Structured service
Companies that own and operate capital intensive equipment used by
oil companies for the development of oil and gas fields at offshore
locations ? often referred to as ?contractors' ? typically offer
such equipment to oil companies under operating lease contracts for
a certain period of time, including operational services. The
contractors own the equipment and make substantial investments in
the construction or acquisition of it. Technology is essential and
most contractors have their own engineering capabilities to develop
and adjust their equipment. Examples of such companies are
operators of FPSOs (Floating Production, Storage and Offloading
vessels), offshore drilling contractors, and offshore pipe-laying
and/or sub-sea installation companies.
The assets:
Offshore equipment suitable for structured debt financing ideally has a global employment market and a proven performance track record. Most FPSOs and floating drilling rigs (semi-submersibles and drill ships) qualify for these requirements. Pipe-laying vessels and other specialised ships and barges may qualify as well. The value of assets in their own right (i.e. independent from the company owning the assets) reduces reliance by the debt provider on the corporate credit profile of the contractor owning the assets and creates access to different types of debt financing.
The location:
The offshore oil and gas market has a global profile both in terms of the home country of the contractors, the location of the field developments and the home country of the oil companies involved. Leading contractors originated from the US (drilling), Norway (drilling and floating production), The Netherlands (floating production), France (pipe-laying) and Japan (floating production). Major offshore field developments can be found in the North Sea, the Gulf of Mexico, Brazil, West Africa, South East Asia, and Australia. Oil companies from around the world are involved in offshore field developments, often in co-operation with the host country's national oil companies.
The key players and their roles
The below schedule shows the interrelationships between the contractor, the debt provider and other parties relevant to arranging the debt financing for the contractor.
1. The equipment is constructed by fabrication yards for delivery to the contractor.
2. The contractor leases the equipment to oil companies and provides operational services.
3. The debt provider provides financing to the contractor.
4. The debt provider obtains an assignment of the construction contract.
5. The debt provider receives (part of) the lease payments for the contractor's equipment for repayment of the debt.
In reality the interrelationships described above are often much more complex and may involve several parties.
Elements of structured debt financing
Depending on various factors, including the credit profile of the contractor and the type of assets involved, the following elements of debt financing offshore oil and gas service companies can be identified:
Charter based financing
If a contractor has obtained one or more charter contracts for its equipment, financing can be based on advancing the future payments under such contracts. The charter contracts will then be the direct source of repayment of the debt. Charter based financing has the following characteristics:
? Contracted fixed day rates: Payments due under the contracts are typically defined as a fixed amount of USD per day payable during a minimum period of time. This means that income under the contract is not impacted by the level of oil prices or the actual volume of oil recovered, which is a major source of comfort to debt providers. Minimum contract periods can vary from a couple of months for a drilling rig to drill a number of wells, to 5-10 years for an FPSO to operate on a large oil field. Most suitable for charter based financing are the longer term contracts. Long term contracts are less common for drilling rigs than for FPSOs. The tenor of an FPSO contract is generally equal to the minimum expected economic life of a field on which the FPSO is contracted to produce, while drilling rigs are generally used for shorter periods of time on a single field (up to 1 year). Oil companies only tend to charter drilling rigs for longer periods of time when they expect the supply of rigs to fall short of demand, or when they need to ?sponsor' the construction of a certain type of rig which may otherwise not have been built.
? Performance risk on contractors: Charter payments are normally subject to the performance of the equipment in accordance with pre-agreed specifications. The operational track record of the contractor is therefore of key importance to the debt provider. In addition, substantial expertise is required to judge whether the contract terms include adequate provisions for maintenance and periods for repair in case of equipment failure (so called ?downtime?). Over the past years most contractors have shown satisfactory operating performance and even where equipment failed, oil companies tended to allow the contractors cure periods beyond contractual provisions and did not terminate contracts, mainly because it was difficult and/or expensive to find replacement equipment. In particular FPSOs, which are always up to a certain level tailored to a specific field, are difficult to replace. Drilling rigs are less tailored to specific operations and the risk of oil companies replacing rigs with others if they do not perform well is somewhat higher. Banks seem to have become relatively comfortable with performance risk on contractors over the past couple of years.
