Risks in Upstream O&G

8/2/2019 Risks in Upstream O&G

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[email protected] (91 11) 51305310

Discussion Materials

Risks in Upstream Oil & Gas

JM MORGAN STANLEY


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Table of Contents

K:\Arjun\Ajay Greenbook Profiles\Risk Seminar\Seminar Final.ppt\10 DEC 2004\10:22 AM\2

What is Risk?Section 1

Exploration RiskSection 2

Market RisksSection 3

Political RisksSection 4

Environmental RisksSection 5

Risk Mitigation Structure: The VPP ModelSection 6

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Section 1

What is Risk?


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Risks in Upstream Oil & Gas What is Risk?

Risk

JM MORGAN STANLEY

Risk

Stems from uncertainty where information about a situations outcome is:

Insufficient

Lacking or

Simply Wrong

Project Risk:

Refers to uncertainty arising from the financial, political, contractualand market context in which a project is undertaken that might havepotential adverse consequences for the sponsors claims on, and

equity investments, in that project

Risks may be specific to the sub-sector, country and politicalenvironments

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E&PProject


Types of E&P Project Risks

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Environmental

Risks

Exploration

Risks

Reserve Risk

Market Risks

EconomicRisks

Political Risks

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Risk Identification and MitigationProcess

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4. Allocation of risks (mitigation does not eliminate all risks):

Contractual allocation

Write a contract if possible and cost effective

Often too costly to write a complete contract

Incomplete contracts lead to incentive conflicts

Residual allocation

Solve incomplete contracts with residual allocation

Co-locate residual risks and returns

Give the risk bearer an incentive to manage the risks

1. Identification of Risks:

Conduct feasibility studies - Appointment of consultants and specialists

Accumulate experience with a range of projects and settings

2. Assessment of severity :

Evaluate assessments of consultants and risk advisors

Ratings and Rankings are a useful source of measuring and assessing risks

Decide which risks are the most important?

3. Mitigation (reduce the risks, if you can):

Redesign the project to increase revenues or decrease costs

Conduct further analysis (assessment)

Abandon the project: Be willing to walk away

Be careful of psychological commitment

Remember sunk costs are sunk

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Section 2

Exploration Risk


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Risks in Upstream Oil & Gas Exploration Risk

Exploration Risks

JM MORGAN STANLEY

Uncertainty of not finding the projected quantities

of oil with the requisite geometric conditions

Fluid Uncertainty

Quantities of trapped

hydrocarbons

Geometric Uncertainty

Trap Position

Trap Shape

Interpretative Uncertainty

Stems from use of indirect

measures

Parametric Uncertainty

Stems from incomplete

knowledge of basin

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Reserve / Production RiskA Part of Exploration Risk

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Reserve

Risk

Classification

Proven Reserves

Probable Reserves

Possible Reserves

Extractability

Degree of difficulty in

extracting

Proven Reserves ~Economically Recoverable

Reserves

Area of closure

Key Determining Variables

Percent Full-up Reservoir Thickness Geometry Factor

Percent Gas Cap Porosity Water SaturationFormation Volume

Factors

Recover Efficiency Gas / Oil Ratio Condensate Ratio Rock Formulation

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Managing Exploration Risks

JM MORGAN STANLEY

Geometric Studies

Source Risk, Reservoir, Trap

size and positioning

Volumetric Studies

Volume of Hydrocarbons,

Migration, Distribution

Flow Studies

Testing stabilized flow,

Evaluating quality

Exploration Risks: Must be Accurately Identified

Most exploration risks can be identified through in-depth geometric, volumetric and flow studies

Data gathered must be integrated with engineering and economic analysis to facilitate decision making

However, interpretative and parametric uncertainty can only be minimized, not completely eliminated

Necessary that experts interpret all available data - Use of different interpretative scenarios"

Computation of sensitivity indices

Gather data from previously drilled wells in the area

Engineering

Scenarios

Conceptual

Development Plan

Facilities CostsProduction Profile

Recovery Factor

Economic

Analysis

Cash Flow

Model &

ValueMeasures

DecisionPost-drill

Review

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Technical E&P Firms

JM MORGAN STANLEY

Degolyer & McNaughton

Ryder Scott Co. and Netherland

Sewell & Associates, Inc.

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Section 3

Market Risks


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Risks in Upstream Oil & Gas Market Risks

Market Risks

JM MORGAN STANLEY

Market Risk

Price Risk

Prices of Hydrocarbons

can often be volatile

Influenced by

geopolitical instability

and developments in

the host country

Extraction costs

Assumes greater

significance for

oil

Purchaser Risk

Is there an organized

market for the product?

