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WHAT CAN DEVELOPERS AND GOVERNMENTS

DO TO MINIMISE LENDING RISKS AND ATTRACT


DEBT FINANCERS TO OIL SHALE
DEVELOPMENTS?


Sima Ajam
*






ABSTRACT: For a considerable time, many have believed that oil shale has the potential to be a major
source of energy production. However, despite the availability of proven reserves and increased demand
internationally, oil shale projects continue to face challenges in financing. The paper aims to examine the key
characteristics of oil shale and provide a critical analysis of the main lending risks associated with debt
financing oil shale developments. The paper will find that many of the lending risks that threaten the oil shale
sectors profitability and its ability to secure financing sit outside the resource itself and the technology used to
make it into oil; it is available and in many cases existing infrastructure used for conventional oil can be
utilised to transport the end product. It is price and market risks that are very potent and there are many
opportunities for government intervention in that area. Using information from various approaches adopted in
successful international developments, it will suggest ways to mitigate lending risks, through co-operation
between developers and the introduction of government policies that encourage and incentivise private-sector
debt financing of oil shale developments.


*
The author is currently completing his LLM Degree in Petroleum Law & Policy (by distance learning) at the
CEPMLP, University of Dundee. He is a solicitor specialising in Oil and Gas Law, working as an in-house
Legal Advisor for Perenco Holdings, an international Oil and Gas Exploration and Production Company. He is
the primary legal counsel for the UK subsidiary of the Company, providing legal advice and assistance to the
business on a wide range of commercial transactions relating to its gas producing activities in the UK SNS. He
holds an LLB (Hons) degree from the University of Manchester. Email : sajam@uk.perenco.com
ii

TABLE OF CONTENTS

1. Introduction ................................................................................................................. 1

2. Oil Shale : An Overview .............................................................................................. 2

3. Debt Financing Oil Shale Developments ..................................................................... 2

4. Key Lending Risks in Oil Shale Developments ........................................................... 3
a) Technology ............................................................................................................ 4
b) Transportation & Infrastructure .............................................................................. 4
c) Production Costs .................................................................................................... 4
d) Market Forces ........................................................................................................ 5

5. Risk Mitigation ............................................................................................................. 6
5.1 Developers: Overcoming the Obstacles .......................................................................... 6
a) Establishing own Supply Sources and Connecting Infrastructure ........................... 6
b) Utilising Existing Infrastructures ........................................................................... 6
c) Collaboration and Sharing of Know-how ............................................................... 7
5.2 Government Policies & Incentives .................................................................................. 7
a) Price Protection ..................................................................................................... 8
b) Guaranteeing a Market ........................................................................................... 8
c) Direct Subsidies ..................................................................................................... 9
d) Debt Guarantees .................................................................................................... 9

6. Conclusion .................................................................................................................... 9

Bibliography

1

1. INTRODUCTION

Maturing conventional oil and gas fields, slowing production and increasing demand are
raising the importance of unconventional hydrocarbons - petroleum that cannot be extracted
by using traditional drilling methods - as a source of energy. Oil sands (frequently referred to
as oil shale) now account for 6.5% of world oil output, up from 3.6% at the start of the
decade
1
. This growth has been spurred by high oil prices and strong demand from the US,
which sees unconventional oil as a part of the solution to its energy security issues
2
. As a
result, we now see numerous oil shale development projects planned or under construction,
trying to capitalise on the success of other deals. Nevertheless, oil shale projects continue to
face unique challenges in financing
3
.

Viewed as high risk, oil shale financing covering the period up until early 2006, has
historically been affordable only to major oil companies and characterised by on balance
sheet financing, whilst smaller independents struggled with the rigidity of traditional
financing options
4
. Their position was not helped by the recent decline in oil prices and rising
costs which do not yield the necessary return on investment that most banks are comfortable
with to provide a loan for financing such developments.

This paper analyses the key lending risks in oil shale developments and identifies ways in
which co-operation between developers, through sharing of know-how and technology,
utilisation of existing infrastructure and government policies that address price and market
risks can encourage financing frameworks that give lenders sufficient comfort to undertake
long term investments in oil shale developments.



