Funding challenges

in the oil and gas sector

Innovative financing solutions for
oil and gas companies

Oil and gas industry

faces a major funding
challenge
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

Oil and gas fund raising

US$ billion

its contribution to the worlds future energy

900

needs. Despite the industrys immense appetite

800

for capital, compared to other capital intensive

700

industries, it has been relatively conservative

600

when it comes to financial structuring.

500

Equity
Bank loans
Project finance
Bonds

400
300
200
100
0

2010

2011

2012

2013

Source: ThomsonONE

In addition to traditional sources of capital, more creative financing

techniques and new sources of finance will help to ensure that
sufficient and efficient funding is available to finance projects in the
future. In response to heightened political and economic instability,
companies have begun to diversify their sources of funding. This
has involved a shift from bank-led financing to non-bank and capital
markets-based funding.

Banking sector appetite for 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 smallto-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.

| Funding challenges in the oil and gas sector

Range of financing solutions has

expanded
Most companies have in place a corporate revolving credit facility
(often syndicated across a number of banks) that gives them
financial flexibility for their day-to-day operations. Amid the current
negative stock market sentiment towards the industry, companies
may benefit from yet more diverse sources of funding.

Principal sources of oil and gas funding

Exploration and
appraisal

Development and
production

Portfolio expansion

IPO

Reserves based
lending

Cash flow from

operations

Public bonds

Bank loans

Retail bonds

Public bonds

Project finance

Infrastructure
funds

Private equity
Further issues

Private placement
Multilateral
development
banks

Proceeds from
divestments

Mezzanine
finance
Increased predictability of cash flows and business maturity

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 Londons 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

Capital imbalances between independent
oil and gas companies
Recently, independents have faced greater challenges than their
larger peers in attracting financing on reasonable terms. Lenders
are looking for companies led by a strong management team with a
combination of a good reputation in the industry, quality projects or
assets, financial track record and the ability to deliver on promises.

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.

Funding challenges in the oil and gas sector |

Oil and gas sector bonds by type

Convertible bond,
2.2%

Private
placement
bond,
19.7%

Hybrid bond,
0.4%
Public bond,
77.7%

Source: Understanding debt markets: E&P funding options remain robust, Societe
Generale, 14 November 2013, via ThomsonONE.com

Most bonds are issued in the public bond market and this will
continue to be the case, although the private placement market
also provides an important liquidity source. Companies are
increasingly using private transactions to place subordinated notes
with select investors. The attraction of private placement is around
flexibility on maturity and greater certainty around execution.
There is potential for the high yield capital market to provide
further support to the independent oil and gas sector. The Nordic
high yield bond market is a good example of this potential source
of higher risk funding for independent E&P companies. Retail
bonds are also likely to be more widely used by small to mid-cap
companies looking to diversify from traditional bank funding at
the same time as extending repayment periods. This could be an
alternative option for companies where issue sizes have been too
small to access the wholesale bond market. However, there is a risk
that if a company publicly states how much it wants to raise and
then fails to reach that target, this may negatively impact investor
sentiment. Also retail bond demand can be volatile.
With many governments seeking to maximize in-country value
creation from oil and gas activities, some companies are also
looking to access investment communities in the major jurisdictions
in which they have interests. A secondary listing of shares on a
local exchange makes the company more accessible to the local
investment community and helps build local capability.

| Funding challenges in the oil and gas sector

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 companys 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 Petrobras 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.

NOCs took advantage of the rally in emerging market bond markets

in the last couple of years, as international investors sought
exposure to higher growth Asian markets. CNPC and Petrobras
were responsible for the two largest bond issuances in the sector in
2013. However, performing on a global stage invites the attention
of a new global audience comprised of shareholders, potential
partners, competitors, future host governments and capital
providers. This audience, to varying degrees, will demand a level of
transparency and a level of commitment to international financial,
industry and regulatory standards of reporting and accountability.
Prepayment transactions are increasingly being employed as a cost
effective way for NOCs to obtain immediate funding in exchange
for future oil supply from a portfolio of producing assets. The main
risk for the lenders is non-performance of contract delivery. These
deals have been popular with Russian NOCs, with more interest
being shown by NOCs in Asia and Africa. NOCs have also sought
opportunities to form joint ventures with the larger, better-capitalized
oil companies in international exploration projects. However, for
some resource acquisitive NOCs, the tried and tested IOC approach
of cost optimization and the possible carve-out of underperforming
overseas operations are expected to move up the agenda.

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 industrys relatively
poor recent track record of completing projects on-time and onbudget 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 offtake agreements with
credit worthy buyers provide greater predictability around cash flows.

Corporate and project finance

considerations
Corporate finance

Project finance

Complexity

Typically lower

Can be complex

Recourse

Gives rise to a
claim against the
corporate balance
sheet and uses
up corporate debt
capacity

None or limited recourse

finance projects limited
to the project balance
sheet and are more
highly structured for
credit enhancement

Size

Borrowing capacity
linked to sponsor
credit strength

Variable dependent on
structuring and risk
profile

Maturity

Short to medium
repayment periods
typical, Long-dated
capital available

Longer repayment
periods may be
achievable

Depth of
market

Very deep and liquid

for investment grade
credits

Bank markets continue

to provide majority of
capital. Capital often
structured to incentivize
refinancing post
construction of projects.
Infrastructure funds,
pension funds and other
institutional investors
increasingly looking
to invest in long dated
infrastructure

Gearing

Lower levels
achievable, debt on
sponsor balance
sheet

High levels due to

structuring and risk
allocation. Typically off
balance sheet.

