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Commodities Linked

Financing Structures
Session 9 + Session 10 + Session 11 + Session 12
360 Evaluation Framework

8. Accounting & Tax Aspects 1. Problem Statement

1
8 2
7. Regulatory Aspects 2. Proposed Solution

7 3
6. Legal Aspects 3. Commercial Considerations

6 4
5. Basel Capital &
5 4. Risk Aspects (Credit Risk, Market
Associated Considerations Risk, Operational Risk)

Commodities 2
1. Reserve Based Financing (“RBF”)

Commodities 3
1.1 RBF: Problem Statement

• When an oil field is “discovered”


• No one can accurately forecast how much oil exists under the earth's surface
at that location
• No one can make definite calculation on how much of that oil will be possible
to extract

• This is plainly on account of highly complex geology, sampling errors,


and limitations of present technology

Commodities 4
1.1 RBF: Problem Statement (continued…)

Faced with such situation, model-based estimation is used, to make


informed estimates of the reserve:
• Proved Reserve (P1)
• Probable Reserves (P2)
• Possible Reserves (P3)

Commodities 5
1.1 RBF: Problem Statement (continued…)

• Proved Reserve (P1)


• Basis technical reports and seismic analysis, this is the estimated amount of
oil which is recoverable with certainty in future years under current economic
and operating conditions
• Proved reserves of a field are defined as having a better than 90% chance of
being produced over the life of the field
• Relatively conservative estimate of production

Commodities 6
1.1 RBF: Problem Statement (continued…)

• Probable Reserves (P2)


• Reserves which are estimated to have 50% (or more) chance of being
technically and economically viable for production
• Not as certain as P1 reserves
• In past, P2 reserves have become more viable with enhanced recovery
techniques, and with availability of more geological information (during life of
the field)

Commodities 7
1.1 RBF: Problem Statement (continued…)

• Possible Reserves (P3)


• Reserves which are neither P1 nor P2
• Which are estimated to have a meaningful – typically more than 10% but less
than 50% - chance of being technically and economically viable
• As we live through life of a field, some of the P3 reserves tend to graduate to
P2 and P1 eventually

Commodities 8
1.1 RBF: Problem Statement (continued…)

Source: Wikipedia
Commodities 9
1.1 RBF: Problem Statement (continued…)

• New upstream Exploration & Production (E&P) projects are typically


incorporated as SPVs (Special Purpose Vehicles)
• Why?

• How are such E&P SPVs financed?


• See next slide…

Commodities 10
1.1 RBF: Problem Statement (continued…)

Exploration
Lifecycle of an Oil Field

Technical Appraisal

Regulatory / Environmental Clearances

EPC Phase begins…

Construction

Initial and ongoing production

Equity, Subordinated Debt


Source of Financing

Project Financing

Reserve Based Financing

Balance Sheet Lending

Commodities 11
1.1 RBF: Problem Statement (continued…)

For an Upstream E&P company, the problem statement is as follows:


• Given the E&P SPV structure, how do we:
• Finance an ongoing, producing oil field?
• Leverage existing oil field cash flows for upcoming capital expenditure?
• Raise debt without balance sheet support from parent (such as corporate
guarantee)?
• Optimize equity and RoE?

Commodities 12
1.2 RBF: Proposed Solution

Reserve Based Financing


• Hybrid of project finance, corporate finance and asset-backed finance
• Basically, financing against oil and gas field
• Security over reserves / cash flows, and Non-Recourse Loan

• Loan Amount is present value of net cash flows from production from
the given oil field

Commodities 13
1.2 RBF: Proposed Solution (continued…)

• Loan Amount  PV of Cash flows for Debt Servicing


• Expected net cash flows from production from the oil field
• [ Type of Reserves (P1, P2, P3) ] * [ Expected Oil Price + Any hedging for oil
price (typically mandated by lenders) ], minus
• Operating Expenses, minus
• Government Royalties and Taxes , minus
• Future Capital Expenditure

Commodities 14
1.3 RBF: Commercial Considerations

• What’s in it for E&P company…?


• Cheaper cost of financing (than would be available through normal corporate
loan)
• Higher debt capacity, with progressive field performance
• Non-recourse financing, Good for parent from leverage perspective, positive
from ratings perspective
• Able to avoid further equity infusion into project, leading to better RoE

Commodities 15
1.3 RBF: Commercial Considerations (continued…)

• What’s in it for the lenders…?


