Understanding Joint Ventures in the Oil and Gas Sector

8/22/2019 Understanding Joint Ventures in the Oil and Gas Sector

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Private and confidential

Oil & Gas Conference

Joint Venture Financing Discussion Materials

11 July 2013


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Contents

Section Page

1. Understanding Joint Ventures 2

2. Funding Options 8

3. Case Study 13


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1. Understanding Joint Ventures


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Understanding Joint Ventures

Definition of a Joint Venture

The Term joint venture (JV) is one of art, not law. The term itself is very vague and does not describe the actual structureadopted or even the objectives. It merely suggests that each of the investors are to a greater or lesser extent activerather than passive participants

Likewise, there is no law of joint ventures as such and this area usually involves a mix ofcontract and corporate lawand in some cases concepts from partnership, equity or agency law.

Examples of joint venture relationships include mining or exploration agreements (involving an investor and an operator),investment arrangements (i.e. involving a capital investor and an existing trading company), co-suppliers which requiregreater size to be competitive and gain economies of scale etc.

Rationale for a Joint Venture:

Allows international investors to acquire local knowledge and contacts by entering a joint venture with a local entity.

Newrest and Uganda Inflight Services

It is a means of implementing changes to a companys strategic position and spreading its financial risk - i.e. byallowing it to concentrate on its areas of relative competence while diversifying into unfamiliar business areas.

MTN Uganda and American Towers Joint venture

Allows a company to deal with business opportunities in its core area of competence which are too big for it. Thereforejoint venture entities can cope with large contracts and gain economies of scale.

Very Common in Construction sector (primarily roads & bridges) where local company does not have balance sheet

In contrast to using a company or partnership structure, a joint venture is seen as having advantages in terms ofgreaterflexibility. Parties are free from many of the restrictions under the partnerships and companies acts. Also, as opposed to apartnership, a joint venture structure gives each party a limited liability in the sense that each party is severally liable (andnot jointly liable) for its share of monies owing to third parties


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Understanding Joint Ventures

Joint Ventures

Equity Joint Ventures

Corporate Merger

Holding Company Structure

All Corporate law protections

Un-Incorporated Joint Ventures

Contractual JV

Governed by JV agreement

Unregistered arrangement

The Relat ionsh ip

is managed

so le ly by a

shareholdersagreement

Incorporated

JVs function likea stand alone

Company Partnerships Unit Trusts

Incorporated Joint Ventures


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Key considerations of Incorporated Vs Unincorporated Joint Venture

Privacy An unincorporated joint venture agreement is a private arrangement and therefore is not

subject to public scrutiny like the articles of an incorporated company.

Legal Protection

The nature of the business or the sophistication of one the parties may lead to a choice ofincorporated entity.

The framework provided by corporate law and additional protection available to shareholders may bepreferred as an incremental safeguard to contractual rights.

Accounting Treatment Partners may prefer an unincorporated venture allowing them to keep separate accounts and

maintain their own accounting policies

Transfer of Interests

It is easier to transfer shares to incoming parties which is a big advantage of an incorporated jointventure.

Because it tends to be specific as to the parties needs, a transfer of shares is unusual once JVagreement has been reached

Financing

If the parties want to use collective financing and grant security over the joint venture assets,

a company is necessary.

Additional shares can be issued as a way of securing further capital

Fiduciary

Relationships Easier to manage under an incorporated JV


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Joint Venture Agreement Check List

Joint Venture Objectives Should provide some detail on objectives of the JV

Conditions to Agreement

Will include Items such as:

Regulatory consents

Licenses required

Approval of business plans

Parents Board approvals

Term of Venture

Can be set up to be dependent on:

Investors equity falling below a certain threshold

Listing on an exchange

Completion of a specific project or a specifies date

Financing

Start-up Capital typically would be Equity (subscription for shares); agreement will set out thenumber, class, price

Can be complemented with debt financing

Subsequent capital raising to be set out in share holders agreement

Ownership of Interests

In an unincorporated JV property is beneficially owned in proportion to their interest

Profits and losses also shared in proportion to these respective interests

Under an Incorporated JV, the Company itself owns the assets and JV shareholders own theshares

Auditors Need to specify independent auditors who will act as experts and not arbitrators

Management

Critical to separate Management from shareholders or board oversight

Contracting a management company which provides indemnity to JV in case it breaches itscontracts can be useful

Also useful in allowing for knowledge transfer when Management is delineated


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Joint Venture Agreement Check List

Management

Committee & Board

Representation

Mandate and structure of Management Co (Un incoporated) and Board of Directors (Incorporated) aresimilar

Each party will have representatives proportionate to their shareholding

Certain decisions can be majority and others unanimous allowing minority some veto power

Matters such as issue of new shares; acquisitions or divestments, dividend payments and majoramendments should require unanimous consent

Confidentiality Key to define confidential information and obligations of each party

Dispute Resolution

Certain experts believe remaining silent on this point will force parties to reach commercial solution

Alternative could be to appoint an expert or arbitrator. Time consuming but better than relying oncourts

Other Alternatives include; Swing man Director; shot gun provisions (forcing either party to buy or sellfrom other party); auction system (sell shares to highest bidder)

