Sunday, 20 January 2019

SMC – Small project, big thinking

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Salalah Methanol Company has a financial and operational performance track record. The real question was how to leverage that performance to achieve an optimal financing for SMC’s new ammonia plant. By Abdullah al Habsi, SMC, and Tristram Gang, Standard Chartered.

SMC’s 3,000 metric tonnes per day natural gas-based methanol plant is located in the Salalah Free Zone (SFZ), a dedicated industrial hub, at Salalah, Oman. It was commissioned in May 2010 and since commercial operations commenced the plant has produced over 8m metric tonnes of methanol while operating at production levels exceeding nameplate capacity. SMC has been profitable in every year of full production and has had an unblemished track record of servicing its original project financing debt.

On the back of SMC’s methanol plant and with an eye towards driving downstream development in Salalah, Oman Oil Company SAOC (Oman Oil or OOC), Takamul Investment Company SAOC (Takamul) along with SMC (together the sponsors) decided to diversify SMC’s existing methanol capability by expanding into ammonia production.

The physical engineering and chemical processes were meant to be highly synergistic. The ammonia plant would utilise hydrogen-rich purge gas generated by the methanol plant as feedstock. This configuration would make it possible to produce ammonia without sacrificing energy efficiency. Additionally, the configuration would require significantly less capital expenditure vis-à-vis a greenfield ammonia plant of similar capacity, making SMC a highly competitive producer of ammonia globally.

The path forward on the physical engineering and operational processes was clear. The challenge ahead was engineering a financial structure that would achieve an ambitious set of objectives set out by the sponsors:

1 – Since commencing operations, SMC had been a solid provider of dividends to its shareholders. Additionally, those same shareholders needed to limit their equity spend on the ammonia expansion so that shareholder funds could be spent elsewhere. OOC had a number of pure greenfield projects in the pipeline and could neither jeopardise its dividends from SMC nor expend a large amount of equity in getting the ammonia plant off the ground. Thus, the financing structure had to ensure success of the ammonia expansion while also minimising impacts on shareholders. If the financing structure required a substantial amount of new equity from the shareholders, it was likely the ammonia project would be shelved

2 – While ammonia would initially be sold both domestically and internationally, the sponsors needed to maximise flexibility in the financing structure both generally and specifically for potential future downstream developments

3 – Similar to the desire to save equity for other projects, OOC also needed to reserve commercial bank debt for future plans. Thus, the financing structure would need to source non-bank funding as much as possible without putting any underlying project timelines at risk

With the task clearly set out, it was up to SMC and its advisers Standard Chartered, financial, and Allen & Overy, legal, to develop a funding structure and liquidity plan that would cover all objectives while ensuring that ammonia implementation work could commence as soon as possible.

The financing structure

The most critical piece of the funding structure puzzle was utilising SMC’s existing cashflows to minimise shareholder impact while maintaining bankability. Given that SMC had significantly reduced its existing debt, continued to generate healthy cashflows, and equity from shareholders had already been contributed in relation to the methanol plant, the financing for the ammonia plant was proposed to be undertaken fully through debt. There would be no new equity required from the sponsors. It was also imperative that sponsors continued to have access to distributions during construction of the ammonia plant. However, lenders rarely allow dividends during construction, even in robust brownfield projects.

A balance needed to be found. In an attempt to find an equitable approach, a novel cashflow waterfall and cash sweep mechanism was introduced. The cashflow waterfall ensured that various lender protections typically in place for operations – debt service reserve account, maintenance reserve account etc – were fully funded before any dividends during construction could be made.

Similarly, the cash sweep was structured to be effective during construction as opposed to the usual cash sweep during operations. Fifty percent of available funds generated from methanol sales during construction would be swept to prepay debt. This would allow SMC to avoid principal repayments while the ammonia plant was under construction yet distribute funds to its shareholders during ammonia implementation, all while ensuring a fair risk balance with lenders.

Lastly, financings for industrial production projects often incorporate broad completion support regimes. In these regimes, shareholders will often provide substantial additional equity and/or debt protection in the event that the project is delayed, over budget, or under-performs. SMC and the sponsors had successfully implemented its methanol plant on time and on budget, and therefore wanted to use this past success to minimise the completion support required for the ammonia plant. However, lenders would ultimately require some protection against unforeseen construction issues.

The solution was a cost overrun reserve account (CORA) capped at US$40m. The CORA would initially be provided for, on or before financial close, with cash and/or a CORA cash equivalent constituting either (1) corporate guarantees from OOC and/or (2) fully subordinated letters of credit issued by a banks with an acceptable long-term unsecured debt rating.