• Fully secured, asset backed financing
• Facility Risk Rating significantly better than Counterparty Risk Rating
• Lower RWA, Lower Basel Capital required, Better RoB3C

• Upfront Fees and Healthy Loan NIM


• RoFR on hedging business
• RoFR on Capital Markets take-outs
• Typically, such borrowers tap capital markets to refinance once credit improves

Commodities 16
1.4 RBF: Risk Aspects

• “…As we know, there are known knowns; there


are things we know we know. We also know
there are known unknowns; that is to say we
know there are some things we do not know.
But there are also unknown unknowns — the
ones we don't know we don't know…”
Donald Rumsfeld
21st US Secretary of Defence
Serving from 2001 to 2006
Commodities 17
1.4 RBF: Risk Aspects (continued…)

Credit Risk
• Reserve Risk
• Bank’s lending is based solely on assessment of reserves (P1, P2, P3)
• Change in technical assessment can lead to change in borrowing base case
• Way-out
• Banks finance mainly basis P1 and partly basis P2. No lending is done against P3. Further
haircuts are taken to arrive at borrowing base case

Commodities 18
1.4 RBF: Risk Aspects (continued…)

Credit Risk
• Off-taker Risk
• Need to assess who is the off-taker
• Way-out
• Sole off-taker, or multiple off-taker?
• Check the type of offtake contract entered into. Is it ‘Take or Pay’ contract?
• What are Condition-Precedent? Tenor of such contract?
• Off-taker’s financing standing?

Commodities 19
1.4 RBF: Risk Aspects (continued…)

Credit Risk
• Evacuation Risk
• Specially high for land-locked projects
• Way-out
• Are there near-by pipelines available?
• Who operates them? What’s the capacity utilization of those pipelines?
• Can they carry grade of crude produced by this oil field?
• Is there ready-access near well-head?

Commodities 20
1.4 RBF: Risk Aspects (continued…)

Market Risk
• Commodity Price Risk, FX and Interest Rate Risk
• Way Out
• Mandatory hedging
• Layered hedging approach

Commodities 21
1.4 RBF: Risk Aspects (continued…)

Operational Risk
• Operator Risk
• Way Out
• Deal with operators with credible track record
• Regular visits by independent technical experts
• Independent technical audits, paid for by banks

Commodities 22
1.4 RBF: Risk Aspects (continued…)

Operational Risk
• Political / Regulatory / Environmental Risks
• Way Out
• Selecting your ‘Target Market’ correctly is probably the best line of defense!
• Adherence to ‘Equator Principles’
• https://en.wikipedia.org/wiki/Equator_Principles
• Political insurance

Commodities 23
1.5 RBF: Basel Capital Considerations

• RBF is a fully secured, asset backed financing


• Facility risk is lower
• Lender has escrow over cash flows
• Lender has right to replace oil field operator

• Facility Risk Rating significantly better than Counterparty Risk Rating


• Lower RWA, Lower Basel Capital required, Better RoB3C

Commodities 24
1.6 RBF: Legal Aspects

• English Law is preferred


• Need strong covenants
• Oil reserves cannot be pledged !!!
• Need fool-proof escrow mechanism
• Financial covenants and associated restrictions
• Specific cash waterfall provisions
• Prohibitions on additional indebtedness and distributions

Commodities 25
1.7 RBF: Regulatory Aspects

• Regulatory risks are much lower in G4 jurisdictions


• In developing markets
• Adherence to ‘Equator Principles’ helps
• Political risk remains, and cannot be fully mitigated

Commodities 26
1.8 RBF: Accounting & Tax Aspects

• Accounting Aspects
• Off-balance sheet treatment at parent company level (SPV structure used)
• Adequate disclosures needed

• On-balance sheet loan treatment at SPV level

• Tax Aspects
• Minimum Alternate Tax (MAT) related considerations

Commodities 27
2. Catalyst Leasing (“CL”)

Commodities 28
2.1 CL: Problem Statement
Cracking
• Process whereby complex
hydrocarbon molecules are
broken down into simpler
molecules
• Rate of cracking and the end
products are strongly
dependent on the temperature
and presence of catalysts