Non-Compete Difficult to enforce unless there is a proprietary aspect to the JV

Should have an expiry period and cannot be open ended

Pre-emptive rights

Most critical provision of an incorporated JV

Issue of new shares will require consent of all and offered on a pro-rata (rights) basis

Transfer of shares should have pre-emptive right

Additional

Agreements

Management Contracts

Financing Agreements

Technical Services Agreement Brand Licence Agreement


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Funding Options


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Risk-Free

Rate of

Return

Common Stock

PIK Preferred Stock

Cash Pay Preferred Stock

Subordinated Notes

Senior Secured Notes/Mortgage Notes

Senior Notes (Unsecured)

Common Stock

PIK Preferred Stock

Subordinated Notes

Senior Notes (Unsecured)

Credit Facilities

Short-Term U.S. Treasury Bill

Senior Secured Notes/Mortgage Notes

Risk

Premium

Expected and

Required

After-Tax Rate of

Return

(%)

Risk to Investors

Operating

Company

Seniority

Holding

Company

Trade-off between Capital Structure and Risk

Several Corporate Finance Tools at your disposal


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Project Overview

Indigenous FinancingA Case Study on the Busingye Catering Dilemma

Project SponsorCNOOC

Project Term10 years

Project Winner - Busingye Catering

PartnerNew York Global Catering

Project Capital Cost US$ 50m

Debt Financing Available US$ 20m

Equity Required US$ 30m

Promoter (Busingye) provides:

Cash US$ 0.5m

Kisassi Land US$ 0.5m

Dilemma:

Bus ingye only has US$ 1m avai lab le for equi ty funding but

wants 48% own ership of the JV. This imp l ies B usingy e has a

funding gap of US$ 14m

Busingye wants

48% own ership

of the JV butonly has US$

1m at his

dispo sal and

needs to find

fund ing for the

balance


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Financial Projections

Indigenous FinancingBusingye Catering

Busingyes Cash flows improve dramatically by 2018 when his annual portion of PAT reaches US$11.2m

An IRR of33% is achieved

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Total

Revenues - 30 60 90 104 155 163 171 180 189 1 141

Gross Profit - 11 21 32 36 54 57 60 63 66 399

EBIT - 8 15 23 26 39 41 43 45 47 285

Interest Expense - -2 -2 -2 -2 -1 -1 -1 -1 -1 -12

PAT - 5 9 14 16 23 24 26 27 28 171

PAT to Busingye - 48% - 2.2 4.3 6.5 7.5 11.2 11.7 12.3 12.9 13.6 82.2

PAT to NY Global Catering - 52% - 2.3 4.7 7.0 8.1 12.1 12.7 13.4 14.0 14.7 89.0

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Total

Calculating IRR

Net Cash Flow (50) 9 13 18 20 28 29 30 31 32 209IRR 33%


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Solutions

Indigenous FinancingA case Study on the Busingye Catering Dilemma

Shareholder loan with Payment-In-Kind (PIK) component

Pay interest and dividends with additional debt or equity instead of cash.

Busingyes debt obligation will grow with interest being added to principal every year. Hepays out at the most convenient time based on his cash flows.

Illustration Borrows $14 million at 10% a year; in year 2 will owe $15.4, year 3; $16.9million; year 4 $18.5 million

Major advantage is that it matches with Busingyes cash flow. He has a 33% return andhas no issue paying a 10% PIK cost.

Equity participation rights triggered in year 3

Gives Busingye an option to buy-into equity when his cash flows improves in year 3 atpre-determined valuation.

Keeps option to purchase 48% for $15 mm with modest escalator

Convertible loan (initially take on debt financing) coverts to equity in year 3

Gives Busingye embedded option to convert his loan to equity in year 3 Preferred Stock

Sweat Equity

Contribution to a JV in the form of effort


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Funding Options

Arguments for Indigenisation:

Broadening of economic wealth

Increased local ownership and participation in the assets

A programme that allows employees /communities to own shares within the organisation

A flexible Government approach to the application of the Indigenisation policy is key. If an immediate transfer of ownership tolocals would jeopardize profits, the company can submit a plan to equip locals with necessary skills to take over in the futu re

Key points

Financing Options

Maximising Domestic Benefit

Vendor/Partner

Finance

Simple to implement

Funding rate determined with reference to vendor cost

Existing shareholders remain in control of the transaction and structure

Gives rise to a direct cash flow impact on the business

External

Finance

Commercial funding rate for indigenous partners

Existing shareholders debt subordinated in terms of redemption and security

Reduces flexibility to sustain structure but promotes independence

State development banks Brazil (BNDES); South Africa (DBSA/IDC)

Ultimately, the company needs to be paid for the equity stake in the business that will pass on to employees/management

There are multiple funding options that can be utilised to facilitate this transfer

Is it deductible from cost oil? If so, the State is implicitly paying for the bulk of it

Paid for by tax rates of beneficiaries?

