INTERNATIONAL PROJECT FINANCE

WHAT DO DERIVATIVE INSTRUMENTS OFFER BY WAY OF

RISK MANAGEMENT IN OIL AND GAS PROJECT
FINANCING?

CHIEMEZIE EJINIMMA
c.u.j.ejinimma@dundee.ac.uk

Abstract: The evolution of derivatives is one of the great achievements of modern

finance, and it has become an essential tool in risk management, basically offering
organisations the possibility to reduce risk within the larger financial system, which
they do not have direct control over, thereby allowing them to focus on the risk they
are better able to manage. However the concern has been on the application of these
derivative instruments especially among end users, with respect to specific projects.
Recognising the need for proper risk management strategies in attracting debt finance
for projects, this paper tries to analyse how derivatives can be used to mitigate key
risk components capable of adversely affecting the viability of oil and gas projects.
The conclusion highlights the necessary conditions for effectively extracting the best
out of the use of derivative instruments for risk mitigation.
.

List of abbreviations
OTC Over The Counter
IPE International Petroleum Exchange
NYMEX New York Mercantile Exchange
SYMEX Singapore International Monetary Exchange
LIBOR London Inter Bank Offered Rate
1. INTRODUCTION

Designed as an alternative form of arranging capital for investment purposes, project

finance came about as a method of raising long-term debt financing for projects based
on the expected cash flow to be generated by the project alone 1 . In other words, the
essence of the project lending is its focus strictly on the project being financed, thus
the lender principally looks to the project as the source of repayment. This
presupposes a critical analysis of the constituents of the project.

Traditionally, oil and gas projects have been financed using company internally
generated funds or through corporate borrowings from commercial lenders 2 . But the
tightening of credit standards partly due to market volatility and constricted margins
especially in downstream projects has made corporate borrowing less available,
especially for independents and companies with lower credit standings. This has
necessitated a movement toward project finance. Though this move, is not strictly as a
result of a quest for alternative financing, but also as a means for allocating the many
risks inherent in the sector.

The oil and gas industry is characterized by large-scale projects, which have long
gestation period and are highly capital intensive in nature, more so, they lack the
variety of end products open to most companies. Though oil remains the largest single
product category in international trade both in terms of value and volume 3 , its
unprecedented price volatility following the oil shocks of the last 30 years has had a
dramatic impact on industry profits as well as producing countries’ revenues. Gas on
the other hand is a more constrained product trading mainly in the regional markets
and involving inflexible projects.

Though the peculiarities of the oil and gas industry still makes project financing
within the sector inherently high risk, lenders can reduce the risk by careful analysis,

1
Nevitt, P.K. and F.J. Fabozzi, Project Financing (London: Euromoney Books, 2000)
2
Milbank, et al., Project Finance: The Guide to Financing International Oil and Gas Projects, 1
(England: Euromoney Publications PLC, 1996)
3
International Trade Statistics 2003, http://www.wto.org/english/res_e/statis_e/statis_e.htm, (Last
visited 16/04/04)

1
skilful structuring and an overall risk management strategy, and this is where the use
of derivative instruments comes into play.

Derivative instruments can be defined as instruments whose values depend on, and
are derived from the value of an underlying asset, reference rate or index and they
exist as both exchange-traded and privately traded contracts 4 . The use of derivatives is
increasing at a rapid pace; this is evident from the exploding derivatives market and
from various surveys 5 on derivatives which holds that well- run corporations and
financial institutions are constantly using derivatives, as informed professionals
understand the critical role that derivatives can play in re-apportioning and reducing
risk for companie s doing business across international borders and expanding within
the global economy. Thus derivatives use is driven by two motivations - Risk
management, and Speculation. This paper focuses on the first stated motive behind
the use of derivatives.

The paper is structured into four parts; Chapter 2 analysis risk management in oil and
gas project finance, firstly by giving hindsight into the structure of oil and project
finance, and then reviews the risks which can affect the viability of projects, with
emphasis on market and financial risks. Chapter 3 then goes ahead to discuss how
derivatives in its different structures can be applied to reduce the identified market
and financial risks. Chapter 4 makes concluding statements and presents suggestions
to enhance the effective use of derivatives.

