IFR Mid East 2006 - New sukuk technology
East Cameron Partners, an independent oil and gas exploration and production company based in Houston, Texas, has recently issued an innovative sukuk bond. By Iad Georges Boustany, General Manager, BSEC.
East Cameron Partners holds leasehold interests in a producing gas and condensate field in federal waters of the United States, 20 miles offshore the State of Louisiana, referred to as EC 72 and EC 71 (the properties). The leases in which the originator holds its interests are federal oil and gas leases and administered by the Minerals Management Service of the US Department of the Interior (the MMS).
As of January 2006, the properties were estimated to contain 61.7bn cu ft of proved gas reserves and 1.06m barrels of proved crude and condensate reserves attributable to the originator's interest in the properties. Approximately 62% of the proved reserves are classified as proved developed (including proved developed producing, proved developed shut-in and proved behind pipe) with the balance being classified as proved undeveloped. The production facilities on the properties currently consist of two platforms and two caissons containing seven producing wells.
Description of the structure BSEC and Merrill Lynch have designed a two-tier structure whereby an Issuer SPV located in the Cayman Islands will issue US$165.67m of sukuk bonds. The proceeds from the sale will then be advanced by the Issuer SPV to the Purchaser SPV (established under the Laws of Delaware) pursuant to the Funding Agreement to fund (1) the purchase of the purchased ORRI from the originator for US$113.84m, (2) the funding of the development plan for US$38.28m, (3) the reserve account with an initial balance of US$9.5m and (4) the purchase of natural gas put options for US$4.05m pursuant to the hedge agreement with the hedge counterpart.
Also, the originator will contribute the contributed ORRI to the Purchaser SPV as a capital contribution. The Purchaser SPV will hold a non-operating, non-expense bearing, overriding royalty interest in the properties that will entitle it to receive 89.68% of the originator’s net revenue interest in all hydrocarbons produced and saved from the properties until an aggregate quantity of about 63m MMBtu equivalent of hydrocarbons has been delivered to the Purchaser SPV.
All gas produced from the properties and all condensates are currently being sold to two offtakers, respectively Cedar Gas Company and Shell Trading (US) Company.
Merrill Lynch Commodities Inc agreed to act as back-up off-taker to purchase all gas from the properties in the event that the Cedar Gas Company off-take agreement expires or is terminated. The off-takers will pay hydrocarbon sales proceeds into an allocation account held by the originator, and these amounts will be allocated to pay:
20% approximately to the federal government and to private royalty holders; and The remaining 80% net revenue interest allocated as follows: 90% approximately to the Purchaser SPV, representing proceeds from the sale of ORRI volumes, for deposit into a collection account in the name of the Purchaser SPV; and the balance (roughly 10%) to the originator.Amounts in the collection account will be applied by the Purchaser SPV in accordance with payment priorities (1) for payment of expenses, (2) for amounts necessary to pay sukuk returns and amounts to redeem the sukuk, (3) to pay amounts owing, if applicable, to the hedge counterparty and (4) to the extent of any excess, equally toward distributions to the originator and early redemption of the sukuk.
The sukuk bonds are designed to be redeemed as follows (i) following the grace period (a) the sukuk will be redeemed over time in amounts that will vary based on a formula that is directly proportionate to the periodic production of hydrocarbons from the properties; and (b) following all other payments in the relevant payment schedule, 50% of the excess cash will be transferred to the Issuer SPV to further redeem the sukuk, with the other 50% going to the originator as a distribution and (ii) On maturity date, the Issuer SPV will be required to redeem in full all outstanding sukuk bonds. The grace period is the period starting on the closing date and ending 12 months thereafter, or upon delivery of certain volumes.
The Purchaser SPV will be entitled to defer payment towards the redemption of the funding to the extent that it does not have sufficient funds to make such payments and, in the event of such a shortfall, the Issuer SPV is entitled to defer payment towards the redemption of the sukuk.
In addition to its obligation to repay the principal amount of the sukuk, the Issuer SPV will be obligated to pay an aggregate of US$90.83m of sukuk returns to the certificate-holders, and the Purchaser SPV will have a corresponding payment obligation to the Issuer SPV.
The Purchaser SPV’s obligations to pay amounts owing under the funding agreement will, except to the extent of funds remaining in the collection account and the reserve account, expire upon delivery of all hydrocarbon volumes attributable to the ORRIs.
Operations and development of the properties
Historical operations – Hydrocarbons were first discovered on the properties by Conoco Inc and its partners in 1954. From the commencement of production in 1958 through to year-end 2005, the field had produced 269 Bcf of gas and 2.5m barrels of condensate. Since taking over operations in mid-2003, the originator has drilled five wells (all successful) and performed six re-completions (four of which were successful). As of March 1 2006, there were seven wells producing in paying quantities on the properties.
