Funding Challenge in Oil and Gas sector
1395/11/17
The oil and gas industry has been experiencing a period of major investment
Dr. Peyman Molavi, Molavi Investment & Finance Academy
The oil and gas industry has been experiencing a period of major investment, with upstream spending topping $700 billion in 2013. 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.
Banking and 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 small to-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.
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.
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 Petro bras 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.
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 on budget 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 off take agreements with credit worthy buyers provide greater predictability around cash flows.
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.
Reference:
http://www.petroleumreview.ro/magazine/2015/dec-jan-2015/31-september-2014/267-funding-challenges-in-the-oil-and-gas-sector-innovative-financing-solutions-for-oil-and-gas-companies
http://www.ey.com/uk/en/newsroom/news-releases/13-08-19---consolidation-expected-as-confidence-in-aim-oil-and-gas-companies-dented
http://www.ey.com/gl/en/industries/oil---gas/ey-at-the-world-petroleum-congress-funding-challenges-in-the-oil-and-gas-sector
http://www.energyglobal.com/upstream/exploration/18082014/oil-and-gas-funding-challenges-1147/
http://www.petroleumreview.ro/en/magazine/2015/dec-jan-2015/31-september-2014/267-funding-challenges-in-the-oil-and-gas-sector-innovative-financing-solutions-for-oil-and-gas-companies