Source: Energy Information Administration (EIA) Commodities 29


2.1 CL: Problem Statement (continued…)

• What is a Catalyst?
• A substance that speeds up a chemical reaction
• But is not consumed by the reaction
• And hence a catalyst can be recovered chemically at the end of the reaction

• In general, chemical reactions occur faster in the presence of a catalyst


• Catalyst provides an alternative reaction mechanism with a lower
activation energy than the non-catalyzed mechanism

Source: Wikipedia Commodities 30


2.1 CL: Problem Statement (continued…)

Source: Wikipedia Commodities 31


2.1 CL: Problem Statement (continued…)

Source: Wikipedia Commodities 32


2.1 CL: Problem Statement (continued…)

• Example of metals used in catalytic converters


• Precious Metals
• Platinum
• Palladium
• Rhodium

• Aluminum
• Manganese, Nickel etc.

Commodities 33
2.1 CL: Problem Statement (continued…)

• Lifecycle of a catalyst
• Refinery buys metal (required for manufacturing of catalyst)
• Now, that metal is purchased and owned by refinery
• They have price risk on metal
• They have working capital locked in that catalyst over entire life of the catalyst (typically
5 years)

• Purchased metal is delivered to catalyst manufacturer (such as BASF)

Commodities 34
2.1 CL: Problem Statement (continued…)

• Lifecycle of a catalyst
• Manufactured catalyst is installed in refining complex
• Typical life of 5 years

• At the end of usable life, catalysts is removed and sent back to manufacturer
of metal recovery
• Typically, recovery rates are around 80%

• Balance 20% metal is purchased (fresh) by refinery and delivered to catalyst


manufacturer for making fresh catalyst

Commodities 35
2.1 CL: Problem Statement (continued…)

• So, for a refiner, the problem statement is:


• We have locked significant working capital in catalysts
• We own the metal and hence carry price risk (i.e. market risk) on our balance
sheet
• How do we optimize this situation?

• With rising metal prices, the working capital costs, as well as price
volatility have become significant

Commodities 36
2.2 CL: Proposed Solution

• Leasing !

Commodities 37
2.2 CL: Proposed Solution (continued…)

• What is leasing?
• A contractual arrangement for the lessee (user) to pay the lessor (owner) for
use of an asset

• Two types of Leases


• Operating Lease
• Financial Lease

Commodities 38
2.2 CL: Proposed Solution (continued…)

Operating Lease Financial Lease

Lessee (user) pays lease rentals during entire life of Lessee (user) pays lease rentals during entire life of
the lease. The ownership of asset is with lessor the lease. While the ownership of asset is with
Description (owner). Lessee does not have any contractual lessor (owner), the Lessee (user) has right to
right or obligation to ownership of asset. ownership of asset, typically at end of lease.

Lessee (user) has option (typically at the end of


lease period) to buy the asset.
Asset remains with lessor (owner) for entire lease
Ownership period.
The actual transfer of asset may or may not take
place.

Asset is on the balance sheet of lessor.


Typically, the asset is shown on the balance sheet
Accounting of the lessee. This is akin to treatment of a loan on
For lessee, the lease rentals are operating
balance sheet.
expenses and are a P&L item.

Commodities 39
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
1

1. Refiner (Company A) approaches Bank XYZ (“Bank”) for a metal


lease (say, Platinum Lease)

Commodities 40
2.2 CL: Proposed Solution (continued…)

• Metal Lease
• Instead of “lending” a certain amount (say USD amount), a bank leases
certain quantity of metal (e.g. 100 Kg of Platinum) to a client
• Banks hold unallocated metal in their metal account
• Recall our discussion on Allocated and Unallocated Accounts!

• Banks use this unallocated metal to make metal leases

Commodities 41
2.2 CL: Proposed Solution (continued…)

• Metal Lease
• During the life of the lease, client pays lease rentals to the bank
• Option 1
• Lease rentals can be linked to LIBOR, and can be calculated on “notional” value of leased
metal

• Option 2
• Lease rentals can be direct % of metal leased out

Commodities 42
2.2 CL: Proposed Solution (continued…)

• Metal Lease
• On maturity, the lease is typically settled in metal terms
• Client credits unallocated metal back to bank’s metal account
• Some banks also offer a facility to ‘cash-settle’ the lease
• In other words, client just buys the metal on market and delivers to the bank

