Alternative Financing
Structures within
Commodities
Arrangements
Craig Enochs
Jackson Walker, L.L.P.
Houston, Texas
Agenda
1
Introduction
2
First Lien Structures
3
Prepaid Swaps
4
Contact Information
Page 2
Credit Markets and the Commodity Industry
 Credit at one time was an afterthought in wholesale commodity
and derivative transactions:
 THE GISB contained a one-paragraph adequate assurance provision
 The ISDA was used by many without a Credit Support Annex
“Those were
the days…”
Page 3
1
Introduction
Credit Markets and the Commodity Industry
 Credit Defaults in the late 1990s:
 Credit terms more closely scrutinized in commodity trading
agreements
 More credit support required, usually in the form of parent guaranties
supplemented by cash or letters of credit
 Bankruptcies in the early- to mid- 2000s:
 Tested parties’ ability to enforce guaranties and receive payment
following default
 Some guarantors issued guaranties exceeding their net worth
 If subsidiary trading party was insolvent, parent guarantor frequently
was insolvent as well
Page 4
1
Introduction
Credit Markets and the Commodity Industry
 What else could go wrong?
 More bankruptcies
 2008 financial crisis
 Credit downgrades across the board
 Dodd-Frank uncertainty
 Where does that leave us today?
 Companies have been forced to become more sophisticated and
innovative in addressing their credit risk
 Some forms of collateral that previously were popular, such as credit
default swaps, surety bonds, and some sovereign debt, are now less
attractive or are unavailable
Page 5
1
Introduction
Credit Markets and the Commodity Industry
 2 Growing Issues Facing Commodity Market Participants:
 Inability to access credit markets in order to fund existing or new
commodity operations and add value to company
 Lending markets remain tight
 Cost of credit continues to rise
 Inability to post collateral to trading counterparties under physical and
financial commodity transactions
 Related to the first issue—more difficult and expensive to get
revolving cash or letter of credit facility
 Physical and financial deals are core to business, so how do
parties manage exposure?
Page 6
1
Introduction
Credit Markets and the Commodity Industry
 2 Examples of Alternative Credit and Financing Structures:
How can I
trade when
collateral is
tight?
First Lien
Credit Facility
How can I
fund inputs for
commodity
production?
Prepaid Swap
Transaction
Page 7
1
Introduction
First Lien Structures
 General Overview
 Debtor under an existing credit facility has provided a first lien and
security interest in a tangible asset to lenders
 Debtor enters into trading agreements with hedge counterparties
relating to the asset, and offers first lien as collateral

Ex: Debtor enters into ISDA with Gas Annex in order to purchase fuel
for electric generation facility
 Hedge counterparty holds first priority lien and security interest on
the tangible asset pari passu with lenders
Page 8
2
First Lien Structures
First Lien Structures
 General Overview (cont.)
 Lenders willing to share first lien because trading relationship with
hedge counterparty:

Reduces risk
 Ex: If hedge counterparty sells natural gas to run debtor’s power
plant, reduces the risk that the plant will be unable to produce
electricity
 Increases value of the asset
 Ex: If debtor sells a power plant’s electricity to hedge counterparty,
this mitigates the risk of not finding a purchaser for the plant’s
output or that power prices may decline over time
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2
First Lien Structures
First Lien Structures
 Documents in First Lien Structures
 Loan Documents: May impact a hedge counterparty’s rights in
relation to other lenders

Credit Agreement

Intercreditor Agreement

Security Agreement or Collateral Trust Agreement

Designation and Joinder Agreement
 Trading Documents: Between hedge counterparty and debtor

