Striking it rich

With global demand for oil spiralling in the face of limited supply capacity, it is difficult to see how oil prices will come down any time soon. While this is good news for producers, commodity financiers face aggressive competition in a market that shows no sign of cooling. Erika Morphy reviews the sector.

There are many ways to characterise Melrose Resources’s operations, but parochial is not one of them. The E&P (exploration and production) company’s operations span from Bulgaria to Egypt to the United States. So when it turned to Standard Bank to help it push further into emerging markets, the bank constructed a solution in which it leveraged the company’s global reach.

In essence, Standard helped the multinational utilise its success in certain markets by providing it with a multi-jurisdictional facility. This was structured to allow the company to borrow against assets in one location to support operations in another, or move cash from one jurisdiction to another, without having to enter into a new facility or change contract terms.

“It is a much better facility for borrowers like Melrose Resources,” says Terry White, manager of energy finance at the bank, “because it provides inter-jurisdictional liquidity”. The company can take its success in one area and use it in another that may not be performing as well. And if that jurisdiction’s operations turn out to be worse than expected, it has the support of the facility, adds White.

New structure, familiar drivers

Melrose’s facility may be a relatively recent structure (it was completed in November 2004) but the trends driving it are quite familiar. Indeed, little has changed in the competitive landscape for oil finance – commodity finance in general in fact – over the past year to eighteen months. High prices have had and will continue to have a huge impact on both producers and bankers, with more opportunities opening up for corporates. At the same time, increasing financial competition – that is, financial providers eager to get a piece of the commodity business – is driving banks to provide greater credit lines, longer tenors and, as can be seen with Melrose Resources, more innovative structures tailored to meet operating demands.

In general, now is a good time to be a borrower no matter what the industry, particularly in the North American market, says Emmanuel Chesneau, SG CIB’s managing director, commodities finance, Americas. “There is a lot of money chasing fewer deals and pricing is coming down because of it.”

Most financiers that focus on this area expect oil prices to remain high and the banking market to stay hot. In fact, if anything the trends of the past two years will likely accelerate in the near term. Bankers involved in this space are projecting that the equity money that has invested in E&P companies in emerging markets will come to fruition in the coming months – with as much as 20% of these companies making discoveries. Financiers will be tasked with separating the wheat from the chaff, while trying to remain competitive.

But oil finance – an admittedly amorphous reference to a huge area spanning downstream and upstream activities from exploration to production to retail – has always been influenced by more than just the price of the commodity or defined by just the terms of a particular deal.

And the current market environment is no exception: for besides the role prices are playing on development and financing, at the same time there are other trends coalescing in this space. And while they are not as sexy a story as that of prices, each nonetheless is, or will be, or can be, a significant factor to both borrower and lender. The following are just a few – but they are something to think about as oil’s price-per-barrel continues along its skyward track.

At one level the standard structure for oil and other commodity products doesn’t deviate from certain norms: the bank monitors and takes control of future cash flow arising from a commercial contract between a producer and a buyer. However underneath that basic description is a wealth of choices for the participants, thanks in large part to the creativity of banks.

Over the past two years, ABN Amro, for example, has introduced a number of unique ownership-structured products that target many points along the commodity supply chain cycle – from storage to transport. Now it is developing linkages to connect these products together; the end result for customers, according to the bank, is a longer credit line or cheaper finance rate.

Few believe this cycle of innovation – not only on the part of ABN Amro but with other banks as well – will end any time soon.

White says the structure it developed for Melrose Resources is likely to be replicated with other clients. Indeed, he says, such a facility is particularly relevant as more firms in such countries as Canada and the United States use their equity in their developed market operations to not only develop emerging markets’ activities but also – depending on events – vice versa. “The success in an emerging market can be plugged back into the development in a home market,” White says.

Providing a structure that also covers the international assets of a US oil company is, like Standard’s structure for Melrose Resources, a strategy SG CIB deploys to stay competitive in the US oil commodity finance market, Chesneau says. “US banks looking at the same customers would be more reluctant to provide financing against non-US assets,” he says. “But SG as an international bank would be more willing to provide a financing package that includes non-US assets in European and emerging market countries,” he says. “We don’t want to compete strictly on pricing. Rather, we compete by providing innovative structures.”

The role of equity

Perhaps the most interesting by-product of the ever growing availability of equity is not the liquidity it has provided the oil sector – but rather, the fact that its existence has increased the amount of debt available to corporates as well.

Over the past two years, the London-based Alternative Investment Market, or AIM’s, star has ascended in the commodity finance universe. Opened ten years ago, a significant number of commodity producers listed on the exchange in 2003 and 2004, earning billions in financing as a result.

For companies, the additional source of capital allows them to gain a greater foothold in the production spectrum. It also gives the larger firms, indirectly, a subtle edge over financiers. Of course, financing is never a simple either-or proposition, especially as debt is normally less expensive than equity and an equity position means a company must dilute its ownership structure. That said, a company that raises capital in the debt markets could theoretically do the same with a larger listing on AIM.

