What do the changing energy markets mean for raising debt in the upstream oil and gas sector? 

The uncertainty brought about by the pandemic, oil price wars and significantly decreased global demand for oil products during 2020 has highlighted the importance of a flexible and diverse approach to financing. Coupled with this, the continued focus on the energy transition has underscored to companies the importance of robust environmental, social and governance (ESG) measures when seeking access to capital. The pandemic will pass, but ESG will remain relevant. In an industry as capital-dependent as the E&P sector, companies are being forced to adjust to the new pricing environment and to assess their debt financing options.

At the World Energy Capital Assembly on 30 November 2020, a panel of experts from financial institutions and corporates focusing on the oil and gas sector provided their insights into the future of debt financing. In this article we build on that panel discussion and consider how market factors prevalent over the last few years have shaped the financing strategies of E&P companies as well as the approach taken by potential financiers. We also set out our thoughts on the future of financing in the upstream oil and gas industry.

Financing in a Pandemic: Lessons from 2020
During 2020 the market witnessed dramatic decreases in end-customer demand, resulting in lower prices and in turn, dwindling revenues for some producers, requiring many lenders to adopt a more flexible, long-term approach designed to help their clients weather the storm. The banking market is resilient and it has, throughout its history, evolved to withstand both external and internal shocks. Similarly, E&P companies are more accustomed than most to adapting to downturns in the cyclical industry in which they operate. While the current recession does not originate from the financial system, financiers and their clients have still been significantly impacted by the pandemic. Lessons learnt from the 2008 global financial crisis and the 2015/2016 oil price falls have meant that many oil and gas market players were prepared and have been able to adapt quickly to the changing market conditions, in particular by managing their financing portfolios. Capital and liquidity buffers brought in after the financial crisis were tested and the market, once again, proved that it is sufficiently experienced to respond to unanticipated events. The pandemic has simply emphasised the importance of continuity planning and disaster-preparedness.

Generally speaking, during 2020 the upstream oil and gas market saw a decrease in demand for new capital as corporates leant towards more conservative spending strategies, but it evidenced an enhanced willingness amongst lenders to support their clients during these challenging times. Much of the focus in 2020 was on managing existing credit facilities through (among other things) extensions, amendments, waivers, added flexibility for redeterminations and pricing revisions. In an environment of uncertainty concerning debt capacity and pricing, as well as the ability for borrowers to service debt, liquidity suffered but the market recognised the need to adopt a long-term approach during such periods of volatility.

Traditional reserve-based lending remains at the forefront of upstream E&P financing and the general consensus is that this did not change during 2020, nor is the RBL likely to be replaced in its entirety in the longer-term. The RBL is an inherently versatile product; it is built to adapt to underlying shifts and volatility in the market while retaining its core structure and characteristics. The events of 2020 have proved no different; while they did not expose any fundamental issues with the RBL structure, they highlighted that the model is not always geared in favour of the borrower and the increased number of waiver and amendment requests made and granted in the past several months should not come as a surprise. However, once again they emphasised the willingness of many lenders to adopt a flexible approach to redeterminations on the back of shrinking or negative borrowing base cases.

Some E&P companies have found it easier to weather the crisis than others. For instance, some entered the crisis well-armed with all or a significant part of their production hedged. Factors such as the credit rating (if any), size of the corporate, asset base and nature of reserves, diversification, stage of production all have also contributed to their ability to access capital and maintain lines of credit. Importantly, the height of the pandemic proved to be a watershed moment for ESG. While, conceptually, ESG is nothing new, the past year has cemented its central importance in the strategies and policies of all energy companies – the consensus across the industry is that ESG is no longer a “nice to have” but a “must-have” for all energy players, regardless of size or position, particularly those wanting to raise finance.

For companies with a stronger balance sheet, corporate financing and high yield bond issuances have also helped provide much-needed liquidity. Unsurprisingly revolving credit facilities and other shorter-term financing products such as standby facilities, bridge loans and trade and commodity finance have played an important crisis management role during 2020. Products such as prepays and forward sales have also proved useful, including for entities without access to an unrestricted pool of capital, and the commodity trader counterparties have therefore continued to play an important role in funding the junior end of the E&P market. If 2020 proved anything, it was that there was no one-size-fits-all solutions to E&P companies’ financing needs, as companies and lenders came up with creative solutions.

Outlook for 2021: The Future of Financing in the Upstream Sector
Notwithstanding the uncertainties that remain prevalent in the markets, oil and gas remains relevant and will continue to play a vital role in the energy transition, and capital remains available to the industry, especially to companies with a high quality asset base. Capital will be essential to enable companies to fulfil work programmes for existing assets or to finance new asset exploration and development as demand rebounds, albeit at a gradual pace, buoyed in part by hopes of a vaccine success.

Whilst the pandemic has again focused market participants on near-term liquidity levels and the importance of financials, the fundamental financing conditions have not significantly changed. Market experts talk of a shift from more traditional forms of debt to hybrid financing structures. As observed during 2020, it is generally expected that the RBL is here to stay and will continue to fulfil a large proportion of capital needs in the upstream oil and gas sector, with other sources of capital such as bonds, hedging, trade finance and corporate loans being sourced as and when available or appropriate. The potential for a mix between traditional debt finance, alternative debt structures and equity financing also provides oil and gas market players with some flexibility to lay the foundations to develop and mould these structures. Borrowers and lenders alike may favour the risk assessment and allocation model customarily seen in a project financing, as well as the ability to diversify financing portfolios. Notwithstanding this, the stage of development of the borrower’s asset(s) is a key driver in determining the source of capital. Exploration risk and the relatively high probability of failure at this stage mean that an E&P company with only exploration-phase assets is unlikely to access project finance. Likewise, corporate-level borrowing may only be suitable where the company has an asset base comprising a mix of exploration, development and production stage assets, while RBLs by their nature require an adequate borrowing base of proved reserves. However, equity (or quasi-equity) funding may be available from time to time even for exploration-intensive borrowers given the potential return on equity available in a success case.