First lien protections often documented under an ISDA, but can be
incorporated into NAESB or EEI
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2
First Lien Structures
First Lien Structures
3 Types of First Lien Credit Structures
Replacement
Threshold
Tail Risk
•First lien wholly
replaces any other
collateral obligations
•Hedge counterparty
assigns a value to the
first lien
•Debtor initially posts
collateral up to a fixed
amount
•Debtor not required
to provide cash,
letter of credit or
guaranty
•Such value
establishes debtor’s
fixed collateral
threshold
•First lien covers
debtor’s “tail risk”
over and above the
credit limit
•Cheaper to
implement than
other forms of credit
support
•Debtor only provides
alternative forms of
collateral if hedge
counterparty’s
exposure exceeds
collateral threshold
•Debtor’s collateral
obligations are fixed
despite market
fluctuations altering
exposure
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2
First Lien Structures
First Lien Structures
 Debtor’s Order of Preference for First Lien Structures
 Replacement Structure
 Debtor provides no collateral except the first lien
 Tail Risk Structure
 Debtor’s collateral obligations are fixed up to a certain amount, and
the first lien covers all other hedge counterparty exposure
 Threshold Structure
 Debtor still receives value for its first lien, but may have to post
additional collateral depending on hedge counterparty’s exposure
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2
First Lien Structures
First Lien Structures
 Counterparty’s Order of Preference for First Lien
Structures
 Threshold Structure
 Accounts for the value of debtor’s first lien, but also protects
against market risk by requiring additional collateral
 Tail Risk Structure
 Hedge counterparty initially receives collateral as security, and
enjoys the benefits of first lien protection
 Replacement Structure
 Risk that hedge counterparty’s exposure will exceed the value of
the first lien, and no other collateral available
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2
First Lien Structures
First Lien Structures
 Advantages to Debtor
 No additional collateral needed
 No liquidity needed
 More equity may be available under Credit Agreement
than in other credit structures
 Lower administrative burden
 More efficient use of the capital locked up in the assets of
the first lien estate
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2
First Lien Structures
First Lien Structures
 Advantages to Counterparty
 Right in tangible asset rather than contractual interest
 Aligned interests with lender
 “Right-way risk”
 As the price of input or product increases (thus potentially
increasing a hedge counterparty’s exposure), the value of the
asset on which counterparty holds a first lien also increases
Page 15
2
First Lien Structures
First Lien Structures
 Disadvantages to Debtor
 Counterparty still may demand additional collateral or
price concessions
 Low asset valuation for credit purposes
 First liens are fairly illiquid and contingent upon terms of a Credit
Agreement or actions by lenders
 Requires positive multiple of equity to debt on assets in
facility
Page 16
2
First Lien Structures
First Lien Structures
 Disadvantages to Debtor (continued)
 First lien places hard assets at risk that are not otherwise
affected in other credit structures
 Even if counterparty accepts first lien, counterparty may
impose conservative risk limits and parameters in the
transactions secured by the first lien
 Impacts ability to trade with hedge counterparty
Page 17
2
First Lien Structures
First Lien Structures
 Disadvantages to Counterparty
 Highly illiquid collateral
 Extended delay between default and payment
 Lack of control in collateral
 Acting as part of a group of creditors rather than individually
 Risk if counterparty’s interests diverge from other lenders and
hedge counterparties
 Not fungible
Page 18
2
First Lien Structures
First Lien Structures
 Additional Considerations with First Liens
 Voting Rights
 Generally contained in the Credit Agreement
 Matters on which hedge counterparty can vote (and weight of vote)
often differ from lenders
 Ratio of (i) exposure to debtor, compared to (ii) cumulative debt under
credit facility
 Compared to lenders in the credit facility, hedge counterparty may
have little or no voting power
 Hedge counterparties must work with lenders because interests
are linked
Page 19
2
First Lien Structures
First Lien Structures
 Additional Considerations with First Liens (continued)
 Payment of Debt
 Hedge counterparty’s collateral rights stem from Credit Agreement
 When Credit Agreement is paid in full or terminated, hedge
counterparty must ensure that it will be covered
 Can the lenders release the lien without the hedge counterparty’s
consent?
 Can the lenders release the lien without the debtor providing
alternative forms of collateral?
 Documentation of first lien terms in trading agreements
 Events of default, additional representations, etc.
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2
First Lien Structures
Prepaid Swap Transactions
 General Overview
 Parties enter into an ISDA Master Agreement.
 “Swap lender” and “swap debtor” enter into a commodity
