IBP2182_12 FLOATING LNG: PROJECT STRUCTURES AND RISK ALLOCATION AND ALIGNMENT IN FLNG PROJECTS John D.

White1, Hannah Longley2

Copyright 2012, Brazilian Petroleum, Gas and Biofuels Institute - IBP

This Technical Paper was prepared for presentation at the Rio Oi & Gas Expo and Conference 2012, held between September, 1720, 2012, in Rio de Janeiro. This Technical Paper was selected for presentation by the Technical Committee of the event according to the information contained in the final paper submitted by the author(s). The organizers are not supposed to translate or correct the submitted papers. The material as it is presented, does not necessarily represent Brazilian Petroleum, Gas and Biofuels Institute opinion, or that of its Members or Representatives. Authors consent to the publication of this Technical Paper in the Rio Oil & Gas Expo and Conference 2012 Proceedings.

Abstract
The forces driving the development of FLNG are primarily economic. These include the monetisation of otherwise stranded gas reserves, such as those in deepwater or remote fields or reserves that may otherwise be uneconomic to develop and market. In each case, physical impossibility and/or high capital costs mitigate against monetisation. As a result, in deepwater oil fields associated gas may be re-injected (potentially impacting optimum recovery of reserves) or in some cases flared (raising environmental concerns) and in relation to non-associated gas fields may simply be left untapped. FLNG may prove to be the means to bring such stranded gas to market. FLNG will make economic sense if the demand (and price) for gas or LNG justifies the cost and risk of its development. However, there may also be demand for FLNG in certain countries/regions due to governmental policy, including the implementation of energy security policies, domestic supply requirements, lack of alternative evacuation options and the need to manage oil field production. Industry players have predicted lower per unit liquefaction costs for FLNG than for land-based projects (although these calculations may vary in the current market). However, other costs may also be relevant - including upstream development and operating costs. More than that, however, the demand must be such that it cannot be satisfied by other means, such as oil, nuclear, renewable or other sources of gas or conventional LNG. This paper will consider the market forces driving the development of FLNG, evaluate key structuring issues in developing a successful FLNG project and identify ways in which parties may seek to achieve a sustainable allocation of risks and rewards in key contracts across the value chain.

1. Introduction
During the first quarter of 2012, various developments indicate renewed vigour in the LNG sector. The number of anticipated new import terminals in comparison to export terminals suggests that demand projections may be running ahead of potential supplies (many of the proposed liquefaction plants were postponed due to the recession and those under construction have been hit by delays and cost overruns). It is likely that new LNG plants may be proposed or existing plants expanded to balance the market in the longer term. This global trend is reflected in recent activities in the development of floating LNG projects. Over the past few years, the market has seen a considerable increase in the development of floating regasification projects and whilst there appear to be some LNG vessels available for floating storage and regasification unit (FSRU) development, LNG shipping is tight. Floating liquefaction projects have been discussed at length but unlike floating regasification the first project is yet to be commercially proven.

______________________________ 1 LL.B., Partner Baker Botts 2 LL.B., Senior Associate Baker Botts

Rio Oil & Gas Expo and Conference 2012 The term FLNG is often used in a generic manner to refer to floating regasification and floating liquefaction projects. Whilst this paper will focus primarily on floating liquefaction, analysing possible project structures and key areas of risk allocation and alignment throughout some of the major project development contracts, our analysis begins with a review of some fundamental differences between floating regasification and floating liquefaction and the market drivers relating thereto.

