During March of 2017, Enable Midstream Partners LP announced that it would be conducting a non-binding open season in order to solicit commitments for expansion projects to support growing production in the Anadarko Basin.

Around the same period, the Williams Partners’ Atlantic Sunrise Expansion project, which is an expansion of the existing Transco natural gas pipeline, received its Federal Energy Regulatory Commission (FERC) approval, and Pembina Pipeline began construction on a $235 million expansion of its 75,000 barrel per day (Mbbl/d) pipeline located in the northeast corridor of British Columbia.

These are just a few of the publicly-announced midstream expansion projects that generated headlines in first-half 2017 as interest in investing in oil and gas midstream expansion projects increased.

This interest is in part due to the recent relative stabilization of oil commodity pricing, with crude oil prices trading between $41/bbl and $55/bbl over the most recent 52-week period ending Aug. 1. While it is not generally expected in the near term that oil prices will surge back to $100/bbl—as was the case from 2011-2014—the current pricing is considered sufficient, taking into account projected lower deltas in price fluctuation, to support additional investment in upstream exploration and production-related oil and gas projects. As interest in investing in upstream growth projects increases, interest in financing additional midstream infrastructure—to monetize upstream exploitation—should also rise.

Financial institutions and private-equity funds, collectively referred to in this article as “credit parties,” have shown a recent willingness to invest in expansion projects. Kinder Morgan Inc. recently sought and obtained financing for a $5.5 billion expansion of its Trans Mountain Pipeline, and several tar sands pipeline expansions have also successfully found debt and investment sources to support their aggressive growth plans.

Private equity
This interest is being driven in part by the longer-term offtake contracts that expansion pipeline developers have been able to negotiate, which provide assurances to potential credit parties that there will be sufficient cash flows generated by the pipeline to repay the indebtedness. And, as noted above, the interest is not just coming from traditional debt-lending financial institutions, but also from private equity.

Representative of a growing trend in the overall energy sector and more specifically in pipeline expansion projects, in June 2016 private-equity firm Riverstone Investment Group purchased a 50% equity stake in the Utopia Pipeline Project, another Kinder Morgan venture. Other large energy firms, such as Crestwood Equity Partners, EIG, and NGL Energy Partners, have similarly formed partnerships with First Reserve, Cheniere Energy, and Oaktree Capital, respectively, to provide them with desired capital for expansion projects.

Assuming these trends continue as expected, project developers should find ample opportunity in the marketplace to fund their expansions through a combination of debt and equity, and through variousfunding models.

This article focuses on the issues arising with respect to one common model for funding midstream infrastructure expansions—a project financing debt structure.

Such debt facilities are most commonly made available by banks and other traditional debt financing sources (such as pension funds and insurance companies), but many energy and infrastructure funds have also entered the debt financing space for projects that meet their investment criteria.

Special purpose
In a project financing, a single-asset, special-purpose vehicle is formed to own the expansion project, and will also incur any indebtedness that is required to fund the project. Ideally, the entity created to own the expansion project will be distinct from the entity that owns the existing midstream asset, but this can depend on the type of asset that is being expanded.

Using pipelines as an example, if new pipe is being added to an existing line to branch out to serve new territory, there is greater potential for the owner of the expansion project to be separate from the original pipeline owner (as credit parties can more easily assign value to the separate pipeline assets).

The expansion pipeline owner will often share common facilities such as pump stations and storage tanks with the original pipeline owner, which will require more detailed attention in the legal documentation. But such issues are commonly dealt with by experienced project counsel and should not jeopardize financing availability. The same principles would hold in the case of an expansion of an oil or natural gathering system to serve new fields.

On the other hand, in the case of an expansion of pipeline capacity (e.g. through the addition of new compression being added to an existing pipeline), it can be more difficult for credit parties to segregate value and instead they must analyze the credit risk of the expansion in combination with the existing asset.

In such a case, the aggregate debt capacity of the improved project would need to be analyzed to determine whether financing the expansion would be practical.

Assuming that the expansion project can be evaluated on a standalone basis, a project financing will require a stringent separateness covenant in order to insulate the expansion project’s assets and value from adverse effects that could accrue from other parts of the project. In basic terms, a separateness covenant is an agreement by the borrower/asset owner to keep its books, accounts, records, assets, etc., separate from those of its parent company(ies), its sister company(ies), and its subsidiaries. This will most directly apply to cash flows generated by the expansion project and the hard assets constituting the expansion project.

