Funding challenges in the oil and gas sector. Innovative financing solutions for oil and gas companies

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1 Funding challenges in the oil and gas sector Innovative financing solutions for oil and gas companies

2 Oil and gas industry faces a major funding challenge The oil and gas industry has been experiencing a period of major investment, with upstream spending topping $700 billion in This record level of investment is set against a backdrop of over the next 20 years to finance its contribution to the world s future energy needs. Despite the industry s immense appetite for capital, compared to other capital intensive industries, it has been relatively conservative when it comes to financial structuring. Oil and gas fund raising US$ billion Equity Bank loans Project finance Bonds Source: ThomsonONE In addition to traditional sources of capital, more creative financing techniques and new sources of finance will help to ensure that sufficient and efficient funding is available to finance projects in the future. In response to heightened political and economic instability, companies have begun to diversify their sources of funding. This has involved a shift from bank-led financing to non-bank and capital markets-based funding. Banking sector appetite for oil and gas investments The last few years can be broadly characterized by a scarcity of public equity financing, combined with corporate credit conditions that were initially tight but are now accommodative. Banks were forced to introduce tighter lending controls in response to new legislation. In many jurisdictions, the process of rebuilding their balance sheets is largely complete. However, caution around risk management and the pressure to deliver an appropriate return has led banks to tighten lending standards, particularly for smallto-medium-sized borrowers. In response, companies have started to access alternative sources of finance, such as the bond market, project partners, private equity and export credit agencies. There is now both more competition for funding and also a wider range of debt and equity providers serving the market. 1 Funding challenges in the oil and gas sector

3 Range of financing solutions has expanded Most companies have in place a corporate revolving credit facility (often syndicated across a number of banks) that gives them financial flexibility for their day-to-day operations. Amid the current negative stock market sentiment towards the industry, companies may benefit from yet more diverse sources of funding. Principal sources of oil and gas funding Exploration and appraisal IPO Private equity Further issues Development and production Reserves based lending Public bonds Retail bonds Project finance Private placement Multilateral development banks Mezzanine finance Portfolio expansion Cash flow from operations Bank loans Public bonds Infrastructure funds Proceeds from divestments Increased predictability of cash flows and business maturity Capital imbalances between independent oil and gas companies Recently, independents have faced greater challenges than their larger peers in attracting financing on reasonable terms. Lenders are looking for companies led by a strong management team with a combination of a good reputation in the industry, quality projects or assets, financial track record and the ability to deliver on promises. Small-cap explorers Almost six years on from the onset of the financial crisis, equity capital market conditions for most small exploration companies remain difficult. There continues to be divergence in the availability of capital within the sector. Companies without cash flows from operations, lacking in scale or with risk concentrated in a single project or country are likely to face a more challenging funding outlook. Companies that are able to deliver, and also communicate, exploration and commercial success will face fewer challenges in raising capital. Companies that have a proven track record and the ability to communicate it can enable investors to understand and price risk, which facilitates investment. Where there are gaps, investment can often be difficult. Equity issuance is often the first or only option for pure-play exploration companies, which lack tangible assets but offer material upside in the event of exploration success. These companies generally have low debt capacity due to a lack of proved reserves and cash flow. Investors took flight from perceived riskier stocks in the aftermath of the financial crisis and confidence, in exploration companies in particular, has yet to fully return. As one indicator of this, the 2013 total funds raised from new and further issues by oil and gas companies listed on London s Alternative Investment Market was the lowest amount for 10 years. Companies experiencing capital constraints are forced to be more innovative as they assess all the funding options available to them. In addition to conventional finance, companies are engaging in higher volumes of farm-out transactions, mergers and loan arrangements with service providers. The ability of the smaller explorers is important to the industry as they are often the source of innovation which is then picked up by their larger peers. Mid-to large-cap independents Independent oil and gas companies are the largest users of reserve-based lending (RBL) facilities. These players typically use RBL structures for development financing and general corporate purposes. However, the covenant light nature of alternative funding sources is attracting companies towards non-traditional sources of finance and away from the bank markets. Bond markets are increasingly being accessed to finance new development opportunities within the mid-cap E&P sector. Recent years have seen some of the highest new issuance volumes in the public bond market as corporates seek to lock in low benchmark rates before the anticipated QE tapering by the US Federal Reserve. Bonds provide capital with fewer continuing obligations than bank loans. Funding challenges in the oil and gas sector 2