1
Lees A. The Right Game. The Credit Crunch Treating The Disease Rather Than The Symptoms. 28 July
2009. http://www.scribd.com/doc/17761313/Andy-Lees-The-Weakest-Link at p. 4 (last visited on 21 December
2010)
2
Guiny S. and Sacks J. Oil Sands Boom or Bust. Hydrocarbons World, Volume 3, Issue 2 at p. 22
3
Newendorp T. Impact of Sustainable Energy Policies on Energy Security Risks: The Role of Financial Markets
in Energy Security. Taylor-DeJongh - United Nations Economic Commission For Europe (November 2008) at
p. 14
4
Taylor-DeJongh, Inc. Financing Unconventional Oil : the Canadian Experience (20 August 2006) at p. 3
2

2. Oil Shale: An Overview
The term oil shale generally refers to any sedimentary rock that contains solid bituminous
materials that are released as petroleum-like liquids when the rock is heated in the chemical
process of pyrolysis. Oil shale can be mined and processed to generate oil similar to oil
pumped from conventional oil wells; however, extracting oil from oil shale is more complex
than conventional oil recovery and currently is more expensive. This is because the oil
substances in oil shale are solid and cannot be pumped directly out of the ground; the oil
shale must first be mined and then heated to a high temperature then the resultant liquid must
be separated and collected. An alternative process referred to as in situ retorting involves
heating the oil shale while it is still underground, and then pumping the resulting liquid to the
surface
5
, however, many claim that this is not a sustainable, economically viable technology.

While oil shale is found in many places worldwide, by far the largest deposits in the world
are found in the United States in the Green River Formation; estimates range from 1.2 to 1.8
trillion barrels
6
. In Gladstone, Queensland, Australia, there is a large-scale demonstration
project where, from June 2001 through March 2003, 703,000 barrels of oil were produced
from oil shale. Significant oil shale reserves also exist in the Republic of Estonia, where
active oil shale deposits amount to about 1,200 million tons and, at current levels of
consumption, are forecast to last one hundred years
7
.

There are currently 1.7 trillion barrels of oil sand reserves located in Alberta, Canada and, by
2011 these are set to make up 80% of Albertas oil production, compared to 30% in 1996
8
.
Recognising the potential value of this resource, Canada has been actively encouraging the
growth of the oil sands industry, which is forecast to increase production from 1.1 million
barrels per day in 2006 to above 3 million barrels per day in 2015.

3. Debt Financing Oil Shale Developments

Though oil shale is viewed as a proven source, access to financing has not always been
consistent. Enthusiasm for commercial lending over the past decade was driven by a number

5
Oil Shale & Tar Sands Programmatic EIS. Oil Shale/Tar Sands Guide. http://ostseis.anl.gov/index.cfm. (last
visited on 21 December 2010)
6
Bartis J.T. et al. Oil Shale Development in the United States: Prospects and Policy Issues (RAND Corporation,
2005) p. 9
7
Op.cit. Oil Shale & Tar Sands Programmatic EIS
8
Op.cit. Newendorp at p. 15
3

of factors, including a general rise in the price of oil since 2004 and the continued growth of
US demand for crude oil imports
9
. However the industry is currently in the process of making
investment decisions on projects that will come on stream after 2012 and these will need to
be financed in an era where such circumstances no longer exist and have been overtaken by a
new set of dynamics and constraints, including cost pressures and technological limits (there
is a necessity to prove up technologies before debt financing can become available, unless
there is some sort of loan guarantee)
10
. Government policies also influence project risks and,
therefore, the willingness of lenders to project finance.

Debt financing is essential for providing oil corporations with the cash to build and operate
drilling rigs, pipelines, oil tankers and receiving terminals. From a debt financers
perspective, the availability of capital will vary according to each projects risk and return
profile. However at the very basic, all projects must be technically, commercially, and
financially viable over a long life (typically 20+ years)
11
.