Commodities 43
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
2

2. After all due-diligence, Bank approves Platinum Lease for Company


A, and asks for delivery location

Commodities 44
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
3

3. Company A instructs the Bank to Catalyst


credit unallocated Platinum to metal Manufacturer
(e.g. BASF)
account of Catalyst Manufacturer

Commodities 45
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)

4. Using the credit of unallocated Vault


4
metal in its metal account, Catalyst
Manufacturer approaches vault for
Catalyst
allocated metal and gets it delivered Manufacturer
to its manufacturing plant location (e.g. BASF)
Commodities 46
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) 5 (Bank XYZ)

5. Manufactured catalyst is delivered


Catalyst
to Company A, which deploys the Manufacturer
same in its refining operations (e.g. BASF)
Commodities 47
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
6

6. At periodic intervals, Company A


Catalyst
makes lease rental payments to Manufacturer
Bank (e.g. BASF)
Commodities 48
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
7

7. At end of useful life of the catalyst (typically, which


would be co-terminus with lease maturity), Company A
sends catalyst to manufacturer for recovery
• It would instruct manufacturer to recover as much metal Catalyst
as possible, send it back to vault and then credit bank’s Manufacturer
unallocated metal account for the same amount (e.g. BASF)
Commodities 49
2.2 CL: Proposed Solution (continued…)

Refiner Bank
(Company A) (Bank XYZ)
9

8. Assuming 80% recovery of metal, Bank gets 80% 8


repayment of lease (in form of unallocated metal) in its
metal account
9. Company A repays balance 20% of lease in unallocated
Catalyst
metal account
Manufacturer
(e.g. BASF)
Commodities 50
2.3 CL: Commercial Considerations

• What’s in it for Refiner?


• No metal price risk!
• Under Operating Lease, Refiner does not own the metal

• No locked working capital


• Only lease rental expenses through P&L

Commodities 51
2.3 CL: Commercial Considerations (continued…)

• What’s in it for Refiner?


• A large number of refiners own catalysts (i.e. metal is on balance sheet)
purchased few years ago
• Entering into lease (for the first time) means selling the existing metal and
leasing it back
• With metal prices having risen significantly, this implied prospects of one-time
MTM gain!!!

Commodities 52
2.3 CL: Commercial Considerations (continued…)

• What’s in it for the bank?


• Lease rentals
• Extremely sticky, stable, granular and repetitive revenue stream
• Highly scalable

Commodities 53
2.4 CL: Risk Aspects

• Credit Risk
• Carries full credit risk on Refiner (lessee)

• Market Risk
• Limited market risk (to the extent of unrecoverable portion of catalyst)

• Operational Risk
• Very limited

Commodities 54
2.5 CL: Basel Capital Considerations

• Lease carries full credit risk on the counterparty


• Akin to a loan

• Full RWA at counterparty risk rating


• Heavy on Basel 3 Capital requirements

Commodities 55
2.6 CL: Legal Aspects

• English Law is preferred


• Standard lease documentation

Commodities 56
2.7 CL: Regulatory Aspects

• Lower regulatory risks


• Recent environmental norms around disposal of catalysts
• Most manufacturers (being large companies themselves) comply with the
same

Commodities 57
2.8 CL: Accounting & Tax Aspects

• Till 2019
• Standard accounting (off-balance sheet) and tax treatment

• From Jan 01, 2019


• ‘IFRS 16 – Leases’ becomes applicable
• Need to recognise nearly all leases on the balance sheet
• Will be applicable in India as well

Commodities 58
3. High Seas Financing (“HSF”)

Commodities 59
3.1 HSF: Problem Statement

• High Seas
• (noun)
• the open ocean, especially that not within any country's jurisdiction

Source: Google Dictionary search

Commodities 60
3.1 HSF: Problem Statement (continued…)

• United Nations Convention on the Law


of the Sea
• EEZ
• Area over which a state has special rights
regarding the exploration and use of
resources
• Up to 200 nautical miles (nmi) from coast

Source: Wikipedia
Commodities 61
3.1 HSF: Problem Statement (continued…)

• World’s EEZs

Source: Wikipedia
Commodities 62
3.1 HSF: Problem Statement (continued…)

• High Seas financing refers to financing of cargo which is typically


outside of any country’s EEZ (i.e. outside 200 nmi from coast)
• Why on high seas?
• International waters, and hence no regulatory issues, tax or customs
challenges
• Freedom towards choice of law (English Law, NY Law)
• Easier to repossess / liquidate cargo in case of disputes, defaults etc.