The shift to hybrid structures is, in part, led by the corresponding transition in underlying stakeholder business models and the nature (and related requirements) of investors. Stakeholders are more likely to be seeking a diversified approach across the energy value chain, rather than focusing on businesses that have a homogeneous asset base. As well as reducing banks’ exposure to risk, it is arguable that diversification to some extent provides an oil company with a more steadfast buffer against changes in market dynamics (whether due to pandemics or otherwise), government policies and consumer and stakeholder pressures. Diversification also provides access to a broader pool of lenders outside of the cohort of financiers focused on the energy sector, and these new players may offer a wider array of products, nuanced and more flexible financing structures, longer tenors and competitive financing.

At the forefront of financing in the upstream oil and gas industry will be the continued focus on the energy transition. Over time and as part of the ESG emphasis we noted in 2020, it is likely to become customary for financial institutions to consider, within their overall assessment of the base case economics, factors such as a borrower’s commitment to its ESG programme and more generally, towards the energy transition (including through the integration of carbon capture technology and less carbon-intensive extraction methods in operations) and the sound management of future decommissioning liabilities, and these considerations will continue to adapt to underlying shifts in the market.

Financiers will continue to require borrowers to demonstrate compliance with ESG requirements. Corporates are therefore advised to adopt an early and meaningful approach to ESG and implement this across all aspects of their business; turning a blind eye now and acting in retrospect could have a detrimental impact on access to (and maintenance and cost of) capital. A detailed discussion of the impact of ESG requirements on financing approaches is beyond the scope of this article, but it is likely that corporates and their financiers will face enhanced transparency and reporting obligations and, without a consolidated set of industry standards, this could be administratively burdensome for all involved. More detailed environmental and social due diligence is likely and this may increase transaction lead times, as well as costs. In addition to continued focus on the environmental impacts of the asset, ESG conditions are likely to trigger reporting requirements and potentially restrictions on how companies should be run and operate. Continued long-term focus on ESG may also benefit borrowers as financiers continue to expand their offering of green- or sustainability-linked products through which margin decreases or other financial incentives are employed to reduce a borrower’s carbon emissions. Borrowers have been asking lenders and other stakeholders for guidance on how ESG is being assessed and what their expectations are. So far, there is little by way of uniformity, although banks appear willing to engage and find ways to help their clients understand what is required for ESG purposes. In the longer-term, pressures from the sector may even lead to financial institutions taking the initiative to develop a uniform set of standards that would apply to their decision-making processes for E&P companies seeking access to capital, and these standards could potentially even be adopted more broadly by other stakeholders, such as shareholders.

As more companies, led by many of the European supermajors, continue to announce plans to shed non-core assets and businesses as they implement their ‘green’ agendas and transition to cleaner fuels and power generation, it is anticipated that M&A activity will revive as independents, juniors and E&P-focused equity investors swoop in, bringing with it renewed demand for acquisition financing.

As the markets shift to favour companies invested in businesses compatible with net zero and carbon neutral goals, experts anticipate that we will start to see a growing number of banks that were previously active in the market moving away from oil and gas. This will create space for domestic financial institutions that have previously struggled to compete with international players, in particular in developing markets where fossil fuels are likely to continue to play a meaningful role in these countries’ development agendas over the coming years. The role of local banks, as well as development banks, is therefore likely to increase and client relations could be key in securing this access to future capital.

Conclusion
The oil and gas industry remains, and will remain, relevant, particularly as the vaccine roll-out in early 2021 brings with it hope of a return to normality in the coming months, and with it, a gradual recovery of demand. E&P companies will continue to require financing to meet development and production needs, whether in the form of traditional RBL products, corporate loans, bonds, high yield issuances, project financing, trade finance, equity financing or other more innovative or hybrid structures. . Fossil fuels remain a key part of the energy transition, and we are likely to witness a rise in M&A activity driven by the transition in the coming months as companies looking for value seek to acquire assets being put up for sale. However oil and gas companies will be under increased pressure to meet (and demonstrate compliance with) an evolving set of ESG requirements. Without a comprehensive standard that is applied across the market, but where there are a broad range of stakeholders with different (and sometimes competing) goals, companies must work with their lenders and other stakeholders to actively define their ESG policies and procedures and implement these across their value chain.

Access to capital, and the nature of the product(s) available, will continue to be influenced by the size and financials of the particular borrower. Nuanced and hybrid financing structures are likely to be developed and tested, in particular where linking pricing or other financial terms to ESG targets. Corporates should focus their efforts on taking advantage of emerging opportunities, whilst mitigating risks and considering their long-term financing requirements.

Lauren and Nadine are lawyers in V&E’s energy transactions and projects team in the London office. Lauren’s practice includes advising on the development and financing of projects in the energy sector, acting for clients on complex projects in emerging markets and across the globe. Nadine’s practice includes advising on international energy projects and transactions, with a strong focus on mergers and acquisitions in the upstream oil and gas sector across Latin America, the Middle East and Africa.

Lauren and Nadine can be contacted at:
https://www.velaw.com/people/lauren-davies/
https://www.velaw.com/people/nadine-amr/