? Credit risk on oil companies: The charter payments made by the oil companies are the primary source of repayment, and the risk of payment default by the oil companies needs to be carefully considered. Smaller, highly leveraged or less cost-efficient oil companies may for example be vulnerable to low oil prices, disappointing field performance or political developments in certain countries. In the case of FPSOs however, comfort can be derived from the economics of the underlying field in its own right. In the same way as the value of the equipment reduces reliance by the debt provider on the contractor, the value of an oil field on which an FPSO is producing reduces reliance by the debt provider on the oil company, as it could be replaced by another oil company. For drilling contracts this is less obvious as drilling rigs are usually not dedicated to a specific field for longer periods of time.
Construction financing
Contractors generally require debt financing to be provided when equipment is still under construction. Construction periods may take up to two years and during such period major milestone payments have to be made to suppliers and fabrication yards. As long as equipment is under construction, uncertainties remain as to the ultimate cost required to complete the equipment, the remaining time required for completion, and as to whether the equipment will ultimately comply with the required specifications. Many projects have experienced cost overruns and delays which have made debt providers quite reluctant to accept construction risk on offshore equipment, in particular where the contractor may not have sufficient financial resources to withstand such overruns and delays. The following factors could play an important role in improving confidence:
? Sub-contracting strategy: The contractor typically assumes the responsibility for turnkey delivery of the equipment to the oil company. Subsequently contractors try to shift this responsibility as much as possible to subcontractors. However, this can only be done effectively if the project specifications delivered to the subcontractors are sufficiently detailed and not subject to further change. This seems only achievable after extensive and detailed front-end engineering of the whole project. A number of so called ?fast track' construction projects undertaken in the past were based on less detailed front-end engineering and relied on subcontractors' flexibility to incorporate design changes during the construction process, which proved to be less cost effective.
? Project interfaces: Inherent in constructing equipment to be used for offshore oil and gas services is the integration of different engineering disciplines, including marine technology and oil and gas drilling and processing technologies. The interfacing of these technologies requires very specialised expertise and is essential for avoiding cost overruns and delays. A number of projects undertaken under the responsibility of contractors lacking or partially lacking such expertise have incurred substantial delays and cost overruns and sometimes even permanent technical shortcomings.
Acquisition financing
Besides constructing equipment, contractors can also acquire equipment from other contractors or from oil companies who wish to dispose assets. The current trend of consolidation in the oil and gas industry in general is also experienced in the offshore services industry, and contractors use the acquisition of companies or assets as a means to keep up with the pace of growth. In addition there is a tendency of oil companies to return to their core business, including the sale of non-core assets like the equipment that can also be owned and operated by contractors. The selling and buying of drilling rigs (so called ?asset plays?) has been quite common for many years. More recently the market has also experienced an increasing number of FPSOs changing ownership. The following issues need to be dealt with by debt providers in the context of such acquisitions.
? Fast execution required: As is the case in acquisition financing in general, funds have to be made available to the seller within a certain time frame which is normally a relatively short period of time. This means that acquisitions are typically financed by means of a temporary debt facility, or bridge financing, until a more appropriate and permanent facility has been put in place. If the ability to put in place a permanent facility is uncertain, for example due to market risk, then provision of bridge financing requires careful consideration of possible fall back scenarios.
? Acceptance by the oil company: Equipment sold from one contractor to another while it is being leased to an oil company, generally requires the consent of the oil company for such change of ownership. The oil company obviously wishes to be comfortable with the new owner and operator of the equipment which it is leasing. Part of the consent process is likely to require the involvement of the debt provider, as the oil company is to be made comfortable with the security position that debt providers may take over the equipment. The seller may have a different credit profile and a different type of financing arrangements in place than the buyer and this may be viewed as an unwelcome change by the oil company. Although charter contracts generally require oil companies to be reasonable in giving their consent to a change of ownership, negotiating conditions for such consent can be quite challenging.
