Structure  Debtor still receives value for its first lien, but may have to post additional collateral depending on hedge counterparty’s exposure Page 12 2 First Lien Structures

13  Counterparty’s Order of Preference for First Lien Structures  Threshold Structure  Accounts for the value of debtor’s first lien, but also protects against market risk by requiring additional collateral  Tail Risk Structure  Hedge counterparty initially receives collateral as security, and enjoys the benefits of first lien protection  Replacement Structure  Risk that hedge counterparty’s exposure will exceed the value of the first lien, and no other collateral available Page 13 2 First Lien Structures

14  Advantages to Debtor  No additional collateral needed  No liquidity needed  More equity may be available under Credit Agreement than in other credit structures  Lower administrative burden  More efficient use of the capital locked up in the assets of the first lien estate Page 14 2 First Lien Structures

15  Advantages to Counterparty  Right in tangible asset rather than contractual interest  Aligned interests with lender  “Right-way risk”  As the price of input or product increases (thus potentially increasing a hedge counterparty’s exposure), the value of the asset on which counterparty holds a first lien also increases Page 15 2 First Lien Structures

16  Disadvantages to Debtor  Counterparty still may demand additional collateral or price concessions  Low asset valuation for credit purposes  First liens are fairly illiquid and contingent upon terms of a Credit Agreement or actions by lenders  Requires positive multiple of equity to debt on assets in facility Page 16 2 First Lien Structures

17  Disadvantages to Debtor (continued)  First lien places hard assets at risk that are not otherwise affected in other credit structures  Even if counterparty accepts first lien, counterparty may impose conservative risk limits and parameters in the transactions secured by the first lien  Impacts ability to trade with hedge counterparty Page 17 2 First Lien Structures

18  Disadvantages to Counterparty  Highly illiquid collateral  Extended delay between default and payment  Lack of control in collateral  Acting as part of a group of creditors rather than individually  Risk if counterparty’s interests diverge from other lenders and hedge counterparties  Not fungible Page 18 2 First Lien Structures

19  Additional Considerations with First Liens  Voting Rights  Generally contained in the Credit Agreement  Matters on which hedge counterparty can vote (and weight of vote) often differ from lenders  Ratio of (i) exposure to debtor, compared to (ii) cumulative debt under credit facility  Compared to lenders in the credit facility, hedge counterparty may have little or no voting power  Hedge counterparties must work with lenders because interests are linked Page 19 2 First Lien Structures

20  Additional Considerations with First Liens (continued)  Payment of Debt  Hedge counterparty’s collateral rights stem from Credit Agreement  When Credit Agreement is paid in full or terminated, hedge counterparty must ensure that it will be covered  Can the lenders release the lien without the hedge counterparty’s consent?  Can the lenders release the lien without the debtor providing alternative forms of collateral?  Documentation of first lien terms in trading agreements  Events of default, additional representations, etc. Page 20 2 First Lien Structures

21  General Overview  Parties enter into an ISDA Master Agreement.  “Swap lender” and “swap debtor” enter into a commodity swap transaction whereby each month during the term:  Swap lender is the fixed price payor and pays a fixed price of $0.00.  Swap debtor is the floating price payor and pays an index price multiplied by a notional quantity of commodity production.  “Swap lender” makes an initial upfront payment to “swap debtor”.  Valuation based on (i) fixed price for the commodity, multiplied by (ii) cumulative quantity for the entire term of the swap.  Discounted to net present value and paid upfront. Prepaid Swap Transactions Page 21 3 Prepaid Swap Transactions

22  General Overview (cont.)  Notional quantity under the swap is only a portion of swap debtor’s total commodity production  Ex: Parties may enter into the prepaid swap with respect to 20% of swap debtor’s anticipated commodity production  Mitigates swap lender’s risks associated with any fluctuations in actual commodity production or commodity prices  Swap debtor uses prepayment to fund inputs into its business.  Ex: Ramp up costs for production  Swap lender takes a security interest in the commodity being produced. Prepaid Swap Transactions Page 22 3 Prepaid Swap Transactions