Development plan – The originator has designed the development plan for the properties based on the three following criteria: (a) development of the reserve base as completely as possible; (b) utilisation of the existing wellbores and facilities to their maximum extent; and (c) utilisation of available capital as effectively and efficiently as possible.
The operations proposed to develop the properties in accordance with the above criteria can be divided into the following four categories: (i) projects to be initiated upon the closing date, which involve existing wells and facilities;
(ii) projects involving workovers of existing wells that will be undertaken as the current production in those wells declines to non-economic levels; (iii) a drilling programme for new wells and sidetracking programmes for certain existing wells, which will maximise realisation of the undeveloped reserves of the properties; and (iv) later workovers to access reserves in wells drilled prior to 2006 and in wells drilled in connection with the programme described in clause (iii).
Risk and mitigants
Operational risk - Operational risk is the risk that the originator/operator fails to meet the forecast production levels or any of its commitments under the transaction documents or fails to operate the properties in compliance with relevant laws and regulations. This risk is mitigated by the following:
The production facilities are relatively straightforward to operate, requiring only two full-time personnel on the platform to perform the production activities. The majority of the additional well developments (80%) are re-completions of existing previously drilled wells. PMI, an MMS-approved operator with significant offshore production and drilling experience, will be appointed as a back-up/contract operator under a back-up/contract operating agreement. The back-up/contract operator will be responsible for all services required to operate and develop the properties and will be liable for failure to comply with all relevant laws and regulations governing operations of the properties.Reserve risk - Reserve risk is the risk that the actual hydrocarbon reserves would supply less than the volumes expected to be produced in the base case financial plan as per the technical report. This risk is mitigated on account of the following:
The subsurface geology of the properties is very well understood (the properties were initially developed by Conoco in 1957 and have been the subject of numerous tests (seismic and other). GCA has confirmed the level of proved reserves estimated by the assessment methodology used by Harper as sound, and substantial due diligence has been conducted on the reserves by Harpers Associates and Gaffney Cline on behalf of investors.Furthermore, approximately 58.74% of proved reserves are classified as proved developed, with relatively low risk and costs associated with buying such reserves into production. To provide additional security, the estimated capex required in the field development plan will be pre-funded.No probable or possible reserves have been taken into consideration, only proved.Production stress factors on proved reserves have been considered while determining the size of the offeringEvent risk - Event risk is the risk of dramatic and unanticipated changes in the market environment such as natural disasters, specifically hurricanes that may disrupt production. This risk is mitigated by the following:ECP will be required to maintain an adequate insurance package for the assets (which includes catastrophic loss) to cover damage to the platform and wells. The requirement to have a funded reserve account to cover six months' senior expenses and sukuk return over the life of the instrument (Hurricanes Rita and Katrina resulted in a two-month shutdown). The transaction is volume based and though hurricanes typically result in a temporary shut in of wells, the sukuk-holders' primary collateral (the gas) would not be affected.Legal final maturity of 10 years, ie, six years more than the expected time needed to provide for a production shortfall.Price risk - Price risk is the risk that oil and gas prices might significantly drop, thereby affecting the value of the VPP. This risk is mitigated on account of the following:
Markets consultant Pace Global has projected long-term gas prices gradually to reduce to US$5/mcf by 2011. In a downside pricing scenario where gas prices are assumed to be at US$5.5/Mcf for 2006 and decrease gradually to US$3.5/Mcf in 2009 and stay at this low level thereafter, the sukuk would be fully redeemed by January 2014 (ie, in 7.75 years).Sharia considerations
The following main features enabled this transaction to be vetted as Sharia-compliant:
The underlying asset (oil and gas hydrocarbons) is lawful and compliant;The transaction is based on an acquisition of a physical asset: Purchaser SPV is purchasing on a true sale basis a physical asset which is opined on as being a real property (and registered in an official public registry with the MMS);The sukuk qualified as a sukuk al-musharaka as defined by industry standards established by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), paragraph 3/6, under the heading, Musharaka Certificates; the venturing parties being ECP and Issuer SPV;The funding agreement (linking the Issuer SPV to the Purchaser SPV) is a Sharia-compliant instrument aiming at (i) materialising the contribution of the Issuer SPV (as a musharek) and (ii) conveying to Issuer SPV a certain risk and reward profile that is passed on to the sukuk-holders;The hedge is essentially an obligation, or in Sharia terms iltizam, which is lawful because of true commercial value (it should not be viewed as a mere speculation). In the customary practice of modern finance such a sale is commonplace and there are well-established mechanisms for its pricing. It is clear that such a sale has commercial value and therefore may be considered as lawful under Sharia law.A Fatwa (Sharia endorsement) was obtained from prominent scholars.