Iranian E&P; the funding challenge

Hadi Alviri, ACA, CFA
Oil and Gas Financial Advisor

Since the introduction of Iran’s new upstream contracts – known as the IPC  there has been much speculation with regards to the fate of the new model and whether after years of international sanctions, the new fiscal regime can provide a fresh flow of blood to Iran’s ageing oil and gas sector. The primary goal of the new fiscal terms was to address the shortcomings surrounding the older buyback model, most notably to align risk and return, which would result in international oil companies (IOC) to make a reasonable risk adjusted rate of return in contrast to other jurisdictions with similar profiles to that of Iran. Whether this objective has been fully achieved remains to be seen given that no post-IPC contract has been signed at the time of writing – although French major, Total, announced
it will go ahead with development of South Pars phase 11 this summer. Negotiation are however ongoing with a number of IOCs on certain fields for which memorandums of understanding (MOUs) or heads of agreements (HOAs) have been signed.
This could be an indicator that the new framework has been attractive enough to draw attention from international
players having said that the size of this interest has not been material given the ongoing cash flow challenges faced by IOCs amid falling oil price on one hand and the partial ongoing US sanctions on Iran on the other.
Apart from addressing the profitability concern of international players, the new fiscal terms also included  provisions to enable transfer of know- how and technology to local companies which would help Iran become less reliant on foreign companies in the long-term and develop inside expertise. According to the IPC framework, IOCs have to partner up with an Iranian Exploration and Production (E&P) company and the field development activities will be conducted through a Joint Venture (JV) comprised of at least two partners – although Iranian companies can
choose to perform field development on their own. This initiative presents Iranian oil and gas companies with  various opportunities and challenges. Apart from NIOC, Iran has never had E&P companies as commonly known in the international oil and gas sector. Those companies active in the Iran’s upstream sector have played the contractor role carrying out various EPC, EPD or other services amongst others for the operators. This meant that in  conjunction with the new fiscal terms, qualified Iranian oil and gas companies have had to go through establishing their E&P segments.
When it comes to mounting E&P entities in Iran, nothing has been keeping the architects of these new ventures
awake at night as much as the funding challenge they will face for the huge field development projects they are looking to get into. The size of the prize in Iran’s upstream sector is astronomical. In 2015, NIOC introduced +50 fields for developments amongst which are a mixture of oil and gas fields located onshore or offshore, some  requiring application of technologies to increase recovery factors from already producing reservoirs whilst others are Greenfield developments. According to energy consultancy, Wood Mackenzie, some opportunities with total reserves of over 26 billion barrels of oil equivalent were presented for development with an estimated capital expenditure (capex) of about $114 billion in 2017 terms. Based on publicly available information, seven Iranian E&P companies have signed agreements for 13 fields with a total development capex estimate of $26bn.
Whilst the required funding varies by individual fields from $350mn to $10bn, it is clear that the scale of these  projects presents huge
financing challenges for Iranian companies. To overcome this obstacle, local companies have a number of pathways, each of which will come with their own bottlenecks and is far from straightforward.
Here we looking at some of the options available, and in each case we will identify the key roadblocks to successful fundraising faced by Iranian companies. Before we do that however, let’s take a quick look at the bigger picture surrounding Iran and factors impeding international financing.