Credit party protection
Another important consideration for credit parties of expansion projects is to preserve their ability to step into the expansion project owner’s shoes under all relevant contracts, in particular transportation agreements and any other revenue-generating contracts, that the expansion project owner is a party to. This protects the credit parties from loss of the value of these important contracts in the event such project owner fails to timely perform its obligations thereunder.

While common and almost universally required by credit parties, in project financing situations, these step-in agreements (commonly called “consents to assignment” or “direct agreements”) can be time consuming and difficult to negotiate with customers due to customary credit party protections therein, such as clauses granting credit parties an extended cure period to cure nonperformance on the part of the borrower/project. Accordingly, if it is considered possible that a subject expansion project could be financed through a project finance structure, it is advisable to include provision in customer contracts upfront requiring customers to enter into such an agreement.

Credit parties to a project-financed expansion project will want to confirm that they have appropriate security documents in place to grant them a lien over all assets of the expansion project owner, which as discussed above, should be segregated from the assets of the original project owner and any other entity so that they can realize the full value of the project in the unfortunate event of a default and foreclosure. This can be tricky when it comes to real estate liens since typically portions of the original project and portions of the related expansion project might utilize all or part of the same tract of land covered by the same lease.

Segregating these interests may require lessor consent or other amendments to the relevant real property documentation and, if both the original project and the expansion project have been financed, the relevant sets of credit parties may need to enter an inter-creditor arrangement to document the relevant rights of each in the event that the original project owner or expansion project owner defaults on their debt. As with the above issues, while these agreements are not uncommon in financed expansion projects, they are highly specialized and intricate arrangements that will require time and knowledge to navigate.

Financing midstream project expansions can be an attractive option for lenders and private-equity funds, but there are certain complications specific to these types of financings that such credit parties should take note of, in addition to the structural items noted above.

EPC agreements
Developers of expansion projects have to engage the market to find a construction contractor to assume the obligation of constructing the project, typically through an engineering, procurement and construction (EPC) agreement. While credit parties prefer fixed-price EPC agreements where the contractor agrees to perform all necessary work for construction of a finalized project, EPC contractors in many markets have become resistant to agreeing to fixed-price contracts, resulting in cost-plus EPC agreements with an initial fee set for the contractor and the actual costs of parts and labor billed to the project developer on a monthly basis. Since construction costs represent the primary expense for expansion project developers, credit parties should be aware of the pricing structure used and how it can impact the value and risk profile of the expansion project.

In addition, pipeline and other midstream projects often face complicated permitting requirements.

Federal and state regulatory authorities can be slow at granting the necessary permits and approvals to authorize the construction of an expansion project, and the uncertainty of success in obtaining these permits can be a limiting factor in obtaining financing commitments. While extreme, the current backlog of energy projects awaiting FERC approval as a result of an over- six-month shutdown of the agency this year due to failure to have an acting quorum of members is exemplary of the types of complications that can arise in the permitting process.

While expansion projects can sometimes piggyback off the permits and approvals obtained by the existing project, such permits will often need to be amended or extended to cover the expansion work, placing these projects at the back of the line in obtaining approval.

Shutdown questions
Another major consideration is the effect that pipeline expansion work can have on the existing asset. For example, during various stages of construction, it may be necessary to shut down or disable portions of the existing pipeline in order to tie it in with the expansion project.

Since this downtime is outside of the ordinary course of business, the existing project owner, whether the same or different from the expansion project owner, will have to be sure that it coordinates with its current customers to minimize any potential disturbances caused by this downtime.

The expansion project may also require upgrades to be made to pump stations and other shared facilities, the cost of which may be split between the existing and expansion projects. If the existing project has any outstanding debt, the cost of these upgrades will have to be approved by the credit parties of that outstanding indebtedness.

The costs of exploration and extraction of commodities, risks posed by the potential for changing political climates in the U.S. and abroad, and impacts in the demand for oil and natural gas as renewable energy sources become more feasible and inexpensive, all factor into the value of midstream expansion projects as a steady source of returns for potential credit parties.

And of course, it is also worth noting the role that environmental and social factors play in financing projects—especially as some recent, larger-scale midstream projects have received substantial public attention.

Despite these drawbacks, there is still an active and competitive market for the project financing for development of pipeline expansion projects, driven in part by the additional demand for infrastructure to support the additional upstream projects that are being financed.

Developers of expansion projects that are supported by a good business case with reasonable projects for creditworthy revenue-producing customers should have multiple possible financing sources in the current market. It will be an exciting market for credit parties to closely track during the rest of 2017, and in the years ahead.

Thomas Tomlinson is a partner and Jason Keating is an associate with Bracewell LLP.