Nicholas Watson in Prague -
The credit crunch and lower oil prices have forced oil companies, both big and small, to become much more innovative in their financing methods.
Small oil and gas companies, which typically rely on borrowed capiÂ¬tal to fund the production part of their business, have suffered parÂ¬ticularly badly from the shortage of credit. But international oil comÂ¬panies (IOCs) and large producing nations have also been forced to shelve energy projects; even though IOCs and producer countries have built up substantial cash piles in recent years, most large-scale energy projects are still funded by project financing, which, difficult to arrange in the best of times, is proving especially problematic at present.
The precipitous decline in global project finance is illustrated by the latest figures. According to DeaÂ¬logic, a provider of investment banking analysis, the first quarter saw the volume of global project finance fall by 43% from the year-earlier period to $40.4bn. The oil and gas sector accounted for 8% of that volume, which included the $2bn reÂ¬serves-based refinancing for UK-listed oil and gas independent Tullow Oil.
The first quarter followed a banner year for project finance in 2008, when the biggest project-finance deal on record - the $20bn raised to finance phase two of Russia's Sakhalin 2 oil and gas development - helped push up overall oil and gas sector project financing by 142%, to $76bn. As a result, the oil and gas business accounted for 24% of total global project finance in 2008, which Dealogic said reached $315bn - up by 13% from 2007.
But with Western banks now more reluctant to participate in project financing as they struggle to cope with the effects of the global finanÂ¬cial crisis, some of the slack is being taken up Islamic finance.
Islamic finance, meaning transactions that comply with Sharia law and do not involve usury, is certainly not new to project finance, but its role has increased as the conventional banks that have dominated this arena have pulled back. "Gulf banks were, for decades, treated dismissively or plainly ignored in mega-billion-dollar energy investÂ¬ment deals. However, that environment has changed to the point that Islamic loans now take a larger allocation of local energy projects, alongside the more active regional banks," notes Justin Dargin, a reÂ¬search fellow at the Dubai Initiative of Harvard University in the US.
Outside the Middle East, China, with $2 trillion in foreign reserves and a sovereign wealth fund worth an estimated $200bn, is also proving to be a generous partner for cash-hungry oil proÂ¬ducers as it tries to secure energy supplies to feed its still-growing economy.
On April 17, China announced its fifth loan-for-oil deal in little more than two months by agreeing to lend $5bn through state-owned China National Petroleum Corporation (CNPC) to the national oil company of Kazakhstan, KaÂ¬zMunaiGaz (another $5bn will go to the DevelÂ¬opment Bank of Kazakhstan to stimulate the diversification of that country's economy). The $5bn will be used jointly to purchase MangisÂ¬tauMunaiGaz from Indonesia's Central Asia PeÂ¬troleum, the second such joint arrangement between the two comÂ¬panies after CNPC acquired a 67% stake in PetroKazakhstan, while KazMunaiGaz took the remainder.
However, this loan-for-oil deal was dwarfed by February's $25bn transaction under which the China Development Bank agreed to lend $15bn to Russia's Rosneft, the state-owned oil firm, and $10bn to the Russian pipeline monopoly, Transneft, in return for 1.1bn barrels of oil to be produced over the next two decades from fields in eastern Siberia that are under development. Rosneft says it will receive $10bn this year and the remainder in 2010. The 20-year loan has a five-year grace period, under which only interest payments are made, while the interest is linked to Libor. "The loan effectively solves any funding problems that the comÂ¬pany may have for a long time at a very cheap interest," says Oleg Maximov of Russian investment bank Troika Dialog.
The oil will be piped to China by a spur that is being built from the East Siberia Pacific Ocean (ESPO) oil pipeline, which Transneft beÂ¬gan to construct in April; according to the intergovernmental agreeÂ¬ment, the pipeline should be completed by the end of 2010. The Rosneft loan is somewhat ironic: the deal was negotiated by Igor Sechin, Russia's deputy prime minister and chairman of Rosneft; Sechin is widely thought to have orchestrated the Kremlin's attack on oil company Yukos because he was worried about a plan by former Yukos owner Mikhail Khodorkovsky to build a privately owned pipeline to China from the firm's Yuganskneftegaz oilfields, which were seized and transferred to Rosneft.
The three other deals agreed by Beijing since February were a $10bn line of credit to Brazil's state-controlled Petrobras for future supplies; a $4bn loan to Venezuelan state-owned PdV; and a $1bn loan to African oil producer Angola.