In carrying out this research, a major limiting factor has been the time constraint,
coupled with the fact that it was not possible to get primary information from oil and
gas companies, thus secondary information ha ve been relied on. Nevertheless, effort
has been made to prepare an objective paper within the prevailing constraints.

4
Chance, D.M., An Introduction to Derivatives and Risk Management, 31(Orlando: Harcourt College
Publishers, 2001)
5
Horng, Y. and P. Wei, An Empirical Study of Derivatives Use in the REIT Industry, Real Estate
Economics, Vol. 27 (1999)

2
2. RISK MANAGEMENT IN PROJECT FINANCE

Risk can be said to be a situation where the future outcome is not known with
certainty, but where the various possible outcomes can be predicted from knowledge
of past or existing events 6 . The outcome referred to is in regard to cost, loss, or
damage. The process of assessing and modifying on a continuous basis – the many
trade-offs between risk and reward is known as Risk Management 7

No business activity is without risk, thus one of the key criteria in embarking on a
project is to identify the principal risks to which it is exposed and to manage those
risks. An essential element of this aspect of management is the understanding of the
level of risk the stakeholders in the project are prepared to bear. Normally the lenders
to a project (which are principally – banks) are risk-adverse. As a rule of thumb,
banks will not accept risks which are unable to be subjected to proper assessment or
analysis or which are conceivably open-ended in their effect 8 . Thus banks demand
predictability.

Before delving into the realms of risk assessment and management, the structural
aspects of oil and gas project finance will be examined.

2.1. STRUCTURE OF AN OIL AND GAS PROJECT FINANCE

A fairly standard approach to structuring a project’s financing in the oil and gas
industry is for the sponsors to establish a single purpose vehicle company. The vehicle
company in relative terms often have a small capitalization as compared to the
financial needs of the project. Funding of the project is then routed through the
vehicle company. Traditionally, information of such financing will not appear on the
sponsors’ balance sheet, i.e. they are classified as off-balance sheet items. If it does, it
is only as a footnoted contingent liability. Similarly, the assets acquired in the course
of carrying out the project appear on the financial statements of the vehicle company

6
Helliar, C., Risk, Derivatives and Management Control, 21-22 (Unpublished PH.D Thesis submitted
to the CEPLMP, University of Dundee, 1999).
7
Gastineau, G.L. et al., Risk Management, Derivatives, and Financial Analysis Under SFAS No. 133,
(Virginia: Blackwell Publishers, 2001)
8
Vinter, G., Project Finance: A legal Guide, 95-96, (London: Sweet & Maxwell, 2nd ed. 1998)

3
alone. From the above it can be rightly inferred that one purpose of project finance is
to minimize the sponsors’ exposure to risk and thus help to preserve its own credit
standing and future access to financial markets.
Single purpose vehicle companies may take a variety of forms; this is primarily based
on the sponsors. If the project involves multiple sponsors (such as Exxon, Shell, BP),
a separate corporate entity, partnership construction trust, or a contractual joint
venture may be created.

Smith9 in his analysis suggests that the presence of multiple sponsors may be
necessitated by the following reasons:
• The oil or gas resource is jointly owned
• The government of the country where the project is located mandates joint
venture with local interests.
• The size of the project is massive that it yields greater economies of scale than
several smaller units
• The capabilities of the sponsors are complementary
• The project obviously exceeds the technical, human, or financial resources of
a single company
• There is a clear need for risk sharing

Subsequent to the establishment of the vehicle company, the financing of the project
is designed to cater for the totality of the envisaged risks involved. This paper looks
primarily at the market and financial risk, which affects the viability of a project.

2.2. MARKET AND FINANCIAL RISK EVALUATION.

In concise terms, market risk refers to issues surrounding the existence of the
consumers or buyers of the product of the project as well as fluctuations in price of
the product. While financial risk refers to the occurrence of losses from movements in
interest rates and exchange rates 10 .

