CHAPTER 12 EXOTIC AND ALTERNATIVE FINANCING STRUCTURES -- WHERE IS THE MARKET GOING?
| Jurisdiction | United States |
(May 2006)
EXOTIC AND ALTERNATIVE FINANCING STRUCTURES -- WHERE IS THE MARKET GOING?
Vinson & Elkins, L.L.P.
Houston, Texas
JEFFREY MUÑOZ
Jeffrey Muñoz is a partner in the Houston office of Vinson & Elkins, L.L.P. His principal areas of practice are general business and transaction law, with an emphasis on asset and corporate acquisitions, and financing transactions. He has developed both a domestic and international practice representing clients in Europe, Latin America, and Africa as well as the United States in various asset transactions, as well as the development and financing of domestic and Latin American energy related projects. Jeff has represented a broad range of clients including energy, private equity, chemical, real estate, utility and telecommunications companies.
Jeff is a Member of the American Bar Association; Houston Bar Association; American Institute of Certified Public Accountants; and Texas Society of Certified Public Accountants. He is listed in "Texas Rising Star" in mergers and acquisitions, Texas Monthly, 2005. He is co-author of Annual Survey of Texas Oil and Gas Law Developments (1994-96).
Jeff earned his B.B.A. in accounting, magna cum laude, at the University of Texas in 1987 (Beta Alpha Psi; Phi Eta Sigma). He earned his J.D. from Stanford University in 1993, where he was Business Manager and Editor of Stanford Law and Policy Journal and Vice President of the Stanford Law Student Association, and was admitted to practice in Texas in 1993. He is also a Certified Public Accountant.
With oil and gas prices at historic heights, it seems that most market participants are drawn to investing in some type of oil and gas project. Commercial banks that, as recently as a few years ago, were avoiding the mid to lower end of the oil and gas sector are now looking to loan money to anyone with "E&P" or "Oil" in their name, regardless of their credit rating. With all of this capital trying to find a home in the oil patch, why are producers or lenders interested in any type of a financing structure other than a conventional borrowing base revolving credit facility? Money. Lenders and investors are always looking for higher returns and producers are trying to find additional sources of capital in order to drill more wells or acquire more properties. Oil and gas may be the life blood of any industrialized economy, but money is the life blood of the energy sector. Even with the higher transaction costs and longer time frames to complete these alternative financing structures, both producers and investors remain interested in developing novel and innovative financing techniques to serve particular niches in the market.
Because of high commodity prices, there is a renewed interest in volumetric production payments in order to effectively monetize proved developed producing reserves either as part of an acquisition or from existing properties. Producers believe they can take the proceeds from the sale of a VPP and discover the next Spindletop.
Net profits interests are also seeing renewed use as part of tax-exempt investors' portfolios, in connection with industry transactions (particularly with service providers in the energy sector receiving them in lieu of cash for providing services) and as another means of investing in the oil and gas sector and still limiting the investors' total exposure in the transaction.
Hedge funds and other private equity funds continue to make inroads in the energy finance area. These investors require higher returns than traditional banks and are drawn to higher risk projects. Hedge fund and private equity investors have started using equity kicker financings to help raise their returns while providing debt capital to thinly capitalized producers in the oil and gas sector. Thinly capitalized producers believe that these investors will provide them with more capital at an accelerated rate and, while costly, this capital may be less expensive than bringing in an industry partner or venture capital funds -- perhaps their only other alternatives.
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Tax-exempt investors, given the limitations that the tax code imposes upon them, are exploring the use of VPPs and net profit interests, either through direct investment or through a royalty trust structure, in order to participate in oil and gas investments. Even with the increased costs associated with setting up these structures, producers believe, given these investors' tax-exempt status, that these investors may provide them with a source of less expensive capital.
Up until recently, a relatively unknown area in the realm of oil and gas finance was Islamic finance. With high commodity prices, the Middle East is awash in available capital. With the limited amount of investment opportunities in that region, these funds are slowly beginning to find their way to the U.S. energy markets. These types of transactions require even more structuring than any of the previously mentioned non-traditional financing techniques in order to achieve the desired tax and financial outcomes, as they are also required to conform to Islamic principals and tenets.
