part 1: project finance
funding gap in an uncertain world
In 2016 the Deloitte Centre for Energy Solutions published a report [1] that predicted an anticipated CAPEX funding gap for the oil and gas industry of around $1Trillion USD by 2020.
In some African countries, oil and gas corporate debt has all but dried up as many indigenous producers took on debt immediately before the latest oil price down-cycle. This consequently put the local banks under considerable stress from which they have yet to recover[2] .
In addition, as we all know oil appears to be in the $50-60 /bbl band with an uncertain future, which puts pressure on independent E&Ps to pay off historic debts and pay dividends before attempting to contribute to field development projects through operating revenue.
While there is an abundance of viable field development projects, the only viable method of finance appears to be one that utilises the anticipated forward revenues of each project. With the emergence of independent E&Ps in West Africa, a “Leveraged Project Finance” (LPF) model would appear to be a potential solution to this lack of funding problem.
a return to Project Finance
In the 1970s UKCS[3] oil fields and US Power generation used LPF solutions to acquire finance on an individual project basis. Various definitions of Project Finance are used but for clarity, a modern definition of LPF cited from HSBC[4] is useful:
“….the raising of finance on a limited recourse basis, for the purposes of developing a large capital-intensive infrastructure project, where the borrower is a special purpose vehicle and repayment of the financing by the borrower will be dependent on the internally generated cash-flows of the project”.
There are significant advantages to leveraged project finance including: –
Off Balance Sheet financing – a Special Purpose Vehicle (SPV) is used to hold the finances and cash-flows and assets of the project. SPVs provide ‘bankruptcy remoteness’ whereby the SPV operates as a distinct legal entity with no connection to the sponsor firm[5] (or License Holder in the E&P case). This ensures protection of the License Holder balance sheet.
Disparate shareholders in project specific entity (SPV) – enables a range of different stakeholders to share financial risk within the SPV, including contractors, equipment suppliers, Project Sponsor (License Holders) and off-takers. This therefore enables the shareholding amongst stakeholders that can best manage the operational risk and undertake the financial risk. In addition this model puts the project completion risk with the stakeholder that is based placed to manage that risk, the execution contractors.
Build-Operate-Transfer project model – the entity that builds and provides finance builds, installs and operates the fixed assets until cost and margin recovery, whereupon the commercial entity holding the assets is transferred to the License Holder.
High leverage – the SPV commercial entity raises debt based on an agreed $/ unit of product repayment profile with the project sponsor (License Holder). The amount of debt that the SPV can raise can be sized on the project revenues (low outcome scenario[6] ) to minimise the risk of default. However in typical LPF models other than oil and gas, the leverage ratio can extend up to 70%. As the cost of debt is traditionally less expensive than the expected Return on Equity the overall cost of capital of the SPV can be highly competitive based on this level of leverage ratio.
An essential factor in raising the SPV debt is the strength of the balance sheet of the shareholders in the SPV and the source of the remaining funds to meet the required project capital.
LPF models offer a high degree of flexibility and enable potential sources of funds and repayment models that would not normally be available to the license holder:-
Volumetric Production Payments (VPPs[7]) to the SPV from the off-taker for a predefined volume of product. This is a separate contract to the SPV and entitles the off-taker to a fixed volume at a discounted price, with no expectation of a shareholding in the SPV. The payment thus allows the project to pass FID as a source of capital, all be it that an agreed volume of product will then pass to the off-taker for no further payment.
Project Sponsor prepayments – as the SPV are remunerated on a tariff basis $ unit of product until repayment, the project sponsor has the option to invest some capital to complete the required capital accumulation.
Export Credit Agency (ECA) support[8] – dependent on the source of the equipment and the jurisdiction of the project ECAs can provide debt[9], as part of a syndicated debt approach to enable export sales of home country equipment.
consortium led LPF enabling project certainty
So what would this look like specifically for oil and gas?