But from a bank’s perspective the new availability of equity significantly enhances the liquidity of the underlying asset.

“Knowing that there is a very strong secondary market for these assets makes us feel much more comfortable with them,” White says. Basically in the worst case scenario, the equity markets provide an exit strategy.

This, in turn, allows the bank to offer better terms, he says. Also, the liquidity provided by AIM allows the bank to lend a higher percentage against the value of the asset – thus increasing the amount of debt available to the company.

Democratisation (or not) of the Eastern bloc

The former Soviet bloc countries of Kazakhstan, Turkmenistan and Uzbekistan, to name a few, are considered to have terrific reserve potential. The problem – or perhaps to put it more aptly – the reality of the situation is, many of these governments are exhibiting signs of reverting to their old, authoritarian ways.

Yukos, of course comes to mind, although that is more of a special or isolated case. Instead, says one banker, what is more worrisome are the small-scale erosions in freedoms and rule of law.

“Yukos definitely had a chilling impact on investment in Russia,” the banker says. “It brought people back to reality.” Prior to what happened with Yukos, he says, the market had become overheated in response to what was an aggressive run on Russia – especially considering what stage it was in its corporate governance development. “Now firms and bankers are more cautionary, which is healthier,” the banker says.

At the same time, there is still a “fair amount” of tolerance on the part of financiers for this erosion, the banker says. “Banks are very sophisticated about political risk so they tend to look at the Yukos position as a Russian issue in general and an issue about Mikhail Khodorkovsky in particular.”

If anything, in the equity markets there is increased tolerance for country risk in emerging market plays. These companies that at one time would have been viewed as extremely high risk are merely seen as high risk now. “Shareholders are a lot more accepting of political risk now than they were five or ten years ago,” the banker says.

The bottom line? There are warning signs emanating from the governments in some of these countries, but the debt and equity markets haven’t reacted to them yet, the banker concludes.

Meanwhile for corporates the watchword is caution. That and establish good relationships in the country as well as contingency plans.

Standardisation of contracts in emerging markets

Oil exploration and production in emerging markets is a risky endeavor – starting with the contract stage.

“Rules change,” says Andrew Derman, partner, with Thompson & Knight, which represents both nationally and privately-owned oil companies in South America, Asia, Africa, and the Middle East. There is always a risk of doing business with a government in an emerging market, he says, as such governments are more inclined to suddenly change the rules affecting operations. Unpleasant surprises can range from expropriation to a new VAT or royalty tax.

The biggest problem for companies, he says, is deciding whether the government representative that signs the contract actually has that authority. “We often have to do significant research, examining the country’s constitution and subsequent delegation of authority, to decide if this person’s signature would be valid.”

He tells of one instance in which he was negotiating with a top minister in an Eastern European country. “At that point, the minister said he could sign, but I didn’t see that he had the authority.” Eventually, Derman says, the president of the country abdicated Congress and thus was empowered to act executively and legislatively. A signature by a delegated authority at that point, he said, he viewed as law.

While such angst will never completely disappear, financiers report that many of these countries are moving towards a normalisation of contract terms as well as making other nods to international law.

“There is a general movement towards production sharing contracts or production sharing arrangements in emerging markets and these contracts tend to be more stable,” White says. “It is quite an interesting development.”

A steel of a deal

Oil is not the only sector experiencing capacity problems. Steel has been plagued with production limitations in recent years as well – so much so that four separate steel managers recently found themselves banding together in order to solve the problem.

In a £3.6bn deal, the four – Duferco Group from Switzerland, Marcegaglia from Italy, Grupo Imsa from Mexico and Dongkuk Steel from Korea – committed to investing in, and subsequently being able to purchase the steel slab surplus produced by Corus’s Teesside plant, Teesside Cast Products.

Corus had wanted to sell the Mexican-based plant, White & Case partner Paul Marchand explained. White & Case represented each of the four companies separately in the joint transaction.

The four companies “wanted to secure a fixed supply of steel slab and Corus wanted to sell the business. But the problem with selling a business is that you have to take control of it and deal with the problems of running it”, he says. None of the four wanted to become actual owners of the facility.

The solution, Marchand said, was to negotiate four separate agreements but all on the same terms with Corus, who will remain in control of, and run the facility with the goal of providing product to the four investors.

“Duferco, Marcegaglia, Grupo Imsa and Dongkuk are happy because they avoided having to buy the business and take on its liabilities,” Marchand says. “Corus is happy because it secured a commitment for its capital expenditures.”

Under the terms of the agreement, the four receive 78% of the plant’s output. In addition, they have contracted to fund around 73% of the expected $100m of capital costs anticipated at the plant during the next ten years, potentially increasing annual output from 3.4 million tonnes to four million tonnes.

The total deal, which closed 7 January, is valued at approximately £3.6bn and is spread over ten years.