First and foremost it is important to note that the geopolitical landscape including the election of Donald Trump in the US and possibility of sanctions snapback, instability in the Middle East or tensions between Iran and its Arab
neighbors will result in an increase in perceived political risk and consequently, the availability of finance for Iran will be greatly diminished under such scenario.
Due to the long-term attribute of conventional hydrocarbon development projects, having a stable, transparent and predictable political outlook is essential for long-term financing deals. On the risk dimension, overall business risk
is the next layer of uncertainty which will deter international financing be it in the form of debt or equity. As an  example, Iran has been suffering from a poor banking sector with substantial liquidity concerns and distorted non-performing loan portfolios in conjunction with lack of sufficient transparency in banking matters. Also within the business risk category is the systematic credit risk whereby across different sectors, private and public, companies – many of which profitable – struggle to honor their financial commitments to various stakeholders.
When it comes to different methods of funding upstream development projects, one key aspect is the equity interest that the Iranian partner has in the joint venture which will determine the portion of funding obligation the party to the JV has. Clearly a lower equity interest will reduce the amount of capital needed, however, the downside is that
a lower stake in the JV could translate into a reduced influence in JV voting rights and less control over the joint operations destiny.
Another key aspect of the funding dilemma is the question between raising debt or equity capital. In global E&P activities, it is common that during the exploration and appraisal stages of the upstream value funnel – where subsurface risks are higher – financing is normally equity sourced. In the later stages of asset life, during  development or enhanced recovery, some form of debt financing is more typical.
When it comes to Iranian E&P companies, given that in the IPC framework, exploration activities have been entirely assigned to foreign companies and the local players are active only during field development, raising some form of debt appears to be more economical and less risky from a financier’s perspective. The decision between equity and debt however, is only part one of the financing maze and there remains other complexities surrounding raising various forms of debt capital. One of the most typical methods is raising debt through bond issuance in public  markets. Whilst this provides a relatively relatively cheaper form of funding for well-established entities
with strong credit ratings, Iranian companies are not rated in the international capital markets and are unlikely to be
able to access such funding. On the other hand, even if they do get rated, because of the risks mentioned earlier, it is likely that the cost of funding through public bond markets will be higher than that tapped by their International counterparts.
Another form of debt potentially accessible for Iranian E&P companies is through the Buyers’ Credit lines  established between Iranian government and banks and export credit agencies in a number of countries including China, South Korea, Italy and Denmark. The funding will be in the form of a loan facility extended to an Iranian E&P company by the foreign bank to finance the purchase of capital goods for the field development. In this arrangement, an Export Credit Agency (ECA) will guarantee the loan and the government of Iran will provide a sovereign guarantee backing the Iranian borrower. The two main challenges in this method from an Iranian company’s  perspective is firstly, the lending bank will impose a minimum amount of loan facility to be spent in the lender’s country and this can be as high as 85% of the facility value. Given that pretty much all of the Iranian E&P companies will be the non-operating partner in the JV, the procurement strategy will be undertaken by the operator at worst and by agreement at best. Hence the Iranian partner is unlikely to succeed in forcing purchases from a specific source or region. The second obstacle facing local companies is that in order for the Iranian government to issue sovereign guarantee, the government will need the company to pledge collateral up to 120% of the loan value. With the sums of financing in question, such huge collateral seems difficult if not impossible to provide.
Term loan facility is another method that Iranian E&P companies can potentially raise debt financing. Accessing loans from European or Asian banks however, is not typically the most economical way to fund upstream projects, not least because bank loans generally tend to be more expensive than raising funding in bond capital markets. Unlike bonds, bank loans will require sufficient collateral and guarantees that most of local companies will struggle to provide.
One other key distinction to consider when it comes to the financing strategy, is whether funding is destined for a specific project – so called project finance – or the financing is backed by company’s balance sheet, known as  corporate finance. It is common amongst established upstream players to use the strength of their balance sheet to raise financing.

This is particularly the case for larger conglomerates or those benefiting from a strong credit rating as mentioned
earlier. Other things being equal, the risk exposure from a financier’s perspective is greater when there is non- recourse arrangements which means only the income from a specific project can back up debt commitments. In contrast when funding is raised through corporate financing, it’s the creditworthiness of the entity – which will likely have many assets in its portfolio – that will honor debt repayments.
Having said that, not all companies share the luxury of having strong balance sheets and credit ratings, operate in stable low-risk parts of the world. In such cases it is inevitable that cash flow based project financing solutions may be the only alternative. There are several types that a project finance transaction can be packaged but the majority will be tightly monitored and require some form of guarantee from the sponsor or a credible external party.
When it comes to Iranian companies, again the challenge with arranging creditworthy guarantees and sufficient collateral will pop up on the way to a successful project financing package.
One type of cash flow based financing which is asset specific and has been used by E&P companies around the world,
is what is called Reserve Based Lending (RBL). In this method, the amount borrowed is sized to the present value of
future expected cash flows of the specific field. Hence this route doesn’t necessarily require a strong balance sheet
and the provider of finance is primarily taking reserve estimation and future oil price risk. Due to the focus of RBL
on future cash flows of the asset, it is not uncommon for the bank to request future field production to be hedged to
protect the lender in the event of an oil price fall. RBL is used widely in the E&P sector to increase recovery factors or to finance acquisition projects. The key factor considered when deciding how much loan is to be extended is the amount of reserves available and whilst for the riskier development stage, only proved reserves is taken into account, for the less risky producing assets, proved and risked probable reserves are typically included in the assessment.
Whilst RBL appears to be an attractive financing solution for Iranian E&P companies, the lender will still require security from the borrower. Sometimes this security is taken over the account in which the proceeds from the sale of hydrocarbons produced from the specific field are deposited. Apart from the security challenge for Iranian upstream companies, the governing law of oil and gas in Iran indicates the ownership and the related proceeds from the sales of the hydrocarbons belongs to the NIOC and therefore the lender under an RBL arrangement cannot have a claim to these, should the borrower default on the loan repayments. There are other approaches used around the world to  help exploration and production companies fund their share of costs for upstream activities. Carry arrangements
are instances where one party pays for all the costs of the other party and effectively carries the other venturer and
gets paid back through the carried partner’s share of cash inflows during the production stage.
This model is mostly used during the exploration phase where a small sized license holder doesn’t have enough
capital for high cost exploration drilling and by getting carried by a larger party, will effectively share some of the
downside risk in case of a dry hole and upside opportunity in the event of a discovery. In countries with National Oil
Companies (NOC) presence such as Iran, the IOC may carry the state entity knowing that the liability of the NOC is effectively backed by the government.
Therefore, when it comes to Iranian E&P companies, given that the funding is needed during the development phase and considering the circumstances where upsides are limited for the IOC, it seems unlikely that international oil companies will be willing to take the credit risk and carry their local partners, particularly at a time when IOCs are stretched globally with cash shortfalls due to low oil prices
in recent years.
The way forward for Iranian exploration and production companies is challenging when it comes to funding their
upstream aspirations. However through risk management planning and forming strategic partnerships, the long-term objectives will be more achievable.