Author: Jonathan Gregson

Sector Report: Oil and Gas

Uncertainty in the oil and gas industry over future prices is forcing global banks to look harder for potential funding opportunities.

With global energy prices hitting new peaks, and all the indicators from the futures market saying they will stay up there in the foreseeable future, it would be reasonable to expect a wave of investment in new projects and corresponding demands on the commercial banks and capital markets.

Yet so far investment activity has been subdued.While there has been plenty of activity among the oil majors in the bond markets, it has been aimed primarily at restructuring their balance sheets rather than at raising additional capital to increase production. Moreover, it has been accompanied by practically all the majors—and a good slice of the independents— using their exceptionally healthy free cash flow either to pay down debt or to buy back their own shares.

While many commercial banks would be only too happy to take part in financing viable projects, the opportuni-ties just aren’t there. Given the tightness of global energy supplies, from crude production through to refinery capacity, this standstill situation remains something of a paradox.

The main reason why there is so little activity at present is that nobody is sure which way energy prices are headed in the longer term.As Leo Drollas, chief economist at the London-based Centre for Global Energy Studies, puts it, “Things are pretty evenly divided between those who argue we are entering a new paradigm of high prices because we’re already hitting peaks of production and not discovering new oil, and those who say we’ve been through this before back in the early 1980s, when inflation-adjusted prices were the equivalent of $90 a barrel in today’s money, and that prices will come back once OPEC softens its line and temporary refining capacity restraints are made good.” A greater degree of unanimity on future spot prices is necessary before long-term investment decisions can be taken.

Drollas believes the majors haven’t been investing as much on the upstream side as they should have been commensurate to the current high prices, though this may be because they are “opportunity- constrained outside OPEC.” Even where there have been major investment programs, in West Africa or US offshore fields, this has not been as much as might be expected, and mostly it is being funded by the companies’ own free cash-flow

Cost Reductions Begin to Pay Off

Another reason for the coolness in demand for bank finance, according to John Martin, managing director, integrated energy, at ABN AMRO, is that cost-reduction improvements implemented in previous years are now coming through. “The companies themselves have sufficient liquidity to make their current investments,” he says. However, he believes that the timing lag with prospective new investments means there will be a call for large funding programs in the future.

For the time being, the main action on the bond markets is being generated by the majors’ extending maturities on existing debt “in what is a very attractive market,” says Martin, pointing to BP’s recent $1 billion-plus balance sheet restructuring program. Exploration and development is mainly self-financed, except among the sub-investment-grade independents, which have seen another round of private placements accompanied by mainly short-term bank financing. Some independents in the US have been tapping the bond market, and Martin believes that successful mid-size European companies, such as Cairn Energy, which currently rely on bank finance, will soon be accessing capital markets.

“As a rule,” says Robin Baker, managing director of energy project finance at Société Générale (SocGen), “the banks are happy to finance the development rather than the exploration stages.However, with current oil production there’s not much of that business around,” he explains.“The situation with natural gas is much more interesting, with demand growing steeply on the back of economic growth, especially in Asia, and some degree of fuel substitution,” he says.

Russia’s oil and gas industry, which already contributes more than 40% of the country’s GDP, has by far the greatest potential for expansion of any non-OPEC country and is currently in the process of restructuring its financial base in order to meet the challenges ahead. Traditionally, the massive state-owned monopolies such as Gazprom and Transneft have depended mainly on domestic banks and financial consortia to meet their funding requirements. The larger energy companies all have their own inhouse bank—Gazprom’s wholly owned subsidiary Gazprombank, for instance. Russia’s largest privately owned energy company, LUKoil, which accounts for some 20% of Russian production and is currently sitting on the secondlargest proven reserves of any oil company in the world, has a controlling interest in Bank Petrocommerce. Funding was typically short term or, in the case of large integrated projects such as Sakhalin 2 or pipeline extensions, project-financed with the support of multilateral organizations and export credit agencies.

