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:
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.
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.
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.
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.
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.
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.
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.
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.
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.
Managing contractor and counterparty exposure
The impact of lower oil prices extend beyond the oil producing companies to an array of oil services companies, suppliers and related infrastructure. In challenging economic conditions and with reduced access to traditional funding, the risk of contractor and counterparty default increases. How well can counterparties and contractors withstand the new economic reality? It would be advisable to investigate the risk of off-taker or counterparty default through rigorous selection, and to include processes for pre-empting any issues in the corporate contingency plan.
When assessing counterparty or contractor default, consideration should also be given to the selection of governing law and the forum for dispute resolution. It is particularly important to ensure that a reasonable forum is agreed, and if arbitration is selected, that the counterparty is a resident of, or has material assets in, a country that is signatory to the New York Convention on the Enforcement of Foreign Arbitral Awards.
Proactively review and renegotiate contractual arrangements
Proactive review of contracts and management of issues in line with contractual rights and obligations can save time and money in weathering the issues that may emerge as a result of changing economic conditions. Establishing whether any contracts should be renegotiated or terminated, and considering the impact of any early termination provisions, will be essential.
Some of the key areas of re-negotiation that may be relevant in helping to shape strategic plans with respect to suppliers and counterparties include provisions relating to:
- Suspension of services, and for what reasons;
- Late payment;
- Penalties, termination and suspension of contract provisions; and
- Consent rights on assignments.
Where there is room for re-negotiation it is worth considering the counterparty’s pressure points in order to reach a better negotiated solution than the original contract would provide.
Early analysis of dispute resolution recourse rights and understanding what potential court action could be taken in relation to a contract breach (and whether court action is available to prevent an anticipated breach of contract) are also key to determining how far to manage non-performance.
Construction projects: mitigating the risk of contractor exposure
Construction contracts are critical to the development of new projects and require careful commercial consideration. Areas of particular concern are likely to be events of default, delay, termination rights and payment on termination, force majeure and change in law provisions. The level of protection afforded by these provisions will need to be reviewed in light of the project’s particular circumstances.
Oil companies should also ensure that they have adequate protection in a construction contract to avoid, or otherwise reduce, the impact of cost overruns or delays occurring during the construction phase.
If the decision is made to suspend or halt construction or operation of facilities, there are steps that oil companies can take to mitigate their exposure to contractor compensation payments.
Initial steps include carrying out a review of all construction contractor arrangements, and entering into re-negotiations where necessary in order to build in flexibility. Areas for re-negotiation include:
- Dividing the work into separable parts, and agreeing a procedure for notices to proceed;
- The ability to omit work from the scope on the owner’s call; and
- Rights of owner suspension, including if possible a pre-agreed schedule of suspension costs.
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.
Shareholder activism, communication and public relations
The expected fall in the share prices of most oil companies brings with it a risk of shareholder discontent. While for the most part this may be par for the course in tougher economic conditions, in some cases shareholder discontent can evolve into shareholders seeking to exit the upstream sector, demanding a corporate sale, and shareholder activism. These activities can be both distracting, as they take up management time, and create a negative perception of the company and the management team.
Given that issuing dividends amid falling share prices is usually illogical, the directors’ main defence against shareholder challenges is in managing shareholder relationships appropriately and effectively. Clear communication of key issues that reinforces a sense of strong leadership is essential.
Alongside the company-specific risks of contractor default, the challenges of finding finance, the need to divest assets and tighten operating margins are also the wider political ramifications of the falling oil price. OPEC’s recent decision not to reduce output contributed to the price of oil touching US$67 at the time of writing, and oil export-reliant countries such as Venezuela, Morocco, Algeria, Russia and Malaysia are likely to suffer disproportionately. While there is no indication yet of these countries taking severe counter measures, equity investors and debt providers will be keen to ensure the efficacy of their political risk insurance. In particular, their concerns will centre around the potential for government action that adversely affects the economic viability of their investments, such as breach of contract, adverse regulatory changes, currency restrictions, inconvertibility and even nationalisation (whether overt or covert).
In general, cost recovery schemes under production sharing contracts start to look more attractive to contractors where crude prices are low and profits scarce, as they give greater assurance to the contractor given that costs are generally recovered before the application of the government take.
Prolonged low oil prices may therefore cause governments to review the basis on which cost recovery is established. In the short term, if lower prices delay payment to the state this may lead to the government looking to amend the pricing structures or the entire basis of the grant of rights in order to achieve a higher return. This has certainly been the case in countries such as Russia where the use of production sharing contracts has been abandoned in favour of risk services agreements that deliver a higher return to the state.
Equally and opposite, if low prices continue and this slows or stops upstream exploration investment, governments may look to alter the cost recovery mechanisms to make investment into their economies more attractive. It is difficult to make generalisations given the range of production sharing contracts and cost recovery schemes in operation, but there is some commonality in the approach taken by a number of governments. Malaysia’s risk service contracts with pricing support mechanisms and favourable cost recovery have encouraged investment in margin fields. This mechanism could be used for less marginal fields where the oil price is low for a sustained period of time.
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 above, 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.