4. Key Lending Risks in Oil Shale Developments

The lenders assessment of risks in the construction and operating phase of the project will
involve careful scrutiny of the likelihood and implications of a number of factors, including:
i. Availability of energy and transportation for supplies to the project and access to markets,
both in terms of physical access (transportation and communications) and commercial
access;
ii. Cost overruns: in supplies of transportation of energy, machinery and/or raw materials or
in the cost of contractors and labour; and
iii. New technology: lenders require reliability of process and the equipment to be used must
be well established. If new technology is involved, more lending risk is involved.
Therefore, as a rule, lenders are reluctant to support projects that use untried technology,
for fear of delays, cost over-runs and outright failure
12
.


9
Ibid. at p. 7
10
Greenpeace & Oil Change International. BP & Shell: Rising Risks in Tar Sands Investments. 16 September
2008. http://www.greenpeace.org.uk/media/reports/bp-and-shell-rising-risks-tar-sands-investment (last visited
on 21 December 2010)
11
Op.cit. Taylor-DeJongh at p. 9
12
See generally Clifford Chance, Project Finance(IFR Publishing, December 1995)
4

a) Technology
The feasibility of various technological approaches to recover and process oil shale at
commercial scale remains uncertain; in situ retorting in particular is a massive operation that
is very complex, expensive and requires high levels of technical expertise, excellent project
management skills and availability of a high skill labour pool. In the United States over the
past two decades, very little research and development effort has been directed at reducing
the costs of in situ retorting and the technical viability of in-situ retorting will not be fully
established for at least six years
13
. Therefore, projects to produce oil from oil shale using
promising but untried processes will struggle to get finance in the absence of strong credit,
such as a government agency guarantee or a large company with excellent credit rating.

b) Transportation & Infrastructure
The distinct nature of oil sands as a hydrocarbon resource requires a production infrastructure
that stretches from gas field to pipeline to shale deposit to pipeline to up-grader to pipeline to
refinery
14
. It is a system of immense complexity that may also require regulatory approval. In
larger regions, for example, the U.S., if you look at a map of the pipelines that run crude oil
and where the refineries are, the middle part of the country has access to crude pipelines.
However, if you look at the coasts, they don't have crude pipelines that run to them. So when
the oil shale is developed to the point where it's very commercially available, getting it to a
significant portion of domestic refining capacity is a problem
15
.

In addition, due to the nature of the product, not all refineries are equipped to process oil
shale crude, which limits its market penetration. If there are dedicated refineries, these help to
improve market access. However, the constraint in pipeline capacity remains an important
roadblock
16
.

c) Production Costs
The lender will want to ensure that it addresses the potential impact of financial
developments that sit outside its control, such as:
i. Increases in world commodity prices, especially for energy supplies and raw materials;

13
Op.cit. Bartis J.T. et al at p. 15
14
Op.cit. Greenpeace & Oil Change at p. 10
15
Lonnie T. Oversight Hearing on Oil Shale Development Efforts. April 12, 2005. Bureau of Land
Management. U.S. Department of the Interior before the Senate Energy and Natural Resources Committee.
www.doi.gov (last visited on 21 December 2010)
16
Op.cit. Guiny S. and Sacks J at p. 22.
5

ii. Falls in the price of the product on world markets;
iii. Trends in international trade, protectionism and tariffs; and
iv. The likely strength of any competition
17
.

The economic viability of the sector is deeply dependent on high prices, which allow ultra-
heavy crude from oil shale to compete with conventional sources of crude. As with many
commodities, crude oil prices are highly volatile and, to hedge against the possibility of
downward price movements, lending for oil shale developments which have high capital
costs tends to be deferred until a sufficient safety cushion builds up between anticipated
production costs and what the market is willing to pay. This results in the threshold, or
hurdle price, of crude oil required to trigger lending being substantially higher than the
crude oil market price that would otherwise be required to motivate investment. Investments
in natural-gas-to-liquids plants provide an example of this behaviour. Even though current
gas-to-liquids technologies appear to be profitable at crude oil prices in the low $20s per-
barrel range, commitments to construct full commercial-scale plants were not made until
crude oil prices reached a hurdle price well above $30 per barrel
18
.