Commodities 63
3.1 HSF: Problem Statement (continued…)

Voyage of
30 days

Voyage of 45 days

Commodities 64
3.1 HSF: Problem Statement (continued…)

• Crude Purchase
• Say an Asian refinery purchases crude from LatAm
• The voyage, via CoGH, typically takes about 45 days
• For that entire period, that crude is inventory of the books of refiner
• This inventory can cause problem for refiner due to
• Price risk
• Locked up working capital
• Higher balance sheet debt to finance the working capital

Commodities 65
3.1 HSF: Problem Statement (continued…)

• Refined Product Sale


• Asian refinery is looking to sell refined product (e.g. Gasoline) in US markets
• The voyage, via Suez, typically takes about 30 days
• For that entire period, that product is inventory of the books of refiner
• This inventory can cause problem for refiner due to
• Price risk
• Locked up working capital
• Higher balance sheet debt to finance the working capital

Commodities 66
3.1 HSF: Problem Statement (continued…)

• So, for a refiner, the problem statement is:


• We have locked significant working capital in crude / refined product
• We carry price risk (i.e. market risk) on our balance sheet
• How do we optimize this situation?

• With rising crude & product prices, the working capital costs (i.e.
balance sheet impact), as well as price volatility have become
significant

Commodities 67
3.2 HSF: Proposed Solution

• High Seas Financing

Commodities 68
3.2 HSF: Proposed Solution (continued…)

Day 0.5. Cargo


reaches
international
waters outside of
LatAm country. Day 45. Cargo
Cargo is purchased reaches Indian
by Bank XYZ from ports
Day 44.5. Cargo
Indian company
reaches
Day 0. Cargo leaves international
LatAm country. waters outside
Cargo purchased India. Cargo is sold
and owned by back to Indian
Indian company in company by Bank
LatAm ports XYZ

Voyage of 45 days

Commodities 69
3.2 HSF: Proposed Solution (continued…)

Out of the entire 45 day voyage period


• First half day
• Cargo is in territorial waters, EEZ
• Owned by End-User (Indian Company)
• Indian Company’s working capital is locked

Commodities 70
3.2 HSF: Proposed Solution (continued…)

Out of the entire 45 day voyage period


• At end of half a day
• Cargo reaches international waters
• Bank XYZ buys cargo from Indian Company and pays it for the same
• Cargo is now owned by Bank XYZ
• Indian Company’s working capital is freed up!

Commodities 71
3.2 HSF: Proposed Solution (continued…)

Out of the entire 45 day voyage period


• 44 days of high seas voyage
• Cargo is in international waters and owned by Bank XYZ

Commodities 72
3.2 HSF: Proposed Solution (continued…)

Out of the entire 45 day voyage period


• At end of the journey (just outside Indian waters)
• Cargo reaches end of its journey in international waters
• Bank XYZ sells cargo back to Indian Company
• Cargo is now owned by Indian Company and it pays bank for the same
• Indian Company’s working capital locked again for last half a day (till Indian
ports)

Commodities 73
3.2 HSF: Proposed Solution (continued…)

• In other words
• Out of the entire 45 day voyage period
• Bank owns and finances the cargo for 44 days
• Indian Company’s working capital is locked only for 1 day (in total)

• Solution solves for 98% of working capital utilization problem


• Also takes away market risk for 98% of the voyage time

Commodities 74
3.2 HSF: Proposed Solution (continued…)

Day 45. Cargo


Voyage of Day 0. Cargo leaves
reaches US
Indian ports. Cargo
ports 30 days owned by Indian
company in Indian
Day 29.5. Cargo waters and EEZ
reaches
international
Day 0.5. Cargo
waters outside of
reaches
USA. Cargo is sold
international
back to Indian
waters outside of
company by Bank
India. Cargo is
XYZ
purchased by Bank
XYZ from Indian
company

Commodities 75
3.2 HSF: Proposed Solution (continued…)

• Same solution can be used for refined product shipped from India
• In parallel to earlier solution:
• Out of the entire 30 day voyage period
• Bank owns and finances the cargo for 29 days
• Indian Company’s working capital is locked only for 1 day (in total)

• Solution solves for 97% of working capital utilization problem


• Also takes away market risk for 97% of the voyage time

Commodities 76
3.3 HSF: Commercial Considerations

• What’s in it for Indian Refinery Company?