At io we have formulated a “contractor led” version of the LPF model, the characteristics of which include:
SPV consortium members – these include EPIC Contractor, Equipment Provider, Rig Provider with sufficient capabilities to complete the design, fabrication, installation, commissioning and operation of the field development fixed assets. Typically the SPV consortium would offer a “capped” capex model, locking in costs for the license holder, thus putting “completion risk” with the contractor consortium.
SPV raise debt – this is sized using a Reserves Based Lending (RBL) approach to minimise the risk of default from operating revenues for the installed assets. Debt issued by consortium members established “relationship” banks that understand the financial performance of the SPV shareholders which is important in the event of the project revenues turning out less than expected. The implication for the contractors from this sort of LBF model is that only those with the most robust balance sheets are going to be able to convince the debt providers that they have strong enough financial position to cover debt interest payments in the event of project delays.
SPV shareholders risk equity – SPV members use the SPV debt and cash prepayments to manufacture, install and commission the asset. As the leverage ratio is around 70%, therefore the consortium members are typically putting an element of sales value at risk. As the SPV shareholders (contractors) typically undertake “project completion risk” and are held to first production and throughput targets, their equity within the SPV is put at risk as ROE repayment is subject to their execution performance.
SPV repayment – based on a $/bbl or $/mscf charge, this is calculated to enable SPV shareholders to service debt and to recover cost and margins. The repayment of the SPV starts only when operating revenues are available. In the io model there is an additional bonus and penalty applied on top of this based on the contractors performance level (based on first production data and equipment availability). This bonus and penalty is with the purview of the license holder to award, based on monthly determination of a pre-agreed performance scorecard.
the advantages to the io “contractor led LPF” from the perspective of the license holder include:
Puts completion risk with contractor consortium – as the contractors are risking sales value above the debt financing, they will be focused on project delivery and therefore protection of this margin. Additionally as the consortium members are linked by one Service Contract, all the consortium members’ destinies are inter-linked to project success based on first production date.
Provides an alternative source of capital – from a Tier 1 source that can potentially offer a cheaper cost of capital supported by ECAs.
Limits exposure of the License Holders balance sheet – off-balance-sheet financing
Enables contractor repayment only when operating revenue is available – with minimised requirement for up front CAPEX.
Aligns License Holder and contractor risks – if the project is delayed the contractor’s repayment is in turn delayed and as a result they incur additional SPV debt interest payments.
Based on a “capped capex” offer – SPV debt providers will want to see a fixed capex, so the SPV consortium members offer a “capped capex” model to mitigate debt provider concerns, which is in turn advantageous to the license holder as he knows that his CAPEX cannot grow, in turn enabling him to obtain his contribution to the SPV more easily.
At io we have been developing the Contractor Led Leveraged Project Finance Model and have been applying it to field development partnering discussions with a number of West African projects. io have applied the LPF model to subsea, major LNG infrastructure, shared gas infrastructure and brown field re-development projects. io and parents are entering into partnering agreements with license holders based on the io LPF model.
If you have funding challenges for field development or want to make you current funds go further we would like to hear from you.
[1] “Short of Capital? Risk of Underinvestment in Oil and gas is amplified by competing cash priorities – Deliotte Centre for Energy Solutions [2] Nigerian banks suffer from exposure to oil groups – Maggie Fick, Financial Times, April 21st 2016 [3] United Kingdom Continental Shelf [4] https://www.hsbcnet.com/gbm/attachments/products-services/financing/project-finance.pdf [5] http://www.pwc.com/gx/en/banking-capital-markets/publications/assets/pdf/next-chapter-creating-understanding-of-spvs.pdf [6] In oil and Gas the P90 reservoir outcome [7] http://www.investopedia.com/terms/v/volumetric-production-payment.asp [8] http://www.oecd.org/trade/xcred/eca.htm [9] http://www.oilandgascouncil.com/expert-insight/importance-of-export-credit-agencies-in-energy-project-finance-william-breeze-hsf