4 Oil and gas sector bonds by type Convertible bond, 2.2% Private placement bond, 19.7% Hybrid bond, 0.4% Public bond, 77.7% Source: Understanding debt markets: E&P funding options remain robust, Societe Generale, 14 November 2013, via ThomsonONE.com Most bonds are issued in the public bond market and this will continue to be the case, although the private placement market also provides an important liquidity source. Companies are increasingly using private transactions to place subordinated notes with select investors. The attraction of private placement is around flexibility on maturity and greater certainty around execution. There is potential for the high yield capital market to provide further support to the independent oil and gas sector. The Nordic high yield bond market is a good example of this potential source of higher risk funding for independent E&P companies. Retail bonds are also likely to be more widely used by small to mid-cap companies looking to diversify from traditional bank funding at the same time as extending repayment periods. This could be an alternative option for companies where issue sizes have been too small to access the wholesale bond market. However, there is a risk that if a company publicly states how much it wants to raise and then fails to reach that target, this may negatively impact investor sentiment. Also retail bond demand can be volatile. With many governments seeking to maximize in-country value creation from oil and gas activities, some companies are also looking to access investment communities in the major jurisdictions in which they have interests. A secondary listing of shares on a local exchange makes the company more accessible to the local investment community and helps build local capability. International oil companies maintaining conservative balance sheets For the international oil companies (IOCs), maintenance of an investment grade rating has traditionally been a central pillar of their financing strategy. Typically these companies target a gearing ratio of less than 30%. While hydrocarbon prices remained buoyant, the primary source of funding for IOCs has been the massive operating cash flows they have generated. However, cash flow is not easy to forecast and can be impacted by factors largely outside of a company s control, such as movements in commodity prices. In a flatter price environment and with consistent capital project inflation, operating cash flows are unlikely to fully finance the level of earnings required to cover planned capital expenditure. In order to bridge the gap IOCs are both divesting non-core assets to release capital that can be recycled into higher return areas of the business and seeking to de-capitalize parts of the business that struggle to compete for internal capital allocation. Sometimes this has led to outright exit from traditional components of their value chains. IOCs are coming under increasing pressure from shareholders to curtail capital expenditures and increase their cash returns. In addition to re-examining and reducing their capital programs, IOCs are also pursuing a range of initiatives to further optimize their capital structure. These include operational improvements around the better management of working capital, exit from lower risk/ return assets, forward sales of production, active management of their bond and bank financing positions and further use of structured products. The extent to which these initiatives have been implemented varies widely between companies and also between the different businesses within the IOCs. Large funding requirements for NOCs The national oil companies (NOCs) now often have larger capital budgets than their IOC counterparts. They are now more actively seeking cost effective ways of funding their domestic resource development plans or financing the acquisition of international assets. The scale of their spending obligations means that many NOCs are looking to diversify their funding sources. In the last couple of years, NOCs have been active in local and international debt markets. Partially privatized NOCs are now competing with the IOCs on global capital markets. NOC ownership models have changed, and the likes of Petrobras and Gazprom have reduced the level of government ownership, and to some extent state control over their operations by listing on capital markets. This has opened up access to new sources of financing for domestic and international expansion plans. 3 Funding challenges in the oil and gas sector