2. Forces Driving the Development of FLNG

FSRUs provide a quick, flexible and cost efficient means of addressing growing demand for natural gas in certain countries, particularly where there are limited alternative sources of energy. FSRUs are often significantly cheaper than land-based regasification terminals with a shorter completion time and simpler permitting requirements. FSRUs may also offer increased flexibility by being purpose built for smaller growing markets, used to satisfy seasonal demand and used for conventional LNG trading purposes. FSRUs are ship-based LNG receiving, storage and offloading systems designed to receive LNG and regasify the LNG into natural gas to supply local demand. The FSRU may be purpose built or may be developed through the conversion of an existing conventional LNG vessel. Some FSRUs have been designed to operate as conventional LNG vessels with the ability to trade LNG cargoes globally whilst others have been designed to be permanently moored alongside a jetty. In addition, shuttle regasification vessels (SRVs) are purpose built vessels designed to operate as conventional LNG carriers but with the ability to regasify LNG and deliver natural gas into a gas transmission and storage system while the vessel is anchored offshore at a buoy. There are around eleven existing projects and an estimated three times as many projects in planning or construction stages. Excelerate, Golar and Hoegh are companies which have established track records in the FSRU market. A floating liquefaction project involves the production of LNG using an FPSO type vessel moored directly above offshore fields. FLNG has the potential to offer a solution for gas in remote locations eliminating the need to build a costly fixed pipeline to a land based liquefaction plant. Whether or not FLNG can offer a fast-track, flexible and cheaper alternative than a conventional land-based liquefaction plant has been the subject of much debate. For many years the question has been whether FLNG facilities can be developed on a commercially and economically viable basis, particularly with the potential uncertainty of recoverable gas reserves and production levels. In addition, project structure models which are typically utilised for the development of traditional onshore LNG facilities require careful scrutiny in the FLNG context, especially regarding risk and reward allocation and the ability to secure an economic return which supports the large capital expenditure required to build an FLNG unit. There are currently around ten floating liquefaction projects that are either planned or underway across the globe. In May 2011, Shell made a final investment decision (FID) to proceed with the development of its Prelude floating liquefaction project offshore Australia. In addition to Shell, other industry players that have considered, or are seeking to develop, floating liquefaction facilities include ConocoPhillips, Excelerate, Flex LNG, GDF Suez, Golar, Hoegh, Inpex, Petrobras, Petronas, Santos, SBM, Technip, Teekay and Total. Whilst Shells decision is perceived as a vote of confidence in the concept of floating liquefaction, the scale and risks of constructing and implementing an FLNG project are still viewed as big hurdles for smaller companies. In addition to the extensive FLNG safety studies, conceptual design and detailed feasibility and engineering studies conducted by Shell, the super major also has the means to underwrite the project itself. Larger companies may take advantage of balancing high upfront costs with economies of scale, synergies for developing future FLNG units and overall return for the project in question (for example, separate sales of associated condensate and LPGs which bring down the overall cost of the project or using FLNG as a means of monetising associated gas in an already profitable oil field development). The larger players with a global LNG portfolio are also more likely to have a proven track record of LNG project development and will be better placed to mitigate risks of prolonged delays in start-up or indeed a complete failure to come on stream. Smaller players may still struggle to make FLNG work and may also find it harder to get an FLNG project over the line without a viable allocation of risk and reward throughout all areas of the value chain. Set out in Table 1 below is a short description of some of the FLNG projects that have received attention in the press. The progress of such projects will be closely monitored over the next few years, particularly as the start of commercial production gets increasingly closer to becoming a reality. 2

Rio Oil & Gas Expo and Conference 2012 Table 1. Selected FLNG Projects Location Australia Prelude field and Concerto field Australia Bonaparte basin Australia Timor Sea 2 mtpa PTTEP Others: SBM, Linde 2-3 mtpa Anticipated Capacity 3.6 mtpa Parties Shell (100%) - Inpex to acquire 17.5%, Korea Gas Corporation 10% and CPC 5% Others: Technip, Samsung GDF Suez (60%), Santos (40%) Status Under construction FID taken in May 2011 Operations expected to commence 2017 Pre-FEED stage. FID planned for 2014 Operations expected to commence 2018 Pre-FEED stage. FID planned for 2012 Operations expected to commence 2016 Brazil Pre-salt fields Indonesia Abadi field Masela block Israel Myra & Sarah fields Malaysia Kanowit field 1.2 mtpa 3 mtpa 2.5 mtpa 2.7 mtpa Petrobras, BG, Repsol, Galp Others: Technip-Modec-JGC FEED stage FID postponed

Inpex Masela (60%), Shell (30%), FEED expected to commence EMPI (10%) FID planned for 2013 Operations expected to commence 2018 Israel Land Development Energy Feasibility study underway Others: ENR (DSME subsidiary) Petronas (1st FLNG unit) Others: Technip, DSME FEED studies complete EPC awarded Delivery targeted for 2015/2016 FEED tender process EPCI to be awarded in 2013 Operations expected to commence 2016

Malaysia Rotan field, Block H Papua New Guinea Elk & Antelope fields, Gulf Province Papua New Guinea Gulf of Papua

1.5 mtpa

Petronas (2nd FLNG unit)