Market risk evaluation requires the assessment that the demand for the project’s
products or services will be adequate to generate the revenue needed to cover the
9
Smith, R.C. and I. Walter, Global Banking, 61 (New Yo rk: Oxford University Press, 1997)
10
See supra note 6, p. 16

4
project’s operating costs and debt service requirements, as well as a fair return to the
sponsors. Considerations here will include: the existence of a local, regional or
international market; commercial accessibility to markets; envisaged competition
from a similar existing or proposed project11 .
Financial risk evaluation on the other hand, entails an assessment of the potential
impact on the viability of the project of financial developments outside the immediate
control of the project sponsors or lenders, such as: volatility in interest and exchange
rates; fluctuations in commodity prices (in relation to the projects supplies and raw
materials); rate of inflation.

An occurrence of all or some of the above stated market or financial risks could have
a crippling effect on the viability of a project, thus a critical assessment and
management of these risks is imperative.

2.3. COMPLEXITIES IN RISK MANAGEMENT

Risk management problems are often complex; a good reason for this is that the
market and financial risks faced by oil and gas project companies often has a long
horizon. Also the location of the project is resource specific. For example a U.S.
sponsor company may consider undertaking an oil or gas project in the North Sea and
arranging the financing in pound sterling over the ten years it will require completing
the project. Such a transaction involves long-term interest rate risk and foreign
exchange risk, which might prove difficult to manage.

Managing the market and financial risks associated with oil and gas projects would
definitely require an assortment of financial derivatives instruments.

3. DERIVATIVES AND RISK MANAGEMENT

Since the price shocks of the 1970’s, oil markets have passed through a great deal of
unease12 , prompting structural changes in the industry. The traditional approach to
counteracting risk has been through such methods as sheer size, diversification, and

11
Clifford Chance, Project Finance, 43 (London: IFR Publishing Ltd, 1991)
12
Majed, G.R.I., A Survey of Financial Derivatives Utilised Within the Petroleum Industry, 87-115
OPEC Review 20(1) (1996)

5
vertical integration of the upstream production and downstream refining assets.
Finnerty13 argued that the increase in market volatility and the frequency of tax and
regulatory changes stimulated financial innovation and had led companies to try to
lessen the financial constraints that they faced. In our own context, project sponsors
and lenders can maximize their efficacy despite the number of constraints imposed by
markets, governments and themselves, through financial innovation.

Derivatives being at the forefront of financial innovation have been used successfully
in project financing to control costs of funding, prices of output or values of currency.
As Nevitt and Fabozzi 14 highlight, the ability to control project risk using derivatives
have transformed hitherto marginal or unprofitable projects to highly profitable
concerns. In the same vain, projects have been able to achieve lower funding costs
from commercial lenders due to risk reduction arising from the proficient use of
derivatives.

3.1. Structures of Derivatives Transactions

In essence, derivatives transactions are bilateral contracts. As earlier defined, they are
payment exchange agreement whose value depends on or derives from the
performance of an underlying asset, reference rate or index. Derivatives transactions
cover a wide range of underlying constituents 15 , ranging from interest rates, exchange
rates, commodities, equities and other indices. They can be either, standardised and
traded on exchanges, or custom- made and sold over the counter (OTC)16 by dealers or
financial intermediaries.

Over time so many derivatives have been created, but basically, they can be
classified 17 into two major groups: forwards-based derivatives and options-based
derivatives.

13
Finnerty, J.D., Financial Engineering in Corporate Finance: An Overview, 14-33, Financial
Management, (Winter, 1988)
14
See supra note 1, p. 229
15
Stout, L.A., Insurance or Gambling? Derivatives Trading in a World of Risk and Uncertainty, 38
Brookings Review 14(1), (Winter, 1996) 38
16
Reynolds, B., Understanding Derivatives, 9 (London: Pitman Publishing, 1995)
17
ibid

6
Forwards -based derivatives
There are three main types of forwards:
• Forwards contracts
• Futures contracts
• Swaps

A forward contract can be said to be the simplest form of derivatives. It is an

agreement between two parties, which obligates – one to buy and the other to sell –
some commodity at a specified later date and at a price established at the time of
contracting18 . Forwards contracts are mainly OTC products. Thus, each party to the
forwards contract bears the risk that the other party defaults on future commitments.
This explains why futures contracts are often preferred to forward contracts.