23 Page 23 3 Prepaid Swap Transactions Swap LenderSwap Debtor Fixed Price x Notional Quantity Commodity Swap $0.00 Fixed x Notional Quantity Index Price x Notional Quantity Prepayment

24  Who Uses Prepaid Swap Transactions?  Producers of agricultural commodities in non-U.S. markets  Foreign farmers have a need for upfront capital to purchase inputs into their business (seed, fertilizer, irrigation systems)  Fairly limited access to traditional financing sources in credit markets and banking industries  Lack of subsidies and government programs, unlike in U.S. agricultural markets  Often, swap settlement via physical delivery of commodity instead of cash settlement  Commodity quantity is generally a fraction of farmer’s total anticipated crop production Prepaid Swap Transactions Page 24 3 Prepaid Swap Transactions

25 Page 25 3 Prepaid Swap Transactions $0.00 Fixed x 200 tons cocoa Physical delivery of 200 tons cocoa Cocoa Aggregato r Farmer $2,000 (Fixed) x 200 tons = $400,000 Commodity Swap Prepayment Total Anticipated Crop: 1,000 tons of cocoa beans Prepaid Swap Quantity: 200 tons $0.00 Fixed x 200 tons cocoa Physical delivery of 200 tons cocoa Cocoa Merchant $2,200 (Fixed) x 200 tons = $440,000 Commodity Swap Prepayment

26  Issues in Agricultural Commodity Prepaid Swaps:  International laws and customs  Typically under-developed or undeveloped countries  Unstable political regimes and trade customs  Merchants and aggregators must ensure that they will get paid, either in cash or in kind.  Unsophisticated commodity participants  End user farmers in third world countries Prepaid Swap Transactions Page 26 3 Prepaid Swap Transactions

27  Who Uses Prepaid Swap Transactions?  Oil and Natural Gas Producers  Oil and gas producers have a need for upfront capital to invest in drilling and operating expenses  Prepayment upfront to invest in developing wells with index-based cash settlement under prepaid swap transaction  Oil or gas quantity under the swap is generally a fraction of producer’s total anticipated oil or natural gas reserves under the lease(s) Prepaid Swap Transactions Page 27 3 Prepaid Swap Transactions

28 Page 28 3 Prepaid Swap Transactions Bank (or Trading Affiliate) Natural Gas Producer $2.75 x 200,000 MMBtu = $550,000 Commodity Swap $0.00 Fixed x 200,000 MMBtu NYMEX-Henry Hub x 200,000 MMBtu Prepayment Total Anticipated Gas Production During Swap Term: 1,000,000 MMBtu Prepaid Swap Quantity: 200,000 MMBtu

29  Issues in Oil and Natural Gas Prepaid Swaps:  Broad expertise required to review and analyze the deal  Derivatives, E&P, Lending, Tax  More diligence involved than traditional commodity swap  Leases, operating agreements and reserve reports  Loan terms included in ISDA Schedule  Security documents evidencing lender’s interest in mineral rights  State and local laws involving real property and extraction of minerals  Non-Owner Operated Wells: is swap lender comfortable with how wells will be operated? Prepaid Swap Transactions Page 29 3 Prepaid Swap Transactions

30  How Else Might Prepaid Swaps Be Used?  Electric Generation:  Hedge fund purchases power plant  Investors have cash to purchase the plant, but need money for ramp up costs and operations  Under prepaid swap, the plant could get a prepayment based on a percentage of the plant’s total capacity.  Once power is generated, the plant sells that portion of the capacity in the market at index and flows through the index payments to the swap lender. Prepaid Swap Transactions Page 30 3 Prepaid Swap Transactions

31 Conclusion  Credit markets drive collateral scarcity in a reinforcing cycle  Credit market struggles will continue to drive innovative collateral solutions  These solutions are likely to come from new structures rather than new forms of collateral

32 CRAIG R. ENOCHS Jackson Walker L.L.P McKinney, Suite 1900 Houston, Texas (713) KEVIN M. PAGE Jackson Walker L.L.P McKinney, Suite 1900 Houston, Texas (713) Page 32 4 Contact Information


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