2 mtpa

Liquid Niugini Gas - InterOil FEED stage (52.5%) and Pacific LNG (47.5%) FID planned for 2012 Others: Flex LNG, Samsung Operations expected to commence 2014

3 mtpa

PNG FLNG - Petromin (34%), Hoegh (33%), DSME (33%)

FID planned for 2012

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3. Project Structuring Basics

The very nature of a floating liquefaction project involves the production of LNG directly at offshore fields, meaning the FLNG unit will be physically proximate to the gas production facilities. The legal and fiscal regime governing the development and production of gas will be crucial to establishing a successful and economically viable project with an appropriate allocation of risks and rewards at each stage of the value chain and will almost certainly impact the choice of FLNG project structure. Whilst the applicable granting instrument will set forth the rights and obligations of the parties vis--vis the host government, the joint operating agreement will set out the rights and obligations of the upstream participants amongst themselves. The parties will also need to consider any prohibitions or restrictions which may be imposed according to local laws (such as domestic supply requirements and any government approvals which may be required for the export of gas in the form of LNG), together with the overall regulatory framework and political environment. Analysis of the applicable fiscal regime will be crucial since the tax position is likely to have a significant impact on the economics of the project and will influence the ways in which the parties may seek to optimise their choice of structure. Set out below is a short description of three basic structures for an FLNG project together with some issues for consideration. The chosen business model is likely to vary depending on the jurisdiction, the identity, strength and capabilities of the parties involved and their commercial goals. Ultimately a hybrid structure may be developed to address specific FLNG complexities. 3.1. The Integrated Project Model Figure 1 indicates a simple integrated model where the upstream participants build or procure all necessary infrastructure to produce, liquefy and market the gas. The equity interests reflect their participating interest shares in joint operating agreement and each participant retains title to its share of gas until the gas is sold as LNG.

Upstream Supply Chain PSC Contractors Ownership Interest Liquefaction Plant Sales Contracts

Buyers

LNG Sales Contract

Figure 1. Integrated Project Structure In an integrated model, the FLNG unit would be treated as part of overall project infrastructure. The operator would typically be responsible for procuring all necessary assets and services required to develop the field. Potential benefits of using an integrated model include alignment of interests and sharing of costs across the value chain and the opportunity for each upstream participant to deal with its own allocation of production (assuming each party markets its share separately). However, operational issues would need to be addressed including entitlement to capacity, availability of storage and offloading capability and obligations and liabilities for failure to offload LNG (bearing in mind the potential consequence of shutting down the FLNG unit thereby shutting in production). 4

Rio Oil & Gas Expo and Conference 2012 3.2. The Project Company Model Figure 2 indicates a project company model where the project company builds or procures all necessary infrastructure to produce, liquefy and market the gas. The upstream participants sell gas to the project company. The project company owns the FLNG unit, processes and liquefies the gas bought from the upstream participants into LNG and sells to LNG buyers for its own account.

Upstream Supply Chain Gas Sales Agreement Sales Contracts Project Co. (LNG Plant)

LNG Sales Contract LNG Buyers

Figure 2. Project Company Structure The project company model is often used in the context of conventional onshore LNG projects but not for traditional upstream field developments. Potential benefits of the project company model include opportunity for wider equity participation and the project company assuming the benefits and risks associated with marketing and selling the LNG. This structure may be utilised where the upstream participants are unwilling or unable to fund the capital expenditures or operating costs associated with an FLNG unit or in circumstances where the project company is intended to bear operating risk. 3.3. The Tolling Model Figure 3 indicates a tolling model where the tolling company builds or procures and operates the FLNG unit and provides liquefaction services to the upstream participants on a tolling basis. The tolling company typically receives a fee to cover fixed costs, variable costs and a return on capital expenditures but does not take title to the gas and/or LNG.