5 NOCs took advantage of the rally in emerging market bond markets in the last couple of years, as international investors sought exposure to higher growth Asian markets. CNPC and Petrobras were responsible for the two largest bond issuances in the sector in However, performing on a global stage invites the attention of a new global audience comprised of shareholders, potential partners, competitors, future host governments and capital providers. This audience, to varying degrees, will demand a level of transparency and a level of commitment to international financial, industry and regulatory standards of reporting and accountability. Prepayment transactions are increasingly being employed as a cost effective way for NOCs to obtain immediate funding in exchange for future oil supply from a portfolio of producing assets. The main risk for the lenders is non-performance of contract delivery. These deals have been popular with Russian NOCs, with more interest being shown by NOCs in Asia and Africa. NOCs have also sought opportunities to form joint ventures with the larger, better-capitalized oil companies in international exploration projects. However, for some resource acquisitive NOCs, the tried and tested IOC approach of cost optimization and the possible carve-out of underperforming overseas operations are expected to move up the agenda. Project finance Compared with other infrastructure intensive sectors, such as power and utilities, project finance has been less widely used by the oil and gas industry. The industry is inherently long term in nature which can be a challenge when trying to arrange project financing on acceptable terms. Future revenue streams are typically less stable and predictable in oil and gas projects than in other large-scale infrastructure projects, which may have regulated or inflation linked returns and are not directly exposed to commodity price risk. The logistics, infrastructure and social issues caused by the increased size of projects have made achieving time, cost and quality targets more challenging than ever. The industry s relatively poor recent track record of completing projects on-time and onbudget will test banking sector appetite for lending to the oil and gas sector. The pool of providers also diminishes as the length and size of the funding requirement increases. Project financing has typically been more prevalent in the downstream sector than in the more capital intensive and riskier upstream segment. In 2013, the Sadara Chemical Company JV successfully completed project financing for the Sadara chemical complex in Saudi Arabia. The total raised was approximately $12.5 billion, which represented the largest ever project financing in the Middle East. Some of the proposed LNG export projects in the US have also been successful in attracting project financing from multiple lenders. These brownfield projects typically provide lower construction risk and fewer delays to the completion schedule. LNG projects that are underpinned by long-term offtake agreements with credit worthy buyers provide greater predictability around cash flows. Corporate and project finance considerations Corporate finance Project finance Complexity Typically lower Can be complex Recourse Size Maturity Depth of market Gearing Gives rise to a claim against the corporate balance sheet and uses up corporate debt capacity Borrowing capacity linked to sponsor credit strength Short to medium repayment periods typical, Long-dated capital available Very deep and liquid for investment grade credits Lower levels achievable, debt on sponsor balance sheet None or limited recourse finance projects limited to the project balance sheet and are more highly structured for credit enhancement Variable dependent on structuring and risk profile Longer repayment periods may be achievable Bank markets continue to provide majority of capital. Capital often structured to incentivize refinancing post construction of projects. Infrastructure funds, pension funds and other institutional investors increasingly looking to invest in long dated infrastructure High levels due to structuring and risk allocation. Typically off balance sheet. Funding challenges in the oil and gas sector 4

6 Local content requirements can also make arranging project finance for some oil and gas projects more challenging. Oil companies may need to assist weaker local partners to raise their share of funding and be a lender on the same terms as the banks. Credit enhancement can enable increased support for long-term investment in challenging markets. Export credit agencies (ECAs) have stepped up to supplement the banking sector in an effort to support local firms, with many now offering working capital cover to banks and introducing or expanding securitization guarantee products. The International Finance Corporation (IFC) supports private investment in the oil, gas and mining sector, to help developing countries realize the benefits from their natural resources and to ensure that local communities enjoy tangible benefits. In the year to 30 June 2013, IFC s new commitments in the sector totalled $390 million. While this is relatively very small, their participation in a project can act as a catalyst for other investors and lenders. ECAs and development finance institutions are increasingly providing support for larger transactions. They are becoming more flexible and commercial and are prepared to work alongside commercial banks. Under a new organizational strategy, the three World Bank Group heads will work more closely together to combine grants and concession finance, private sector business investment and investment guarantees. A combination of the International Development Association s partial risk guarantees, long-term financing from IFC and political risk insurance from the Multilateral Investment Guarantee Agency can help to mobilize energy sector investment. Infrastructure investment There is growing interest amongst investment funds in infrastructure as an asset class. Infrastructure investment remains a core objective for many governments as a means of stimulating economic growth. The Europe 2020 Project Bond Initiative, a joint credit enhancement program by the European Commission and the European Investment Bank, is designed to stimulate capital market financing for infrastructure delivered under project finance structures. The liquidity line under the Project Bond Credit Enhancement Initiative will allow projects to achieve a credit rating more attractive to investors. The majority of institutional investors in infrastructure debt are public pension funds, insurance companies and private sector pension funds. The long-term nature of most oil and gas projects might provide a match to the long-term liabilities of insurance companies and pension funds. However, just as Basel III regulations are constraining the ability of banks to lend long-term, EU Solvency II requirements could limit European insurers ability to continue providing long-term funding. Solvency II aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current solvency requirements. Insurers are faced with the challenge of balancing an appetite for greater returns against compliance with new regulations. An obstacle to direct pension fund involvement in infrastructure projects has traditionally been their lack of understanding of the industry and their inability, due to a lack of resources or expertise, to evaluate and monitor such projects. Compared to infrastructure projects that provide more predictable future cash flows, upstream oil and gas projects may be considered to sit at the higher end of the risk spectrum due to the risks of downward shifts in commodity prices and the challenges of increased project size and complexity. In other industries, banks are looking to invest during the construction period of long-term projects with a predefined exit at the end of construction. Insurers are perhaps more likely to invest after the development and construction phases because they have traditionally had a limited appetite for construction risk. 5 Funding challenges in the oil and gas sector

