Letters of Credit are common in the oil business. Both producers and buyers regularly have to post Letters of Credit (LOC) to guarantee obligations. These letters are often costly and tie up resources that prevent the business from using those assets elsewhere. A viable alternative may be a surety backed letter of credit.
Why are Letters of Credit Needed in the Oil Industry?
Letters of credit are needed by many parties in an oil transaction. Producers are regularly asked to post LOCs to guarantee performance to refineries and shipping companies. These LOCs guarantee that the producer will meet their contractual production commitment.
Alternatively, refiners, shippers, and other buyers are often asked to post LOCs to a producer. These LOCs guarantee payment for the product or can also guarantee performance, such as shipping.
What is a Surety Backed Letter of Credit?
A surety backed LOC is an Irrevocable Letter of Credit (ILOC) backed by the guarantee of a surety bond company, typically through a counter credit agreement. The purchaser of the LOC is the bond principal. The principal must be qualified by the surety bond company. If the surety bond company is comfortable with the principal and the obligation, they will back the principal to the fronting bank. The fronting bank will then issue the LOC with the guarantee of the surety bond company.
The transaction itself is not seen by the beneficiary of the LOC, because the terms are no different. As long as the beneficiary accepts the fronting bank as a viable lender, the surety backed LOC should also be acceptable.
Benefits of a Surety Backed Letter of Credit
Because the agreement is backed by a financially sound and strong surety company, a company such as an oil producer, buyer, or refiner can often obtain better terms than they could on their own. In most circumstances, no collateral is required to obtain the surety backed LOC. Therefore, an oil company can use its assets to grow its business instead of having those assets locked up to secure a LOC. We have seen millions of secured cash freed up by switching to surety backed LOCs.
Surety backed LOC are also cost effective, especially in the current high-rate environment. Surety-backed LOCs generally cost between 1.5% and 3%. This is usually very competitive with the rate of a normal LOC when some companies are paying more than 10%.
Finally, the principal company can still maintain its other banking relationships. There are no requirements to move deposits, loans, or other credit products to the fronting bank. The surety bond company is the bank’s customer.
Drawbacks to a Surety Backed Letter of Credit
Surety Backed LOCs also have drawbacks. They are not a solution for companies who have low liquidity or financial challenges. Most surety companies will want the oil producer to be overqualified to obtain this product.
Secondly, there is limited availability of surety backed letters of credit. The market is fairly small compared to the need, and some bond companies will have limitations on the maximum amount of LOC they will issue. Common thresholds are $25 million and $50 million, although significant capacity exists for larger companies.
Surety backed LOCs still require indemnity. This means that if a loss occurs, the fronting back will get reimbursed from the surety. The surety will then have the right to get reimbursed from the principal company. It is a credit product, and losses should be avoided at all costs.
Many in the oil business do not realize that surety backed LOCs exist. This product can free up cash and collateral to allow the business to expand or use the capital elsewhere. In a high interest rate environment, surety backed LOCs may help companies become even more profitable in 2024.
Josh Carson is Vice President and Partner at Axcess Surety Bonds. For 20 years, Carson has helped energy companies, contractors, and related businesses with surety bonds, finance, and business management. Carson holds an Associate in Fidelity and Surety Bonding and a degree in Finance.
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