Weathering the storm - Implications of the financial crisis for junior oil and gas companies - Simonsen

Up to this point there have been no bankruptcies on the NCS, but the crisis has brought considerable stress to borrowers relating to breach of covenants in loan agreements, and several companies have struggled with refinancing. It seems likely that this will lead to further consolidation on the shelf.

We talked to Roar Tessem, Managing Director of Spring Energy, to hear how his company is responding to the present challenges and opportunities.

”It is obvious that many of the smaller companies are struggling now. We can also see that larger companies are reducing their exploration budgets. Spring Energy has a strong capital base in a situation where many other companies are striving to reduce their positions. This has enabled us to make transactions during the financial crisis that would have been more challenging under more normal conditions."

Despite the turbulence on the financial markets, the company has continued to pursue its ambitious growth strategy. Most recently, Spring Energy acquired its first producing asset in a swap structured deal with Wintershall announced on 18 November 2009. The deal gives Spring Energy a 2.5 % working interest in the producing Brage field as well as interests in an exploration and appraisal portfolio consisting of five licenses. In consideration Spring Energy is transferring a 5 % working interest in PL 378 and will also carry part of the exploration well costs on behalf of Wintershall relating to the acquired licenses.

Mr. Tessem explains that the main purpose of the Wintershall deal is to acquire production and enhance the value of the company´s exploration assets.

 He considers the company´s strong financial position as one key factor in enabling Spring Energy to be offensive in the present market conditions.

In late April 2008, private equity investor HitecVision announced that they were providing USD 120 million in equity financing for Spring Energy. During the summer of 2009 the company significantly expanded  its credit facility by entering into a NOK 1 000 million exploration loan facility with a bank syndicate comprising Merchant Banking, Skandinaviska Enskilda Banken AB, DnB NOR and BNP Paribas.

Since being qualified as a licensee by The Ministry of Petroleum and Energy (MPE) in July 2008, the company has through license applications and farm-in transactions built a considerable portfolio of exploration and appraisal assets now encompassing 19 licenses.

This leads to the other key factor to Spring Energy´s success according to Mr. Tessem: the ability to follow the company´s strategies and plans.

”Spring Energy always assesses value creation  exit and value realization options when entering into a license. It is also important to consider the company’s ability to develop in the event of a discovery or if it will be necessary to farm-out or sell.”

Mr. Tessem believes that a common problem for many of the smaller companies is the lack of such clear exit strategies.

”Many companies hope to make discoveries without having a well thought-through idea about the next step. They may hope to sell but what if there is no buyer?”

Rounding up the conversation Mr Tessem says that he expects more consolidation on the shelf and that Spring Energy is well positioned to act on potential opportunities. He is now waiting for the announcement from the MPE relating to the Awards in Predefined Areas 2009 round (APA 2009). The 21st Licensing Round has also been initiated with nominations in January 2010 and awards expected spring 2011.

International perspective

The financial crisis has obviously had an impact on oil and gas companies internationally as well. To get another perspective on the current situation, we shared a coffee and some thoughts with Mr. Magnus Nordin, managing director of Swedish junior Tethys Oil, at the company’s technical office in Geneva.

Tethys has pursued a different strategy for financing its operations than Spring Energy. While Mr. Tessem has secured a strong financial base for Spring as a foundation for fast expansion, Tethys has rather been undercapitalised throughout the company´s stages of development.

Mr. Nordin explains that this is a deliberate strategy. The company is publically traded with a rather tight shareholder structure. The management and board of directors holds almost 30 % of the shares and most of the other major shareholders are solid and in it for the long term.

This has enabled the company to recurrently tap on the major shareholders´ resources through private placements to finance Tethys´ operations.

According to Mr. Nordin this strategy has several benefits:

“It keeps the organisation alert and minimises unnecessary spending. Furthermore, as we raise capital for specific needs that enhance the value of our projects, we are able to increase the price of the shares between each share issue. This is a way to maximise shareholder value while keeping dilution at a minimum. It also limits the risk for our shareholders as they only need to provide smaller amounts for specific purposes.”

It was a private placement in this manner that enabled Tethys to add to its core assets by financing the acquisition of Block 3&4 onshore Oman.

Regarding the general situation for junior oil and gas companies, Mr. Nordin emphasizes the implications of oil prices.

“Despite experiencing the worst economic crisis since the 1930s, we now have oil prices that are on historically high levels. This has mitigated the effects on oil companies. It is also interesting to ask oneself what will happen with oil prices when the economy stabilizes.”

He agrees that the crisis has opened up possibilities for smaller companies with access to equity finance, but believes that the oil price depression was too short to truly knock out the weaker players.

“Compare it with the Asia crisis 1997-99 when the possibilities for acquisitions at bargain prices were significantly higher. At this time the window for bargain hunting was probably only open for six months, and most of the stronger companies were to slow to act.”

Mr. Nordin believes that even in the event of a new strong economic downturn, a collapse in oil prices is unlikely. His long term view on the direction of the oil prices is positive.

”As new oil and gas discoveries in general are either small or located at remote or difficult places, in the long term I expect prices to rise. This will probably happen in a  slow and orderly fashion based on increased production costs.”

Regarding the immediate future, Mr. Nordin is in a good mood. A few days before our meeting, Tethys released positive test results with good flow rates for the high quality light oil found on Block 3 in Oman, and the company is now eagerly waiting for test results to come in from its heavy oil discovery on Block 4. When the structure was drilled earlier this year a 400 metre section of heavy oil was intersected and the company believes that oil in place may amount to significantly more than 1 bln barrels. The question now is whether it’s commercially viable to produce it? As Mr. Nordin says: ”Zero percent of 2 bln barrels is still zero”.

Following a series of unsuccessful exploration wells in Denmark, Turkey and Morocco, it does seem like Tethys’ luck has changed with the successful appraisal work in Oman. But, if there is one lesson to be learned from the financial crisis it is the fact that circumstances may change rapidly and companies need to be prepared.

Norwegian legal aspects

Recent years has seen growing participation of smaller exploration focused companies on the NCS. Naturally, such players in most cases have relatively weak balance sheets compared to traditional NCS participants. When increased leverage is added to the equation, it is obvious that the risk of defaulting on license obligations as well as loan agreement covenants is increased. This is addressed in the Norwegian legislation where several provisions in the Petroleum Act (PA) and Petroleum Regulations (PR) are related to financial capability requirements.

When applying for a production license, the applicant must demonstrate financial capability (PR § 8).

There is a general requirement that a licensee has “relevant qualifications” (PA § 9-7). This should be interpreted as including financial strength to perform all obligations pursuant to license terms. There is also a requirement for the licensee to provide adequate security for its obligations (PA § 10-7).

Furthermore, the  licensees are jointly and severally responsible to the state for financial obligations arising out of the petroleum activities pursuant to a license (PA 10-8). For damage deriving from pollution liability is strict (PA § 7-3).

When petroleum activities reach the end of production, the legislation imposes requirements on licensees for cessation of activities and decommissioning, as well as regulating liability for abandoned facilities  (PA § 5-4). Decommissioning liability is further extended by newly introduced provisions establishing obligatory alternative liability for assignor for cessation obligations when license interests are assigned (New PA § 5-3(3)). The meaning and implications of the new provision is further elaborated elsewhere in this issue.

Norwegian petroleum legislation emphasizes assessment of the financial capability of entities participating in petroleum activities as a matter of importance. In light of the financial crisis and recently introduced legislation the need for oil companies to take a good look at their license partners’ financial credentials is higher than ever.