Production costs are highly sensitive to changes in capital costs and natural gas prices,
making oil shale projects vulnerable to increases in raw material costs. In addition, increased
construction costs are compounded by labour shortages and the inclusion of up-graders
contributes to larger project sizes, which in turn can lead to an erosion of the projects
economics
19
. In such a volatile, uncertain, and often punishing climate, lenders have favoured
more conventional upstream projects to bring crude oil to market with relatively low capital
costs
20
.

d) Market Forces
A source of market uncertainty is the potential behaviour of OPEC member nations. If they
perceive that world crude prices are sufficiently high to encourage large investments in
alternative sources of liquids, such as oil shale retorting plants, OPEC members could
purposely increase crude oil production to lower world oil prices and to prevent long-term

17
Clifford Chance. Project Finance (IFR Publishing, December 1995)
18
Op.cit. Bartis J.T. et al at p. 15
19
Op.cit Lonnie T.
20
Op.cit Bartis J.T. et al at p. 46.
6

loss of their market share and power. Such actions would yield substantial economic benefits
to energy consumers, but lenders and oil shale projects would suffer large losses.

5. Risk Mitigation

5.1 Developers: Overcoming the Obstacles

The key lending risks identified thus far sit largely outside the control of the industry.
Nonetheless, there are a number of steps that developers can take to minimise lending risks
associated with oil shale development projects, including:

a) Establishing own Supply Sources and Connecting Infrastructure
For example, by setting up transportation networks or power generating plants specifically
for the project. In Nigeria, because the location of the heavy oil to be recovered by in situ
techniques is close to the coastal areas, small pipeline networks can be built to the coastal
areas where the produced heavy oil can be transported to market through ship, anchored by
long-term agreements with major producers. Alternatively, heavy oil can be piped to nearby
refineries that can handle heavy oil. Developers can negotiate with the owner of the proposed
refinery for the possibility of having necessary facilities installed that will make it possible to
directly refine the heavy oil. In case the proposed refinery cannot handle heavy oil then the
possibility of building an up-grader that can convert the heavy oil to light sweet crude can be
considered for the future, when heavy oil production reaches an economically viable level
21
.

b) Utilising Existing Infrastructures
The Canadians faced a pipeline and a refining problem with their tar sands in Alberta. To
combat this, a leading Canadian company and ConocoPhillips decided to reinvest, or invest
in each other; Conoco Phillips made its refineries in the U.S. open to bitumen so the tar sands
from Alberta go to two or three mid-U.S. refineries. This is the adaptability on the refinery
issue to get both tar sands and oil shale to market and to refine and get it into the system as
well
22
.


21
Ayodele R.O. Strategies for Commercializing Nigerian Unconventional Oil. 15 August 2006.
www.nigeriaworld.com (last visited on 21 December 2010).
22
Fine D. Oil Shale: Toward a Strategic Unconventional Fuels Supply Policy. Heritage Lecture No. 1015 at p.
7. April 26, 2007.
7

c) Collaboration and Sharing of Know-how
Some multinational oil companies like ExxonMobil, Shell, and ConocoPhillips already
operating in situ techniques for the recovery of heavy oil in Canada, Venezuela and some
other locations around the world. Because the costs are cheaper, they can easily implement
such operations in places like Nigeria, for example, by transfering the technical know-how to
the country through their other operating subsidiaries around the world
23
.

5.2 Government Policies & Incentives

Whilst businesses can signal their readiness to take the initiative by indicating willingness to
start high-risk, capital-intensive oil shale development projects, the financial community will
not agree to underwrite projects involving new technologies that are ready for
commercialisation unless the government is prepared to share major risks not under industry
control. The basic principles underlying any proposals for risk sharing should include a
program that is simple and unambiguous to administer, under which lenders and the
government know exactly what they can expect and what risks they will run. Government
participation should:
i. be limited to external risks and there should be no dilution of management responsibility
to complete the project;
ii. focus on the first generation of production-sized plants using new technologies where
lending risks are highest; and
iii. provide for withdrawal of government participation when the risks have been reduced to
manageable levels either through operating experience or a reduction in pricing and other
regulatory activity
24
.