Futures contract on the other hand, is a forward contract traded on an organized

exchange with contract terms clearly specified by the rules of the exchange 19 . The
principal difference between futures and forward contracts lies in the fact that futures
are traded in exchanges, in which a clearing house interposes itself between buyer and
seller and guarantees all futures transactions, while forwards are OTC products. The 3
major futures exchanges are the New York Mercantile Exchange (NYMEX), the
International Petroleum Exchange (IPE) and the Singapore Interna tional Monetary
Exchange (SYMEX)20

A swap as the name suggests, is an agreement between two parties to exchange one
stream of cash flows for another stream of cash flows over a period in the future 21 .
The cash flows can be fixed at outset or calculated by factors in the performance of
the underlying product. Swaps are can be classified under the following headings 22 :
interest rate; currency; commodity; and equity swaps.

Options -based derivatives

18
Kolb, R.W., Financial Derivatives, 2 (Florida: Kolb Publishing Company, 1993)
19
ibid, p. 4.
20
See supra note 12
21
See supra note 4, p. 7
22
Hull, J.C., Options, Futures, and Other derivatives, 111-137 (New Jersey: Prentice-Hall International,
Inc. 1997)

7
An option simply stated is the right to buy or sell, for a limited time, a particular good
at a specified price 23 . Thus the option contract provides one party (the option holder)
with a right but not an obligation, to buy or sell an underlying product at an agreed
price on or before a set date to a counter party. While the counter party (the option
writer) is obligated to sell or buy the underlying product if the holder exercises the
right. A value is therefore attached to the option, which is called the option price or
option premium 24 . From the foregoing, it can be rightly deduced that the option-based
contract is one-sided, i.e. if the right is exercised, it follows that the holder has a
favourable outcome and the writer can have only an unfavourable outcome and vice
versa.

Although there are several other varieties 25 of derivatives, they are variants or
combinations of the above two classes.

3.2. USES OF DERIVATIVES INSTRUMENTS IN MARKET AND

FINANCIAL RISK MANAGEMENT RISKS ASSOCIATED WITH
PRICE FLUCTUATIONS AND VOLATILITY OF EARNING:
In an oil and gas project financing, lenders and sponsors rely on revenue from the
project to meet operating costs expenditures, debt service and returns on investment.
The project loan will typically be made on the projects output (commodity) price
projections. Thus there is an inherent exposure to market risks here arising from price
fluctuations due to economic factors outside the control of the lenders and sponsors.
This may have adverse effect on the earnings of the project. The use of petroleum
futures contracts traded in the futures exchanges can reduce this risk to a minimum.
For example, at any one time, petroleum futures such as crude oil futures are available
for up to 12 and 36 future delivery months on the IPE and the NYMEX respectively, 26
with the associated advantages, whic h include a high degree of liquidity, low
transaction costs and low default risk, the exposures to market risks can be greatly
reduced.

23
Kolb, R.W., Financial Derivatives, 5 (Florida: Kolb Publishing Company, 1993)
24
Briys, E. et al., Options, Futures and Exotic Derivatives: Theory, Application and Practice, 9-20
(Chichester: John Wiley & Sons Ltd, 1998)
25
Bernstein, P. et al., The Question of Derivatives, 55, Journal of Accountancy 179(3) (1995)
26
See supra note 12

8
Oil or gas swaps can also be used to package and transfer the oil or gas price risk from
the project company (the seller) to a financial intermediary. No physical oil is actually
exchanged, but the project company is actually guaranteed a fixed price for a
predetermined volume of oil by means of the contract papers. This in effects insulates
the project company from adverse market risks. When the physical oil market moves
against the project company, it receives a payment that in effect provides it with the
agreed fixed price, in the same vain, if the physical market moves in favour of the
project company, the gain is passed on to the financial intermediary, therefore
preserving the fixed price level. The pair of offsetting financial transactions between
the project company (the seller) and the financial intermediary is the essence of a
swap. In effect, a fixed price is exchanged (swapped) for a floating market price.

