cod project finance

cod project finance

Exploring the Role of Project Finance in the Oil and Gas Industry

1. Introduction to Project Finance

The energy sector as a whole has been at the leading edge of the growing use of this technique. As the world becomes more involved in large-scale projects to underpin long-term supplies of energy resources, the prominence of project finance becomes more apparent. The nuclear industry has used project finance and has played an important part in meeting the world’s electricity needs for nearly four decades. As the price of oil has increased, the development of the reserves of such areas as the North Sea, South East Asia, South America, and more recently Africa and Central Asia, have needed project finance to underpin these investments. Major pipeline projects, huge tank farms, and processing and chemicals plants in turn have been important justifications for new market syndicated loans or the secondary markets in such instruments in the absence of somewhat less clear structural financing arrangements.

Project finance is a burgeoning area of importance and interest not only within finance but in the broader fields of business management, engineering, and economics. Although extensive and widespread, project finance is used in industries that are well as those that are not so well publicized. The oil and gas sector is the world’s largest business in terms of capital spending, and yet project finance in support of development is little known and understood. While this industry is responsible for some of the greatest projects of the twentieth century, the role of project finance as a source of funding does not enjoy any widespread awareness.

2. Key Concepts and Principles of Project Finance in the Oil and Gas Industry

The fundamental reason why project finance is chosen over other types of finance in the oil and gas industry and other capital-intensive industries that are similar is that limited or non-recourse financing, risk sharing, and monetization of the competitive advantages that the investors who are involved perceive at the time of financing and that are inherent to the technical and regional characteristics of the investment have to be achieved. Without loss protection and a corresponding stake in the equity of the project company, which during select circumstances usually leads to controlling influence and management, the absence of these properties means that the risk has not been project-financed and has not been transferred to the investor. So too, no notarial segregation of project cash flows creates obligations on the part of the sponsor to equity the project company up to the investors, and in select circumstances up to its pool of employees, if it fails to perform, which invalidates the financial purpose of project finance.

One of the complex challenges with identifying what makes a financial agreement truly “project finance” is that, superfluously, any financable venture is project finance. This is, however, not strictly true. Very few commercial ventures that are currently deemed “projects,” or “asset-level project finance” are structured in a way that integrates the elements of project finance. Even in the name, there is confusion within the financial industry, let alone with the multitudes of outside stakeholders concerned with when to use project finance. On exploration and production, oil-field services, refining, marketing, and distribution projects, project finance over the last 100 years has been demonstrated to be highly effective where exploration and production is. It has been highly probable as the sole private alternative for larger developments in capital intensive, high risk, and long-term frontier provinces, which have, as a result, lacked smaller independents.

3. Case Studies and Best Practices

Project finance, particularly the development and production aspects in natural resources project finance, confronts the practitioners with numerous conflicting interests and political sensitivities. This presents an ever-present temptation to the project staff to resort to suppliers, equipment manufacturers, transport and shipping providers who deliver tougher products at lower prices. The investor’s opinion often becomes polarized by the potential of early production at lower costs with few impediments. The analysts are presented with conflicting market opportunities with little contribution made legally, ethically, to pressing political or socio-economic market conditions. Headline stories of Burma, Azerbaijan, and Sudan are often accepted as normal requirements for natural resources projects requiring regime and human rights accommodations. This is not a response to such pressure but calls for continued role and adherence to international guidelines and intuitive standards co-financing agencies and OCSE have developed. This standard will increase not only with the economic crisis but also with the ACC.

Case Study: Practicing Ethical Project Finance

Trade financing is a specific application of project finance, particularly in the crude oil industry. A matrix crude oil transaction often involves project financing, commodity swaps, purchase contracts, and distribution of crude, and a variety of production and investment products to develop the relevant oilfield or oilfields. This often requires specialized finance structures, international banking centers, as well as financial instruments. The transfer of the title to the crude is the fundamental basis of purchases and swaps which underpin trade financing.

Case Study: Trade Financing

This section provides case studies which illustrate various aspects of project finance, including practicing ethical project finance and mitigating project finance risk.

Case Studies

In this chapter, we will address case studies of project finance that are relevant to the oil and gas industry, as well as best practices in project finance which are applicable to the oil and gas industry.

Introduction

4. Challenges and Future Trends

Shrinking free cash flow, oil demand, macroeconomic environment constraints, climate change initiatives, and priority actions from supporting zones are set to influence the value and cost of financing sources for both equity and debt. Public equities of global players of the oil economy are already under pressure from alternative business models and exit strategies, and many marginal oil producers are suffering from negative cash flows. Long-dated fixed assets, such as exploration and production infrastructure, refining, gas facilities, and petrochemical and LNG plants, have potential long-term cash flows but also suffer from volatile discount rate fluctuations. The lower bound of the cost of equity may be around 8-9%, the upper bound around 15-18%, but the weighted average cost of capital (WACC) is expected to be around 12-13% on a sustained basis. Long-term weighted average costs of capital start with low levels of equity required return on new opportunities of existing oil and gas projects and are mostly influenced by market risk premia instead of expected average returns, including regulatory actions and changes in the business environment. Premiums for emerging markets, political and related credit risks, and industrial and commercial risks that give rise to financial covenants, the costs and financial practices related to the management of reserves and potential long-term evidence of stranded assets, divorce the market from risk premiums alone, but then oil and gas companies, asset managers, and investors cleverly consider the weighted average cost of capital as a competitive and unifying hurdle rate for strategic direction and risk-adjusted economic performance.

Forty years after the first project finance transaction in the United States, financial innovation brought about different forms of long-term debt to fund projects in addition to nonrecourse loans, leasing, and vendor financing solutions aimed at project needs for medium-term debt and specific types of equipment. Within the context of the commodity cycle and the evolution of oil and gas economic activities, nonrecourse project finance has solidly shown how it provides access to higher leverage ratios, asset arbitrage, and a fixed liability structure. On the other hand, the promoters and sponsors of oil and gas opportunities continue to explore solutions that capture specific project characteristics and sources of cash flow that are able to attract other forms of financing.

The future of project finance in the oil and gas industry will be driven by a number of factors. The most important factor is the expansion of project finance in the Middle East, Central Asia, and other less favorable jurisdictions. In this respect, the increasing tendency of the banking community to get involved in longer-term, more challenging projects will be crucial. However, the establishment and improvement of local financial markets in oil and gas exporting countries, rather than loans and equities syndicated from international markets, can become alternative tools for their financing.