swap transaction whereby each month during the term:
 Swap lender is the fixed price payor and pays a fixed price of $0.00.
 Swap debtor is the floating price payor and pays an index price
multiplied by a notional quantity of commodity production.
 “Swap lender” makes an initial upfront payment to “swap
debtor”.
 Valuation based on (i) fixed price for the commodity, multiplied by (ii)
cumulative quantity for the entire term of the swap.
 Discounted to net present value and paid upfront.
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 General Overview (cont.)
 Notional quantity under the swap is only a portion of swap
debtor’s total commodity production
 Ex: Parties may enter into the prepaid swap with respect to 20% of
swap debtor’s anticipated commodity production
 Mitigates swap lender’s risks associated with any fluctuations in
actual commodity production or commodity prices
 Swap debtor uses prepayment to fund inputs into its
business.
 Ex: Ramp up costs for production
 Swap lender takes a security interest in the commodity
being produced.
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
Prepayment
Fixed Price x Notional Quantity
Swap Lender
Swap Debtor
Index Price x Notional Quantity
$0.00 Fixed x Notional Quantity
Commodity Swap
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 Who Uses Prepaid Swap Transactions?
 Producers of agricultural commodities in non-U.S. markets
 Foreign farmers have a need for upfront capital to purchase inputs
into their business (seed, fertilizer, irrigation systems)
 Fairly limited access to traditional financing sources in credit markets
and banking industries
 Lack of subsidies and government programs, unlike in U.S. agricultural
markets
 Often, swap settlement via physical delivery of commodity instead of
cash settlement
 Commodity quantity is generally a fraction of farmer’s total
anticipated crop production
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
Total Anticipated Crop: 1,000 tons of
cocoa beans
Prepaid Swap Quantity: 200 tons
Prepayment
Prepayment
$2,200 (Fixed) x 200 tons = $440,000
$2,000 (Fixed) x 200 tons = $400,000
Cocoa
Aggregato
r
Cocoa
Merchant
Physical delivery of 200 tons cocoa
Farmer
Physical delivery of 200 tons cocoa
$0.00 Fixed x 200 tons cocoa
$0.00 Fixed x 200 tons cocoa
Commodity Swap
Commodity Swap
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 Issues in Agricultural Commodity Prepaid Swaps:
 International laws and customs
 Typically under-developed or undeveloped countries
 Unstable political regimes and trade customs
 Merchants and aggregators must ensure that they will get paid,
either in cash or in kind.
 Unsophisticated commodity participants
 End user farmers in third world countries
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 Who Uses Prepaid Swap Transactions?
 Oil and Natural Gas Producers
 Oil and gas producers have a need for upfront capital to invest in
drilling and operating expenses
 Prepayment upfront to invest in developing wells with index-based
cash settlement under prepaid swap transaction
 Oil or gas quantity under the swap is generally a fraction of
producer’s total anticipated oil or natural gas reserves under the
lease(s)
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
Total Anticipated Gas
Production During Swap
Term: 1,000,000 MMBtu
Prepayment
Prepaid Swap Quantity:
200,000 MMBtu
$2.75 x 200,000 MMBtu = $550,000
Bank
(or Trading
Affiliate)
Natural Gas
Producer
NYMEX-Henry Hub x 200,000 MMBtu
$0.00 Fixed x 200,000 MMBtu
Commodity Swap
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 Issues in Oil and Natural Gas Prepaid Swaps:
 Broad expertise required to review and analyze the deal
 Derivatives, E&P, Lending, Tax
 More diligence involved than traditional commodity swap




Leases, operating agreements and reserve reports
Loan terms included in ISDA Schedule
Security documents evidencing lender’s interest in mineral rights
State and local laws involving real property and extraction of
minerals
 Non-Owner Operated Wells: is swap lender comfortable
with how wells will be operated?
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3
Prepaid Swap
Transactions
Prepaid Swap Transactions
 How Else Might Prepaid Swaps Be Used?
 Electric Generation:
 Hedge fund purchases power plant
 Investors have cash to purchase the plant, but need money for ramp
up costs and operations
 Under prepaid swap, the plant could get a prepayment based on a
percentage of the plant’s total capacity.
 Once power is generated, the plant sells that portion of the capacity
in the market at index and flows through the index payments to the
swap lender.
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3
Prepaid Swap
Transactions
Conclusion
 Credit markets drive collateral scarcity in a reinforcing cycle
 Credit market struggles will continue to drive innovative collateral
solutions
 These solutions are likely to come from new structures rather than
new forms of collateral
Contact Information
CRAIG R. ENOCHS
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
(713) 752-4315
cenochs@jw.com
KEVIN M. PAGE
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
(713) 752-4227
kpage@jw.com
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Contact Information