• Extremely efficient use of working capital
• Since lower working capital is needed, this helps in balance sheet
deleveraging!
• Commodity price risk is mitigated

• Fee (consideration for the deal) is typically charged through, as a


haircut on purchase consideration

Commodities 77
3.3 HSF: Commercial Considerations (continued…)

• What’s in it for the bank?


• Bank is extending financing against a highly marketable security (Crude /
Refined Product) in international waters
• Extremely high Facility Risk Rating
• Low RWA, Very high RoB3C
• Little linkage to Counterparty’s risk rating

• Commodity price risk is mitigated by Bank through hedging


• Bank hedges itself through Futures / OTC hedges

Commodities 78
3.3 HSF: Commercial Considerations (continued…)

• What’s in it for the bank?


• Extremely sticky, stable, granular and repetitive revenue stream
• Highly scalable
• Very high entry barriers

Commodities 79
3.4 HSF: Risk Considerations

• Credit Risk
• Minimal credit risk
• Bank is extending financing against a highly marketable security (Crude /
Refined Product) in international waters
• FRR can reach as high as AA+ (international ratings)

Commodities 80
3.4 HSF: Risk Considerations (continued…)

• Market Risk
• Commodity price risk is mitigated by Bank through hedging
• Bank hedges itself through Futures / OTC hedges

Commodities 81
3.4 HSF: Risk Considerations (continued…)

• Operational Risk
• Massive !!!
• Cargo quality inspection, certification
• Cargo Operator’s record and credentials
• Sanctions risk
• Type of Vessel (Single Hull / Double Hull)

Commodities 82
3.4 HSF: Risk Considerations (continued…)

• Operational Risk
• Massive !!!
• Environmental Risks & associated liabilities (can run into billions of dollars)
• Any accident, related remediation, financial liability and SOP protocols
• Piracy and SOP protocols

• Insurance with Loss Payee Nomination (to bank) is a MUST HAVE !

Commodities 83
3.4 HSF: Risk Considerations (continued…)

• Reputational Risk
• Very high
• Needs sign-off from senior approvers, possibly from a committee of Board of
Directors

Commodities 84
3.5 HSF: Basel Capital Considerations

• Extremely efficient
• Bank is extending financing against a highly marketable security (Crude /
Refined Product) in international waters
• FRR can reach as high as AA+ (international ratings)
• Low RWA, Very high RoB3C

Commodities 85
3.6 HSF: Legal Aspects

• HSF done solely in international waters to avoid any legal / tax /


customs issues
• Done under English Law
• Extensive and highly technical documentation
• Marine insurance policies
• SOPs and Protocols running into hundreds of pages

Commodities 86
3.7 HSF: Regulatory Aspects

• Very high Operational Risk and Reputational Risk


• Adequate heads-up to regulatory authorities is needed before such
solutions are offered for the first time

• Honestly, the real regulatory impact is yet untested!

Commodities 87
3.8 HSF: Accounting & Tax Aspects

• Standard on-balance sheet accounting treatment


• Tax treatment is cleaner, as all transactions done in international
waters (outside jurisdiction of any specific country)

Commodities 88
High Seas Financing

• Can be replicated for many other high-seas commodity cargos


• Crude
• Refined energy products
• Dry-Bulk cargo
• Edible oils

Commodities 89
4. Ore Pre-Pay (“OPP”)

Commodities 90
4.1 OPP: Problem Statement

• Ore Pre-Pay (“OPP”) structure is conceptually parallel to Reserve


Based Financing (“RBF”) studied earlier

Commodities 91
4.1 OPP: Problem Statement (continued…)

Commodities 92
Source: Wikipedia
4.1 OPP: Problem Statement (continued…)

• Galena
• Natural mineral form
• Important ore of Lead + Zinc, and
• An important source of silver

Source: Wikipedia
Commodities 93
Source: Maps of India Commodities 94
4.1 OPP: Problem Statement (continued…)

• Galena Composition (by Weight) • Galena Composition (by Value)

Sulfur Silver
13% 1%
Lead
Silver 32%
68%
Lead
86%

Commodities 95
4.1 OPP: Problem Statement (continued…)

• So, for a mining company, problem statement is:


• Its Lead / Zinc mine is producing ore (Galena) which has rich Silver
concentration
• By value, the ore carries a significant amount of silver
• Can it monetize the future silver production, and raise financing against the
same which can pay for immediate capex?

