Involving the insurance market in a production loan is a financing technique that has rarely, if ever, been implemented in the oil and gas industry. But based on the recent success of such a loan, executives at one of Enron Corp.'s financial-services units believe the industry will see many more deals of this type. Enron Global Risk Markets (EGRM), working with Goldman Sachs & Co., recently developed financing for a $102-million natural gas production loan that used a combination of derivatives, insurance and bank credit. The structure provided financing against future production of 160 billion cubic feet of natural gas during a five-year period from fields in Texas, Louisiana and New Mexico. The name of the E&P company receiving this loan has not been disclosed. "Our goal is to provide producers with a more efficient and effective source of funding for their exploration, development and production operations," says Douglas Jones, head of the upstream team for EGRM. "The key is parsing the various transaction risks such that each risk element can be transferred to the advantaged market for that risk, including, in this case, the insurance market." "Enron separated the 'funding' aspect of the loan from the risk-bearing aspect," explains Brad Blesie, EGRM's head of structuring. "The funded capital provider was insulated from the attendant risks via an insurance policy that, in effect, guaranteed a level of cash flow sufficient to service the loan. Derivatives and reinsurance contracts were used to further refine the specific risk ultimately born by the insurer." With the help of Goldman Sachs, EGRM identified a variety of insurance companies interested in this type of risk. Swiss Re emerged as the sole underwriter. From start to finish, the deal took about three and a half months to arrange, Blesie said. "It was extremely complicated to structure and execute given the precedent-setting nature of the transaction," he says. "But now that the basic technology has been developed, future deals should take considerably less time to close. The insurance market is clearly an advantaged source of capital for certain types of risk. The key is transforming such risks into a form suitable to that market." The advantages of involving insurance markets are numerous, according to Blesie. "Insurance companies have large portfolios of risk," he notes. "To the extent that incremental risks brought into those portfolios are uncorrelated with existing positions, the overall portfolio effect is positive." Secondly, insurance companies have the ability to view risks from a different perspective. They apply a probabilistic approach to underwriting versus a rigid application of various rules-of-thumb. As a result, those companies are able to quantitatively assess the overall risk of very complicated transactions in the context of their own existing portfolios. Jones says, "We closed a first-of-its kind transaction involving the transfer of risk associated with the future production of proved reserves into a market that can efficiently analyze, price and warehouse this particular type of risk." At Swiss Re, executives are also excited about the deal. "Risk capital was further optimized by Enron's hedging of gas prices over the life of the financing to eliminate volatility with respect to the future price of natural gas," says Victoria Mace, head of Swiss Re's Energy Industry Solutions Team. Blesie did not say at what price the natural gas production is hedged. "While the cash flows associated with the bulk of the financed reserves are completely hedged, a portion of the underlying asset value is exposed to price risk," he says. "The insurance company is not exposed to any price risk, however, given the ultimate structure of the deal." Because of transaction costs associated with a deal of this type, it may not be as efficient for transactions below a certain size, although Blesie did not quote an exact cutoff point. Also, the client company's risk profile must be taken into account. Despite the complicated nature of the arrangement, Enron, Goldman Sachs and Swiss Re are each evaluating additional opportunities to re-create the deal for other clients, Blesie says. "The insurance market has expressed tremendous interest in this type of transaction." -Jodi Wetuski