The below is an excerpt taken from a bulletin published on the Norton Rose Fulbright (United States) website earlier this month. Please click here to read the entire bulletin, which also includes an overview of managing contractor and counterparty exposure, proactively reviewing and renegotiating contractual arrangements, mitigating the risk of contractor exposure in construction projects, shareholder activism, communication and public relations, and political risk.
Following a prolonged period of high oil prices, the world must adjust to a ‘new normal’. Opinion as to where the average spot price will hover following the current volatility varies but the consensus is that oil prices will remain considerably lower than they were pre-June for the foreseeable future.
Where does this leave oil companies, many of whom modelled their new exploration and production (E&P) projects around oil prices of US$90-100 bbl? What are the wider ramifications of the lower oil prices – on the web of oil services companies, suppliers and related infrastructure – and how can oil companies mitigate the effect that lower oil prices may have on both themselves and those with whom they do business?
This briefing sets out some of the strategies and options that E&P companies (as opposed to petrochemical or refining companies, banks or oil service providers) might think about as the market adjusts to a new normal, and highlights some key issues to consider.
When, not if
Effective hedging means that many oil companies may not feel the effect of lower oil prices until 2016-2017. However, most economists maintain that the economic climate has undoubtedly and irrevocably changed for the next few years and oil companies would be wise to review at what point they are likely to be exposed.
This would be a good time to review financial models and agree a strategy to manage the business should oil prices breach certain thresholds.
Many oil companies may decide to reduce their overall capital expenditure load. This may emanate in an overall cut in expenditure budget, or a strategic change in direction away from capital-intensive, high risk and technically challenging drilling projects towards improving margins and generating maximum value from existing operating projects through step-outs and neighbouring structure exploration.
If there is a case for divesting assets, then a well-structured, targeted and timely divestment plan will be essential for generating maximum value. Oil companies looking to raise capital and drive shareholder value will be separating core from non-core assets, and/or divesting underperforming or non-core assets in order to put capital to use more efficiently elsewhere.
Alternative sources of finance
In a period of lower oil prices it will almost inevitably become more difficult for companies to raise development capital. Ultimately, lenders will look to the long term sales contracts that underpin a project and the credit of the counterparty to ensure that there is long term and adequate cash flow available for debt service. Given that the price agreed under many off-take and long term sales agreements is often determined according to industry price indices, a period of lower oil prices will inevitably have an impact on a company’s ability to generate revenue, and so attract finance.
E&P companies seeking finance may need to explore alternative sources of finance to fully fund the development and operation of their projects, and in a tightening bank market, there is likely to be an increasingly reliance on these alternative sources of finance.
Alternative finance approaches are growing in number and scale. Understanding how these different financing tools work and interact together is essential to navigate the sometimes challenging intercreditor issues. This is particularly relevant given the likelihood of a new investor base with different investment appetites and requirements. Regulatory frameworks may also have an impact on the availability of options.
Some of the options for oil companies seeking finance include:
1. Private equity
Management teams seeking capital to realise or accelerate development projects are seeing increasing interest from private equity funds. For private equity funds – particularly the increasing number with dedicated energy funds – a period of lower oil prices is an opportunity to acquire and develop assets with attractive valuations. Private equity funds are playing a growing role in mature producing fields, high-impact exploration and facilities, and we anticipate significant activity in PE investments as energy producers look to sell assets and bridge cash shortfalls.
2. Commodity and royalty streaming
This source of finance is likely to become more prevalent in the oil sector if it becomes difficult to raise capital through the equity and debt markets. Streaming finance is raised by selling a right to a commodity in exchange for an up-front payment.
3. Offtaker financing
Downstream oil purchasers can be a good source of additional finance if they are prepared to make an equity investment in or provide straight commercial debt to a project. The most common form of off-taker financing is a combination of:
- An advance payment for future production (a prepayment) which is amortised against deliveries, and
- A discount to market price under the offtake agreement.
4. Trading house development finance
Trading houses with growing balance sheets are increasingly financing select developments and acquisitions, in order to access offtake and financial return opportunities.
