Financial Roadmap of an Independent’s Asset
Finance theory is based on a very simple principle: Reward is a function of risk. In other words, when comparing two investments—two “assets”—the riskier one should serve a higher return (yield) than the other.
A fair and efficient market is, by definition, a market that serves an adequate level of return for a given level of risk. The reality of finance is obviously somewhat different, and even though we understand the definition of a transparent and efficient market, we still have not witnessed a pure and perfect market. This is probably where finance and geology meet: Neither is a pure science.
Although we all know our stated equations, we struggle in our everyday job to approach the perfect system (be it a financial or a hydrocarbon system). Even though risk/reward theory can be challenged (as evidenced by the abundant number of academic papers addressing the inefficiency of the market), it remains a powerful paradigm to understanding the basics of finance, how funding flows into the oil and gas business, and ultimately how money is made available to companies exploring, appraising, and developing oil and gas assets.
Financing Assets and Companies at an Early Stage: The Equity Stage
From an investor’s point of view, an asset’s life cycle can be simplified into four main stages: exploration, appraisal, development, and production (Fig. 1). Every stage carries its own intrinsic risks and therefore attracts different investors.
Investing in an asset starts with the exploration and appraisal phase. Typically, the asset is still very immature. A company might own an exploration license and a few km2 of seismic. Even though it is early in the life cycle, management is already looking for further funding. It’s time to meet the “equity investors.”
During the exploration and appraisal phases, the developer will be able to raise financing mostly through the equity channel. Equity investors are generally aware of the limited success rate, but are very keen to play the game nonetheless. In these phases, investors will focus on the potential of the asset. For instance, a recent study of international independent exploration and production (E&P) companies highlighted an average drilling success rate of around 35% for wells bearing commercially recoverable hydrocarbons.
Similarly, Schlumberger concluded that two out of three wildcat wells in frontier environments are unsuccessful. Nevertheless, investors know a commercially successful well can generate massive revenues that will largely cover their costs, and they appreciate that independent E&P companies can offer higher shareholder returns. For instance, stock market analyses have shown that the E&P sector has recently overperformed market indexes in difficult times. US independent E&Ps in 2010 were providing shareholder returns of 41.5% year on year, while the Dow Jones Index was yielding 11% during the same period. On the UK market, for the same period, the main index grew by 5%, whereas UK independents were growing by 13%.
Equity Funding the Early Stage: Big Risk, Big Returns
An equity investor willing to play the appraisal and exploration game is likely to be funneled through two main channels. On the private side, the investor will bring funds into a company in exchange for not-publicly traded shares that generally represent a fairly illiquid security. The process is generally done “over the counter” at a price negotiated between the company and the investor. Most independent E&P companies will use this route at first, attempting to gather a group of sophisticated investors with sufficient fire power to finance the early stages of exploration. At this stage, management is very likely to represent a significant part of the shareholding.
On the public side, the investment is done through a stock market. Listed securities are by definition more liquid and investors are generally free to sell at any point. E&P companies generally do not go to the stock exchanges at first; they usually strengthen the management, build the “equity story,” polish the message to investors, and improve their understanding of the asset prior to launching an initial public offering (IPO).
Raising money in an exchange, however, is an extremely powerful tool and can seriously increase the pool of liquidity for a company. But it does carry a fair amount of work—governance, transparency, regulatory obligations, and the like. Some of the most successful independent E&Ps have managed to go through this channel and listed their company (Fig. 2).
Companies will generally be listed after a couple of years, during which they establish an exploration and appraisal track record and become operational. For instance, when Kosmos went for its IPO in 2011, it had gone through significant changes since the 2003 step-in of two large private equity funds. In 8 years, the company managed to discover a world-class asset, funding its development through nonrecourse financing such that it was successfully listed on the New York Stock Exchange (NYSE) shortly after first oil.
Development and Production Stage: The Funding Mix
When the exploration and appraisal phase is successfully completed, the asset matures into the development stage. Investors will expect an asset to reach the development stage when the field development plan is approved (a regulatory event) or the final investment decision, “FID,” is taken (a sponsor decision). The project’s financing generally morphs during this time, as operators begin to look for debt investors rather than equity investors. In other words, instead of offering a “piece of the pie” to investors in exchange for capital, operators look for loans to fund the project.