Commodities 96
4.1 OPP: Problem Statement (continued…)

• Reference:
• Annual Report

Commodities 97
4.2 OPP: Proposed Solution

• Ore Pre-Pay Structure


• Bank ABC hires geological and seismic engineering consultant to conduct
detailed technical analysis of ore deposits
• The consultant estimates:
• Quantity of the ore deposits,
• Quality / Grade of the ore deposits, and
• Commercial recoverability of the ore

Commodities 98
4.2 OPP: Proposed Solution (continued…)

• Ore Pre-Pay Structure


• This technical report helps Bank ABC determine the following:
• Quantity of ore that can get mined
• Timelines
• Costs
• % Silver content of that ore

• This helps the bank estimate future silver production – quantity and timelines
– with reasonable certainty

Commodities 99
4.2 OPP: Proposed Solution (continued…)

• Ore Pre-Pay Structure


• Estimated future silver production can help determine the value of the same
• Present Value of this future production (with appropriate haircuts)
determines amount that be lent against the same

Commodities 100
4.2 OPP: Proposed Solution (continued…)

• Armed with this data, Bank ABC enters into Ore Pre-Pay structured
loan as follows:
• Bank ABC lends to mining Company XYZ an amount as loan
• To repay the loan (notional and associated interest), Company XYZ needs to
deliver Silver to Bank ABC
• Amount of Silver to be delivered and delivery dates are pre-determined and
agreed upon under structured loan

Commodities 101
4.2 OPP: Proposed Solution (continued…)

• Company uses loan proceeds for capital expenditure


• In future, from mining of ore, Silver is produced, which is converted into
ingots
• Silver Ingots are sent to LBMA approved refinery for further assaying,
purification and conversion into LBMA Good-Delivery Silver Bars
• Company XYZ deposits these Good Delivery Silver Bars into LBMA Certified
warehouses

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4.2 OPP: Proposed Solution (continued…)

• LBMA warehouses give credit entry for Silver metal to Company XYZ’s
Unallocated account
• Recall our discussion on Allocated and Unallocated Accounts!

• Company XYZ uses the Unallocated Account to repay the loan


• For any reason, if company fails to deliver Silver, then it has an option to cash
settle / market settle the loan (with certain condition precedents)

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4.3 OPP: Commercial Considerations

• What’s in it for Mining Company?


• Ability to monetize future production
• Conceptually parallel to ‘securitization’

• Ability to pass-through silver price risk


• Cheaper cost of financing (than would be available through normal corporate
loan)
• Able to avoid further equity infusion into mining project, leading to better RoE

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4.3 OPP: Commercial Considerations (continued…)

• What’s in it for the lender?


• Fully secured, asset backed financing
• Facility Risk Rating significantly better than Counterparty Risk Rating
• Lower RWA, Lower Basel Capital required, Better RoB3C

• Upfront Fees
• Healthy Loan NIM

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4.4 OPP: Risk Aspects

Credit Risk
• Ore Quality Risk
• Bank’s lending is based solely on assessment of ore
• Change in technical assessment can lead to change in future cash flows
• Way-out
• Haircuts are taken to arrive at loan amount

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4.4 OPP: Risk Aspects (continued…)

Market Risk
• Commodity Price Risk, FX and Interest Rate Risk
• Way Out
• Bank manages its market risk through OTC / Futures hedges

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4.4 OPP: Risk Aspects (continued…)

Operational Risk
• Operator Risk
• Way Out
• Deal with operators with credible track record
• Regular visits by independent technical experts
• Independent technical audits, paid for by banks

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4.4 OPP: Risk Aspects (continued…)

Operational Risk
• Political / Regulatory / Environmental Risks
• Way Out
• Selecting your ‘Target Market’ correctly is probably the best line of defense!
• Adherence to ‘Equator Principles’
• https://en.wikipedia.org/wiki/Equator_Principles
• Political insurance

