Project Finance Outlook and the Selection of Counsel

01 August 2007

Jonathan Marsh, Group Head of M&A and Finance Legal Department, TOTAL SA

Challenge to Contractual Rights 

Projects in the oil and gas industry have always involved a certain degree of political risk, but the current environment is particularly sensitive. The economically viable project on paper must also overcome multiple industrial and operational risks, causing sponsors to seek stable and transparent legal environments and protection for foreign investment. This fundamental basis for foreign private investment is under severe challenge. The entire spectrum of erosion of contractual rights can be observed, from outright confiscation and nationalisation, to confiscatory and repetitive tax increases, coercive tactics to force renegotiation of prior agreements, and the abuse of regulatory powers to extract concessions. 

This phenomenon has come in waves many times in the past, but what is new and surprising this time is that it is not limited to developing countries, but rather includes some OECD countries historically wedded to strict application of the rule of law and contractual right protection. Governments have taken aim in particular at project contracts negotiated when oil prices were low in the late 1990s. International oil and gas companies took significant risks in agreeing to invest in that context. Now that these high risk investments are beginning to pay off, governments suddenly want a larger share of the pie. This phenomenon appears to be contagious, as it has recently affected some other sectors as well now, including telecoms and electricity. 

Exploration, development and production of natural resources increasingly requires long term private sector support to provide know-how and significant technological and financial investment, particularly for the more difficult environments such as the deep offshore, the arctic and complex geological formations. The prerequisite for any industrial sponsor making massive long-term investments is of course a stable legal, regulatory, fiscal and contractual framework. 

Those countries tempted to seek a greater share of the economic rewards generated by past foreign private investment are taking a short-term view. Their actions will create a short-term local windfall, but over the medium to long-term it is difficult to see how they will attract the requisite additional foreign private investment to maintain current production, let alone develop new resources. This in turn could create production shortfalls and paradoxically reduce host country revenues over the longer term. 

Having made these observations, the challenge to the legal community will be whether innovative project finance or other legal strategies can counter the expropriation movement sufficiently to allow project sponsors and lenders to invest capital and human resources in countries with a history of breaching the letter or the spirit of its agreements. Political risk insurance can provide some comfort if available at a reasonable cost and if the risks identified and covered are those ultimately arising. Reliance on investment treaties and contractual arbitration clauses can also provide some comfort; but obtaining and enforcing a judgement can take many years, judicial risk is high and sponsors may experience difficulties continuing operations in the country. Ensuring continued foreign private investment in the face of a growing nationalisation movement will require the development of innovative strategies. 

Ever-increasing Liquidity 

As seen above, political risk continues to be an integral element of non-recourse project finance. Why is there so much liquidity and competition among capital sources to invest in projects? 

Despite the many risks involved in projects, empirical studies have shown that the project finance sector enjoys healthy recovery rates comparing rather favourably to risks involved in other higher yield areas such as the leveraged buy-out sector. To the extent risks may be higher in a given project, export credit agencies are increasingly filling the gap by providing direct credit support and assuming project risks. 

Many of the recent deals have been refinancings, which being in the post-construction phase, in fact involve dramatically lower risk. As long term interest rates remain relatively low, investors seek the marginally higher yields offered by projects. Refinancings with capital market elements, such as project bonds, should increase. We should begin to see more deals involving participation of the local emerging capital markets. In the chase for yield on the equity side, we can expect greater involvement of private equity and hedge funds in project investment as well. 

With the refinancing trend a new category of secondary market for institutional investors has appeared, such as infrastructure investment funds and the new conduit bond structures. These vehicles have tapped into the retiring baby-boomer generation seeking higher yields, and this type of underlying capital may be composed largely of the longer term ‘buy and hold’ category for the forseeable future. Happily for sponsors and host-countries, insofar as the ultimate investors are more passive, and the risks for them largely diversified geographically and across a variety of industries, these investors can afford to grant longer maturities and impose somewhat less stringent covenants than previously observed. For sponsors, this means access to a new category of investors benefiting from comparatively higher liquidity and lower cost of funding. 

Securitisation techniques should become more common in emerging markets generally, and in Islamic jurisdictions we should observe more asset backed sharia compliant securitisations. 

Industrial sponsors are increasingly engaging in co-lending alongside senior lenders, on a pari passu fully secured basis. This is a new source of liquidity, and also reduces risk for lenders. 

The development of a robust secondary market has been accompanied by a growing credit default swap market covering project loans, allowing lenders to offload risk. 

Against this backdrop, emerging market economies overall are much healthier than in the 1990s, with significant foreign reserve build up and financial institution liquidity. Capital flows into emerging markets are increasing. 

Finally, the emergence of public-private partnership initiatives have allowed new industrial sectors to access project financing, particularly in developed European nations seeking to comply with EU deficit targets. 