The following paper will provide a brief overview of various financing techniques (such as those described above) that are considered somewhat non-traditional or novel and some of their potential uses in oil and gas financing. This overview will attempt to describe, with respect to each such technique, the basic format of the technique, some of the risks and associated mitigants, required documentation and common documentation issues and, in some cases, some additional applications of the technique. The descriptions of each technique will not follow the same format, as the nature of the different structures do not lend themselves to a strict comparison on a set criteria.
I. VOLUMETRIC PRODUCTION PAYMENTS
A. What is a Volumetric Production Payment (VPP)?
1. A VPP is a non-operating, non-expense bearing, limited term overriding royalty interest carved out of the working interests in oil and gas leases. Because there is considerably more case law surrounding overriding royalty interests and their treatment, a VPP is often called a term overriding royalty interest to further support its characterization as a real property or immovable interest (depending, of course, on the particular state law).
2. A VPP covers a fixed quantity of hydrocarbons underlying, and to be produced, from the burdened oil and gas leases. Typically, a VPP is structured so as to deliver to the VVP owner a scheduled quantity of hydrocarbons per day over a fixed time period.
3. A VPP usually terminates when the fixed quantity of hydrocarbons, as adjusted for any differences in factors assumed by the VPP owner (such as delivery location, time of delivery, quantity of the hydrocarbons to be delivered and the quality of those hydrocarbons), is delivered or the oil and gas leases that are burdened by the VPP terminate.
4. Oil and gas production attributable to the VPP is typically taken in kind by the VPP owner, as compared to the traditional production payments that are payable in dollars.
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B. Risk Allocation/Mitigation
1. Reserve Risk
The VPP owner assumes the risk that the oil and gas leases burdened by the VPP contain sufficient reserves producible at the projected rate to satisfy the scheduled deliveries of VPP hydrocarbons. The VPP owner looks solely to the VPP hydrocarbons for the discharge of the VPP, and the VPP seller (the working interest owner of the oil and gas leases burdened by the VPP) is not personally liable for the payment and discharge thereof except out of the produced VPP hydrocarbons.
The VPP owner can mitigate its reserve risk by the following:
(a) limiting the VPP to oil and gas leases containing proved reserves of oil and gas;
(b) performing adequate engineering due diligence and obtaining an independent reserve report for verification;
(c) having the VPP burden diversified properties (to minimize the effect of a significant casualty event affecting all the properties burdened by the VPP); and
(d) appropriately sizing the VPP.
Sizing of the VPP involves determining the scheduled quantity of VPP hydrocarbons that the VPP owner can expect the VPP seller to deliver on a daily basis. While there is not a set basis, typically the VPP owner will set the volumes to be delivered out of a range from 40% to 50% of the expected volumes to be produced from the VPP seller's working interest in the burdened oil and gas leases -- therefore allowing for a significant decrease in production before the VPP will be negatively affected.
2. Oil and Gas Commodity Price Risk
The VPP owner assumes the risk that the VPP production will be sold at a price sufficient to recover the investment in the VPP (the purchase price of the VPP) and the VPP owner's expected return on the investment. The VPP owner commonly mitigates this risk by arranging to sell the VPP hydrocarbons at monthly index related prices and entering into commodity price hedges to lock in the price that it has used to determine the purchase price of the VPP.
3. Interest Rate Risk
The VPP owner assumes the risk that interest rates will rise or fall during the term of the VPP, affecting the rate of return on its investment. The VPP owner mitigates this risk by sizing the VPP appropriately and, again, entering into commodity price hedges to hedge the price of the VPP hydrocarbons to be sold in order to achieve a fixed rate of return.
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4. Operation Risk
Although the VPP seller is obligated to operate the burdened oil and gas properties, or cause such oil and gas properties to be operated, as a prudent operator, disregarding the existence of the VPP as a burden of such properties, the VPP owner retains the risk that the VPP seller is unable or unwilling to fulfill this obligation. In...
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