The government can provide risk participation on either a project-by-project basis or on a
more general program basis. Different provisions and conditions would be needed depending
on whether the particular risk is future market price, technological uncertainty as to the
workability, or cost of production facilities. The key point is that the government should use
its capacity to assume or alleviate a major part of extraordinary risks, while depending on

23
Op.cit. Ayodele
24
Franklin A.L. Financing High Risk High Cost Energy Developments. Harvard Business Review Nov/Dec78
Vol. 56 Issue 6 pp. 161-170 at p. 164
8

industry and private capital to assume risks and take responsibility for the design and
operation of new facilities
25
.

a) Price Protection
A basic device can be as simple as a fixed price for the output of a facility that meets the
standards of financial and technical responsibility. If the market price turns out to be higher
than the guaranteed price, the government could share the incremental revenues on a pro rata
basis with the producer, while the producer would share the downside risks. This may be
coupled with long term purchase contracts for added certainty. For example, in the US, a
contract between the government and shale oil producers that all of the production from 2013
in shale oil from Colorado and the Rocky Mountains to 2020 be dedicated to the Strategic
Petroleum Reserve (SPR). This would be a powerful incentive for the oil shale industry as it
would itself reduce market risk without subsidies to a phenomenally low level, and place the
government in the forefront of assuring energy security. Particular government departments,
e.g. the Department of Defence, could also be a buyer of jet fuel, along with the SPR, which
would accelerate rapid commercialisation
26
.

Another suggestion would be for the developer to negotiate a package with a financial
consortium in which debt service is denominated in fixed annual quantities of oil rather than
in dollars. For the operator, this arrangement would be the equivalent of a long-term supply
contract. The consortium would negotiate a target price schedule with the government
adequate to return the invested capital with interest. Delivery contracts to pipeline companies
or users could then be negotiated at competitive prices and any resulting profits (or losses)
shared between the government and consortium members. With such a plan, the producer
would have an assured market and "price" for most of his capacity and unusual price risks
would be separated from normal operating risks assumed by the operator
27
.

b) Guaranteeing a Market
To answer the question of how high-cost oil shale could compete with the greater volume of
lower cost, conventional oil, it has been proposed that an "all events" tariff is applied that
would allow all costs of an oil shale production plant (including construction, debt service

25
Ibid. at p. 165.
26
Op.cit. Fine D. at p. 6.
27
Op.cit. Franklin A.L. at p. 166
9

and return on equity) be reflected in the gas rate of the top five gas distribution companies,
thus spreading the higher costs of oil shale production uniformly across all customers.
Legislation can be enacted to require the use of increasing percentages of crude derived from
shale into pipeline and possibly into electrical distribution nets as another way of passing the
costs to the consumer. This device, however, could prove unworkable if new capacity were
delayed for technical reasons to the point where production could not meet the mandated
minimum percentages
28
.

c) Direct Subsidies
To get the first round of production and processing plants started the government could
provide direct capital subsidies. One approach might be to ask for competitive bids from
producers for the amount of subsidy each would require to build a plant of stated
specifications and capacity. Alternatively, either fixed subsidies per unit of output or a fixed
tax credit per unit of output might be provided. Or tax credits equal to a substantial part of the
capital cost of the plant. These would have the advantage of simplicity and certainty to the
producer, but they might raise difficult political or budgetary problems for the government
29
.

d) Debt Guarantees
Long-term lenders would be protected from the risk of cost escalation for new plants or from
failure of the project by guarantees of debt interest and repayment. One simple device is a fee
schedule for the guarantee that is high enough to give private investors an incentive to end the
guarantee but not so high that it prevents financing of the development. To encourage the
private sector to assume responsibility, the government guarantees or other financial
participation would be terminated when the uncertainties were sufficiently reduced
30
.