Swaps can even be used to collateralise a project loan in the first place, thereby
helping sponsors to convince a bank to value existing reserves at a higher level for
purposes of financing. This in effect could even give sponsors an advantage over
competitors in developing new oil reserves. In some cases, 27 the project company
might be required to execute a swap in order to receive a loan; otherwise the bank
might have to do a swap to hedge its own loan exposure.

The use of oil or gas options will provide the project company with the protection
needed, and leave it with the full benefits associated with a favourable development of
the commodity price.

Risks associated with movements in foreign exchange rate

Oil and gas projects produce revenues in one currency (usually in U.S. Dollars), but
might be financed by obligations payable in another currency (e.g. Sterling), this
automatically gives rise to currency risk. Thus any significant devaluation in the
revenue currency as a result of movements in exchange rate, will impair the project’s
ability to repay its lenders, unless there is a corresponding increase in revenues as a
result of price increases.

27
Razavi, H., Financing Energy Projects in Emerging Economies, (Oklahoma: Penn Well Publishing
Company, 1996)

9
Derivative instruments can be used to reduce the foreign excha nge risk that the
project company faces. Using an illustration; suppose the project company is due to
pay £1 million to one of its British lender banks in 90 days, the cost in U.S. dollars of
making the payment depends on the sterling exchange in 90 days. Say the 90-day
forward rate for £/$ is 1.7000, the company can choose to hedge by entering into a
long forward contract to buy £1 million in 90 days for $1.7 million. This in effect
locks in the exchange rate for the sterling it requires. If the exchange rate rises to
1.8000, the company is better off by $100,000 28 plus the extra charges associated with
a default on loan repayment, if it hedges. On the other hand if the exchange rate falls
to 1.6000, hedging makes the company worse off by $100,000. This illustration shows
that the purpose of hedging is to make the outcome more certain, it does not
necessarily improve the outcome. To further illustrate the point, suppose the project
company expects to receive $1.7 million in 3 months from sales, going into the
foreign exchange forward contract at the rate of £/$ 1.7000 ensures that the company
can meet its loan obligation of paying £1 million even if the ruling rate at the day of
payment has increased to £/$ 1.8000. But if the ruling rate decreases to 1.6000, the
company will still be bound by the forward contract it has entered at the rate of
1.7000, thus losing a $100,000 since it will still purchase the required £1 million for
$1.7 million.

By trading in the foreign exchange forwards market as illustrated, the project

company has effectively established a rate for its currency. Thus the company has
used the forwards market to reduce the risk associated with adverse fluctuations in
foreign exchange rate.

As an alternative, the project company can buy a call option to acquire £1 million at a
certain rate say 1.7000, in 90 days. If the actual exchange rate in 90 days turns out to
be 1.7000 or above, the company exercises the option to buy the sterling it requires,
but if the actual exchange rate turns out to be below 1.7000, the company buys the
sterling in the open market (and discards the option since they are now worthless).
Thus, option trading in effect also enables the company to insure itself against adverse
rate movements while benefiting from favourable movements.

28
£1,000,000 * 1.8000 = $1,800,000. (Therefore $1,800,000 - $1,700,000 = $100,000)

10
Interest rate Exposures
Derivatives can also be used in mitigating interest rate risks. Financing issues such as
locking in favourable financing rate opportunities, and ensuring positive returns on
investments can be efficiently managed using interest rate swaps. Interest payments
can be exchanged between two parties in order to achieve changes in the calculation
of interest on the principal, for example from floating (i.e. variable) to a fixed rate of
interest. Thus the project company can borrow from its bank at a floating rate 29 and
then swap this into fixed rate with a swaps dealer. Depending on the movements in
interest rates, the project company may gain at the expense of the dealer or vice versa.
But one sure thing is that the project company at any point in time during the contract
will not payout more than the fixed rate. To illustrate, suppose the project company
takes out a loan with its bank in which it pays an interest of LIBOR plus 200 bps30 on
the principal. If the company expects rising interest rates, it means the cost of its loan
will go up. If this happens, the project company may enter into a pay- fixed, receive-
floating swap contract with a dealer. If the floating rate agreed with the dealer is also
LIBOR plus 200 bps, and the fixed rate is ‘F’, the scenario will be as follows:

Project company will pay LIBOR + 200 bps on loan

Project company will receive LIBOR + 200 bps on swap from dealer
Project company will pay F on swap to dealer
Net payment = F

Note that in the in the interest rate swap contract, no principal payments are made,
just the net interest owed will be paid by the party owing.

Other derivatives instruments can be employed to reduce the risks associated with
interest rate fluctuations. Some of them combine elements of different derivatives
instruments, these are called hybrids.31

29
Floating rate is susceptible to rising interest rate
30
bps means basis point, and one basis point is one-hundredth of a percent, so 100 basis point is 1
percent , thus 200 bps is 2 percent.
31
See supra note 4, at 631

11
4. CONCLUSION

Derivatives could be complex, and they have quite often been criticized 32 for having
been the source of large losses by some corporations. But are the instruments really at
fault? Chance 33 answers this with the aid of another question: “is electricity at fault
when someone with little knowledge mishandles it?”

Derivatives are powerful instruments with a high degree of leverage, thus large gains
or losses can result from small price changes. Thus an effective use demands the
following:

• Having the requisite knowledge of its structure and applicability

• The reason for using it should be properly understood; there could be a high
appeal to use it for speculation (not covered in this paper) instead of for
hedging, and this could be very dangerous.
• The appropriate type of derivative should be selected for different situations.

If the above demands are met then based on the analysis carried out in the previous
section, the question “What do Derivative Instruments Offer By Way Of Risk
Management in Oil and Gas Project Financing?” can be answered as follows:
Derivatives instruments reduces the risk associated with price fluctuations and
volatility of earnings, movements in foreign exc hange rate, and Interest rate
Exposures, to the least minimum.
Derivatives are not an end in themselves. Rather, they are merely a category of tools,
though a very efficient set of tools available for risk management in oil and gas
project financing.

32
EIU, Strategic Derivatives: Corporate Practices for Today’s Global Market Place, (London: The
Economist Intelligence Unit Limited, 1995)
33
See supra note 4, p19

12
BIBLIOGRAPHY

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Harcourt College Publishers, 5th ed. 2001)

Clifford Chance, Project Finance, (London: IFR Publishing Ltd, 1991)

EIU, Strategic Derivatives: Corporate Practices for Today’s Global Market Place,
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Gastineau, G.L. et al., Risk Management, Derivatives, and Financial Analysis Under
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Kolb, R.W., Financial Derivatives, (Florida: Kolb Publishing Company, 1993)

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Razavi, H., Financing Energy Projects in Emerging Economies, (Oklahoma: Penn

Well Publishing Company, 1996)

13
Reynolds, B., Understanding Derivatives, (London: Pitman Publishing, 1995)

Smith, R.C. and I. Walter, Global Banking, (New York: Oxford University Press,
1997)

Articles

Bernstein, P. et al., The Question of Derivatives, Journal of Accountancy 179(3),

(1995)

Finnerty, J.D., Financial Engineering in Corporate Finance: An Overview, Financial

Management, (Winter, 1988)

Helliar, C., Risk, Derivatives and Management Control (Unpublished PH.D Thesis
submitted to the CEPLMP, University of Dundee, 1999).

Horng, Y. and P. Wei, An Empirical Study of Derivatives Use in the REIT Industry,
Real Estate Economics, Vol. 27 (1999)

Majed, G.R.I., A Survey of Financial Derivatives Utilised Within the Petroleum

Industry, OPEC Review 20(1) (1996)

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Uncertainty, Brookings Review 14(1), (Winter, 1996)

OTHER SOURCES

Inte rnet

International Trade Statistics 2003,

http://www.wto.org/english/res_e/statis_e/statis_e.htm, (Last visited 16/04/04)

14