Tullow’s cost of capital: Uganda farm-out implies a return for Total of 19%

Tullow’s recent deal with Total in Uganda indicates it (along with the E&P sector) still faces a difficult funding situation, with the implied cost of capital for Tullow of 19%.

Tullow’s Ugandan farm down to Total caused very little market reaction, with analysts calling the deal roughly market neutral. The stock price is now relatively unchanged vs pre-announcement (although this also includes the impact of TEN production cuts announced in the trading statement a couple of days later).

We don’t formally cover Tullow, and do not seek to give an investment recommendation. However, we have run our internal numbers on the acquisition with a view to furthering our work on industry implied costs of capital (see previous blog posts on deals including the late-2016 Ophir FLNG restructure).

From the point of view of Tullow, this seems a good deal – reducing its cash outflows for the next few years, reducing its finance risk in the run up to loan re-negotiations and operationally allows it to concentrate on Kenya. This is at the cost of seeing the immediate value in the project fall and a sacrifice of the upside of future NPVs. The market has judged this to be largely a wash.

Source Edison. Note NPVs are unrisked

From Total’s viewpoint, its working interest increases to over 50% and gives it further resources and future revenues in an asset it knows very well.

Modelling the movements in the companies cashflows (using current cost and revenue assumptions) allows us to extract the effective return that Total will gain from this deal. Immediate $100m payment (with a further $50m on FID and $50m on first oil), together with a $700m capex carry for Tullow means material outflows before 2020, but a large boost to revenues after first oil.

These cashflow movements run out to an implied IRR for Total of 19%, which seems high vs others given the stage of the assets.

As a cross check, we calculated the point IRR for Total’s 2012 deal (using contemporaneous assumptions) in Uganda was around 13%. If we now overlay current expectations of costs and production to the 2012 deal, this IRR falls to 10.5% – as can be seen in the empty spot in the chart below. This shows that Total has effectively commanded that its required returns from Uganda investment have increased markedly in the last five years (13% in 2012 to 19% in 2017) despite hundreds of millions of dollars of investment and a de-risking of the project.

In an era where financially stretched E&Ps are farming out assets for development at implied IRRs of 20% (or thereabouts), we argue that these figures should inform the investor community as to what an appropriate discount rate should be for the sector.