Residual value financing
To the extent that payments under existing charter contracts are not sufficient to fully repay the debt, the debt provider is financing the residual value of the equipment. Residual value can be realised (i.e. converted to cash for debt service) by extensions of existing contracts, by obtaining new charter contracts, or by sale of the asset. For different types of equipment, different approaches to determining residual value can be identified:
? FPSOs: Minimum contract terms of FPSOs are generally based on the anticipated production profile of the field that the FPSO will operate on. Oil companies prefer to limit the minimum contract term to the field's P90 profile, which is the production profile that can be estimated with 90% certainty. P90 profiles can however be as short as 3-4 years, while the economic life of an FPSO is typically 15 years or longer. After a period of 3-4 years the FPSO should therefore have substantial residual value, which can be realised by obtaining new charter contracts. However, FPSOs are to a certain extent tailored to the specific characteristics of an oil field, and it will be uncertain how much needs to be invested in the FPSO to make it suitable for operation on another field under a new contract. The FPSO may require modifications to its oil processing systems due to different oil characteristics, or may need expanded gas compression or water injection facilities. The value of the FPSO under new contracts is therefore difficult to estimate. More comfort is likely to be obtained from extensions of an FPSO contract already in place. As the minimum contract period is based on the P90 profile, there is a 90% chance that the actual production will be higher and that the contract will be extended. In addition, while an FPSO is operating on a certain location, other fields may be discovered in the area around the FPSO which can be relatively economically connected to the FPSO (so called ?tie backs?) and which can improve the probability of contract extension even further. Experience over the past years shows that FPSOs generally remain much longer under contract than their minimum contract term. The probability of extension of existing contracts has therefore become a key determinant of FPSO residual value risk for debt providers.
? Drilling Rigs: As stated above, contract terms of drilling rigs can be as short as a couple of months while their economic life is 15 years or longer, and in many cases even up to 30 years. Unlike FPSOs, drilling rigs are not at all tailored to specific fields and can be used on any field within the limitations of their general specifications like water depth and (in some cases) environmental circumstances and regulatory requirements in certain areas. Drilling rigs have to some extent even developed as a commodity type of asset with market day rates for certain types of rigs operating in certain areas. Statistics on utilisation levels (the average percentage of time that rigs are under contract) are available as well. This makes determining the probability of extension of a contract for a specific rig difficult, as any rig can normally be replaced by another rig with similar specifications. The day rate and utilisation statistics are therefore more commonly used by debt providers for estimating residual values, although market rates have been extremely volatile over the past years, driven by the forces of demand and supply. The demand for drilling services follows the price of oil as drilling (in particular exploration drilling) is less attractive for oil companies during periods of low oil prices. The supply of rigs is however relatively inflexible due to the capital intensive nature and long economic live of the rigs, which generally can not be used for any other purposes and consequently rig values have historically been volatile.
? Portfolio of assets: As is the case for any type of asset, a portfolio of assets of which the performance is to some extent unrelated, for example a number of FPSOs operating on different fields or a number of drilling rigs with different specifications, should reduce the residual value risk from the point of view of the debt provider. This concept is commonly used for financing drilling rigs, and has more recently also been developed for financing FPSOs.
Corporate based financing
When contractors own a large number of assets, financing may be based on the corporate credit profile of the contractor. Such a credit profile is typically determined by historical financial ratios comparing the company's total debt level to its annual operating cash flow or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) available for debt service. Corporate based financing is obviously most appropriate where a company's EBITDA is stable enough to use its historical EBITDA as an indication for the future, but in the offshore oil and gas services sector, EBITDA is often relatively volatile. This will reduce the ?EBITDA multiple? that debt providers are willing to provide as financing. Therefore, also for relatively large contractors, a structured finance approach, taking into account the charter contracts and residual value considerations described above, may offer a higher leverage potential.
Conclusion
The equipment used by offshore oil and gas service companies has a capital intensive and specialised nature and many companies owning such equipment require structured debt financing to benefit from growth opportunities in the market. Early involvement of the structured debt providers in the negotiation of charter contracts, construction projects and acquisitions is essential for ensuring that the key financing elements can be properly addressed. n
Contact:
Marc Borghans, Vice President Natural Resources,
ING Structured Finance, Tel. 31 20 563 4991,
Fax 31 20 563 5164, E-mail marc.borghans@ingbank.com
ING and Financing Offshore Oil and Gas Service Companies
ING Structured Finance has for many years been at the forefront of arranging innovative financing structures for offshore oil and gas service companies. Starting with project financing the first FPSOs operated in the North Sea in the early and mid 1990s, ING had a leading role in developing an innovative concept for financing a fleet of FPSOs, and created solutions for project financing of FPSOs in emerging markets and for financing FPSO projects incorporating field.
