As smaller players get involved in development and production in the North Sea, commercial banks face a more complex lending environment. While there will be more opportunities for structured finance, there is also a more challenging credit assessment process.

The major oil producers, together with the larger independents, are strong enough to raise corporate loans. Below them are some well-established players that use borrowing base facilities, tied to projected reserves and cashflows from packages of oil fields.

But the UK government has been encouraging the exploration of smaller fields, which has brought a new wave of start-up minnows into the North Sea, backed by private equity or capital raised on the alternative investment market (AIM). The big oil companies have been arguing that the new exploration opportunities in the North Sea are not on a scale that compares with other opportunities worldwide, so a new generation of companies have begun doing exploration, often under short time Promote Licences.

These promoters then bring in operating partners to develop the properties, and are looking for borrowing base financings, perhaps featuring a slice of mezzanine debt.

So in addition to oil reserve estimates, bankers are looking for some familiar names at management level, people who have a proven track record.

"Small exploration companies need to show both contractors and bankers that they are worth spending time on," comments one player. "It is not just a matter of having cash, but also showing that you are a worthy counterparty, and that can be a challenge for smaller companies. And there is a growing necessity for companies to be able to demonstrate to the UK Government that they can fund their obligations pre-development, during development, and after cessation of production."

Targets and tangents

The banks are picking their business carefully. But there is no doubt that the run up in oil prices, combined with the desire on the part of the UK government to ensure that oil and gas reserves are fully exploited, means that there are currently plenty of opportunities for equity, mezzanine and reserve based lending in the North Sea.

Banks such as Barclays, ABN Amro, Bank of Scotland, and Royal Bank of Scotland are all heavily involved in reserve based lending, while the Japanese banks are also coming in as Japanese companies take greater interest in the North Sea. Meanwhile SG has recently set up a specialised reserve based lending team to serve the independents. And US/Canadian investment bank Tristone Capital, which specialises in advisory services in the energy sector, has recently set up an office in London.

"For many North Sea production assets which came onstream in the 1980s and 1990s, the economic decision to invest was made by equity at levels below $20 a barrel, and those production assets are now generating large amounts of cash," comments Simon Ashby-Rudd, executive managing director at Tristone Capital in London.

"Most of the holders of those production assets do not want to sell at this moment in time, so there is currently relatively low liquidity in the market for production assets in the North Sea," he explains.

"On the development side, many companies are reviewing their undeveloped discoveries in the North Sea," says Ashby-Rudd. "If they do not reach their own internal economic thresholds they are looking to sell these undeveloped discoveries, because asset prices are currently attractive. So there is more liquidity in that marketplace than there is in production assets."

"For undeveloped discoveries there is plentiful private equity available – for the right management teams," he continues. "Some companies have also raised capital on AIM and are buying undeveloped discoveries, but the majority of these assets are being bought by medium-sized independents, which are financing themselves with revolving credit facilities."

Banks are also chasing mergers and acquisitions (M&A) business, though it is noticeable that high oil prices have not led to much of an M&A boom, at least not for production assets. And some big acquisitions, for example a recent purchase by E.ON, will simply be done via corporate loan facilities.

"Banks such as ourselves are generally looking for a well diversified portfolio of mostly producing assets, though there may also be some development assets included," says Steve Mills, head of oil and gas at Royal Bank of Scotland in London. "For a single field we would normally look to lend on a P90 basis, but once there are multiple fields there is a portfolio effect, so we may use P50 on some fields, but average out across the portfolio. And for fields in the later stages of their lives there are a lot of historical data available, which may make lenders more comfortable that a lot of the uncertainty has been taken out."

"Super majors and large independents do everything on balance sheet, and even some smaller independents have the critical mass to borrow on their balance sheet, but below them are a sizeable number of companies which use borrowing base loan facilities," adds Colin Bousfield, senior director, oil and gas, at RBS.

At the same time, producers are adapting project structures to the remaining suitable assets. "There are occasionally single field project financings in the North Sea, but most are borrowing base facilities, where banks have full recourse to the company, but the debt capacity is assessed on a continuous basis using classic project finance techniques," says Robin Baker, managing director in energy project finance at SG in London.

