Citigroup's gas prepayment deal with Vernon

In 2006, a number of gas prepay deals took place in the US under new Internal Revenue Service (IRS) rules. One of the most interesting and innovative of these deals was completed by Citigroup on June 27. It was a $431 million tax-exempt prepayment transaction for the City of Vernon in California. The transaction, thought to be only the third deal under the new IRS rules at the time, and the first for a Californian municipality, is unique in that it has a fixed-price component and is for an electricity producer.

Under the deal, the City of Vernon prepaid for a 15-year supply of natural gas to be delivered to the Southern California Border beginning August 1, 2006. The transaction provided for delivery of approximately 88 billion cubic feet of natural gas shaped specifically on a monthly basis to meet Vernon's needs. The prepaid gas supply is for the City's 120 megawatt Malburg Generating Station, which is a City-owned facility that began commercial operations in October 2005. The prepay transaction provides approximately 80% of the gas requirements to run the facility.

As well as structuring the overall program, Citigroup led and solely managed the bond issuance, supplied physical natural gas, underwrote 15 years of fixed-price gas risk, arranged and executed associated commodity swaps, structured the note related to the prepay proceeds and provided the interest rate swaps.

The deal's unique structure allowed both fixed and floating prices, with 75% set at fixed and 25% floating. By locking in a significant portion of the natural gas at a fixed price, Vernon was provided with a cost-effective way of passing on long-term, economical power to its customer base.

The transaction required Citigroup to accommodate issues related to power plants such as forced outages, as well as the intricacies of the delivery and balancing provisions on the Southern California (SoCal) Gas Company's pipeline.

All this left the bank with a very complex structure. "The notion of prepays is very straightforward," says Joe Toussaint, managing director at Citigroup. "But there are a lot more moving parts once you get into detail such as the intricacies around delivery. For example, working out how to manage the issues related to SoCal's monthly balancing and how to apportion the cost/benefits was somewhat complex."

As well as providing 80% of Vernon's gas requirements for Malburg, Citigroup won the right to provide the other 20%, and, as Vernon's contracted marketer on the SolCal system, is responsible for delivery and transportation.

Structuring the gas supply contract was a particular achievement as it broke new ground, notes Craig Underwood, president of Bond Logistix, the financial advisor on the transaction. "There hadn't been a deal done like this before, so there were no standard contracts to follow."

To finance the prepayment, Citigroup oversaw Vernon's issue of tax-exempt variable rate demand obligations and auction rate securities, which utilised a Libor-based interest rate swap to lock-in low rates.

Vernon officials chose Citigroup above other banks because it showed a more aggressive desire to get the deal done than some of its peers, says Donal O'Callaghan, director of the light and power department of the City of Vernon. Vernon has been extremely pleased with the results. "We were fully engaged in the whole process and are delighted with a deal that enables us to pass on not only stable power costs but cost-savings to our customers," says O'Callaghan. "It will help make Vernon an attractive place for businesses."

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