The assets:
Offshore equipment suitable for structured debt financing ideally has a global employment market and a proven performance track record. Most FPSOs and floating drilling rigs (semi-submersibles and drill ships) qualify for these requirements. Pipe-laying vessels and other specialised ships and barges may qualify as well. The value of assets in their own right (i.e. independent from the company owning the assets) reduces reliance by the debt provider on the corporate credit profile of the contractor owning the assets and creates access to different types of debt financing.
The location:
The offshore oil and gas market has a global profile both in terms of the home country of the contractors, the location of the field developments and the home country of the oil companies involved. Leading contractors originated from the US (drilling), Norway (drilling and floating production), The Netherlands (floating production), France (pipe-laying) and Japan (floating production). Major offshore field developments can be found in the North Sea, the Gulf of Mexico, Brazil, West Africa, South East Asia, and Australia. Oil companies from around the world are involved in offshore field developments, often in co-operation with the host country's national oil companies.
The key players and their roles
The below schedule shows the interrelationships between the contractor, the debt provider and other parties relevant to arranging the debt financing for the contractor.
1. The equipment is constructed by fabrication yards for delivery to the contractor.
2. The contractor leases the equipment to oil companies and provides operational services.
3. The debt provider provides financing to the contractor.
4. The debt provider obtains an assignment of the construction contract.
5. The debt provider receives (part of) the lease payments for the contractor's equipment for repayment of the debt.
In reality the interrelationships described above are often much more complex and may involve several parties.
Elements of structured debt financing
Depending on various factors, including the credit profile of the contractor and the type of assets involved, the following elements of debt financing offshore oil and gas service companies can be identified:
Charter based financing
If a contractor has obtained one or more charter contracts for its equipment, financing can be based on advancing the future payments under such contracts. The charter contracts will then be the direct source of repayment of the debt. Charter based financing has the following characteristics:
? Contracted fixed day rates: Payments due under the contracts are typically defined as a fixed amount of USD per day payable during a minimum period of time. This means that income under the contract is not impacted by the level of oil prices or the actual volume of oil recovered, which is a major source of comfort to debt providers. Minimum contract periods can vary from a couple of months for a drilling rig to drill a number of wells, to 5-10 years for an FPSO to operate on a large oil field. Most suitable for charter based financing are the longer term contracts. Long term contracts are less common for drilling rigs than for FPSOs. The tenor of an FPSO contract is generally equal to the minimum expected economic life of a field on which the FPSO is contracted to produce, while drilling rigs are generally used for shorter periods of time on a single field (up to 1 year). Oil companies only tend to charter drilling rigs for longer periods of time when they expect the supply of rigs to fall short of demand, or when they need to ?sponsor' the construction of a certain type of rig which may otherwise not have been built.
? Performance risk on contractors: Charter payments are normally subject to the performance of the equipment in accordance with pre-agreed specifications. The operational track record of the contractor is therefore of key importance to the debt provider. In addition, substantial expertise is required to judge whether the contract terms include adequate provisions for maintenance and periods for repair in case of equipment failure (so called ?downtime?). Over the past years most contractors have shown satisfactory operating performance and even where equipment failed, oil companies tended to allow the contractors cure periods beyond contractual provisions and did not terminate contracts, mainly because it was difficult and/or expensive to find replacement equipment. In particular FPSOs, which are always up to a certain level tailored to a specific field, are difficult to replace. Drilling rigs are less tailored to specific operations and the risk of oil companies replacing rigs with others if they do not perform well is somewhat higher. Banks seem to have become relatively comfortable with performance risk on contractors over the past couple of years.