Upstream Supply Chain Sales/Service Contracts Tolling Fee

Toll Co. (LNG Plant)

LNG Buyers

LNG Sales

Figure 3. Tolling Structure 5

Rio Oil & Gas Expo and Conference 2012 A tolling structure will necessitate detailed tolling arrangements to deal with the supply of a minimum volume of gas, capacity rights and offtake arrangements. Potential benefits of this structure may include reduced capital requirements on the upstream participants and facilitation of financing based on long term tolling fees and may also be appropriate if gas is to be received and processed from different fields with different participants. 3.4. Other factors Influencing Choice of Structure The identity and nationality of the FLNG unit owner will need to be considered carefully. In some jurisdictions, ownership (and flag) requirements may be dictated by national legislation. Further, the parties will need to carefully analyse the terms of the relevant granting instrument for the field in which the FLNG unit is to operate to determine whether any issues arise with respect to ownership of property by the joint venture. By way of example, some production sharing contracts provide that ownership of certain property used by the operator for the purpose of operations will vest in the host government and must remain in the relevant contract area or jurisdiction, including following the end of field life. This is an important consideration if the FLNG unit may be moved for use in a different contract area or jurisdiction at the end of field life. Another important consideration is the extent to which the capital expenditure and/or the operating costs of the FLNG unit may be recoverable by the upstream participants. For example, if the granting instrument is a production sharing contract then the upstream participants should be entitled to recover some of their costs out of net revenues from a specified percentage of production. Cost recovery mechanisms vary from jurisdiction to jurisdiction and such provisions are often negotiated so it will be critical to determine what constitutes a recoverable cost and the limitations on recovery in any particular circumstances.

4. Risk Allocation and Alignment of Interests

The offshore location of an FLNG project is likely to have a significant impact on the way in which key contracts are drafted and negotiated. 4.1 Leasing or Ownership? A basic ownership model would involve the joint venture entering into an engineering, procurement, construction and installation contract with a contractor, or perhaps more likely a consortium of companies which possesses the necessary expertise to design and construct the hull and topsides and all necessary processes including the liquefaction facilities and technology licence. This type of ownership structure would allow the risk of cost and schedule to be shared between the joint venture parties and the members of the EPC consortium pursuant to negotiated contractual arrangements. Subject to any restriction which may be imposed by law, or pursuant to the requirements of the applicable granting instrument, ownership of the FLNG unit may give greater control to the joint venture with respect to operating decisions and redeployment or decommissioning at the end of field life. The upstream participants may decide to own the FLNG unit as joint venture property pursuant to the terms of the applicable JOA or form a special purpose company to own the FLNG unit and to charter the FLNG unit to the joint venture. A structure involving a special purpose company potentially allows for increased flexibility in participation and ownership, such as equity participation which differs from the upstream interests or direct involvement of members of the EPC consortium (for instance, the FLNG technology providers). The FPSO leasing or chartering model may be applied to an FLNG unit but one major challenge that arises with respect to applying such model is the considerable cost involved in the engineering, procurement and construction of an FLNG unit and the need for a robust project structure in order to support such cost. Other challenges may include the allocation of operating risk between contractors and upstream participants in relation to technology that has not yet been implemented on a commercial scale and securing the services of a single contractor entity with the required experience and expertise to operate LNG liquefaction, storage and offloading facilities situated on a floating platform. For these reasons, in the context of an FLNG project a traditional FPSO charter and management contract approach may need to incorporate elements of both land based LNG tolling arrangements and charter party arrangements for LNG ships. Alternatively, the upstream participants may decide to rely upon the experience of the field operator or consider forming a special purpose operating company to operate the FLNG unit in order to mitigate operating risks by drawing upon their collective expertise and pooling relevant skills and experience. 6

