A "Tale of Two Cities" for Financing – and Profiting – from Oil
We now know his name was W. Mark Felt. As the source labeled “Deep Throat” during the Watergate years, he became famous for saying, “Follow the money.”
It remains good advice for most investors today, especially in the oil sector.
This column comes to you from Frankfurt. I am here to attend some informal meetings at giant Deutsche Bank to consider the rapidly changing environment in oil finance. As you will see in a moment, the manner of raising money and the location of where that takes place are changing.
Both will have a significant impact on your investment prospects and choices.
There are even more pervasive implications, though.
We are witnessing major changes in the sourcing and structure of financing projects as the international financial crunch and its constriction of credit slowly ease.
You may have noticed that, despite public injections of liquidity and TV declarations of “business as usual,” banks still are not lending at anywhere near pre-crisis levels. This is even more the case in raising funds for expensive oilfield projects.
Funding methods are being replaced, affecting a range of matters in oil and the way in which investors need to consider such changes. It is also the reason for my meetings here in Frankfurt, certainly reflecting rippling concerns in the wider financial community as indicated by who else is attending.
This German banking center used to command a dominant position in developing project funding. That activity would center on Deutsche Bank, a universal private bank, despite the name conjuring up ideas of a state financial colossus.
True, the bank’s many offices worldwide would usually engineer the deals. But it was the gleaming twin towers of the Deutsche Bank headquarters in Frankfurt’s financial district that would symbolize how operating companies secured finance.
These days, this city and its towering bank still have importance in the oil business, but much of the action has moved to London. Therein is a story of changing funding methods and parties.
As such, with apologies to Charles Dickens, this is our own “Tale of Two Cities.” And how this financial tug-of-war plays out will determine both opportunities and problems for the average investor in the tumultuous world of the oil business moving forward.
Each city represents a very different way of approaching project finance…
Frankfurt: The Traditional Approach
Frankfurt speaks of how a traditional energy sector line of credit would emerge. For this, Deutsche Bank was for years the world leader, with other skyscrapers on the Frankfurt landscape, such as Commerzbank and the IBC Banking Center, providing support.
Such an approach takes the crude oil still in the ground, collateralizes it at discount and utilizes bank credit to fund the drilling. Deutsche Bank or some other financial house occupies the position of manager (or main book runner), parcels out portions of the credit line to other banks, and a syndicated loan emerges. Syndication allows banks to spread out the risk, lessening exposure.
Given the rising cost of developing modern oil fields, even the largest vertically integrated oil company (VIOC) – controlling assets from field through refinery to retail outlet – must rely on setting up joint ventures and securing bank loans. When an international company needs more working capital than the combined investment available from its consortium partners (i.e., other oil companies), syndicated bank credit becomes the staple of how one secures it. It also makes Deutsche Bank and its equivalents a great deal of money.
This method of securing funding certainly still exists. Today, however, the project landscape is changing – and investor positioning right along with it.
A rising number of opportunities differ from the more traditional project developments in three fundamental respects. They involve: (1) smaller non-VIOC companies; (2) smaller field projects; and (3) private – not banking – finance. For this, the London Stock Exchange (LSE) and its junior – and somewhat more speculative – Alternative Investment Market (AIM) are becoming the dominant locations.
London: IPOs and Private Placements
In the London approach, there are two primary avenues of finance. Either a company floats an initial or supplemental placement offer (IPO or SPO), securing working capital from portfolio investors on the open market, or it engineers a private placement, thereby obtaining needed finance in less transparent ways.
Now based on the success of either placement, these smaller companies will also often pursue bank finance. Yet when they do, it is usually to fund specific aspects of a project – equipment, wellhead operating expenses, infrastructure – not the overall project itself.
Equity shares – not oil – secure those project-specific loans.
Of course, the London funding avenue cannot entirely forget the likely value of the oil in the ground. Here, however, its function is to entice purchasers of shares in the company rather than providers of syndicated bank credits to the project.
London has become the center for this type of finance rather than New York because U.S. Security and Exchange Commission (SEC) requirements remain far more restrictive in what reserves a company can use for stock purposes than those of the UK Financial Securities Authority (FSA).
Notice the primary difference in what the company employs to secure finance. The Frankfurt model utilizes debt, but the VIOC involved does not sacrifice percentage of ownership. The London model, on the other hand, is all about sacrificing equity portions and thereby does put ownership at risk -first, through the IPO or SPO required to obtain initial finance, and then via lines of credit needed to cover project costs.
This becomes a fundamental element in your investment choice and you need to consider its impact carefully.
Recently, I showed you how we would proceed in this advisory. (See “My 15-Part Strategy to Make You Money.”) When considering companies, whether they are in the business of providing oil, providing technology or offering field and product support, we will need to consider how they obtain funding, what effect the financing method has on operations and whether this is considered an equity or debt play.
For that, our “Tale of Two Cities” will certainly figure prominently in how we navigate the very volatile oil market unfolding.