Thursday, 24 November 2016

Fortuna LNG deal underlines the structurally higher costs of capital seen by E&Ps

By Will Forbes

We believe the poor record of investment returns for large oil companies over the last cycle (taken as a proxy for the industry) should have far reaching effects across the industry. As majors look to increase their below-WACC ROICs (seen consistently over the last decade), they will demand higher returns for the investment projects. This should mean a continued drive for lowering costs and increasing efficiencies for service companies and a more aggressive negotiation with companies looking to farm-down the projects for funding.

In previous posts, we've highlighted the analysis of farm-downs as a relatively transparent lens through which to view costs of capital in the industry, and an addition to CAPM or other based methods of assessing the costs of capital for the sector we focus on, E&Ps.

The recent Ophir/OneLNG deal is another point to add to this growing picture. Based on disclosures from Ophir, it is contributing its upstream equity and a limited amount of capex in return for 33.8% of the JV. Given expected annual cashflows of $560m and a 60% debt financing (we assume 8% here), we estimate the levered cashflow return for Ophir in 2017 is 38%. The unlevered return is 25%

Importantly, the return for OneLNG is an implied 20% (levered return is 30%), which is towards the top end of the implied IRRs for deals we have analysed.

Implied IRRs for buyers of assets
Source: Edison Investment Research


Floating LNG is still an unproven technology, We may well therefore expect that the return demanded by OneLNG is higher than a comparably sized/risked oil-based FPSO development.

As Ophir have stated, FLNG may well become the standard in much the same way that FPSOs have for oil developments. For the moment however, a 20% return for OneLNG on current assumptions re-iterates that incoming partners require high returns even in developments where geological risk is low. 

In an environment where development partners may require such high returns, what is the business case for high risk exploration?





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