Purchaser risk is lower

for oil

Existence of

international spot

and forward market

Higher for low grade

hydrocarbons and gas

Payment Risk

Risk of not receiving

payment on product

delivered

Possible if output

must be sold to one

buyer or a select

group of buyers

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Risks in Upstream Oil & Gas Market Risks

Managing Market RisksGeneral Strategies

Offtake contracts - Specify minimum quantities & prices

Take or pay arrangements

Assignment of assets and contracts

Step-in rights

Conservative financing structure

Support low-cost producers

Call and put options

Forward sales and price contracts

Price /Purchaser

Risk

Sell output where possible to creditworthy buyers

Credit enhancements

Government guarantees of contractual performance

Direct assignment of a portion of the buyers revenue

Escrow account covering major part of debt service

Payment Risk

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Section 4

Political Risks


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Risks in Upstream Oil & Gas Political Risks

Political Risks

JM MORGAN STANLEY

Political Risk

Direct Indirect Interactive

Risk Impact

Nationalization Total Cessation

Expropriation Total Cessation

Crime Production Delays

Terrorism Cessation / Delays

Kidnapping Production Delays

Risk Impact

Civil Unrest Production Delays

Martial Law Production Delays

Remittance

Constraints Cashflow Delays

Fiscal Change Change in Cashflow

Ineffective

Legal System

Production Delays /

Effect on Revenues

Ideological /

Cultural

Opposition

Production Delays /

Effect on Revenues

Risk Impact

Exchange

ControlsCashflow Delays

Labor Unrest Production Delays

Corruption Production Delays

Bureaucracy Production Delays

Pressure

GroupsProduction Delays

Stems from the overall uncertainty related to the exercise of power by a foreign government and by

non-governmental actors and its ramifications

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Managing Political Risks

Difficult to quantify - no single way to eliminate

Can be managed by thorough review of the political, legal and regulatory regime in the

host country

Ensure that all laws and regulations are strictly complied with and all correct

procedures are followed

Some ways of managing and reducing political risks include:

Involvement of multilateral agencies

Private market insurance

Insurance from national export credit agencies (ECGD, COFACE, HERMES etc.) Obtaining assurances from relevant government departments in the host countries

before commencement of project

Securing guarantees from the central bank of host country regarding the availability

of foreign exchange when required

Government to Government contactJM MORGAN STANLEY 15


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Key Ratings & Consultancy Organizations

Country Risk Consultancy Organizations

Bank of America World

Information Services

Business Environment Risk

Intelligence (BERI) S.A.

Control Risks Information

Services (CRIS)

Economist Intelligence Unit

Political and Economic Risk

Consultancy (PERC)

Euromoney - Ratings

Institutional Investor

S&P Rating Group

Moody's Investor Services

AT Kearney

Int. Country Risk Guide

Coplin-O'Leary Rating System

Key Rating and Rankings

IMD: World Competitiveness

Scoreboard

World Economic Forum:

Competitiveness Index

Lehman Brothers and Eurasia:

Political & Economic Stability

Index

BERI: Political Risk Index

COFACE Credit Ratings

AT Kearney: FDI Confidence

Index / Globalization Index /Attractiveness Index

PricewaterhouseCoopers:

Opacity Index

Transparency International:

Corruption Perception Index

UNDP: HDI



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Section 5

Environmental Risks


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Risks in Upstream Oil & Gas Environmental Risks

Environmental RisksKey Pollutants

JM MORGAN STANLEY

Drilling fluids

Discharged oily cuttings from offshore operations

Oil contaminated liquids, such as brines from completion activities

Interface fluids from the wellbore

Drains water/site run-off water contaminated by the oil-based drilling fluid Waste from tank cleaning and packaging activities

Exploration / Developmental Activities

Produced contaminated water

Dissolved & suspended hydrocarbons and other organic materials, as well

as dissolved & suspended solids

Chemicals are used during production to ensure operation efficiency Impurities from natural gas production: carbon dioxide, and hydrogen sulfide

Air emissions from:

combustion engines - pumps and compressors (NO and NO 2 , & partially

burned hydrocarbons)

heater treaters, boilers, and steam generators (NO and carbon monoxide)

In case the company also undertakes transport and storage of crude there is

risk of spillage

Production Activities

Many of the materials &wastes associated withdrilling and productionactivities

have a potential forenvironmental adverseeffects

The scale of environmentalimpact depends primarilyon

the material,

concentration after release,

the environment that isexposed

Degree of environmentalrisk would depend upon:

Regulatory standards andchanges thereof

Degree of compliancemonitoring and enforcement

Environmental pressuregroups in the host country

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Risks in Upstream Oil & Gas Environmental Risks

Managing Environmental Risks

JM MORGAN STANLEY

Environmental risk can bemanaged at each stage ofthe exploration processthrough:

Environmental duediligence

Following a systematic

Environmentalmanagement programme

use of internationalstandards to measureenvironmental performance

E&P firms generally take-upEnvironmental Insurance asan overall risk management

strategy

Prospecting/ exploration licenseGeophysics/ exploratory drilling

Exploration Phase

Preliminary impact assessmentReconnaissance campaignSpecific impact assessmentAntipollution plan (OSCP)

Preliminary and design surveysPre- projects and projects

Building worksDevelopment

Initial ground zero statusEnvironmental Impact Assessments

Environmental Monitoring

ProductionExtension

Antipollution plan (OSCP)Environmental Management Plan

CessationDismantling

Restoration of site

Programme for cessation of activityand restoration of siteFollow- up and audit

Development Phase

Production Phase

Abandonment Phase

Phases Action

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Section 6

Risk Mitigation Structure: The VPP Model


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Volumetric Production Payment (VPP)


Volumetric Production Payment (VPP) can be used as an effective

acquisition financing tool for the purchase of oil and gas assets and

management of inherent risks

Used in conjunction with an outright asset sale, whereby:

the final purchaser of the assets pays the seller the differencebetween the purchase price of the assets and the funds

generated from the VPP

The key determinant in the VPP valuation are risk associated with

the production of reserves

Investors analyze the following important elements in assessing thelevel of risk:

Ratio of the reserve categories (PDP:PDNP:PUD)

Geographical diversity

Delivery locations



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The VPP Structure


SPV Investors

MSCG

Swap Provider

(Aa3/A+)

Asset

Purchaser

Asset Seller

5

41

3Fixed $

Overriding RoyaltyInterest in a fixed volume

of hydrocarbons

Floating $

1. Asset Seller sells to theSPV an OverridingRoyalty Interest/VPP onthe Assets for an upfrontcash payment

2. SPV enters into amarketing agreement withMorgan Stanley Capital

Group (MSCG) topurchase all futuredeliveries ofhydrocarbons at floatingprice

3. SPV enters into a swapagreement with MSCG tofix the floating prices it

will receive from MSCG asthe HydrocarbonPurchaser

4. The SPV sells notescollateralized by the VPPto debt investors

5. Proceeds used topurchase VPP from AssetSeller

MSCG

HydrocarbonPurchaser

(Aa3/A+)

2

$

$

$

$Fixed Volume of

Hydrocarbons

Notes

Assetsencumbered

by theOverriding

RoyaltyInterest



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VPP Valuation


The valuation for the VPP will primarily be a function of the discounted present value of the reserve

production purchased by the VPP purchaser

The Asset Purchaser is responsible for the cost of production and delivery of the hydrocarbon assets

purchased under the VPP. Therefore, the critical variables that will impact the VPP valuation are: the

forward price of the hydrocarbons, the production profile based on an independent engineers report,

and the discount rate commensurate with the risk profile of the hydrocarbons

The price of the hydrocarbons is determined primarily by liquid market indices at the time of pricing.

However, both the discount rate and the volume of the reserve production purchased under the VPPwill depend on the risk analysis of reserve profile of the assets

Risk analysis conducted by the VPP investor

Factor Description Impact on the VPP proceeds

Ratio of proved reserve

categories

(PDP:PDNP:PUD)

Investors will be more comfortable with PDP assets as the reserve

profile analysis would be supported by actual production data. The

comfort level would be lower for PDNP assets. Given the

significant capital expenditure required to bring PUD assets to a

production stage, VPP investors will be least comfortable withassets in this category

A high ratio of PDP assets to other categories

will increase the advance rate and reduce the

discount rate

Geographical diversity Since hydrocarbon production can be disrupted during inclement

weather, for example for off-shore assets, geographic

concentration increases the risk profile of the assets

Geographic diversity is likely to increase the

advance rate and reduce the discount rate

Delivery Locations Liquidity at the delivery locations enhances the ability of the VPP

purchaser to market the hydrocarbons

VPP investors will also be concerned about concentration risk at

delivery locations

Illiquid delivery locations could reduce the

advance rate and increase the discount rate.

The VPP purchaser may also require a higher

marketing charge for illiquid delivery locations

The key determinant in the VPPvaluation will be riskassociated with the productionof the reserves

Investors will analyze thefollowing important elementsin assessing the risk

Ratio of the reserve

categories(PDP:PDNP:PUD)

Geographical diversity

Delivery locations

0

100

Perio

d0

Perio

d2

Perio

d4

Perio

d6

Perio

d8

Perio

d10

VPP ProductionReserves

VPP ValuationReserve Production Profile

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Key Advantages


JM MORGAN STANLEY

Raise funds off-balance sheet at alow cost of funding

Transfer the reserve production risk

Effective management of market risks

Maintain upside potential of developing

additional reserves

Reduce purchase price

Benefit from potential off-credit treatment

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Risks in Upstream O&G