"There is now also a trend for UK companies to add international assets to borrowing base facilities," Baker adds. "The banks will take account of whether a company has emerging markets risk in a portfolio, but it may still be easier to do than borrowing separately for each country."

In order to take advantage of the growing demand for reserve based lending, SG is currently setting up a specialised department, primarily to serve the smaller independents, although North America will continue to be covered from Houston.

Merger manna

The spike in oil prices to above $60 a barrel has temporarily slowed down M&A deals, since the price expectations of sellers of production assets have risen dramatically. Buyers are struggling to justify the premium.

But there have been some big deals. In late September E.ON acquired Caledonia Oil & Gas for £420 million ($740 million), giving it stakes in 15 gas fields, and helping it towards a stated goal of producing 15-20% of its customers' gas requirements in-house, rather than relying upon outside suppliers. Caledonia's previous owner was a group of private equity investors led by First Reserve.

"The market is expecting more corporate takeover activity as way to acquire assets," comments one banker. "It is noticeable that some companies are using increased cashflows to pay down debt, and maybe beautifying themselves for a sale. But though there are significant asset changes taking place, a big gas company like E.ON doesn't need our borrowing base facilities."

In August Kerr-McGee sold most of its North Sea oil interests, including current production of 60,000 barrels a day, to Moeller-Maersk of Denmark, for $2.95 billion. As part of the same disposal process, Centrica acquired Kerr McGee's stakes in a number of natural gas fields for £320 million.

And at the end of 2004 Irish energy group Tullow Oil bought the Schooner and Ketch fields from Royal Dutch/Shell and ExxonMobil for £200 million, using an acquisition financing led by ABN Amro and BNP Paribas. The two fields are connected to the Caister-Murdoch pipeline infrastructure, in which Tullow already participated, so it was buying fields to add to its existing production assets. Tullow subsequently refinanced its debt via a borrowing base facility.

This $850 million facility was led by ABN Amro, Bank of Scotland and BNP Paribas, and was well received in sell-down. In addition to the North Sea, the oil reserves backing the facility include Tullow operations in Africa.

Banks have been boosting their margins by including stretch facilities, and by selling oil price hedging products to clients. The stretch element allows sponsors to borrow against a greater percentage of the NPV of the portfolio life cashflows.

At time Project Finance went to press, Venture Production was in the market with a syndicated borrowing base facility, as part of its expansion plans, which include a more intensive two-year development drilling programme. This loan features a stretch element, and though the sub-set of banks willing to do stretch lending is smaller than for senior debt, it was expected to get a good reception in syndication.

A middle way

But most bankers believe that the development of a mezzanine market is going to be necessary for the next wave of North Sea financings.

"We are supporting a number of companies that have a lesser capital base than has been historically the case in the North Sea, and we are putting together mezzanine lines for some clients, to allow them to develop a number of fields simultaneously, which they wouldn't be able to do in a traditional reserve based lending case," comments Alasdair Gardner, head of oil and energy at Bank of Scotland in Edinburgh.

"We see the inclusion of mezzanine tranches as the way forward for the market," Gardner says. "There are some mezzanine funds offering financing in the North Sea, but we think we have an advantage in that we can underwrite both mezzanine and senior debt, so oil company management do not have to negotiate with two separate institutions."

SG subsidiary TCW is one example of a fund manager that is currently offering mezzanine facilities to North Sea developers.

Another potential source of funding comes from Energy Development Partners, which has raised considerable equity for development work, and may be looking for mezzanine opportunities alongside its equity base.

The EDP strategy is to go to an oil major with an undeveloped field, and do the development work for it, paying some sort of royalty once production starts up.

Private equity player 3i took a small stake in EDP when it was set up back in 2003, headed by entrepreneur Larry Kinch.

EDP has raised a considerable amount of equity in the United States, and is already doing additional drilling in a field that BP owns, thus maximising production from BP's North Sea assets. The attraction for the major is that it does not have to commit capital and management resources to exploring small fields, but that it gets to keep some of the upside if production levels outstrip expectations.

The UK Government estimates that over 300 oilfields are lying dormant, because existing players do not have the capital or technical resources to focus their attention on them. Instead they are paying more attention to vast deepwater fields in places such as West Africa and the Gulf of Mexico. Replacing them will be smaller players, and for the banks with the expertise to assess these risks, the returns are likely to be good.