Reference no: EM133272624
With the US awash in natural gas as a result of fracking, Armadillo Gas decided to build a liquefied natural gas plant on the Gulf Coast to export gas. While small by global LNG standards, the plant cost US$1.5 billion, which prompted Armadillo to use project finance. Sagebrush Construction, Inc., an investment-grade construction firm has signed an EPC contract to construct the plant with standard performance guarantees and liquidated damages. Armadillo, a firm with debt ratings of Baa1/BBB+/A-, signed a 20-year gas supply agreement with the project company, with gas to come from wells controlled by Armadillo (and supported by a reserve study performed by Rocke & Wester, Inc., a leading firm of consulting engineers).
Billy Ray Rogers, the project manager, arranged a 20-year LNG supply contract with Efland Energy Authority (EEA), the government agency responsible for providing electric power in the developing country of Efland. EEA will purchase all of the output of the project and pay for LNG in US dollars, with the price being increased annually by US inflation. (There is no merchant market for LNG, all projects globally being financed with long-term contracts.) In addition, Armadillo signed a long-term LNG transport contract with Aquamarine Shippers, Inc. an investment-grade shipping firm that operates LNG tankers. Finally, EEA, using the proceeds from the privatization of Efland's telecom system, constructed the port facility necessary to receive LNG and feed it to EEA's new gas-fired electric power generating plant.
Efland's foreign currency sovereign debt ratings are Ba3/B+/BB-. Currently, almost all of Efland's electric power is generated using the country's coal resources. Unfortunately, further development of coal mines in Efland would require far more expensive mining techniques. Moreover, Efland is coming under international pressure to curb its greenhouse gas emissions, which caused it to look for alternative sources of energy, such as its deal with Armadillo.
Billy Joe Jackson, the finance manager responsible for arranging financing for the project was updating Billy Bob Jones, Armadillo's CFO on the project's financing plan. "Assuming we put up US$400 million in equity, we need another $1.1 billion in long-term financing. I believe we should sell US$500 million in bonds with a 20-year tenor and arrange a 15-year US$600 million syndicated bank loan. We need to get an investment-grade rating on the bonds, and we need to get the banks comfortable with our revenues from EEA. I've had discussions with Efland's Ministry of Finance about the idea of a World Bank partial risk guarantee of our payments under the LNG supply agreement. While, at first, they were offended by the idea that we doubted their credit, they finally agreed, providing that we pay the World Bank's 75 basis point annual fee. The annual amount of our payment will, of course, decline as our debt is amortized, because the partial risk guarantee will be for an amount equal to our outstanding debt."
"Billy Joe," began Billy Bob, trying to conceal his anger, "Why should we pay 75 basis points extra every year on the outstanding amount of our debt? Our job here in the finance department is to reduce costs, not increase them! There is no doubt that Efland is going to pay us. Power from the new gas-fired plant will be cheaper than that from the old coal-fired plants, and any new coal-fired plants will be even more expensive! Look at how Efland recovered from its 50% currency devaluation four years ago! The country is doing great!
What should Armadillo do if it wishes to execute its financing plan? Why?