? Credit risk on oil companies: The charter payments made by the oil companies are the primary source of repayment, and the risk of payment default by the oil companies needs to be carefully considered. Smaller, highly leveraged or less cost-efficient oil companies may for example be vulnerable to low oil prices, disappointing field performance or political developments in certain countries. In the case of FPSOs however, comfort can be derived from the economics of the underlying field in its own right. In the same way as the value of the equipment reduces reliance by the debt provider on the contractor, the value of an oil field on which an FPSO is producing reduces reliance by the debt provider on the oil company, as it could be replaced by another oil company. For drilling contracts this is less obvious as drilling rigs are usually not dedicated to a specific field for longer periods of time.
Construction financing
Contractors generally require debt financing to be provided when equipment is still under construction. Construction periods may take up to two years and during such period major milestone payments have to be made to suppliers and fabrication yards. As long as equipment is under construction, uncertainties remain as to the ultimate cost required to complete the equipment, the remaining time required for completion, and as to whether the equipment will ultimately comply with the required specifications. Many projects have experienced cost overruns and delays which have made debt providers quite reluctant to accept construction risk on offshore equipment, in particular where the contractor may not have sufficient financial resources to withstand such overruns and delays. The following factors could play an important role in improving confidence:
? Sub-contracting strategy: The contractor typically assumes the responsibility for turnkey delivery of the equipment to the oil company. Subsequently contractors try to shift this responsibility as much as possible to subcontractors. However, this can only be done effectively if the project specifications delivered to the subcontractors are sufficiently detailed and not subject to further change. This seems only achievable after extensive and detailed front-end engineering of the whole project. A number of so called ?fast track' construction projects undertaken in the past were based on less detailed front-end engineering and relied on subcontractors' flexibility to incorporate design changes during the construction process, which proved to be less cost effective.
? Project interfaces: Inherent in constructing equipment to be used for offshore oil and gas services is the integration of different engineering disciplines, including marine technology and oil and gas drilling and processing technologies. The interfacing of these technologies requires very specialised expertise and is essential for avoiding cost overruns and delays. A number of projects undertaken under the responsibility of contractors lacking or partially lacking such expertise have incurred substantial delays and cost overruns and sometimes even permanent technical shortcomings.
Acquisition financing
Besides constructing equipment, contractors can also acquire equipment from other contractors or from oil companies who wish to dispose assets. The current trend of consolidation in the oil and gas industry in general is also experienced in the offshore services industry, and contractors use the acquisition of companies or assets as a means to keep up with the pace of growth. In addition there is a tendency of oil companies to return to their core business, including the sale of non-core assets like the equipment that can also be owned and operated by contractors. The selling and buying of drilling rigs (so called ?asset plays?) has been quite common for many years. More recently the market has also experienced an increasing number of FPSOs changing ownership. The following issues need to be dealt with by debt providers in the context of such acquisitions.
? Fast execution required: As is the case in acquisition financing in general, funds have to be made available to the seller within a certain time frame which is normally a relatively short period of time. This means that acquisitions are typically financed by means of a temporary debt facility, or bridge financing, until a more appropriate and permanent facility has been put in place. If the ability to put in place a permanent facility is uncertain, for example due to market risk, then provision of bridge financing requires careful consideration of possible fall back scenarios.
? Acceptance by the oil company: Equipment sold from one contractor to another while it is being leased to an oil company, generally requires the consent of the oil company for such change of ownership. The oil company obviously wishes to be comfortable with the new owner and operator of the equipment which it is leasing. Part of the consent process is likely to require the involvement of the debt provider, as the oil company is to be made comfortable with the security position that debt providers may take over the equipment. The seller may have a different credit profile and a different type of financing arrangements in place than the buyer and this may be viewed as an unwelcome change by the oil company. Although charter contracts generally require oil companies to be reasonable in giving their consent to a change of ownership, negotiating conditions for such consent can be quite challenging.
