Compared to other infrastructure intensive sectors such as power and utilities, limited recourse and non-recourse project finance is less widely used for upstream oil and gas.
Upstream oil and gas is capable of, but doesn't always lend itself to being project financed. This is because project finance lenders look for stability, and future revenue streams are typically less stable and predictable for oil and gas projects than for large infrastructure or utility projects, which may have regulated or inflation-linked returns.
Oil and gas projects can face substantial logistical, infrastructural and social issues and the industry's track record of completing projects on time and on budget is not necessarily favourable.
The strength of the security package and practicalities of enforcing this security is a key concern for lenders, as stepping into a partly-developed project is rarely, if ever, an attractive proposition.
Other factors lenders will weigh up when deciding whether to finance an oil and gas development include:
- The quality of the resources and reserves;
- The technical complexity of the project;
- The track record of the management team;
- The likelihood in cost overruns and delays in achieving commercial production; and
- The political and fiscal stability of the project's host jurisdiction.
DFIs and ECAs
Banks provide the majority of the capital in project financing arrangements, but increasing pressure on banks to maintain their capital ratios can curb their willingness and capacity to provide the long-term finance often required to fund the development of oil and gas projects.
Development finance institutions (DFIs) and export credit agencies (ECAs) have a role in supporting such transactions, and are becoming more flexible and willing to work alongside commercial banks.
ECAs use loans, guarantees or insurance to promote the export of a country's goods, rather than supporting individual exporters, but their participation in a particular sector gives comfort to other providers of finance.
However, in recent years, pressure on ECAs to align themselves with national and international climate change obligations has made it more challenging for them to support fossil fuels. In the UK, an Environmental Audit Committee report in June 2019 recommended that UK Export Finance should end support for new fossil fuel projects by 2021, and align its work with achieving Net Zero emissions by 2050.
DFIs active in oil and gas sector include the pan-African Africa Finance Corporation (AFC); the World Bank-affiliated International Finance Corporation (IFC); and the European Bank for Reconstruction and Development (EBRD), owned by 69 countries, the EU and the European Investment Bank.
DFI involvement in a project reduces associated political risk, given the standing of DFIs and their relationships with governments, but typically comes with strict requirements for compliance with environmental and social standards.
Mid-to-large cap independents are among largest users of reserve based-lending (RBL) facilities, and tend to use these structures for development financing and general corporate purposes.
RBLs enable companies to raise debt across a number of assets at various development stages and allow borrowers to retain a degree of operational flexibility.
The structure of RBLs in longer-standing North American markets differs those financed internationally.
Key features of RBLs in an international context
- Commercial banks make funds available to cover capex, opex and development costs for specified assets and for general corporate or working capital purposes. Drawings may also cover refinancing of existing debt, including bridge finance, or financing of acquisitions.
- Available loan commitments usually fluctuate on a six-monthly basis by reference to the "borrowing base amount", calculated using the most recently delivered banking case covering each of the included oil and gas fields. This typically identifies the net present value (NPV) of future cash flows from each field, taking into account their current status (producing, non-producing or undeveloped). As commodity prices fluctuate, so do does the available loan commitment, as this will feed into the determination of projected revenue. RBL lenders will only consider proven (P90) and probable (P50) reserves (not possible (P10) or contingent reserves) and will assess the extent to which projected production figures allow the borrower to service its debts.
- Banks usually require loan tenors to match production profiles, as lenders seek full repayment by the earlier of the Reserves Tail Date (the point at which the amount of oil gas left in the reserve is equal to or less than 25%), or a short-to-medium term maturity of 5-7 years.
- Typical financial coverage ratios are:
- Loan life cover (the ratio of the NPV of projected net cash flows for the period of the loan, to the outstanding amount of the loan);
- Project life cover (the ratio of the NPV of projected net cash flows for the period (typically) to the date on which field costs are greater than revenues, to the outstanding amount of the loan); and
- The debt service cover ratio (cash flow available for debt service (CFADS) to the debt service requirement in the calculation period).
- A robust security package will typically be required by the lender, covering:
- Secured project accounts, through which revenues are to pass in accordance with the payment waterfall;
- Security over borrower shares and borrowing group assets (licences, joint operating agreements (JOAs), production sharing agreements (PSAs), project documents, insurances and hedges).
- There will also be a fixed amortisation schedule and prepayment of cash (a cash sweep), to the extent that the outstandings of a loan facility exceed the borrowing base amount.
- Often, a lender will stipulate detailed provisions on the borrower's ability to add or dispose of field assets on which the borrowing base is founded, subject to various conditions being met such as provision of security and ability to service debt.
The main types of production-based financing are:
- Pre-export financing (PXF);
- Prepayment financing; and
- Streaming and royalty arrangements.
A PXF, at its simplest, is a loan secured against receivables. The producer enters a financing agreement directly with the lender, and is the borrower for accounting purposes.
The producer also enters a contract with a third party offtaker, who pays for production directly into a collection account, the proceeds of which, or a portion of them, are automatically applied to repay the lender.
