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Kazakhstan’s state-owned KazMunaiGas (KMG), an umbrella company of several subsidiaries, is closing a $3 billion prepayment deal with commodities trader Vitol for crude shipments from its Tengiz oil field on the northeast shore of the Caspian Sea. The deal, which is KMG’s first foray into prepayment financing, is set to close by the end of March. Negotiations since December have been held against a background of concern over KMG’s leverage ratio, which jumped significantly in 2015, sparking fears the company would breach its Eurobond covenants. Once closed, the prepayment will buoy liquidity, but may not be enough to allay worries facing both KMG and the wider Kazakh energy market. The covenants state KMG must not exceed 3.5x net debt/earnings before interest, tax, depreciation and amortisation (EBITDA). The leverage ratio drove up from 2.5x to 3.3x in the first half of 2015, dangerously close to breaking the covenants and spurring a flurry of measures by top management to increase liquidity and decrease the debt burden. The banks involved in the prepayment deal include Société Générale, Bank of Tokyo-Mitsubishi, Sumitomo Mitsui Banking Corporation and Bank of China. A banking source close to the deal indicated margins were being negotiated at around 185 basis points over Libor (bp), and said KMG were driving a hard bargain to push the margin down, prompting Deutsche Bank to exit negotiations. Prepayment deals have been popularised by a slew of Rosneft deals in 2013, a likely inspiration for KMG’s deal. These prepayment deals are attractive to bankers, traders and producers alike. For banks, they offer a means of taking risk on the better-rated trader, rather than the producer . For Vitol, which won KMG’s open tender and has a history of dealings with the company, the deal is a great boon: “It’s a fantastic guaranteed source of supply, with locked-in quantities. There aren’t many opportunities of this size around,” says the banking source. KMG stands to gain from a guaranteed buyer and reduced reliance on external capital markets, as well as reducing leverage. Prepayment deals are audited off-balance sheet, thus not reported as financial obligations, decreasing the company’s leverage ratio –- which KMG badly needed in order to remain within the Eurobond covenants. Agencies keep keen eye on liquidity adjustments Slava Demchenko and Maxim Edelson of Fitch Ratings in Moscow tell TXF that for their purposes, the prepayment deal doesn’t reduce gross leverage, as they measure funds from operations (FFO) gross leverage – EBITDA less net cash interest, cash tax and including cash dividends from joint ventures (JVs). If KMG’s FFO leverage rises above Fitch’s guidance of 3.8x, they will be put into review for a downgrade. KMG’s Baa3 rating is already under review for downgrade by Moody’s, a note from the agency announced on February 4. The fear of breaching covenants drove KMG to seek to increase liquidity in four ways, the final being the current prepayment deal. In September, KMG announced it would sell half its stake in the Kashagan oil field to the Kazakh sovereign wealth fund S-K, for $4.7billion. This was seen by Fitch as a reflection of the state’s willingness to financially support the oil and gas company in uncertain times. Secondly, KMG obtained consent from its bondholders to include subsidiaries’ cash balances in its net debt/EBITDA Eurobond covenant calculation. This enabled it to include the significant cash accumulated by the London-based subsidiary KMG EP. KMG then launched a $3.4 billion bond buyback in November after receiving the $4.7 billion cash, further reducing debt. While numbers for the second half of 2015 have not yet been released, Fitch experts say they expect leverage to be under 3.5x due to the significant cash accumulation in the second half. They estimate the debt reduction as almost $9 billion. “We believe the company’s management is committed to ensuring the company complies with its Eurobond covenants,” says Edelson. While prepayment financing holds advantages for KMG, the lengthy process of negotiating the deal mitigates this picture. The technicalities had to be ironed out by accountants dealing with this kind of financing for the first time, and rubber-stamped by state bureaucracy. The deal is further legally complicated by the fact the Tengiz oilfield is a JV with Chevron-led TengizChevroil (TCO), Kazakhstan’s biggest producer. TCO has historically marketed its own oil, distributing dividends to KMG but not crude volumes. In this case, KMG would have had to negotiate with Chevron and the other JV partners to provide deliveries of KMG’s share of oil to Vitol. “The company doesn’t own the oil and hasn’t had a historic claim on it ,; so this is an unorthodox transaction,” an oil market analyst tells TXF. The banking source says further prepayments of this size are unlikely in the near future, partly due to the complex negotiations involved. KMG is concerned to close the deal by the end of March, when a source says they aim to launch another bond buyback once the $3 billion enters their cash pool. Tenge fever KMG’s leverage ratio is also under pressure from the depreciating tenge (Kazakh currency). Kazakhstan has had a rocky ride since the central bank’s decision to unpeg the tenge in August last year, following Russia and China’s currency devaluations. The tenge lost a total of 124% of its value against the dollar in the two years from January 2014, a significantly greater depreciation than other oil-producing countries suffered; close on the heels of the rouble, reflecting the republic’s strong economic ties to Russia. KazMunaiGas’s debt was 90% foreign exchange denominated as of July 2015, making it highly vulnerable to depreciation of the tenge. The measures KMG is taking to improve its liquidity also aim to fight this dependence on dollar-denominated debt. The oil-price collapse is having multiple knock-on effects on the Kazakh economy. Samruk-Kazyna, the $64 billion sovereign wealth fund, lost 16% of its assets in the 18 months to January this year. Continued depressed oil prices could lead the fund to run out of money within six or seven years, the chief executive of Kazakhstan’s National Investment Corporation, which helps manage the fund, said in January before being fired. Kazakhstan relies on oil for 60% of its exports. Its overall oil production is falling as most of the country’s oil fields are maturing, so pressure will be on to maintain and expand production in the biggest fields including Tengiz, which produced 26.7 million tonnes of crude in 2014. Kashagan oil field, in the Caspian Sea, is Kazakhstan’s flagship project turned white elephant. The $50 billion project, predicted to produce as much oil as Libya , ground to a halt due to leaking pipelines weeks after it went onstream in late 2013. Shell and other producers involved have poured billions more into it, and KMG claims it will be up and running by the fourth quarter of 2016. “It has been a major blow to Shell and the European producers; it’s become a huge embarrassment to all the parties involved,” says the oil analyst. Against this bleak picture, it seems optimistic of Umrizak Shukeyev, the head of the sovereign wealth fund, to talk of an IPO for KMG in the next three-four years. Nonetheless, the latest prepayment will serve to quell some nerves over in central Asia, at least for a little while.