Residual value financing
To the extent that payments under existing charter contracts are not sufficient to fully repay the debt, the debt provider is financing the residual value of the equipment. Residual value can be realised (i.e. converted to cash for debt service) by extensions of existing contracts, by obtaining new charter contracts, or by sale of the asset. For different types of equipment, different approaches to determining residual value can be identified:
? FPSOs: Minimum contract terms of FPSOs are generally based on the anticipated production profile of the field that the FPSO will operate on. Oil companies prefer to limit the minimum contract term to the field's P90 profile, which is the production profile that can be estimated with 90% certainty. P90 profiles can however be as short as 3-4 years, while the economic life of an FPSO is typically 15 years or longer. After a period of 3-4 years the FPSO should therefore have substantial residual value, which can be realised by obtaining new charter contracts. However, FPSOs are to a certain extent tailored to the specific characteristics of an oil field, and it will be uncertain how much needs to be invested in the FPSO to make it suitable for operation on another field under a new contract. The FPSO may require modifications to its oil processing systems due to different oil characteristics, or may need expanded gas compression or water injection facilities. The value of the FPSO under new contracts is therefore difficult to estimate. More comfort is likely to be obtained from extensions of an FPSO contract already in place. As the minimum contract period is based on the P90 profile, there is a 90% chance that the actual production will be higher and that the contract will be extended. In addition, while an FPSO is operating on a certain location, other fields may be discovered in the area around the FPSO which can be relatively economically connected to the FPSO (so called ?tie backs?) and which can improve the probability of contract extension even further. Experience over the past years shows that FPSOs generally remain much longer under contract than their minimum contract term. The probability of extension of existing contracts has therefore become a key determinant of FPSO residual value risk for debt providers.
? Drilling Rigs: As stated above, contract terms of drilling rigs can be as short as a couple of months while their economic life is 15 years or longer, and in many cases even up to 30 years. Unlike FPSOs, drilling rigs are not at all tailored to specific fields and can be used on any field within the limitations of their general specifications like water depth and (in some cases) environmental circumstances and regulatory requirements in certain areas. Drilling rigs have to some extent even developed as a commodity type of asset with market day rates for certain types of rigs operating in certain areas. Statistics on utilisation levels (the average percentage of time that rigs are under contract) are available as well. This makes determining the probability of extension of a contract for a specific rig difficult, as any rig can normally be replaced by another rig with similar specifications. The day rate and utilisation statistics are therefore more commonly used by debt providers for estimating residual values, although market rates have been extremely volatile over the past years, driven by the forces of demand and supply. The demand for drilling services follows the price of oil as drilling (in particular exploration drilling) is less attractive for oil companies during periods of low oil prices. The supply of rigs is however relatively inflexible due to the capital intensive nature and long economic live of the rigs, which generally can not be used for any other purposes and consequently rig values have historically been volatile.
? Portfolio of assets: As is the case for any type of asset, a portfolio of assets of which the performance is to some extent unrelated, for example a number of FPSOs operating on different fields or a number of drilling rigs with different specifications, should reduce the residual value risk from the point of view of the debt provider. This concept is commonly used for financing drilling rigs, and has more recently also been developed for financing FPSOs.
Corporate based financing
When contractors own a large number of assets, financing may be based on the corporate credit profile of the contractor. Such a credit profile is typically determined by historical financial ratios comparing the company's total debt level to its annual operating cash flow or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) available for debt service. Corporate based financing is obviously most appropriate where a company's EBITDA is stable enough to use its historical EBITDA as an indication for the future, but in the offshore oil and gas services sector, EBITDA is often relatively volatile. This will reduce the ?EBITDA multiple? that debt providers are willing to provide as financing. Therefore, also for relatively large contractors, a structured finance approach, taking into account the charter contracts and residual value considerations described above, may offer a higher leverage potential.
Conclusion
The equipment used by offshore oil and gas service companies has a capital intensive and specialised nature and many companies owning such equipment require structured debt financing to benefit from growth opportunities in the market. Early involvement of the structured debt providers in the negotiation of charter contracts, construction projects and acquisitions is essential for ensuring that the key financing elements can be properly addressed. n
Contact:
Marc Borghans, Vice President Natural Resources,
ING Structured Finance, Tel. 31 20 563 4991,
Fax 31 20 563 5164, E-mail marc.borghans@ingbank.com
ING and Financing Offshore Oil and Gas Service Companies
ING Structured Finance has for many years been at the forefront of arranging innovative financing structures for offshore oil and gas service companies. Starting with project financing the first FPSOs operated in the North Sea in the early and mid 1990s, ING had a leading role in developing an innovative concept for financing a fleet of FPSOs, and created solutions for project financing of FPSOs in emerging markets and for financing FPSO projects incorporating field.
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