Lenders take a security package, including an assignment of the benefit of the offtake agreement, a charge over the proceeds of the collection account and quasi security in the form of guarantees to mitigate against production risk.
The main advantages of PXFs
- Strong offtakers have better credit rating than producers, as they are often located in more favourable jurisdictions, which mitigates a lender's commercial and country risk.
- PXFs are considered by banks to be a form of secured financing, although no physical security is taken over the producer's tangible assets.
- PXFs provide cash that would otherwise be unavailable, by opening up a wider group of lenders.
- PXFs enable borrowers to keep lenders on board, who may have exhausted unsecured borrowing limits with producers.
- PXFs are usually structured offshore and so are attractive to lenders because this mitigates against country risk and, in many cases, currency control repatriation issues.
- Producers must have a bankable offtake contract to secure a PXF – typically, these contracts are expected to exceed the duration of the financing and not be terminable or capable of suspension (the creditworthiness of the offtaker is also taken into account by lenders).
- Commodity price and currency risks may affect lenders' decisions and/or the producer's ability to repay the loan, although hedging can mitigate these risks.
- PXFs only work if there is reasonable certainty regarding production and delivery of the product (production risk), which is affected by factors such as technical capabilities and competing demands on production (producers can issue performance guarantees to mitigate against these risks in part).
- Legal structuring risks – including jurisdictional factors such as central bank approvals, the ability to grant security over accounts, local requirements to repatriate export proceeds, export controls, sanctions, change of law risk and environmental liabilities – can also hinder access to PXFs.
Prepayment financing is where finance is provided to a borrower to pay for goods in advance of their delivery.
So where PXF is a loan secured against receivables, a prepayment facility is effectively a sale and purchase arrangement, where a producer receives an advance payment (essentially a loan) against a commitment to deliver a fixed amount of product in the future, typically priced on a benchmark basis with fixed discounts or premiums.
Unlike PXF arrangements, the direct provider of finance to the producer is not usually a bank, but rather a commodity trading company.
Prepayment clauses and agreements
The trading company makes advance payments to a producer, which may be documented via an advance payment clause in a contract of purchase and sale, but more frequently in a prepayment supplement or prepayment facility agreement between buyer and producer.
These agreements set out more fully terms on which advance payment is to be made, reimbursed and other terms such as representations, warranties, covenants, events of default and cover ratios, similar to a loan agreement.
Reimbursements are generally made by way of delivery of the commodity to the buyer – the invoice value of the delivered product in a given period (usually one month) is deducted from the reimbursement instalment due at the end of the month.
Where there is a shortfall in the value of commodity delivered, the outstanding amount for the period usually has to be repaid in cash.
The buyer may take security over the producer's assets, shares or rights under contract to secure reimbursement obligations, similar to under a PXF or RBL. The key collateral from the lender's perspective, however, will usually be the rights of the buyers under the prepayment agreement and the commercial contract with the producer.
The lenders will also wish to benefit directly or indirectly from any security granted by the producer in favour of the buyer.
The structure of the prepayment agreement may or may not involve hedging arrangements and there may or may not be a collection account. This can depend, among other things, on local currency control regulations.
Where the buyer is set up as a special purpose vehicle (SPV), which can be the case where, for example, there is more than one trading company participating in the financing and they wish to have a common vehicle, there will usually be a final offtaker and the financing structure will look quite similar to a PXF.
Where the buyer is a commodity trading company, there won't necessarily be any final offtaker.
Advantages of prepayment facilities
- Prepayment facilities are similar to PXFs, the main difference being the central role of the buyer (typically a trading house) in the financing; for bank lenders, such buyers could be preferable to a producer as a counterparty, particularly where producer is located in an emerging market.
- Trading houses, particularly large trading houses, may be seen as representing acceptable credit risk to banks, who may have large funding lines available to them.
- Prepayment structures can also reduce country risk (in a similar way to PXFs) in emerging market contexts, as the trader/SPV is located outside the producer jurisdiction.
- Prepayment finance can also be compatible with credit insurance taken by the ultimate lender on underlying producers.
- Large trading houses can provide a full package of debt funding, long-term offtake, marketing arrangements and, in some cases, equity financing.
- Trading companies generally work in partnership with banks and other funding providers on prepayment financings. They can borrow from their own funding providers on a full recourse basis, in which case the trading company will usually have more freedom to structure the prepayment financing as it sees fit; or, they can borrow on a limited recourse basis, in which case the ultimate lending banks or funding providers tend to scrutinise the financing structure more closely.
- One disadvantage of prepayment facilities from a producer's perspective is that the debt funding tends to be intrinsically linked to the offtake, so if the offtake falls away, so does the debt funding.
- Offtake terms are not always as attractive as in cases where the financing and offtake are not connected – sometimes the cost of funding will be embedded in the pricing of the purchase.
- Prepayment financing is not a solution in and of itself to development financing, but has to sit alongside, or be provided after, development financing, because the appetite of prepay funders for construction/development risk may be limited.
