An introduction to tolling agreements in the LNG sector
An introduction to tolling agreements in the LNG sector

The following Energy practice note provides comprehensive and up to date legal information covering:

  • An introduction to tolling agreements in the LNG sector
  • Introduction
  • Tolling Model—structure and key differences with merchant model
  • Tolling Agreement—key issues and clauses
  • Tolling fee and financing issues
  • Capacity
  • Lifting terms and obligations
  • Annual Delivery Program and LNG allocation
  • Additional considerations

Introduction

The business model underpinning a liquefied natural gas (LNG) project is of fundamental importance since this will determine the risk profile of the project as a whole and consequently, the type of financing that will be required. The choice will ultimately depend on a number of factors, including the risk appetite, fiscal and tax considerations and financing issues of the relevant investor as well as their interest in investing in one or more of the LNG chain segments. (For more details on the LNG value chain, see Practice Note: LNG—an introduction.)

LNG projects can be structured in a number of different ways:

  1. integrated/non-integrated

  2. merchant/tolling

In an integrated model, there is unity of ownership throughout the entire LNG chain, from production through to liquefaction—that is, one or more investors holding the underlying upstream concession/PSC also own the rights to the natural gas reserves. As a result, the upstream owners build the infrastructure which is necessary both to extract the natural gas from the ground as well as to monetise it—the LNG liquefaction/regasification plant being a key component of such an integrated project, as it is required to process/liquefy the natural gas and market the LNG produced as a result.

The upstream concession holders also retain an interest in the LNG plant, in the same proportion as each of their upstream project interests.

In a ‘non-integrated’ structure, the LNG plant

owner is not the gas/LNG purchaser, and is not necessarily the end marketer/user of the LNG.

Under a merchant structure, a project company owns the LNG plant, purchases natural gas as feedstock for the plant, processes it and then sells the resulting LNG to buyers. It does not have any interest in the upstream assets (although in practice there may be instances where the entities owning the project company also own the upstream assets). The reasons behind choosing to structure the project through a separate entity as the owner of the LNG plant can include several factors, such as:

  1. tax considerations

  2. local laws requiring a government-owned company to be the owner of the LNG facility

  3. upstream asset owners not willing or able to invest in the LNG plant (or vice versa, the LNG facility owners not being interested in the upstream assets)

For more information on possible way of structuring an LNG project, see Practice Note: LNG—Structuring LNG projects.

This note will focus on the tolling model and in particular on the key considerations and features of the tolling agreement.

Tolling Model—structure and key differences with merchant model

The merchant model exposes the project company to a number of risks:

  1. commodity pricing risk in purchasing gas and selling LNG—since LNG is sold by the project company, separately from the entity producing the gas, it must buy gas from the upstream owners pursuant to a gas supply agreement. Where the upstream asset owners and project company owners are not the same entities, negotiating the gas sales agreement (GSA) may be a difficult process and the project company may ultimately be asked to bear most of the market risk (for example, through netback pricing provisions based on the LNG sale price or through a participating economic interest in the revenues of the project company)

  2. non-performance under LNG Sale and Purchase Agreements (SPAs)—the project company is also in principle open to liability for breach of its LNG SPAs’ obligations even where caused by non-supply of natural gas under GSAs

  3. credit risk of the gas buyers—this can be particularly critical where the gas buyers are locally based entities rather than international energy companies. As a result, any third party financing for this type of structure can be difficult to arrange, unless the lenders are satisfied that the project is economically sound, which requires having in place a healthy revenue stream which is guaranteed under long term GSAs, and ensuring that there is no offtake risk on the part of the gas purchasers

  4. less flexibility for upstream equity owners—all sales are made through the project which takes upside and downside commodity risks associated with buying the gas and marketing LNG

In a typical tolling structure, the LNG plant is owned separately from the upstream assets, with natural gas and LNG being owned by the upstream owners until they are sold. Since the LNG plant owner does not own the natural gas which it processes it will not be acting as a trader, but rather as a service provider: it will simply receive a fee for processing natural gas owned by producer or LNG purchaser.

The diagram below shows the typical tolling structure (non-US):

This structure may be preferred:

  1. because the various participants do not wish (or do not have the expertise) to participate in the various segments of the LNG chain

  2. because the tolling company minimises market risk through the fee structure since the reservation charge is payable regardless of whether LNG has been produced or any LNG sales have been made

  3. where natural gas supply or downstream markets are uncertain, since upstream owners/suppliers may accept bearing the risk by committing to paying tolling fee in exchange for tolling company investing in the project. It is also a good model if wishing to attract an outside investor to the project

  4. if there is an expectation of supply from a variety of fields or where local tax legislation imposes taxes that might apply in the other structures

  5. also, importantly, tolling model facilitates project financing for the LNG plant because the revenues are not directly exposed to market risks

It is important to note that in the US, the tolling model is characterised by separate entities owning and supplying the gas through pipeline and gas sales agreement to the various tolling customers, who then pay the tolling fee to the LNG project company for processing the gas and they then later on sell the LNG to buyers. This model was developed to provide the opportunity to entities who did not own the upstream facilities to also take part in the oil and gas industry by providing a service to third parties wanting to liquefy natural gas—hence the term ‘third party’ tolling model.

Tolling Agreement—key issues and clauses

As shown in the diagram above, separate tolling agreements are commonly entered into between the various upstream owners/tolling customers and the LNG processing company. The terms of this agreement are of fundamental importance within the entire LNG value chain since the tolling tariff which is ultimately agreed upon will underpin the economics of the whole project. In addition, care must be taken to ensure that the tolling agreement is ‘bankable’—that is, it is capable of sustaining and obtaining debt financing.

Please see below for an overview of the main terms of a tolling agreement and the key issues to consider when negotiating such agreement.

Tolling fee and financing issues

Commercially, the tariff which the various upstream gas owners/tolling customers will pay to the LNG plant owner (‘tolling fee’) is essential to guarantee stable cash-flow to cover the plant operating expenses, shareholders return and debt (as well as any taxes).

Typically, the tolling fee is made up of two elements:

  1. a ‘reservation’ (or ‘capacity’) charge, which is payable regardless of whether or not any natural gas is processed in order to ensure that the LNG plant has the necessary capacity to liquefy a natural gas owner's natural gas on a regular basis. This reservation fee allows the project company to recover fixed costs, as well as a return on capital; and

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