Funding challenges in the oil and gas sector |

Local content requirements can also make arranging project

finance for some oil and gas projects more challenging. Oil
companies may need to assist weaker local partners to raise their
share of funding and be a lender on the same terms as the banks.
Credit enhancement can enable increased support for long-term
investment in challenging markets. Export credit agencies (ECAs)
have stepped up to supplement the banking sector in an effort
to support local firms, with many now offering working capital
cover to banks and introducing or expanding securitization
guarantee products. The International Finance Corporation (IFC)
supports private investment in the oil, gas and mining sector, to
help developing countries realize the benefits from their natural
resources and to ensure that local communities enjoy tangible
benefits. In the year to 30 June 2013, IFCs new commitments
in the sector totalled $390 million. While this is relatively very
small, their participation in a project can act as a catalyst for other
investors and lenders.
ECAs and development finance institutions are increasingly
providing support for larger transactions. They are becoming
more flexible and commercial and are prepared to work alongside
commercial banks. Under a new organizational strategy, the
three World Bank Group heads will work more closely together to
combine grants and concession finance, private sector business
investment and investment guarantees. A combination of the
International Development Associations partial risk guarantees,
long-term financing from IFC and political risk insurance from the
Multilateral Investment Guarantee Agency can help to mobilize
energy sector investment.

| Funding challenges in the oil and gas sector

Infrastructure investment
There is growing interest amongst investment funds in
infrastructure as an asset class. Infrastructure investment remains
a core objective for many governments as a means of stimulating
economic growth. The Europe 2020 Project Bond Initiative, a
joint credit enhancement program by the European Commission
and the European Investment Bank, is designed to stimulate
capital market financing for infrastructure delivered under project
finance structures. The liquidity line under the Project Bond Credit
Enhancement Initiative will allow projects to achieve a credit rating
more attractive to investors.
The majority of institutional investors in infrastructure debt are
public pension funds, insurance companies and private sector
pension funds. The long-term nature of most oil and gas projects
might provide a match to the long-term liabilities of insurance
companies and pension funds. However, just as Basel III regulations
are constraining the ability of banks to lend long-term, EU Solvency
II requirements could limit European insurers ability to continue
providing long-term funding. Solvency II aims to establish a
revised set of EU-wide capital requirements and risk management
standards that will replace the current solvency requirements.
Insurers are faced with the challenge of balancing an appetite for
greater returns against compliance with new regulations.
An obstacle to direct pension fund involvement in infrastructure
projects has traditionally been their lack of understanding of the
industry and their inability, due to a lack of resources or expertise,
to evaluate and monitor such projects. Compared to infrastructure
projects that provide more predictable future cash flows, upstream
oil and gas projects may be considered to sit at the higher end of
the risk spectrum due to the risks of downward shifts in commodity
prices and the challenges of increased project size and complexity.
In other industries, banks are looking to invest during the
construction period of long-term projects with a predefined exit at
the end of construction. Insurers are perhaps more likely to invest
after the development and construction phases because they have
traditionally had a limited appetite for construction risk.

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.
There is also considerable scope for governments and international bodies to support innovation in this area.

Exploring the full range of funding options

Debt option

Benefits

Drawbacks

Bank loans

M
ost flexible source of short-term debt financing
for working capital

Capacity constrained except for large investment

grade borrowers or short-term borrowing

Moderately geared borrowers well perceived by

lenders

Pricing, repayment periods and covenants

deteriorating

Flexibility in draw down and repayment profiles

Greater ancillary business requirements

D
eep and liquid market

Public credit rating and ongoing disclosure

requirements

Public bond

Less financial covenants than banks

Long repayment periods available
Benchmark issue lays ground for future issues

Minimum deal size of 200m

Early redemption costs

Flexible maturities available

US private
placement

N
o public credit rating required

Financial covenants required

Flexible maturities available

Early redemption costs

Typically more costly than public markets

Retail bonds

A
ccess to alternative investor base
No financial covenants

Bespoke disclosure and documentation

requirements
Less capacity than public market

Mezzanine
finance

A
ccess to alternative investor base
Suitable for pre-producing assets with
development capex
Flexibility in draw down and repayment profiles

S
imple to arrange
Reservebased lending Flexibility in draw down and repayment profiles
Suitable for pre-producing assets with
development capex

Convertibles

Raise debt at a lower coupon rate than on a

straight bond

Bespoke disclosure and documentation

requirements
Security required
Can be complex in structuring
Shorter repayment periods than other funding
options
Refinancing risk
Security required
Expensive source of finance in the long-term
Potential dilution of equity and earning per share

Source of finance for companies with a low credit

rating and strong growth prospects

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY
organization or its member firms.

About the author:

EY | Assurance | Tax | Transactions | Advisory

Andy Brogan
Andy serves as the Global Oil & Gas
Transactions Leader and has been with
EY for 25 years. Andy has advised oil
and gas companies on a variety of public
and private transactions covering both
upstream and downstream operations in
more than 30 countries.

Our Global Oil & Gas Transaction Advisory

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