High Commodity Prices 

Demand for petroleum products is expected to increase by more than half over the next 20 years or so from population and economic growth. Availability of reasonably priced energy will be critical to ensure continued economic growth and prosperity. For energy supply to keep pace with demand, major infrastructure development will be required to maintain current production, explore and develop new resources, and to provide transportation to markets. 

Spare production capacity remains at historically low levels while demand has continually increased. As a result, despite recent market corrections, commodity prices have enjoyed comparatively higher prices over the past few years. This has encouraged greater investment in oil and gas projects, leading to a general over-heating of the oil service sector causing excessive inflation in development costs. Some delays in projects may be observed over the coming years as industry struggles to bring multiple megaprojects on line concurrently. In sum, we can expect no shortage of oil and gas projects in the years to come. 

Outside Counsel Relationship 

At TOTAL, like many other large industrial companies, selection of outside counsel for projects has evolved with some inspiration from the more formal business procurement functions, in order to seek the highest technical expertise available for a particular project at the most cost effective price. 

Relationship Firms 

Although TOTAL’s in-house lawyers are free to select any counsel appropriate for the task at hand, we have sought to develop strong relationships with a limited number of international firms having demonstrated consistent excellence in the strategic niche areas most important to us. The objective is to balance our desire for counsel having in-depth knowledge of our businesses and the ability to deliver significant business value with our concerns for maintaining competition to achieve cost control and improve service. We have sought to improve our relationships with counsel by clarifying our objectives in a number of areas, for example, regarding budgeting and forecasting of fees, staffing, communication and reporting, knowledge management, management of conflicts of interest, clear and transparent billing policies, and confidentiality. 

Conflicts of Interest 

On the subject of conflicts of interests, we expect firms with which we have developed strong relationships to consider conflict of interest issues beyond the framework of ethical canons, in order to take a broader business oriented view of conflicts of interest. The conflicts and confidentiality issue is particularly acute in connection with regulatory matters and governmental relations. 

Periodic Reviews 

TOTAL conducts periodic reviews with its closest firms to develop and continuously improve cooperation, provide positive and negative feedback regarding work done over the period, discuss our future affairs and changes in the law firm, and more generally to exchange ideas. Transparent and regular communication is critical for maintaining a strong relationship of trust with our preferred firms. We value lawyers and firms able to effectively collaborate with our in-house lawyers. 

Knowledge Management and Training Services 

The outside counsel’s knowledge management capacity is of particular interest to us, in allowing internal lawyers to share in the experience of outside counsel and leverage research capacity with firms’ online libraries. We appreciate proactive continuing education initiatives from law firms on legal and regulatory developments and project structuring and contracting innovations. Access to firms’ extranet services is also valued, so in-house lawyers can conduct on-line searches of firm publications and examine form documentation and other know-how. In the projects world, deal management extranet sites are becoming essential tools. 

Formal Selection Process 

Notwithstanding our close relationships with a limited number of firms, for significant projects, we routinely conduct ‘beauty parades’ to seek optimal balance between skills and costs in counsel selection. In project work, project management skills are essential to keep the long lead time items on track. The level of relevant expertise of the core team of lawyers is of equally critical importance, as is availability of experienced partners. Strong technical expertise must be coupled with communication and interpersonal skills. Overall record and resources of the lawyer’s firm remain important, but ultimately we attach greater importance to the qualities of the individual lead lawyers in counsel selection. 

We also seek close management of costs and disbursements, top quality service delivery intended to exceed our expectations, deep industry and project knowledge, ability and willingness to take some risks in proposing tailor-made legal solutions and innovation to meet the needs of specific projects. We naturally expect outside counsel to fully commit to the highest ethical standards. In the projects area, industry and relevant project knowledge and experience can make the difference to achieve project completion on time with the necessary contractual protections. 

Billing Policies 

TOTAL insists on clear and transparent billing policies from its outside firms. We expect firms to provide advance notice of any anticipated changes to budgets – in addition to avoiding unpleasant surprises, this ensures that the work being undertaken is in line with our expectations, to avoid the classic “leaving no stone unturned” syndrome on those occasions when we merely want to locate the boulders. We encourage reflection on alternative billing arrangements, such as fixed retainers, flat fees and value added concepts. Our objective is to seek to achieve equitable and realistic fees, that may not be based on time sheets, or that may take into account parameters other than hours spent. In many cases, it is appropriate for outside counsel to assume some business risk alongside clients. 

Primary International and Local Counsel 

Almost all of TOTAL’s projects are located outside of France and most even outside Western Europe. As a result, we often engage at least two primary firms for each major project. Given the continued pre-eminence of New York and English law in project documentation, we generally engage US or UK lead counsel, in conjunction with equally important specialised local counsel. We have worked with international firms having vast international networks of local offices, and with those lacking such formal networks but having deep knowledge of the relevant local counsel market. In the end, we tend to attach greater importance to the quality of the core teams being proposed on the lead counsel and local counsel side, irrespective of whether they are members of the same firm.

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