LNG industry venturing into new territory

Oil and gas commercialization in a period of price volatility: Constructively engaging government

There are ever increasing concerns for petroleum exploration and development prospects across Sub-Saharan Africa arising from the dramatic falls in oil and gas prices since mid-June 2014. The primary supply-side reasons are the US shale oil and gas revolution, strong production from conflict regions such as Iraq and Libya, and OPECs November 2014 statement that they would not cut production. On the demand-side, a slowing global economic recovery, in particular lower demand growth from China and rising oil inventories, has led to forward markets for oil prices being flat or falling over the short to medium-term.

Governments in new and near producers and those that have recently made discoveries in Sub-Saharan Africa are increasingly worried about the financial and political implications of stalling exploration and appraisal programs. In turn, many investors and industry watchers are wondering how host governments and communities will react when they realize the envisioned benefits may be slipping beyond their reach. Temporarily at least.

Falling commodity prices and uncertainty in global markets are likely to have a profound effect on the decisions oil and gas firms make on exploration, appraisal, development schedules and operations in Sub-Saharan Africa. Changing the size and scope of these projects will impact government revenues, benefit streams to communities, and the jobs and profits of support service providers and national industries in the host economy. Clearly damaging to the interests of governments and other stakeholders. For new and near producers, the recalibration of expectations around the benefits they anticipated receiving will probably be the greatest and possibly hardest to manage down.

Consequently it is not only commodity prices that are expected to be volatile over the short to medium term but industry-government-community relationships too. Industry investors will be trying to determine the future direction of oil prices and may need to convey some difficult messages about oil and gas commercialization prospects to host governments and communities.

This document takes a forward look at the potential policy risks that may emerge from the commercial challenges facing the oil and gas industry. It highlights a number of important steps host governments can take to mitigate the effects of uncertainty, through maintaining their attractiveness as an investment location, to help ensure they come out of this volatile period in better shape than when they went in.

BROKER ESTIMATES

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Oil price forecasts taken in mid-November showed some signs of long-term price pressure. Of the 16 oil brokers polled, average and median forecasts were revised downwards for 2015-18 compared to the previous month’s estimate.

What will be the impact of price volatility on industry and government?

1. Lower oil and gas revenues and charges being paid to government
As the value of oil and gas production falls so too will revenues to government. While less of a problem for those that have only recently made discoveries, some governments and National Oil Companies that need to raise money to pay for cash-calls could find it is more expensive and harder to do so based on lower valuations of their assets as a result of lower oil prices. The first place they are likely to turn to is the operating parties for preferential financing who may be facing financing challenges of their own.

2. Divestments may be brought forward impacting oil and gas commercialization timetables
Even prior to this recent bout of volatility there were some firms looking to sell down higher equity stakes in assets so as to focus investment on a smaller number of field developments, as well as to dispose of non-core assets entirely. Inevitably these changes in ownership affect commercialization timetables. If approvals can go through quickly and no rash decisions are taken by governments to try and force developments, or unduly influence joint venture arrangements, then smoother divestments should prompt quicker recoveries in exploration expenditure.

3. Delaying oil and gas development projects and scaling back the scope of those that do go ahead
Less favorable economics and reduced global demand for oil and gas could force investors to delay oil and gas development projects or change the scope of those they do pursue. In particular, commercializing gas fields often presents significant economic challenges and it may be necessary to consider smaller or alternative gas commercialization strategies. Given that so much attention has been given to engaging industry around policies for local content, and government efforts to develop supporting infrastructure, delays and changes in scope could be politically unpalatable (for example, from onshore to floating LNG plants).

4. Being forced to find cost reductions wherever possible could reduce funding for communities and impact local content plans if local goods and services are not competitive
If exploration companies are forced to strip back funding to focus only on drilling programs it could impact other business units, such as those involved in supporting community and regional development initiatives. Similarly, they may well push back against any spending on employment or commitments with local content suppliers that drive up costs. Whether local content requirements do drive up costs depends on the competitiveness of local markets for labor, goods and services. An issue the government rather than industry does at least have some influence over.

In addition to these external factors arising from price volatility, host governments will likely face new challenges of their own and the exacerbation of existing ones. Four key challenges for host governments to consider are:

1. Financial difficulties leading to opportunistic increases in local and national charges and taxes
If divestments do look like they are going ahead, it could encourage host governments to increase or impose new Capital Gains Taxes in advance of sales going through. Some countries could be under greater financial pressure than others to bring forward tax payments while they can. For example, following the freezing of donor funds to Tanzania’s budget at the end of 2014, the government needs to increase internally generated revenues. Changing fiscal terms at this stage could well have the effect of stalling some divestments and slowing the release of new funding for field development. For existing agreements this could trigger arbitration proceedings, including under stability clauses.

2. Managing community expectations
Anticipating the reactions of communities and sub-national governments is always challenging. From the beginning, many communities have struggled to understand or accept that despite relatively large sums spent on exploration programs so few local benefits arise at an early stage. The expectation of receiving more significant benefits at the production stage was often enough to keep expectations contained in the short-term. However, will they now accept that because of production delays these claims are even further off in the future?

3. Adapting National Oil Company structures to the new reality
National Oil Companies have typically suffered the most from past periods of price re-adjustment. They may find that earlier upstream ambitions foisted on them by governments keen for national participation have now been reeled back in, potentially requiring another costly and time consuming round of internal restructuring.