All that is changing, with Russia’s oil and gas majors extending maturities partly through refinancing deals with Russian banks and, more importantly, by tapping international capital markets. Gazprom led the way with its record-breaking $700 million eurobond issue late in 2002 followed by a further $350 million three-year issue last February, with the state-owned pipeline monopoly Transneft and pre-Yukos merger Sibneft following suit. The energy giants’ house banks have also been tapping the capital markets, with Gazprombank’s recent $300 million four-year eurobond issue yielding 7.25% heavily oversubscribed, while Bank Petrocommerce successfully placed a $100 million eurobond last January. Western oil majors and bankers are looking to expand their presence in Russia, though. The oil companies are making the move for strategic reasons, while the banks see the prospect of healthy margins combined with increasing security—especially now that Russia is nudging toward being re-rated as investment grade. But within the oil and gas industry there remain many potential pitfalls. Even BP, the most successful of trailblazers in Russia through its $14 billion TNK-BP joint venture, now finds itself in disagreement with its partners Alfa and Access/Renova over when they can cash in the $3.75 billion of BP shares pledged to them over the next three years. Meanwhile, Total has indicated its interest in buying a stake in Sibneft as part of a long-planned joint venture, though this would be contingent on the successful unraveling of the abortive Yukos-Sibneft merger.

Lending opportunities for Western banks are still limited, as Russia’s oil and gas majors continue to raise most of their funding through domestic banks at what are now negative real interest rates, though international involvement is necessary for larger, infrastructure-style projects. Kevin Bortz, director of the European Bank for Reconstruction and Development’s Natural Resources Department in charge of oil, gas and mining activities, explains, “With such projects we lead the financing and provide the political umbrella, being careful to structure it so that commercial banks will be comfortable with the terms.” Russia is the most exciting prospect at present for funding energy projects, the main constraints being legal and contractual uncertainties, which hopefully will be clarified in the near future.

LNG’s Popularity Grows

Liquefied natural gas (LNG) is popular partly because it offers flexibility over pipeline gas in delivery to markets offering the best price. “Major LNG projects have got a lot cheaper in terms of investment per unit of output,” says Baker. “Because of their size and complexity these are usually joint ventures with the national state-owned company that can be project-financed.” The new Egypt LNG project with offtake mainly to France, on which SocGen is advising, is a good example of this.Another is the project-financed deal for additional LNG trains in Trinidad.

Structured Lending Retains Role

“There is some project-based or structured lending going through,” says Simon Byrne,ABN AMRO’s head of oil and gas for greater Europe and Africa. The $12 billion Sakhalin 2 development in Russia’s Far East, led by Shell and Japanese partners, is the largest integrated project of its kind ever and is supported by a broad consortium of banks. New LNG projects in Nigeria (which has announced it will ban flaring), again led by Shell, are going ahead.

The sheer scale of such integrated projects requires the lead to be taken by robust sponsors supported by export credit agencies. “One recent development,” notes ABN AMRO’s Martin, “is that the sponsors are now raising money under the same terms as the banks, so it is not subordinated and ranks pari passu with the external debt raised.”With the larger,multi-billion-dollar deals, the structured financing is becoming ever more complicated—especially with the recent pipeline projects in Azerbaijan- Turkey and the Baltics, where several national governments are involved.The financing of pipeline extensions to feed into the growing European market for natural gas is becoming trickier as a result of consumerist-led EU moves toward spot energy markets. As Robert Paterson, energy partner at PricewaterhouseCoopers Corporate Finance, puts it, “Given the direction of EU regulation and the movement away from long-term contracts, there is a real issue as to how such large long-term projects can be financed in the future, as the banks tend to require a greater degree of certainty.”

Baker at SocGen, one of the lead banks on the Azerbaijan-Turkey pipeline, is more sanguine, arguing that provided there is sufficient security of cash flow and a deep enough market to take up a large throughput, then at least some of the pipelines currently being discussed can be financed. “The European market for natural gas is sufficiently large to move in the direction of spot price indexing,” he says. However, he points out that a prerequisite for applying index-linked pricing in European gas markets to financing new pipelines would be that those spot markets were already sufficiently deep, which is not currently the case. For the immediate future, the financing of major pipeline networks will depend on most of the gas being supplied on a contractual formula basis.Without that degree of comfort, the necessary bank financing is unlikely to be forthcoming.