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4.5 OPP: Basel Capital Considerations

• OPP is a fully secured, asset backed financing


• Facility risk is lower
• Lender has right to replace mining operator

• Facility Risk Rating significantly better than Counterparty Risk Rating


• Lower RWA, Lower Basel Capital required, Better RoB3C

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4.6 OPP: Legal Aspects

• English Law is preferred


• Need strong covenants
• Mines / Ores cannot be pledged !!!
• Need fool-proof delivery mechanism
• Financial covenants and associated restrictions
• Prohibitions on additional indebtedness and distributions
• Pledge of shares

Commodities 111
4.7 OPP: Regulatory Aspects

• Adherence to ‘Equator Principles’ helps


• Political risk remains, and cannot be fully mitigated
• Careful selection of ‘Target Market’ is the only way out (& probably the best
line of defense)

Commodities 112
4.8 OPP: Accounting & Tax Aspects

• Accounting Aspects
• On-balance sheet loan treatment at Mining Company level

• Tax Aspects
• Minimum Alternate Tax (MAT) related considerations

Commodities 113
5. Location Swaps (“Loco Swaps”)

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5.1 Loco Swaps (Crude): Problem Statement

Adequate supply of Arab


Light Crude is available and
freight rates to India
E&P player has
through Strait of Hormuz
upstream
are not reasonable
production
facilities in Eastern
Russia (Sakhalin)
Company has
contracted to
deliver crude to a
refinery in India

Due to heavy traffic /


weather conditions, freight
rates to India through
Strait of Malacca are very
high

Commodities 115
5.2 Loco Swaps (Crude): Proposed Solution

E&P player
contracts location
swap deal

E&P player delivers


Arab Light Crude is his production
delivered to parcel to other
refinery in India refinery in China /
Company looks for a Chinese / Japanese / Japan / Australia
Australian refiner who has contracted to
purchase Arab Light Crude.

It Loco Swaps its production “parcel”


against “Arab Light Crude Parcel”
Commodities 116
5.3 Loco Swaps (Crude): Commercial Aspects

• For E&P Player


• Timely delivery of crude parcel to Indian refinery in achieved
• Cost effective and time effective to enter into Loco Swap, as long as
• Indian Refinery and other refinery (in China / Japan / Australia) are ready to accept
different grade of crude
• Economic compensation (for change in crude grade) is less than freight costs

• Ready availability of willing counterparties


• Role of commodity traders

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5.4 to 5.8 Loco Swaps (Crude): Other Aspects

• Risk Aspects
• Minimal credit risk and market risk, as typically used in Spot purchases
• Operational risk is identical on both legs

• Capital Considerations and Regulatory Aspects


• Not important, as typically very short tenor swaps are entered into
• If no bank is involved, then capital and regulatory considerations may not
even apply!

Commodities 118
5.4 to 5.8 Loco Swaps (Crude): Other Aspects
(continued…)

• Legal Considerations
• Standard purchase / sale documentation

• Accounting and Tax Considerations


• Recorded as two trades – purchase trade and sale trade

Commodities 119
Other Type of Loco Swaps

• Gold Loco Swaps / Precious Metal Loco Swaps


• Recall our discussion on Location Premium
• Loco Swaps are very popular in precious metals
• Settlements
• Metal: Typically settled through Unallocated Accounts
• Always through LBMA Good Delivery Bars
• Difference in Price (i.e. Location Premium) is typically net settled in USD

Commodities 120
Other Type of Loco Swaps (continued…)

• Refined Product Loco Swaps


• Gasoline
• LNG

• Conceptually, schematics and operation of all Loco Swaps is similar to


Crude Loco Swaps

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Disclaimer
• This presentation, including all references / links / related material, is intended to be used and must be used for
informational and educational purposes only.
• The purpose of any discussion / presentation is for analysing, learning and discussing general and generic information,
and should not be construed as financial advice, tax or legal advice, or advice of any nature whatsoever.
• The views and opinions expressed are those of the authors and do not necessarily reflect the official policy or position of
any other agency, organization, employer or any company.
• The author cannot be responsible for use of the information contained in or linked.
• The author is not responsible for any errors or omissions, or for the results obtained from the use of this information. All
information is provided as-is, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the
use of this information.

Commodities 122

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