4. Avoiding potentially damaging rent-seeking claims from local and international players
If appraisal and field development programs for export projects are scaled back then it is possible some governments are courted by non-license holders claiming they can un-lock stalled developments through alternative uses for oil and gas finds. Because of the relatively small and price-controlled domestic markets for power, fertilizers and refined products in Sub-Saharan Africa, many of these alternatives are only commercial when built off the back of export infrastructure, they receive discounted feedstock and/or preferential access to domestic markets.

While the short-term political gains of securing commitments to build infrastructure for oil and gas commercialization are compelling, the longer-term economic and financial benefits for the country usually favor ‘foundation projects’ that export energy to global markets at prices set in arms-length transactions. These provide the critical infrastructure to lower the marginal cost of alternative project developments so they do not require subsidies.

Preserving and enhancing the value of hydrocarbon assets during a period of price volatility

Almost all efforts to reduce costs improve the economic fundamentals of projects.

Clearly, this period of price volatility could make for an uncomfortable time for government, communities and investors as they may wait for the markets to stabilize and work out how to optimize their portfolio of assets. In the interim there are a number of things government can do to help ensure they remain attractive as an investment location. Most notably doing whatever is reasonable to improve the project economics for all investors.

It is likely that a number of already complex off-shore projects lined up for Sub-Saharan Africa will emerge into an even more competitive environment of mega-projects. So ensuring cost controls are tightened can make these projects more competitive and more likely to be delivered on time and budget. On the part of government this may require re-examining local content policies and regulations if they are adding to local drivers of cost inflation and complexity. One way to help investors reduce costs is by developing appropriate local content regulations alongside efforts to improve the business environment so more local firms can compete for contracts.

Host governments need to have faith that when the business cycle does turn, they in particular will see the benefits of having helped investors reduce costs by potentially capturing a larger slice of a larger pie.

Host governments may need to revise their expectations and negotiating strategy with investors to reflect the changed circumstances.

In particular for the technically challenging projects with large infrastructure needs these may no longer be feasible as designed under a scenario of sustained lower prices.

In an environment of uncertainty and possible distrust, the last thing government should do is to try and push investors to go ahead with developments when the commercial reality is against it. Not least because later on it could be difficult and costly to unwind commitments or enticements made during these uncertain times. Equally, it will be hard to dispel doubts that the delays and/or divestments may not solely have been the result of worsening project economics but also government interventions that undermined investor confidence.

To keep investors interested and/or entice new ones host governments should ensure regulatory and legislative reform programs continue, with the goal of making the investment environment even more attractive for when the project economics improve.

As a result of increased exploration interest in Sub Saharan Africa over the past 10 years a number of governments have been reforming their legal and regulatory regimes, including increasing their upstream participation through National Oil Companies.

However, without the commercial pressures on government to put in place regulatory and institutional frameworks, for example for providing timely approvals for commercial deadlines such as FEED and FID, it is hard to see where the domestic pressure for continuing wider reforms will come from.

As and when exploration and development expenditure does return, host governments will likely need to ensure all the necessary preconditions for significant investments in infrastructure are in place. For example, the financing of state equity positions through National Oil Companies, or the legal frameworks for ensuring third party access agreements for pipelines or gas gathering systems. If policy decisions are taken to use National Oil Companies to hold state equity in both upstream and downstream assets, then many will need to improve their asset base and governance structures to be able to attract commercial financing. In particular, despite lower oil prices, National Oil Companies that also have downstream responsibilities will face continued pressure on refinery margins, the bottom line and therefore ability to raise funds.

Consequently, because a stalled reform process adds to regulatory uncertainty and could further delay the time taken for exploration and production programs to bounce back, host governments should not slow down on the fiscal, regulatory and institutional reforms initiated for the sector.

Looking ahead

Change always brings a new set of challenges to a relationship and seeing investors put projects on hold and/or divest assets is the most disruptive part of the investment cycle. A prolonged period of uncertainty will be frustrating for investors and host governments wanting to grow a nascent industry that was envisioned to deliver so many benefits when oil prices were over US$100 a barrel.

During these volatile times the key recommendation for government is to not try to overly influence developments through posturing or short-term incentives that will be regretted and most likely unwound later. It is imperative that investors and financiers remember this as a time of uncomplicated divestments and quietly stalled development plans that solely happened because of worsening project economics from lower oil and gas prices and not because of short-term decisions of governments and communities that tried to force developments in the face of market realities.

Those host countries that are able to continue reforms, address cost constraints and collaboratively work with investors to ensure a more amenable environment for long term oil and gas exploration and development, will ultimately become a more attractive investment location as compared with their peers. This requires ensuring attractive but fair fiscal terms are retained and legislative and regulatory frameworks are clarified to reduce complexity and uncertainty, and local drivers of cost inflation and other above-ground risks are identified and addressed.

By using this opportunity to preserve and enhance the value of exploration and appraisal assets then there is far greater potential for oil and gas commercialization in Sub-Saharan Africa to bounce back and lead to the long-term benefits envisioned by host governments and communities. It may also be much easier to garner interest in future licensing rounds in Sub Saharan Africa if despite the market downturn there is a positive story to tell of continued reforms and other efforts to accommodate serious long-term investors.

 

David Okwara

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