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4.2 Engineering Procurement and Construction (EPC) The risks in relation to FLNG unit construction (as with conventional LNG vessels) are that the FLNG unit will not be completed according to design, will not be delivered on time and on budget or will not be compliant with class or perform in accordance with expected design, capabilities and economics. Construction risks are typically mitigated by design selection, FEED and engineering studies, the use of proven technology and, where possible, experienced and creditworthy contractors under industry accepted contracts. Whilst the traditional FPSO contractual framework may provide useful analogies and guidance, new issues will need to be addressed. The parties will need to decide, for example, whether to use a shipbuilding contract or topside facilities contract as the starting point. Typically a contractor will guarantee an agreed level of performance. Specific remedies in favour of an FLNG purchaser may include liquidated damages for delay in delivery past the scheduled delivery date, warranties in relation to key performance parameters and responsibility to repair defects that become apparent within a certain period of time. However, with the implementation of new technologies and increased commissioning, completion and performance risks (where operations are closely tied to the upstream field) which are likely to result in large financial losses across the value chain in the event of a delay or failure, the project parties and/or LNG buyers may expect to bear more of this risk. There is also a heightened potential integration risk for an FLNG purchaser as it may factually be difficult to prove that a fault or failure in performance was caused by one part or another of the FLNG unit. In order to avoid any legal finger pointing over potential liability for such fault or failure, the FLNG purchaser will ideally seek single point responsibility for performance by the primary contractor. A contractor consortium will need to carefully consider issues of joint and several liability as between the EPC contractor, the shipyard and the liquefaction technology licensor and seek separate rights of contractual recourse. 4.3 LNG Sale and Purchase Agreement (SPA) Any LNG project will require a robust LNG SPA with a creditworthy buyer. However, certain issues become more critical for an FLNG project taking into consideration storage constraints, scheduling and berthing restrictions and challenging weather conditions which may cause delays. In addition, an FLNG unit which is operating in close proximity to offshore fields will necessitate close coordination with other upstream activities (such as drilling services and support vessel logistics) and the LNG offtake programme and shipping schedule will also need to take into account separate offtake requirements for LPG and condensates. With these issues in mind, an LNG SPA will need to pay particular attention to the consequences of late arrival or late departure of an LNG vessel, demurrage, liability for failure to deliver or failure to take volumes of LNG and upstream delays or production issues. The basis on which LNG is sold will also be important. For example, if a specific type of LNG vessel will be utilised to offload LNG from the FLNG unit in order to allow offloading of LNG in dynamic metocean conditions then LNG may be sold on a DAP (Delivered at Place) basis rather than on an FOB (Free on Board) basis. Further, if the LNG vessel fleet is limited, then the seller may need to restrict the places at which LNG is delivered to the buyer and limit diversion opportunities so that the LNG vessel may return in time to offload future scheduled cargoes.

5. Conclusion
Parties are expected to draw upon their experience with oil FPSOs, traditional land based LNG plants and charter party arrangements for LNG ships in order to establish analogous contractual structures in the context of FLNG project development. Ultimately, the selection of an optimal structure will rely heavily upon the legal and contractual framework surrounding the development and production of a particular field and the creation of an economically viable FLNG project with a sustainable allocation of risks and rewards throughout key contracts in the value chain. The introduction of FSRUs has seen a surge of activity, as countries such as Argentina, Brazil, Kuwait and Dubai rapidly became LNG importers and within five years it is anticipated that nearly all Asian countries could be importing LNG. Global LNG demand is expected to double over the next decade, and as the industry demands a new approach to LNG liquefaction FLNG is fast becoming an industry game changer. 7

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6. References
BBC, http://www.bbc.co.uk/news/business-13465870 Downstream Today, http://www.downstreamtoday.com/news/article.aspx?a_id=28159 Energy Delta, http://www.energydelta.org/mainmenu/edi-intelligence-2/our-services/latest-energy-news/murphy-boostsrotan-flng-plan Flex LNG, http://www.flexlng.com/?page=194&news=79 GDF Suez, http://www.gdfsuez.com/en/news/press-releases/press-releases/?communique_id=1177 Komec, http://www.komec.kr/eng/Board.asp?menucode=0503010000&mode=2&no=2846&page=5; http://www.komec.kr/eng/Board.asp?menucode=0503010000&mode=2&no=2847&page=5 Hydrocarbon Processing, http://www.hydrocarbonprocessing.com/Article/2862247/Floating-LNG-group-eyes-newTimor-Sea-project-near-Australia-coast.html Hyrocarbons Technology, http://www.hydrocarbons-technology.com/projects/gulf-lng-project/ ICIS Heren, http://www.icis.com/heren/articles/2012/03/07/9539433/us-excelerate-energy-plots-first-offshore-us-lngexport.html Inpex, http://www.inpex.co.jp/english/news/pdf/2011/e20110722-b.pdf Offshore Magazine, http://www.offshore-mag.com/articles/2011/07/flng-group-eyes-timor.html Petronas, http://www.petronas.com.my/media-relations/media-releases/Pages/article/PETRONAS-FINDS-NEW-OILAND-GAS-FIELDS-OFFSHORE-SARAWAK.aspx PTTEP, http://www.au.pttep.com/projects/proposed Shell, http://www.shell.com/home/content/aboutshell/our_strategy/major_projects_2/prelude_flng/overview/ Upstream Online, http://www.upstreamonline.com/live/article269232.ece; http://www.upstreamonline.com/live/article287059.ece; http://www.upstreamonline.com/hardcopy/article295429.ece; http://www.upstreamonline.com/live/article1245931.ece; http://www.upstreamonline.com/live/article294551.ece;