Streams and royalties
These tend to be more complex financing arrangements.
Streams, in particular, are generally tailored financing arrangements negotiated on a case-by-case basis and can combine elements of equity, debt and even derivatives.
Royalties tend to be somewhat simpler, although whether a funding arrangement is termed a 'royalty' or a 'stream' is up to the participants.
Main characteristics of streams and royalties
Both royalties and streams provide an entitlement to cash payments, usually determined by reference to the amount of oil and gas production from a specific field, multiplied by the percentage of the entitlement agreed by the parties.
They tend not to result in any ownership of the underlying oil or gas field and therefore are not subject to the risk of cost overruns or opex costs. As such, they are not equivalent to an operating interest, but are rather an economic interest.
Typically, these types of agreements provide some exposure to commodity prices, reserves and production upside, but can also provide downside protections against those variables, depending on how parties decide to structure arrangements.
Streams are often agreed where the oil or gas company has a funding need, whereas royalties can arise on inception of a project and can be as simple as a licence fee for the right to exploit concessions, or underlying mineral rights.
Streams can include credit-like protections, such as security interests, often ranking second behind the security interests of a revolving credit facility (RCF) lending pool or bondholders.
Streams are sometimes marketed as being attractive from an accounting perspective, because they can be structured in a way so that they are treated as income, rather than financial liabilities.
They are also attractive because they give producer access to diversified source of funding, meaning producer not solely reliant on banks or the capital markets.
However, like prepayment financing, streams and royalties are not a development finance solutions by themselves and typically sit alongside another form of funding in a package.
Nordic (or Norwegian) high-yield bonds have become an increasingly popular option for financing upstream oil and gas projects in the past five years.
The typical size range for a Norwegian high-yield bond is Norwegian Krone (NOK) 100 million (£8.5 million) – NOK 3 billion (£260 million). Larger issues are rare and more complex, and those seeking issues with a value above NOK 3 billion tend turn to US markets.
Main characteristics of Nordic bonds
Investors in these bonds are typically Norwegian institutional investors and large family offices, as well as US, Asian and, to a lesser extent, other European investors.
Nordic bonds are mostly denominated in NOK but are quite flexible and can also be denominated in other currencies – most commonly USD and EUR (and sometimes GBP).
The bonds are based on standard loan documentation but can be and are commonly tailored for oil and gas issuers, as these often require specific covenants and carve-outs from the standard documentation.
With respect to covenants, Nordic bonds are different to New York high-yield bonds in that Nordic bonds are typically structured around maintenance covenants, rather than incurrence covenants.
Oil and gas bonds are senior secured, junior unsecured, or project finance-specific, with covenants tailored to the type of issue.
The tenure of Nordic bonds tends to be 4-5 years (although there have been issues for 3 years and 7 years).
It is possible to structure inter-creditor issues with RBLs or other bank facilities, and bonds may be issued for oil and gas projects at any stage of development between and exploration and production (inclusive).
Independent verification of reserves and resources may be required for marketing purposes, but are not required for legal purposes nor for listing bonds with denomination of €50,000 or more, and there is no requirement for an annual statement of reserves or similar, once bonds are listed.
Why Nordic bonds are attractive
Issuing bonds does not require heavy due diligence or 10b-5 exercises (or similar) and no formal credit rating is required.
Bonds marketed and issued based on an agreed term sheet and company presentation (the term sheet may be finalised based on pre-sounding of possible investors).
There is no requirement to produce an EU offering prospectus, although a non-regulated information memorandum may be requested by managers for first-time issuers or issuers which are not listed on a regulated market.
The total time from launch to funds received is shorter and the cost considerably lower compared to, for example the New York or Eurobond markets and the process of listing bonds on the Oslo Stock Exchange is relatively straightforward and cost-efficient.
The standard bond loan agreement (modified with terms from term sheet):
- Is to a large extent Loan Markets Association (LMA)-based, but are very LMA "light” (the template bond agreement has approximately 40 pages);
- Security documentation is typically governed by applicable local law affecting assets to be secured;
- Amendments typically require a 2/3 majority among voting bonds.
Changes to loan agreements can easily be discussed on a confidential basis with Nordic Trustee prior to approaching the investors and no single investor has legal action rights (the trustee acts on behalf of the investors, through a no-action clause).
Read a brief Q&A on Nordic bonds and RBLs.
This article is based on a webinar hosted by Fieldfisher and Schjødt entitled "Oil and gas financing in a period of sustained low commodity prices" (please follow the link to access a recording of this discussion on Youtube).
For more information on financing upstream oil and gas projects, download Fieldfisher's updated guidance paper "Financing Upstream: From the conventional to the alternative", visit the oil and gas pages on the Fieldfisher or Schjødt websites, or contact Paul Stockley (Fieldfisher – oil and gas) Oliver Abel Smith/Dougall Molson (Fieldfisher – finance) or Geir Evenshaug (Schjødt – Nordic bonds).
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