NRF20430 A new reality_living with lower oil prices
1. Financial institutions
Energy
Infrastructure, mining and commodities
Transport
Technology and innovation
Life sciences and healthcare
A new reality: living with lower
oil prices
Introduction
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.
Briefing
January 2015
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Portfolio management
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:
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.
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.
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:
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• 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
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
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
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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.
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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.
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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.
Political risk
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.
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Concluding comments
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.