For oil and gas firms operating in Central and Eastern Europe, anÂ¬other big source of funding filling the gap left by risk-averse commerÂ¬cial banks are the multilateral lenders, particularly the European Bank for Reconstruction and Development (EBRD). In April, the EBRD said it doled out a record quarterly amount of €1.1bn in the first three months of the year, which was 64% more than in the same period of 2008. This growth is set to continue; the development bank predicts it will lend at least €7bn this year, compared with €5.1bn in 2008. "We are seeing generally across the region, whether it's the more advanced countries or less advanced, increased demand for financÂ¬ing," says Nandita Parshad, director of power and energy at the EBRD. "We find ourselves being drawn into a number of projects where origiÂ¬nally the idea was to have funding from commercial banks, but, at the 11th hour, the commercial banks weren't there."
Kevin Bortz, the EBRD's director of natural resources, says oil and gas companies approaching the bank generally fall into two main catÂ¬egories: those whose businesses had "outgrown" the EBRD and were sourcing finance from commercial banks until the crisis struck; and those involved in energy security, such as gas storage, which has beÂ¬come an EU priority since January's gas dispute between Russia and Ukraine caused gas supplies to Europe to be cut. "It's coming down to those two cases: working with some of our older clients who were maybe doing less and less with us, by stepping in and helping with their financing when the commercial banks aren't there; and secondly, dealing with energy-security issues, which have become more important," says Bortz.
The most recent example is Russian oilfield services provider InteÂ¬gra Group, which turned to the EBRD in April to help organise $250m in long-term funding in order to restructure its balance sheet. Despite the financial crisis, the EBRD still managed to syndicate $175m of the loan to eight international and local commercial banks.
One oil and gas explorer that has noticed this step-up in lending is UK-listed Aurelian Oil & Gas, whose managing director, Frank Jackson, said he recently received a call from the EBRD out of the blue. "It was curious, because I went to them about a year ago and asked for a meetÂ¬ing, but I didn't get in the front door. And now here they are asking me for a meeting - there's a turnaround in that marketplace," he says.
The EBRD's preparedness to lend - to companies of all sizes, it claims - results from the need to ensure sufficient oil and gas supÂ¬plies are available. Says Bortz: "If the markets aren't there suffiÂ¬ciently, the EBRD is very happy to step in and provide those loans to oil and gas producers. We have historically, since the early 1990s, worked with different upstream producers, some of them very small, some medium-sized and some large."
Junior oil companies such as Aurelian have been particularly badly affected by the crisis, because while the development of a discovered field can be financed with a mixture of equity and debt, small firms typÂ¬ically have to fund exploration work from either cash or bank loans usÂ¬ing any reserves in the ground as collateral. But given adverse condiÂ¬tions on financial markets, secured lending using reserves has been squeezed or has simply become too expensive. Industry players say that where previously they would expect to finance 80% of exploration work using secured project funding, they would now be lucky to get 50%.
With IPOs and secondary offerings of eqÂ¬uity basically off the table, that leaves more innovative methods such as rights issues, where a company offers new shares to existing shareholders in proportion to their existing stake, respecting their pre-emption rights.
The price at which the shares are offered is usually at a discount to the share price, which gives investors an incentive to buy the new shares. If they do not, the value of their holding is diluted, but the rights are tradeable securities in themselves - a sort of short-dated warrant. This allows shareholders who do not want to purchase new shares to sell the rights to someone who does. Whoever holds a right can exerÂ¬cise the right to buy a new share by a certain date at a set price.
The advantage of rights issues over traditional share offerings right now, says Francis Kucera, a partner for the law firm LinklatÂ¬ers with responsibility for capital markets in central and eastern EuÂ¬rope, is that as well as being a less complex process, and cheaper to execute, the shares are offered to investors already conversant with the company and its operations. "The rights go to existing shareholders first and, in an environment where people are risk averse, the view is that people who already know the company and are exposed to it are more likely to invest if the pricÂ¬ing is right, rather than trying to attract new investors," says Kucera.
If a company has to issue shares, advises Aurelian's Jackson, it is best to approach other explorers. "It takes people in the industry to know what value they're looking at."
Farm-in agreements, which are used extensively during normal times as a way of spreading the risk of exploring by bringing in other invesÂ¬tors, are now being used as a means to raise capital and derive greater value from assets than a company would by selling shares at the parent company level. A recent example occurred on May 5, when UK-based Rift Oil said it had reached a deal with an unnamed multinational oil company to fund the $15m-18m cost of drilling up to four wells in PaÂ¬pua New Guinea. The announcement sent its shares soaring by 31%, although admittedly they remain around a lowly Â£0.08 - a sign that the market is still not placing much value for exploration assets.
The market's risk-averse view remains similarly frustrating for other small companies, constraining their liquidity and causing fundÂ¬ing problems: "We're sitting at around the Â£0.16 a share mark, but the underlying assets of our portfolio are worth well in excess of a pound," sighs Jackson.
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