The CORA, coupled with (1) a single point, lump-sum turnkey EPC contract (2) the EPC contractor wrapping the technology risk ensuring SMC and lenders had a single “port of call” for project implementation, and (3) a substantial in-built funded contingency, proved to be an appropriate balance. Shareholders avoided a potentially onerous call on equity funds for overruns or delays while lenders received solid protections around downside risks in relation to the ammonia plant’s construction. No new major equity requirements – first objective achieved.

With equity requirements minimised, the next objective was to ensure that critical flexibilities be built into the financing structure. It was imperative that the funding not restrict potential future uses of ammonia in the Salalah region while also being as sponsor-favourable as possible. SMC successfully incorporated the flexibility to dispose of the ammonia plant, eg for future projects, with a low lender approval threshold – 50% – as opposed to the more usual 100%.

Additionally, the financing structure successfully incorporated the ability for SMC to replace certain lender protection accounts – CORA, major maintenance reserve account, debt service reserve account etc – with an Oman Oil guarantee as an alternative to cash or letters of credit. This cost-reducing feature hadn’t been readily accepted by the financing market since the financial crisis. Flexibility for both the present and the future – second objective achieved.

With the key components of the financing structure largely in place, the focus turned towards funding. In order to achieve objectives one and two, it was necessary that SMC’s relatively restrictive existing project finance debt be fully refinanced, inclusive of terminating its existing, out-of-the-money interest rate hedge.

While this would beneficially free up the financing structure, it would also dramatically increase the funding required. By including the refinancing, the funding need nearly doubled from around US$400m to a total of approximately US$730m.

Complicating matters was the desire to rapidly mobilise sufficient liquidity with as little commercial bank debt as possible. Taking out the existing financing would also add the complexity of dealing with new lenders unaware of SMC’s financial track record. These new lenders would be particularly focused on SMC’s exposure to methanol and ammonia price risk.

On the back of a competitively bid EPC contract from SNC Lavalin, SMC and Standard Chartered worked with Export Development Canada (EDC) such that EDC would provide a substantial component, around 40%, of the total debt requirement. EDC’s collaborative approach helped ensure that project timelines were unaltered and non-bank funding was maximised.

However, it was critical that all new lenders, including EDC, get comfortable with SMC’s market risk dynamics. Leading up to the launch of the financing, chemicals markets had been challenged. Despite SMC”s historical performance, it was therefore critical to demonstrate to new lenders that SMC’s production of both methanol and ammonia could be placed in the global market place at price levels that would provide sufficient debt serviceability.

With Oman Trading International, an experienced trader of chemicals products with an extensive global network, agreeing to offtake 100% of methanol and ammonia production, volume risk was effectively mitigated. The focus therefore turned to competitiveness and price risk. SMC sits on the low end of the second quartile of the cost curve for methanol and at the bottom of the cost curve for ammonia, making it highly competitive on a delivered cost basis for both products.

This competitiveness is underpinned by gas supplied by the Government of Oman on a long-term basis. SMC’s natural gas pricing mechanism in its gas supply agreement provides downside protection for low product price environments. As methanol price increases, SMC pays more for gas, but as methanol price decreases, SMC’s gas cost reduces. This provides SMC with protection against downside price environments while also ensuring an appropriate upside sharing with the government.

This arrangement gives SMC the ability to withstand market volatility. On the back of the gas supply pricing mechanics, sensitivity analysis provided to lenders demonstrated SMC’s ability to service debt even in depressed product price scenarios. Breakeven analysis provided to potential financiers showed that SMC could service debt even if 2016 netback prices (representing a significant low price environment) prevailed throughout the debt tenor. Thus, SMC and its advisers were able to credibly show that market risk was sufficient addressed.

The response was positive, with the financing well received. The transaction was 2.5x oversubscribed at a challenging time for Oman. SMC and its advisers were successful in tapping a diverse and robust set of debt liquidity pools with 40% of the funding coming from non-banks sources.

The deal was signed within five months of official launch at a final funding cost that was significantly cheaper than similar sized limited recourse projects in the market at nearly the same time. Objective number three – obtain sufficient, competitive funding while maximising non-bank sources – achieved.

SMC leveraged a project’s existing operational and financial strengths to optimise the structure for a new financing. The successful closing of the ammonia plant financing will allow SMC to continue play a substantial role in the Sultanate’s strategy of catalysing the development of the Salalah area. SMC has estimated that over US$4bn of revenues will be generated within 20 years of the ammonia plant’s operations. In SMC’s case, a relatively small financing yielded very big results.

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