E&P industry funding cost still high

Cairn’s recent deal with Flowstream gives us another data point to examine cost of capital in the industry. What is the implied cost of capital for Cairn from this deal?

Cairn’s recent deal with Flowstream gives us another data point to examine cost of capital in the industry.

From Cairn’s preliminary announcement
“On 2 March 2017, the Group secured funding of US$75m from FlowStream in exchange for the proceeds from 4.5% of Kraken production. FlowStream’s entitlement to Kraken production reduces to 1.35% if FlowStream achieves a 10% return and reduces to 0.675% after FlowStream achieves a 15% return. An additional tranche of US$125m in return for a further proceeds from production across Kraken and Catcher is available, subject to mutual consent, at Cairn’s option. FlowStream’s sole recourse for the funding is to its production from the assets. The agreement is subject to approval from the UK Oil and Gas Authority.”

So what return does Flowstream achieve from this investment?
Given the terms of the deal, the return is simply a function of the production (we assume the profile below) and prevailing oil prices.

We assume Kraken production comes online in H2 2017, although the rate is 40mbbld. Production therefore averages 20mbbld

Calculating the IRRs for Flowstream under different oil prices scenarios gives us the following chart. This implies that Flowstream is likely to make an IRR over the life of the field of 20-30%. One would have to be fairly pessimistic on both oil prices and production for an IRR to be much lower than 20% over the project lifetime. The forward curve in March of $56/bbl in 2023 produces a 25% IRR.

This produces an additional data point for our E&P funding path. Points from this small but growing dataset indicate that industry funding is not getting any cheaper.

This seems like a hefty price for Cairn to sacrifice, and on the surface it is. However, it is worth bearing in mind that it paid very little for the additional 4.5% interest in 2016 and therefore the unlevered cashflows from this additional interest suggest returns of more than 50%. Within this frame, a deal that implying a cost of capital/funding of 25% (for a very small portion of the overall project funding) is very palatable. The deal is also not particularly tax-efficient (at least as we understand it) as it is not tax deductable.

It is worth noting that Cairn has $350-400m of RBL (undrawn), where the interest rate is likely to be less than 10%, and it has significant cash resources, so we are not sure why it sought such an expensive financing solution.