7 Conclusion Across all segments of the industry, opportunities exist to optimize financing to increase both its availability and reduce its cost. In many instances these opportunities are supported by an appropriately priced supply of finance via existing mechanisms and providers. There is significant scope for these to grow. In other areas there is potential to obtain material financing from newer sources but currently there are structural issues preventing this from happening. These usually relate to the inability of potential finance providers being unable to lay off critical risks. There is, therefore, scope for providers of risk management services (including commodity price risk, project performance risk management and insurance) to facilitate the growth of this market. There is also considerable scope for governments and international bodies to support innovation in this area. Exploring the full range of funding options Debt option Benefits Drawbacks Bank loans Most flexible source of short-term debt financing for working capital Capacity constrained except for large investment grade borrowers or short-term borrowing Public bond US private placement Retail bonds Mezzanine finance Reservebased lending Convertibles Moderately geared borrowers well perceived by lenders Flexibility in draw down and repayment profiles Deep and liquid market Less financial covenants than banks Long repayment periods available Benchmark issue lays ground for future issues Flexible maturities available No public credit rating required Flexible maturities available Access to alternative investor base No financial covenants Access to alternative investor base Suitable for pre-producing assets with development capex Flexibility in draw down and repayment profiles Simple to arrange Flexibility in draw down and repayment profiles Suitable for pre-producing assets with development capex Raise debt at a lower coupon rate than on a straight bond Source of finance for companies with a low credit rating and strong growth prospects Pricing, repayment periods and covenants deteriorating Greater ancillary business requirements Public credit rating and ongoing disclosure requirements Minimum deal size of 200m Early redemption costs Financial covenants required Early redemption costs Typically more costly than public markets Bespoke disclosure and documentation requirements Less capacity than public market Bespoke disclosure and documentation requirements Security required Can be complex in structuring Shorter repayment periods than other funding options Refinancing risk Security required Expensive source of finance in the long-term Potential dilution of equity and earning per share The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.

8 About the author: Andy Brogan Andy serves as the Global Oil & Gas Transactions Leader and has been with EY for 25 years. Andy has advised oil and gas companies on a variety of public and private transactions covering both upstream and downstream operations in more than 30 countries. Our Global Oil & Gas Transaction Advisory Services contacts: Anday Brogan Global and EMEIA Oil & Gas Transaction Adivosry Service Leader abrogan@uk.ey.com Jon McCarter Americas jon.mccarter@ey.com Sanjeev Gupta Asia-Pacific sanjeev-a.gupta@sg.ey.com Roger Dartnell Australia roger.dartnell@au.ey.com Ajay Arora India ajay.arora@in.ey.com Kunihiko Taniyama Japan kunihiko.taniyama@jp.ey.com Grigory Arutunyan Moscow grigory.s.arutunyan@ru.ey.com Jon Clark United Kingdom jclark5@uk.ey.com Tabrez Khan Africa tabrez.khan@za.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. How EY s Global Oil & Gas Center can help your business The oil and gas sector is constantly changing. Increasingly uncertain energy policies, geopolitical complexities, cost management and climate change all present significant challenges. EY s Global Oil & Gas Center supports a global network of more than 9,600 oil and gas professionals with extensive experience in providing assurance, tax, transaction and advisory services across the upstream, midstream, downstream and oilfield service subsectors. The Center works to anticipate market trends, execute the mobility of our global resources and articulate points of view on relevant key sector issues. With our deep sector focus, we can help your organization drive down costs and compete more effectively EYGM Limited. All Rights Reserved. EYG no. DW0411 CSG No NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/oilandgas Connect with us: EY Global Oil & Gas EY Global