6. Conclusion

Oil shale production is characterized by high front-end capital and operating costs (mining,
processing and then oil shale refining) and long lead times between capital investments and
operating revenues. The potential for changes in economic conditions, energy and capital
markets and government policies imposes greater risks than many other energy project

28
Ibid. at p. 167
29
Ibid.
30
Ibid.
10

investments. Coupled with technical uncertainty and the volatility of crude oil and product
prices, oil shale investment risks pose a high hurdle to project financing, especially in first
generation projects.

Nevertheless, arranging debt financing remains the preferred strategy for independent oil
developers. However, in order to be able to approach a bank consortium on somewhat even
terms, developers must have both a proven process and a reliable and substantiated cost of
production that will withstand volatile downdips in oil price. While mining oil shale always
involves technical challenges, current techniques appear able to meet the requirements for the
commercial development of oil shale, which has led many to argue that lack of appetite for
development of proven oil shale resources is a function outside the resource itself and the
technology used to make it into oil; rather it is a function of policy and price
31
. The key
therefore lies in government policies to reduce or share risk to improve the financing climate
and achieve development goals.

Recommended government actions include establishing minimum price guarantees and/or
long-term purchase agreements on terms advantageous to oil shale developers. As the price of
oil will continue as the uncertain variable, governments should focus on looking at market
risk reduction through, for example, floor pricing. It has been suggested that to return
industry a minimum of 15 percent return on investment, this will only be possible at prices of
over $40 per barrel, which is economic. At that price, the industry may have a real candidate
in oil shale
32
.

31
Op.cit. Lonnie T.
32
Op.cit Fine D. at p. 8
11

BIBLIOGRAPHY
SECONDARY SOURCES
Books
Bartis J.T. et al. Oil Shale Development in the United States: Prospects and Policy Issues
(RAND Corporation, 2005).

Clifford Chance. Project Finance (IFR Publishing, December 1995)

Articles
Fine D. Oil Shale: Toward a Strategic Unconventional Fuels Supply Policy. Heritage Lecture
No. 1015 at p. 7. April 26, 2007.

Franklin A.L. Financing High Risk High Cost Energy Developments. Harvard Business
Review Nov/Dec 78 Vol. 56 Issue 6

Guiny S. and Sacks J. Oil Sands Boom or Bust. Hydrocarbons World, Volume 3, Issue 2

Newendorp T. Impact of Sustainable Energy Policies on Energy Security Risks: The Role of
Financial Markets in Energy Security. Taylor-DeJongh - United Nations Economic
Commission For Europe, November 2008.

Taylor-DeJongh, Inc. Financing Unconventional Oil : the Canadian Experience. 20 August
2006.

OTHERS
Internet Sources
Oil Shale & Tar Sands Programmatic EIS. Oil Shale/Tar Sands Guide.
http://ostseis.anl.gov/index.cfm. (last visited on 21 December 2010)

Lonnie T. Oversight Hearing on Oil Shale Development Efforts. April 12, 2005. Bureau of
Land Management. U.S. Department of the Interior before the Senate Energy and Natural
Resources Committee. www.doi.gov. (last visited on 21 December 2010)

12

Ayodele R.O. Strategies for Commercializing Nigerian Unconventional Oil. 15 August 2006.
www.nigeriaworld.com. (last visited on 21 December 2010)

Greenpeace & Oil Change International. BP & Shell: Rising Risks in Tar Sands Investments.
16 September 2008. http://www.greenpeace.org.uk/media/reports/bp-and-shell-rising-risks-
tar-sands-investment. (last visited on 21 December 2010)

Lees A. The Right Game. The Credit Crunch Treating the Disease Rather Than The
Symptoms. 28 July 2009. http://www.scribd.com/doc/17761313/Andy-Lees-The-Weakest-
Link. (last visited on 21 December 2010)

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