Other alternatives include:

The subject is a key

debate in many

mining sectors and

has becomeincreasingly relevant

in the O&G sector

There are mult iple

funding opt ions that

can be uti l ized to

faci l i tate this

transfer of shares in

an Indigenization

scheme


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1994 2000 2006 Current

Consortium

members

Individuals

Staff

+

Communities

+

Commercial

Individuals

Staff

Communities

SABMiller,

Vodacom

Tenor

7 10 years

Emergence of perpetualcommunity structures

Cash flow

Limited dividend flows to participants during transaction,largely option pay-off structures

Emergence of structures incorporating trickle dividends

Focus on meaningful cashflow for participant groupings

Funding Bank funded Vendor financed

Market

conditionsStrong performing equity markets

supports success of BBBEE transactionsVolatile markets exposestructural weaknesses

SABMiller,

Assore,

AECI

Tiger Brands,

Mediclinic

SABMiller,

Assore

The evolution of BEE transaction structuring (South Africa)

Progressing Indigenisation - Financing

Key points

BEE has become

highly sophisticated

over time


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Case Studies


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Case Study - Ghana National Petroleum Corporation (GNPC)

Partner Funding

Ghana National Petroleum Corporation (GNPC) was established in 1983 and is responsible for theexploration, development, production and disposal of petroleum activities in Ghana

Ghanas most successful oil story is the Jubilee field with Tullow, Anadarko, Sabre, Kosmos and GNPC (10%)having an interest in the field, with associated fields in operation (e.g. Tano, West Cape Three Points)

Ghanas fiscus earns 5% royalties; a 10% free carry, an additional, paying interest of 3.75% and an incometax of 35%. Note that prior to the payment of income tax, the oil companies who incurred the expenditure areallowed a full cost recovery upon eligible development expenditure

Jubilees development was accelerated (around 50 months from discovery to operations) with targetedproduction at 120,000 bpd. However, since the start of commercial operations, production has at times beenas low as 63,000 bpd which has reduced revenues relative to projections

In addition to this, Ghanas Petroleum Law that allows for development costs incurred to be recovered beforeprofits are declared, with a reported 20% return being allowed on eligible expenditure. Note that in the case ofJubilee etc, total costs are reported to amount to US$4.2 billion.

Note that one of the factors behind this is that GNPC did not fund itself, but borrowed the money from itsdevelopment partners (at a cost of 20% p.a.) which has to be repaid. Note that this choice has implicationsfor control, influence and relative independence/autonomy of GNPC regarding the investment.

This cost recovery has led to a P&L loss-making situation which means the government has not been able to

levy an income tax (despite the field producing oil since December 2010)

This notwithstanding, in 2012, the fiscus generated US$ 542 million from oil revenues of which royaltiesamounted to US$ 151 million and US$ 390million came from the States free carry

Key points

Industry

development

records wereachieved after the

Jubi lee discovery

which made Ghana

a net oi l exporter

Government

generated US$542mi l l ion from oi l

revenu es in 2012

Jubilees output hasramped up more

slowly than

expected.Revenues for Ghana

have bui l t up slower

than expected , with

various reasons

ci ted for the cause


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Partner Funding

Mozambiques petroleum law stipulates that the state has the right to participate in any petroleum activities,which is negotiated on an ad hoc basis. Practice is the State is carried during exploration and funds itsparticipation during production. As with Ghana, there will be access to royalties and an ability to receive

income tax (post cost recovery)

Since 2004, Mozambique has had operational upstream and midstream gas projects:

Upstream Pande-Temane gas fields (ENH - through CMH - owns a 30% stake)

Midstream ROMPCO gas pipeline (ENH - through CMG - owns a 25% stake)

ENH funded its investments in these projects through a mixture of DFI funding and partner funding. Fordifferent reasons, for example, the financing structure, ENH has similarly not seen large dividends resultingfrom the investments

Since 2010, the Area 1 (led by Anadarko) and Area 4 (led by Eni) consortia have made material offshorediscoveries (175 Tcf gas in place to date) which are likely to mean that Mozambique will become a majornatural gas producer (starting with a 10 MTPA 2 train LNG export project)

Whilst the Area 1 and Area 4 transactions are still under development and will not close until 2014, there aresigns Mozambique and ENH may be approaching these transactions differently:

ENH is appointing independent advisers to determine how it should fund its participation in the LNGtransaction (which requires the raising of up to USD 3 bill ion) and refinance existing deals;

Mozambique has carried out a very careful fact-finding process to broadly determine its partnering andfinancing options, with sovereign wealth entities strongly interested in Areas 1 and 4

The Government has ensured a running yield from securing a capital gains tax take of disposals ofinterests in the blocks (for example, the sale of Cove Energy)

Key points

State has the right

to partic ipate in

petroleum activi t ies,

bilaterallynegotiated upfron t

Subsequently, ENH

has partnered in

world-class offshor e

gas discoveries

(Areas 1 and 4)

which w i l l require i tto make funding

cho ices in 2013/2014

Case Study - Empresa Nacional de Hidrocaronetos de Mocambique (ENH)

ENH has

participated in

onsho re upstream

product ion and

infrastructure

developments since2004


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THE END


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Understanding Joint Ventures in the Oil and Gas Sector

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