At this stage, investors believe key uncertainties about the reservoir have been cleared and that the asset does bear commercial amounts of hydrocarbons. They consider the residual risk to now lie in the construction execution and the production technology selected. Success of the project will transition from being dependent on geologic data interpretation to becoming a function of the capacity of the engineering procurement and contracting team, and the contractual strategy between the oilfield services company and the sponsor. This type of risk will attract investors from a wider horizon and represent a larger liquidity pool. An important number of banks might be keen to provide debt funding at this stage. As an example, liquefied natural gas developments might attract up to 75% of debt 3 or 4 years before first gas is produced.
First oil or gas demarcates the beginning of the production stage, during which the level of risk continues to reduce significantly as the reservoir becomes better understood and operations are up and running. In turn, these milestones can attract a larger diversity of debt investors (such as banks and funds). Indeed, the debt market has proved over the last decade to be a strong supporter of the oil and gas industry. As debt financing focuses on discovered and appraised fields, it allows the operator to further develop and/or leverage world-class assets.
Contrary to equity investors who focus on performance and tolerate volatility in exchange for probability of upside, debt holders generally expect a steady, predictable flow of revenue, or fixed income. The flow of revenue is usually an interest rate based on the cost of risk-free assets (much like government gilts in the UK or T-Bills in the US) and includes a risk premium reflecting the strength of the borrower. Unlike equity holders, most debt issuers have to have a long-term horizon.
Debt investors could actually grant a loan to an independent E&P for more than 5 years, and they will have to work together, with limited opportunity to exit before the end of the facility. Therefore, debt holders will generally base their valuation on more conservative and longer-term assumptions. In other words, when granting a 5- to 7-year loan, a bank will check that, under a conservative long-term oil price scenario, the asset will have the capacity to repay the value of the loan plus interest.
From Theory to Practice: Impact of the 2008 Crisis
Since 2008, the funding market has changed. After 10 years of relatively easy access to funds, the market shrank considerably within a fairly short period. Beyond the macroeconomic impact, the repercussions felt by independent E&Ps were very much a function of their assets’ development stages and the trust built between investors and the management team. During challenging times, markets generally experience a “flight to quality” whereby companies with a reasonably proven basis still manage to attract funds but companies overweight in pure exploration suffer from a scarcity of resources. Investors are likely to back companies with the best management team, superior assets, and best-in-class track record and in turn reduce their exposure to riskier companies.
Crises like the one in 2008 separate independent E&Ps into two major types. On the one hand, growing independent E&Ps that were overweight in assets at an early stage with little-to-no production became more and more inversely leveraged to oil. In other words, they became subject to a double negative impact: an increasing cost of drilling and development, with direct competition from producing assets, together with a funding market becoming more and more risk averse and selective.
On the other hand, E&Ps benefiting from asset portfolios with existing production bases still enjoyed reasonable access to funds. For example, E&P independents Kosmos Energy and Tullow Oil managed to tap both the equity and the debt market for significant amounts. Tullow managed to complete a USD-72.3-million secondary listing on the Ghana Stock Exchange in July 2011 and comfortably sits on USD 3.95 billion of debt facilities (out of which USD 730 million were drawn during the first half of 2011). Kosmos, in turn, managed to raise around USD 600 million on the NYSE and secured a USD-2-billion debt facility in early 2011. It would appear that current debt and equity markets are not closed for business; nonetheless scarcity of capital has forced key players to invest more selectively and to re-focus on their core businesses/clients.
Beyond the jargon, funding markets reflect a simple asset analysis: equity in the early stage followed by debt, with some hybrid instruments in between (such as convertible and mezzanine). As demonstrated by the market over the last 3 years, E&P independents are facing new challenges as they are forced to go beyond understanding what tools are available at each development stage and now have to entertain a network of investors ready to back them during good as well as more difficult situations.
Therefore, the constant challenge for independent E&Ps is less to get the magical sources of funds, but rather to identify which market to access or which investor or bank is likely to understand its business and be available to be mobilized at each stage of development. In other words, to maximize value for its shareholders, the management of an independent E&P will have to regularly “beat the street” to source the most profitable source of liquidity for each stage of its development.
Marc de Saint Gerand is a director in Standard Chartered’s oil and gas project and export finance team. He focuses on structuring and advising on project finance and limited recourse financing in the oil and gas sector, with a dedicated focus on liquefied natural gas. De Saint Gerand previously worked with the European Bank for Reconstruction and Development and with Merrill Lynch’s Energy and Power team. He started his career as an economist at Total’s Gas and Power division in the company’s Paris headquarters and in Doha, Qatar. De Saint Gerand holds an MS in public affairs from Sciences-Po and graduated from the HEC Paris School of Management. He regularly teaches petroleum economics and project finance at Institut Français du Pétrole (IFP School) and Sciences-Po Paris.
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22 July 2019
29 July 2019