Risks in Upstream Oil & Gas

Discussion Materials

JM MORGAN STANLEY

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Risks in Upstream Oil & Gas

Table of Contents
Section 1 Section 2 Section 3 Section 4 Section 5 Section 6

What is Risk? Exploration Risk Market Risks Political Risks Environmental Risks Risk Mitigation Structure: The VPP Model

JM MORGAN STANLEY

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Risks in Upstream Oil & Gas

Section 1

What is Risk?

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Risks in Upstream Oil & Gas

What is Risk?

Risk

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, contractual and market context in which a project is undertaken that might have potential adverse consequences for the sponsors claims on, and equity investments, in that project Risks may be specific to the sub-sector, country and political environments
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Risks in Upstream Oil & Gas

What is Risk?

Types of E&P Project Risks

Exploration Risks
Environmental Risks

Reserve Risk

E&P Project
Market Risks

Political Risks

Economic Risks

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Risks in Upstream Oil & Gas

What is Risk?

Risk Identification and Mitigation

Process

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 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
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Risks in Upstream Oil & Gas

Section 2

Exploration Risk

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Risks in Upstream Oil & Gas

Exploration Risk

Exploration Risks

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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Risks in Upstream Oil & Gas

Exploration Risk

Reserve / Production Risk

A Part of Exploration Risk

Classification
Proven Reserves Probable Reserves Possible Reserves

Extractability

Reserve Risk

Degree of difficulty in extracting Proven Reserves ~ Economically Recoverable Reserves

Key Determining Variables

Area of closure
Percent Gas Cap Recover Efficiency
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Percent Full-up
Porosity Gas / Oil Ratio

Reservoir Thickness Water Saturation Condensate Ratio

Geometry Factor
Formation Volume Factors Rock Formulation
7

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Risks in Upstream Oil & Gas

Exploration Risk

Managing Exploration Risks

Geometric Studies Source Risk, Reservoir, Trap size and positioning Volumetric Studies Volume of Hydrocarbons, Migration, Distribution Flow Studies Testing stabilized flow, Evaluating quality

Engineering Scenarios Conceptual Development Plan Facilities Costs Production Profile Recovery Factor

Economic Analysis Cash Flow Model & Value Measures

Decision

Post-drill Review

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
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Risks in Upstream Oil & Gas

Exploration Risk

Technical E&P Firms

Degolyer & McNaughton Ryder Scott Co. and Netherland Sewell & Associates, Inc.

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Risks in Upstream Oil & Gas

Section 3

Market Risks

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Risks in Upstream Oil & Gas

Market Risks

Market Risks

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 Risks

General Strategies

Price / Purchaser Risk

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

Payment 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
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Risks in Upstream Oil & Gas

Section 4

Political Risks

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Risks in Upstream Oil & Gas

Political Risks

Political Risks
Stems from the overall uncertainty related to the exercise of power by a foreign government and by non- governmental actors and its ramifications

Political Risk

Direct
Risk Nationalization Expropriation Crime Terrorism Kidnapping Impact Total Cessation Total Cessation Production Delays Cessation / Delays Production Delays

Indirect
Risk Civil Unrest Martial Law Remittance Constraints Fiscal Change Ineffective Legal System Ideological / Cultural Opposition Impact Production Delays Production Delays Cashflow Delays Change in Cashflow Production Delays / Effect on Revenues Production Delays / Effect on Revenues

Interactive
Risk Exchange Controls Labor Unrest Corruption Bureaucracy Pressure Groups Impact Cashflow Delays Production Delays Production Delays Production Delays Production Delays

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Risks in Upstream Oil & Gas

Political Risks

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 contact
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Risks in Upstream Oil & Gas

Political Risks

Key Ratings & Consultancy Organizations

Country Risk Consultancy Organizations Key Rating and Rankings

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

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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AT Kearney
Int. Country Risk Guide Coplin-O'Leary Rating System
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Risks in Upstream Oil & Gas

