Issuing Credible Natural Gas Linked Bonds

Article appeared in the Cyprus Weekly newspaper on March 22nd, 2013.

By Constantinos Hadjistassou*, PhD

In attempt to stave off bank runs the President offered as a reward to depositors not withdrawing their savings from financial institutions, for a two years period, a bond tied to the island’s “natural wealth”– presumably natural gas. Under the circumstances financial resources aimed at averting a default were rather limited and thus any incentives to depositors were unavoidably somehow linked to projected (future) returns. One could wonder how pragmatic is it to commit potential future revenues from hydrocarbons?

From the energy policy standpoint, the Aphrodite gas field is perhaps the most recognisable achievement of the previous Government’s legacy but it comes with a few caveats. Converting natural resources into proved reserves has to follow a predefined path which ensures that the likelihood of extracting monetary value from an asset commands confidence. In the petroleum jargon, natural gas or oil proved reserves (or P90 reserves) are those which “by analysis of geological and engineering data have at least a 90% probability of being commercially recoverable under existing economic conditions, operating methods, and government regulations.” Unless a quantity of gas or oil is proved it cannot be included in the assets of an oil company. For the purpose of reporting to investors, major stock exchanges (e.g., New York stock exchange) require oil companies to substantiate their claims of holding assets by valuing them as proved reserves.

More than a year has elapsed since Noble Energy discovered about 200 billion cubic metres (bcm, gross mean) of natural gas, in block 12, the gas field has yet to be classified as a proved reserve. Usually, appraisal drilling is necessary to upgrade a resource into a reserve. Field appraisal is the process of converting probable reserves, with a probability of at least 50% of being recovered, into proved reserves. In doing so, at least one (appraisal) well is drilled in the formation. The wells designed to delineate the extent of the reservoir, provide more reliable information as to the quantity of the hydrocarbons, characterisation of the reservoir (i.e., pressure, temperature, porosity, etc.) and facilitate future production. More importantly, the objective of field appraisal is to quantify uncertainties regarding the commercial value of the discovered accumulation and to help make a decision as to whether the field is worth developing or not.

Depending on the complexity of the geological formation, the volume of the hydrocarbons and the availability of other pertinent information, the appraisal process could span from a few months up to three years. Once the appraisal process concludes independent consultants or specialised companies undertake the task of verifying the proved reserves. Even though the appraisal process is time consuming and cost intensive it is justified in the sense that it mitigates risk which very often outweighs the cost of field appraisal. Simply put a proved reserve offers assurances to potential investors.

Only then it is possible for a company or country to attach a credible monetary value to the reserves which when in-situ command a lower price per barrel of oil or $/million BTU for natural gas. Yet higher value can be earned from the reserves if the infrastructure exists to extract the hydrocarbons and source them to consumers, often, via the international market. Even greater benefits can be realised from the host country if the local oil & gas industry is actively engaged in all phases of developing hydrocarbons, namely: exploratory, appraisal, development, production and abandoment. As expected an offshore field development, which comprises a floating platform, subsea wells, and possibly a submarine pipeline, requires considerable investments especially when in ultra-deep waters and away from the shore. The development of the Aphrodite gas field is expected to cost about $1.5-2 bn.

Prior to developing the Aphrodite field one should consider the fact that the Noble-Delek-Anver consortium will need to recover their costs with a reasonable level of profit. Add to that the cost of the unitisation agreement between Cyprus and Israel due to the fact that the Aphrodite field borders with Israel’s Exclusive Economic Zone (EEZ) expected to be somewhere between 80% for Cyprus and 20% for Israel.

Only when the host Government is granted the permission from the company/ies which hold the concessions rights it is possible for the country to issue hydrocarbon related bonds tied to its share of the reserve. According to unverified sources, provided the oil companies recover their costs, about 70% of the gas sales from the Aphrodite field will end-up in state coffers.

Returning back to the scenario of issuing natural gas linked bonds prospects are not so rosy. Provided that the Cypriot parliament legitimises the Cyprus National Hydrocarbons Company (or KRETYK), any bonds will bear the same rating, from credit rating agencies, as the national oil company’s (NOC’s) host country. The same holds true for other NOCs such as Petrobras and Gazprom which have the same credit rating as Brazil and Russia, respectively. Hence, if Cyprus’s bonds are rated as “junk” the same would apply to the KRETYK gas bonds.

Due to their inherent risk, subordinate bond ratings bear the burden of offering higher returns. In turn this yield is usually tied to the interest at which the host country raises money from lenders by issuing government bonds. However, a higher return on investment implies that the extraction costs of the natural gas need to be competitive. By virtue of their nature ultra-deep offshore, in water depths exceeding 1,500m, gas fields are capitally intensive projects requiring costly equipment. Notwithstanding the optimism there is an upper limit to the value of the bonds an NOC can issue.

A couple of other hurdles will also need to be clarified before issuing natural gas bonds. First, investors will require a “roadmap” for exporting the natural gas from Cyprus. Cyprus’s minute natural gas needs for power generation, estimated at about 1.2 bcm/year, do not financially justify the development of the Aphrodite gas field. To make such a development economically viable there is a need to export an appreciable amount of the natural gas, most probably, in liquefied form. A starting point would be to build a one train Liquefied Natural Gas (LNG) plant with an export capacity of about 5 million tons (of LNG) per annum (mtpa). Raising an estimated €7 billion for a 5 mpta LNG plant is no easy task. Second, either more natural gas fields will need to be discovered by the companies which hold concessions in the Cypriot EEZ or Israel and Cyprus should monetise their reserves and decide to go for jointed exports. For the latter to happen, Israel has first to approve the export of natural gas and reinforce ties with Cyprus.

Crucially important prior to issuing gas bonds there is a need to undertake the necessary studies which probably would include a pre-end engineering design (FEED) study, a feasibility analysis, and identifying potential gas buyers. To summarise, gas bonds can appeal to bank savers only when they are credible financial instruments. Surely natural gas offers hope in the gloominess. Drilling for oil, as indicated by Total, adds to the optimism. If only we had luck with our side and some more space for manoeuvring, that is in retrospect, time.

Related articles:
Explanations for Downsizing the Aphrodite Gas Field

Maximising the Benefits From the Third Licensing Round

Defaming the Petro-Industry

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