We are seeing a growing interest in the use of convertible bonds to finance development of discovered reserves, with all physical offtake committed at a discount to benchmark prices. Committed physical offtake allows for longer term trading positions to be taken to gain a further margin.
5. Equipment and tied-finance
Manufacturers of oil services equipment often provide financing to development projects to finance the purchase of their own equipment and therefore enhance their own sales volumes. Equipment manufacturers have established lending arms in order to participate alongside (and on the same terms as) senior lenders in providing senior secured debt of sometimes up to an additional 100% value of the equipment for the project. Contractors may also provide capital for services, or trading services for equity; in some cases they may also provide capital alongside a private equity fund.
6. Export credit agencies
Multilaterals and export credit agencies are increasingly involved in mega-projects in the energy sector, and their involvement in a project can be persuasive for commercial lenders.
The export credit agencies of countries in which plant or equipment necessary in the project will be sourced can provide credit support guarantees to the commercial lenders, thereby substantially reducing the risk (and pricing) of the financing of the project. Each ECA has its own requirements and criteria to satisfy in order for their participation.
7. Development finance institutions
Multilateral and development finance institutions may be willing to fund part of the project development costs, especially where there is a direct development benefit to the country where the project is based. Each development finance institution has its own set of criteria, usually including environmental and sustainability requirements, in order for the project to be eligible to receive such funding.
8. Completion support
Completion support is often used in project finance transactions to provide the banks with additional protection. It allows the banks recourse to the sponsor for any financial contribution in excess of the agreed initial equity contribution. It can take many forms, but in each case the sponsor provides the banks with recourse by guaranteeing that the project will be completed by an agreed date.
The requirement for completion support reflects the level of risk associated with the pre-completion phase of a project. Completion support provides support during this phase and so helps offset the risk that the banks will not be repaid.
9. Convertible bonds
Convertible bonds are a form of hybrid security that gives investors the right to convert their bonds into shares of the issuer (or sometimes into shares of another company) during a specific period and at a specified conversion price, usually at a premium to the current market share price of the shares at the time of pricing. On conversion new shares are issued to the convertible bondholders as consideration for the redemption of the convertible bonds. Convertible bonds are a comparatively cheap method of funding, since the annual servicing costs are generally lower than those for plain vanilla bonds because the coupon paid to investors is lower or even zero.
The issuer benefits from being paid upfront for shares which are to be issued in the future. This may be of particular value where an issuer is reluctant to seek funding directly through the equity markets because it feels that its shares are currently undervalued.
Care should also be taken by the borrowing entity that it is not exposing itself to unacceptable risk by accepting significant investment across a range of products from a single investor or a group of investors.
Restructuring and insolvency
If market conditions have such an adverse impact on trading conditions that continuing operations ceases to be feasible, restructuring should be considered at an early stage.
It is important to develop a restructuring plan and to consider a standstill agreement, not least to ensure that the directors avoid the severe penalties imposed in most jurisdictions for trading while insolvent. The restructuring plan may include proposals for repaying creditors, seeking additional funding or security collection with respect to debtors; restructuring or preserving assets for sale. It should also propose financing solutions, such as permitted transfers of assets, share pledges and guarantees, borrowing of super senior tranches, shareholder loans and convertible shares.
History demonstrates that the oil sector is capable of enormous volatility, and can generally withstand the swings in pricing and demand flows. How long the current period of low prices will last is a source of constant speculation, and any resulting ‘momentum investing’ may make price changes even more pronounced. Investment decisions relating to projects where production is envisaged for 5-10 years hence clearly should not be taken on the basis of current prices.
The current climate may also present opportunities for E&P companies (and their investors). Private equity funds have billions of dollars of energy capital to deploy to experienced management teams with strong underlying assets, and as noted in the Political Risk section which can be accessed in the full version of the bulletin, governments’ enthusiasm for continued foreign investment during more challenging times can result in a more attractive energy investment regime. There are a range of options available for those seeking alternative financing solutions, and wherever E&P companies sit on the oil price cost curve, now is the time to review portfolios and revisit service and marketing contacts.