Weakening financial metrics, changing investor perceptions of the fossil-fuel industry and ESG regulation have driven up funding costs and led oil and gas companies to divert a rising share of capital spending to energy transition and renewable energy.
“We expect to see a significant rise of non-recourse debt structures including ESG-linked revenue and project bonds, which will complement traditional financing instruments such as equity financing, corporate debt (including labelled ESG bonds), and reserve-based loans,” said Dmitriy Platonov, an analyst in Scope’s project finance team. “This trend will increasingly push oil and gas investors to refocus their efforts on project finance analysis rather than the more traditional approach of corporate balance sheet analysis.”
The trends of weakening financial strength and funding pressure will increase due to rising oil-price volatility in coming years, according to research from Scope. Higher oil price volatility will increase the financial burden on oil majors, lead to wider credit spreads, and accelerate the shift to investments in decarbonisation projects.
Oil majors under pressure from regulators
Regulators are increasing the pressure on oil majors to change their ways of doing business to expedite the energy transition. “This will require sizeable investments into energy transition projects, further increasing the funding gap and ultimately encouraging more off-balance sheet financing solutions.
Use-of-proceeds revenue bonds, where debt service relies on cashflows generated by the project, will emerge as a competitive option to cover the funding gap as they serve the twin purposes of balance sheet relief due to their non-recourse nature while meeting ambitious decarbonisation objectives. “And they provide a cleaner and more rigorous mechanism for the use of proceeds in energy transition projects.,” Platonov said.
Oil and gas firms behind the curve on green bonds
Strong pressure from regulators, NGOs and some investors to exclude the oil and gas sector from the green taxonomy have led to subdued green bond issuance by oil and gas companies. Global green bond issuance has grown with astonishing pace in the last decade but the share of green bonds issued by oil and gas companies is below 3%.
Scope’s analytical approach to the rating of project finance, including oil and gas projects, focuses on the expected loss for investors. “Whereas traditional credit analysis often focuses on the probability of default, our expected-loss assessment considers the long-term economic value of a project and pays equal attention to the likelihood and severity of credit impairment events that may result in losses for an investor,” Platonov said.
While potential price volatility in the oil and gas industry can increase a project’s probability of default especially during economic downturn periods, the project’s long-term economic value (and hence expected recovery rates) often substantially mitigates expected loss for an investor.