GROWTH, PROTECTION AND VALUE REALISATION USING DERIVATIVES

Abstract

Oil and gas producers are familiar with the use of derivatives to hedge oil price risk.

Beyond this, derivatives provide opportunities to enhance more general corporate finance activities.

An example is raising finance for acquisitions or developments. When the maximum senior debt has been obtained, the choice between equity funding or other sources (such as subordinated debt) should also consider the up-front cash available from a structured derivative program—this may lower the overall cost of capital for the acquirer, and directly improve equity returns through lower dilution.

A notable aspect of oil and gas production businesses is the high degree of embedded optionality. Option pricing methods can be used to value and monetise these real options—creating a new source of finance by transferring part of this embedded optionality to a party which can explicitly value and trade it.

Generating value from real options (such as the opportunity to develop a proven, undeveloped reserve) can represent a critical source of finance.

The value of such development assets is not fully recognised by traditional lending banks when the final investment decision remains some way off.

By contrast, monetising real option value can provide funds at a point where they can be applied to appraisal drilling, thus funding the development of the project to a point where conventional debt or project-secured debt becomes feasible.

Companies with both existing unhedged future production and a portfolio of PUD real options are best-placed to benefit from this source of finance.