Section 5

Environmental Risks

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Risks in Upstream Oil & Gas

Environmental Risks

Environmental Risks
Key Pollutants

Many of the materials & wastes associated with drilling and production activities have a potential for environmental adverse effects The scale of environmental impact depends primarily on the material, concentration after release, the environment that is exposed Degree of environmental risk would depend upon:

Exploration / Developmental Activities

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

Production 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
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Regulatory standards and changes thereof

Degree of compliance monitoring and enforcement Environmental pressure groups in the host country
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Risks in Upstream Oil & Gas

Environmental Risks

Managing Environmental Risks

Environmental risk can be managed at each stage of the exploration process through: Environmental due diligence Following a systematic Environmental management programme

Phases

Exploration Phase

Action

Prospecting/ exploration license Geophysics/ exploratory drilling

Preliminary impact assessment Reconnaissance campaign Specific impact assessment Antipollution plan (OSCP)

Development Phase Preliminary and design surveys Pre- projects and projects Building works Development Initial ground zero status Environmental Impact Assessments Environmental Monitoring

use of international standards to measure environmental performance

E&P firms generally take-up Environmental Insurance as an overall risk management strategy

Production Phase Production Extension Antipollution plan (OSCP) Environmental Management Plan Abandonment Phase Cessation Dismantling Restoration of site Programme for cessation of activity and restoration of site Follow- up and audit
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Risks in Upstream Oil & Gas

Section 6

Risk Mitigation Structure: The VPP Model

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Risks in Upstream Oil & Gas

Risk Mitigation Structure: The VPP Model

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 difference between 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 the level of risk:
Ratio of the reserve categories (PDP:PDNP:PUD) Geographical diversity Delivery locations

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Risks in Upstream Oil & Gas

Risk Mitigation Structure: The VPP Model

The VPP Structure

1. Asset Seller sells to the SPV an Overriding Royalty Interest/VPP on the Assets for an upfront cash payment
2. SPV enters into a marketing agreement with Morgan Stanley Capital Group (MSCG) to purchase all future deliveries of hydrocarbons at floating price 3. SPV enters into a swap agreement with MSCG to fix the floating prices it will receive from MSCG as the Hydrocarbon Purchaser 4. The SPV sells notes collateralized by the VPP to debt investors 5. Proceeds used to purchase VPP from Asset Seller
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MSCG Swap Provider (Aa3/A+)

Fixed $ Overriding Royalty Interest in a fixed volume of hydrocarbons

Floating $

Notes

Asset Seller

SPV

Investors

$ Assets encumbered by the Overriding Royalty Interest

Fixed Volume of Hydrocarbons

MSCG Asset Purchaser Hydrocarbon Purchaser (Aa3/A+)

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Risks in Upstream Oil & Gas

Risk Mitigation Structure: The VPP Model

VPP Valuation
The key determinant in the VPP valuation will be risk associated with the production of the reserves Investors will analyze the following important elements in assessing the risk Ratio of the reserve categories (PDP:PDNP:PUD) Geographical diversity Delivery locations
Risk analysis conducted by the VPP investor
Factor Ratio of proved reserve categories (PDP:PDNP:PUD) Description 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 with assets in this category Since hydrocarbon production can be disrupted during inclement weather, for example for off-shore assets, geographic concentration increases the risk profile of the assets Delivery Locations
0

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 VPP will depend on the risk analysis of reserve profile of the assets

Impact on the VPP proceeds A high ratio of PDP assets to other categories will increase the advance rate and reduce the discount rate

VPP Valuation
Reserve Production Profile
100

Geographical diversity

Geographic diversity is likely to increase the advance rate and reduce the discount rate

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

Pe rio d

Pe rio d

Pe rio d

Pe rio d

Pe rio d

Reserves

VPP Production

Pe rio d

10

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Risks in Upstream Oil & Gas

Risk Mitigation Structure: The VPP Model

Key Advantages

Raise funds off-balance sheet at a low 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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